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By:  Gregory S. Weiner                                                  gweiner@pklaw.com

On May 16, 2016 the long awaited Crowdfunding rules became final.  In some 680 pages of regulations, not to mention the length of the text of the enabling law, Congress and securities regulators have sought to balance the ability of small companies to secure capital and protect investors, particularly small investors wishing to invest in those companies.  In the following Q and A material, PK Law seeks to provide a simple overview of Crowdfunding and what it may mean to investors.  It cannot be emphasized enough that the following material is merely an overview and no investor should act upon a Crowdfunding decision without first seeking advice from someone other than an offering company or Crowdfunding intermediary, as discussed below.

  1. Background.
    1. What is “Crowdfunding”?

It is a method of raising capital through the Internet.

  1. Is it like “Kickstarter”?

Yes and no.  Kickstarter also is used to raise funds for projects via the Internet but until the Crowdfunding rules became final, a Kickstarter contributor could only receive a token gift, if anything were offered, for their contribution.  Crowdfunding (more specifically “Equity Crowdfunding”) allows a person to secure a stake in the business which is seeking investment capital, making that person an investor in the entity seeking funds.

  1. Is Crowdfunding something new?

No.  Crowdfunding has been in place in Europe for some time.  Only recently did Congress believe it an acceptable vehicle for investors.  Previously, lawmakers and regulators felt the protection of the public outweighed the need for Crowdfunding.  The enacted laws and regulations seek to balance the interests of the capital marketplace (companies seeking capital) while protecting those who seek to participate in that marketplace.

  1. What role did Congress play in the creation of Crowdfunding in the U.S.?

The Jumpstart Our Business Startups Act of 2012 (“JOBS”) was passed by Congress in March, 2012 and was signed into law by President Obama on April 5, 2012 (the “Act”).  The Act created broad exemptions from numerous securities registration provisions contained in existing securities laws, the Securities Act of 1933 (“1933 Act” or “Truth in Securities Act”) (15 U.S.C. § 77a et seq.) and the Securities Exchange Act of 1934 (“1934 Act” or “Exchange Act”) (15 U.S.C. § 78a et seq.) by amending those laws.  (The Crowdfunding provisions are contained in Title III of the Act and this article focuses solely on that Title.  Titles II and IV also provide Crowdfunding options to companies but are not directed at small investors.)

  1. What was unique in the Act?

The Act created a new entity, a “Crowdfunding portal” which allows Internet-based “platforms” or “intermediaries” to facilitate the offer and sale of securities without having to register with the Securities and Exchange Commission (the “SEC”) as brokers.  While registered broker-dealers may serve as such intermediaries under the Crowdfunding rules without a new filing for Crowdfunding, those entities who are not registered broker-dealers may facilitate the sale of securities between companies and investors.  In other words, the Act allows the purchase of securities without the services of a stockbroker.

  1. What role did regulators play in implementing Crowdfunding?

The Act tasked the SEC with adopting rules to implement the provisions of the Act.  The various rules were fully put into place on May 16, 2016.  In particular, new rules were to be adopted by the SEC to implement the new “platform” or “intermediary” provision of the Act.  The regulations were published at 17 CFR Parts 200, 227, 232, et al. Crowdfunding; Final Rule, Federal Register / Vol. 80, No. 220 / Monday, November 16, 2015 at page 71388 (the “Final Rule”).  The Final Rule explicitly provided for the May 16, 2016 effective date.

  1. Did the SEC have assistance from the financial industry in developing the Final Rule?

Yes.  The SEC sought the input of the Financial Industry Regulatory Authority (“FINRA”) regarding comments to the Final Rule.  FINRA is the largest independent regulator for all securities firms doing business in the USA.  Formerly known as the National Association of Securities Dealers or “NASD”, FINRA is a “self-regulatory organization” or “SRO”.  The SEC requires that all broker-dealers register with the SEC as well as an SRO.  Crowdfunding portals must file with the SEC and report to an SRO, usually FINRA.  FINRA has adopted rules regarding reporting by and oversight of Crowdfunding portals which have been admitted to FINRA.  (Under the Final Rule, an annual report must be filed with the SEC by a company which relies on the Crowdfunding exemption.)

  1. How does the process work?

Companies seeking capital will register a securities offering with a single Crowdfunding platform chosen by the company.  (Each company offering must be made exclusively through a single Crowding platform.  However, a platform may “host” any number of different company offerings.)  Some of the better known platforms are AngelList, CircleUp, Seedrs, Crowdcube and OurCrowd.  (MENTION OF THESE ENTITIES IS NOT AN EXCLUSIVE LIST; NOT AN ENDORSEMENT OF ANY OF THEM BY PK LAW; NOR AN INDICATION WHICH, IF ANY OF THEM, WILL BE PARTICIPATING UNDER THE FINAL RULE!)  The company registering its offering with the platform are then engaged in a “campaign”.  A potential investor opens an account with the platform through which the investor will pay for a portion of the campaign within the Crowdfunding rules, e.g. the Final Rule discussed herein.  The Crowdfunding platform is strictly an intermediary, dispensing funds to the company and maintaining the investor’s equity in their account.  It does not dispense advice or answer questions about the campaign.  The Final Rule contains other Crowdfunding platform prohibitions in addition to the prohibition regarding investment advice.  The Final Rule provides certain “safe harbors” for platform activity so as not to violate the prohibitions.  Each Crowdfunding platform may have its own internal procedures and policies set up within the framework of the Final Rule.

  1. The Basics.
    1. What rules apply to investors?
  • Individual investors, may, over a 12-month period, invest in the aggregate across all crowdfunding offerings up to:
    • If either their annual income or net worth is less than $100,000, than the greater of:
  1. $2,000 or
  2. 5 percent of the lesser of their annual income or net worth.
  • If both their annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth.
  • (The foregoing calculations may be made jointly between spouses.)
  • SECURITIES PURCHASED IN A CROWDFUNDING OFFERING ARE SUBJECT TO A ONE YEAR LOCK-UP PERIOD.  THEY MAY NOT BE RESOLD FOR ONE YEAR.
  1. What does the Final Rule say about company Crowdfunding offerings?
  • All transactions relying on the new rules are required to take place through an SEC-registered intermediary, either a broker-dealer or a Crowdfunding portal.
  • A company is permitted to raise a maximum aggregate amount of $1 Million through Crowdfunding offerings in a twelve-month period.
  • During the twelve-month period, the aggregate amount of securities sold to an investor through ALL crowdfunding offerings may not exceed $100,000.
  • Certain companies are NOT eligible for Crowdfunding under the Final Rule.  Ineligible companies include non-U.S. companies, Exchange Act reporting companies, certain investment companies, companies that are subject to disqualification under the Final Rule, companies that have failed to comply with the annual reporting requirements under the Final Rule during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
  1. What disclosures must be made by a company in a Crowdfunding offering?
  • Generally, to conduct a Crowdfunding offering a company must file certain information with the SEC and provide that information to investors and the Crowdfunding intermediary or platform facilitating the offering.
  • Among other disclosures:
    • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
    • A discussion of the company’s financial condition;
    • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.  A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time is permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor;
    • A description of the business and the use of proceeds from the offering;
    • Information about officers and directors as well as owners of 20 percent or more of the company; and
    • Certain related-party transactions.
  1. What are Crowdfunding intermediaries or platforms required to do?
  • Provide investors with educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered and information a company must provide to investors, resale restrictions, and investment limits;
  • Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with the Final Rule and that the company has established means to keep accurate records of securities holders;
  • Make information that a company is required to disclose available to the public on its platform throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
  • Provide communication channels to permit discussions about offerings on the platform;
  • Provide disclosure to investors about the compensation the intermediary receives;
  • Accept an investment commitment from an investor only after that investor has opened an account;
  • Have a reasonable basis for believing an investor complies with the investment limitations;
  • Provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction;
  • Comply with maintenance and transmission of funds requirements; and
  • Comply with completion, cancellation and reconfirmation of offerings requirements.

Commentators believe the Final Rule may be too restrictive and result in only companies with offerings of low likelihood of success taking advantage of Crowdfunding under Title III of the Act.  Titles II and IV of the Act may be better suited to offerings by companies with greater likelihood of success.  Therefore, investors considering investment in a Crowdfunding campaign under Title III, as discussed in this article, must be particularly vigilant as they could lose their entire investment if the offering company should fail.  Also, in addition to the one-year lockup period under the Final Rule, investors should be prepared to wait for a long period of time before they might realize a return on an investment.  By their very nature, investments under the Final Rule will be without advice from the Crowdfunding intermediary or the company making the offering and, therefore, the investor, in fending for himself or herself, will have to do much research to consider the advisability of and protection of their investment.  Finally, no matter how much education an investor undertakes in a Crowdfunding campaign, and regardless of the amount of regulation imposed in it, fraud is always possible, perhaps even more so under Title III offerings.

Gregory Weiner is a Member of PK Law and part of the firm’s Corporate and Real Estate Group.  He has over 15 years of experience advising clients on legal issues related to technology licensing, intellectual property protection and development, mergers and acquisitions and financing.  Mr. Weiner can be contacted by phone at 410-339-5785 and by email at gweiner@pklaw.com.

This information is provided for general information only.  None of the information provided herein should be construed as providing legal advice or a separate attorney client relationship. Applicability of the legal principles discussed may differ substantially in individual situations. You should not act upon the information presented herein without consulting an attorney of your choice about your particular situation. While PK Law has taken reasonable efforts to insure the accuracy of this material, the accuracy cannot be guaranteed and PK Law makes no warranties or representations as to its accuracy.

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