The Basics –– Technology Platform Operators and Issuers
"Crowdfunding," the selling of small securities offerings in small increments to many buyers ("Crowd"), may have received the most hype of all of the provisions of the Jumpstart Our Business Startups Act ("JOBS Act"). However, it will not be effective until the Securities and Exchange Commission ("SEC") rules implementing the concept become final. "Crowdfunding" will provide exemptions from both the Securities Act of 1933 and the Securities Exchange Act of 1934 ("Exchange Act"), and will preempt state securities laws, but will be subject to a great number of conditions. The current requirements are already onerous, and the final rules may increase the burden on both crowdfunding platform operators and issuers who sell securities on crowdfunding platforms.
Crowdfunding Rules for Issuers
The JOBS Act provides that a crowdfunding issuer may sell no more than $1 million in securities in any 12-month period, with each investor limited to investments of:
- For an investor with an annual income or net worth of less than $100,000 – the greater of $2,000 or 5% of the investor's annual income or net worth; and,
- For an investor with an annual income or net worth greater than $100,000 – the lesser of 10% of the investor's annual income or net worth, or $100,000.
These dollar amounts will be subject to consumer price index adjustment every five years.
Many of the SEC-imposed disclosure requirements for crowdfunding issuers make sense and do not impose unnecessary burdens. But several provisions will make crowdfunding unnecessarily expensive in light of the $1 million annual limit. The biggest expense will be accounting costs. Reviewed and audited financial statements are expensive. But the issue goes beyond the checks issuers will have to write to their accountants. The financial statement requirements reflect a deep misunderstanding by the SEC of how small and young businesses actually operate.
Limited liability companies and other tax pass-through entities usually do tax cash basis accounting, not accrual accounting using GAAP. Forcing young businesses to change the way they do business will discourage use of crowdfunding and add to their operating expenses. Creating GAAP-compliant financial statements requires more than paying an auditor. The business will have to have personnel and systems in place to create the necessary records. Auditors always remind their clients that the financial statements are the work of the client because they audit only the accounting work their clients create.
From an investor's perspective, GAAP-compliant financial statements are often unnecessary. Most investors in young businesses want to know, first, if there are any major liabilities that will eat into the investment proceeds and, second, the business's financial projections. Past operating performance for a business that is doing research and development and has yet to launch a product, or that has launched only a beta version of its product, is less material to investors than in a mature business. Treating pre-revenue businesses like they are doing an IPO is not a practical approach to capital-raising problems.
The other major disclosure expense issue is the requirement that the issuer file annual reports, including financial statements, with the SEC. Issuers often object to the burden of annual reporting, but the bigger problem is investor concerns. Smart investors will not want to finance this expense and will worry that competitors will use this information against the issuer.
If the initial investors are not smart enough to have these concerns, then what about future rounds of investors? Will the annual reporting requirement doom future fund-raising efforts? If so, then the annual reporting requirement is likely to harm the interests of the initial crowdfunding investors.
If these issues are of concern to both smart issuers and smart investors, then who will use crowdfunding? Likely, desperate issuers and unsophisticated investors. This potential for a toxic downward spiral in the quality of both issuers and investors calls into question whether the SEC is really interested in promoting crowdfunding or burying it.
The conditions the SEC's rules will impose on crowdfunding issuers include:
- Initial disclosures, which must be filed with the SEC, including:
- Basic corporate information and website;
- The identity of each person holding 20% or more of the issuer's shares;
- Income tax returns;
- Financial statements, which must be reviewed by a CPA if more than $100,000 is raised and which must be audited if more than $500,000 is raised;
- A business description;
- A business plan;
- The price or the method of determining the price of the offering;
- The purpose and intended use of the proceeds of the offering;
- The target amount of the offering and the deadline to reach that amount, with ongoing updates on the progress in reaching the targeted amount;
- A description of the ownership and capital structure of the issuer including:
- Detailed information on classes of securities, comparing their differences, and explanations of how rights under the securities being offered could be materially limited, modified, qualified, or diluted;
- How principal shareholders of the issuer could adversely affect the purchasers of the securities being offered;
- The issuer's plans for future valuations of its securities;
- The general risks of minority ownership, including risks of sales of the issuer or its assets, corporate actions, and transactions with related parties; and,
- Any other information the SEC may require by rule;
- A requirement for certain ongoing reports to investors and filings with the SEC (subject to any exceptions the SEC establishes by rule) including:
- Reports on the results of operations; and,
- Annual financial statements;
- The opportunity for investors to rescind a commitment to purchase securities when provided with final disclosures and the final price of the securities;
- A restriction on any advertising of the terms of the offering, other than notices directing potential investors to the intermediary;
- Limitations on promoter compensation to be established by the SEC and disclosures of the compensation received;
- A one-year restriction on resale of the securities, with certain exceptions including sales to Accredited Investors; and,
- Disqualification rules that will be substantially similar to the current disqualification rules for persons barred by regulators from certain financial activities because they have violated laws prohibiting fraudulent or deceptive conduct or have been convicted of securities violations.
Crowdfunding Conditions for Technology Platform ("Portal") Operators
Another basic limitation on issuers imposed by the SEC-promulgated rules is that crowdfunding may be conducted only through intermediaries who must be registered brokers or registered as "funding portals." A "funding portal" is a new type of intermediary that will be registered with the SEC and FINRA and for which the SEC and FINRA will establish a separate regulatory scheme. The registration process for funding portals is supposed to be easier than registration for a full broker-dealer and funding portal operators will not have to comply with all of the broker-dealer rules.
However, funding portals that are not also fully registered broker-dealers will not be permitted to:
- Offer any advice or recommendations about securities;
- Solicit any offers to buy securities;
- Compensate personnel based on sales of securities; or,
- Handle any customer funds.
Before discussing the rules that relate to crowdfunding technology platform operators, or funding portals, it's important to consider the theory behind crowdfunding. Traditional securities laws pushed investors to rely on "experts" – registered broker-dealers and investment advisors. These professionals, acting in accordance with SEC rules, were supposed to protect investors. Of course, events leading up to the 2008-2009 financial crash showed that relying on highly-regulated Wall Street to protect investors was a fool's errand.
In contrast, crowdfunding is based on the theory that the "crowd" of fellow investors protects one another. This is accomplished by putting a securities offering up for comments by the crowd of investors. Some people in the crowd will have positive comments about the offering. Others will have negative comments. The crowd can ask issuers questions. All of these interactions can be viewed by everyone else in the crowd.
Whether crowdfunding rules are reasonable should be determined by the extent to which they promote interactions among members of an informed crowd. Therefore, requiring an issuer and its agents to identify themselves when making comments makes sense. So does requiring all comments to be open to all members of the crowd. But a host of other rules have little to do with promoting a healthy crowd discussion. Consider the following examples:
- Rules against an operator of a funding portal owning equity in an issuer and rules against platform operators collecting success fees serve only to limit the amount an operator can profit from any single issuer. This means that to be profitable, a funding portal operator must attract a very large number of issuers. Having a large pool of issuers will force investors to spend more time sifting through and comparing deals and less time analyzing each deal. How does this help investors?
- Rules that prohibit an operator of a funding portal from providing investors with tools to search by the size of the issuer or by the profitability of the issuer serve only to force investors to look at more deals than they want. Pursuant to the SEC rules, funding portal operators will be allowed to offer investors only generic categories of issuers, such as by industry or by geography. This is the equivalent of imposing a rule that a real estate brokerage website can allow users to search for potential properties only by neighborhood, but cannot allow users to search for an apartment, condo, or house or any of those types of housing units by the number of bedrooms or by price. No one operates this way because it is not user friendly and would result in a tremendous amount of wasted effort. Why waste investors' time and effort by refusing to give them information that would allow them to weed out deals in which they have absolutely no interest?
- Because the SEC thinks funding portal operators should not make recommendations, the rules discourage the operators from conducting due diligence, screening issuers based on due diligence, or sharing due diligence results with investors. How does limited due diligence help investors?
With these restrictions on user-friendliness and utility, the launch of the initial crowdfunding portals may resemble the launch of another government-designed website – www.healthcare.gov. Frustrating users by making it impossible to find what they want is not a way to run a capital-raising system.
In light of the above observations, consider some of the conditions imposed on funding portal operators such as requiring them to:
- Provide investor education materials and give disclosures to be established by SEC rule as to risk and other matters;
- "Ensure" that each investor reviews the investor education materials in accordance with standards to be established by the SEC;
- "Positively affirm" that the investor:
- Understands the risk of losing the investor's entire investment; and,
- Can afford to bear that loss;
- Require the investor to answer questions "demonstrating" an "understanding" of:
- The level of risk in start-ups, emerging businesses, and small issuers;
- The risk of illiquidity; and,
- Other matters to be established by the SEC;
- Take measures to reduce the risk of fraud in accordance with SEC rules including conducting background checks on directors, officers, and owners of 20% or more of the issuer;
- Make the information provided by the issuer available to the SEC at least 21 days prior to the first sale of securities and to each investor at least 21 days prior to that investor's purchase of securities, with the SEC reserving the right to establish different time periods;
- Ensure that offering proceeds are made available to the issuer only when the target is reached or exceeded, and allow investors to cancel their commitments to invest as the SEC determines by rule;
- Make efforts to ensure that no investor has exceeded investment limitations to be imposed by the SEC;
- Protect investor privacy to the extent required by the SEC;
- Refrain from providing any promoter, finder, or lead generator with compensation;
- Prohibit its directors, officers, and partners from having any financial interest in the issuer;
- Establish a "channel" for potential investors to communicate with other potential investors and with representatives of issuers and for the public to be able to view these communications; and,
- Abide by any other rules enacted by the SEC.
The Uncertain Future of Crowdfunding
Under the JOBS Act, crowdfunding rules were to have been issued by December 31, 2012. The SEC finally issued proposed rules on October 23, 2013, but these rules have not become final and crowdfunding, therefore, remains unauthorized.
The 535-page SEC crowdfunding release asked for comments on whether stricter rules should be imposed. The SEC's own Investment Advisory Committee –– established under the Dodd-Frank Act –– responded on April 10, 2014. Most of its suggestions involved enhancing the responsibilities of operators of funding portals to assure compliance with the crowdfunding restrictions.
Despite the hype surrounding crowdfunding, this type of offering may be impractical for many companies when it becomes available, even if the final rules impose no significant burdens beyond those imposed by the JOBS Act itself. The $1 million limitation is an obvious problem, especially given that compliance with the various requirements will entail legal, accounting, and intermediary costs that will constitute a relatively large percentage of the capital raised. Also, small company issuers may not wish to publicly disclose their financial statements initially and thereafter on an annual basis. Moreover, issuers may not wish to deal with the number of shareholders that the low investment limits might create. But, on a positive note, crowdfunding investors will not count against the shareholder cap for Exchange Act registration.
Furthermore, the JOBS Act specifically adopts a standard of liability for improper or omitted disclosures in crowdfunding offerings that is, at best, duplicative of existing law, but may be interpreted to provide standards of liability in addition to those currently existing under the securities laws generally.
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