SEC Releases Proposed Rules on Crowdfunding for Security Offerings

The Jumpstart Our Business Startups Act (the JOBS Act) was signed into law in April 2012, and it created a new Section 4(6) of the Securities Act of 1933. This new section exempts crowdfunding security offerings from Securities Exchange Act of 1934 (the Exchange Act) registration and its periodic reporting requirements. The JOBS Act directed the SEC to adopt rules to implement various provisions of the crowdfunding security exemption.

On October 23, 2013, the SEC voted unanimously to release its proposed rules for the crowdfunding security exemption of the JOBS Act (Proposed Rulemaking Release No. 33-9470). The proposed rules appeared in the Federal Register on November 5, 2013, and the comment period runs through February 3, 2014.

Certified public accountants may be interested in these proposed rules if they have clients who desire to sell securities to investors through crowdfunding. In addition, some clients may be interested in purchasing securities that are offered by companies via crowdfunding.

Since the proposed rules are over 500 pages long, today I will only provide background information regarding the crowdfunding securities exemption and mention what entities do not qualify for the exemption and what limitations are placed on investors under the JOBS Act and the proposed rules.

Background

Crowdfunding is a method to raise money using the Internet and serves as an alternative source of capital to support a wide range of ideas and ventures, including charities, civic projects, creative projects, disaster relief, inventions development, and scientific research. When individuals or entities raise funds through crowdfunding, they typically seek small individual contributions from a large number of people. The crowdfunding campaign generally has a targeted amount to be raised and an identified use for those funds. Individuals interested in the campaign may share information about the endeavor with each other and use the information to decide whether or not to fund the campaign.

Crowdfunding has been used to fund, for example, artistic endeavors, such as films and music recordings, where contributions or donations are rewarded with a token of value related to the project. For example, a person contributing to a film's production budget is rewarded with tickets to view the film and is identified in the film's credits. A number of entities operate websites that facilitate crowdfunding, with some websites specializing in certain industries, such as music and the arts. Some of the more popular crowdfunding sites include Kickstarter, Indiegogo, Crowdfunder, RocketHub, Crowdrise, and appbackr.

The idea behind the crowdfunding security exemption in the JOBS Act is to allow private companies to raise relatively small amounts of capital from a large number of investors without having to register the securities issued with the SEC or under state blue sky laws. The proposal would let businesses use the Internet, mobile technology, and social media to raise up to $1 million a year from investors via crowdfunding. Under the JOBS Act, the SEC is required to adjust the $1 million dollar amount every five years to reflect changes in the Consumer Price Index.

Under the proposed rules, the crowdfunding security exemption would not be available to any of the following:

• Foreign issuers
• Issuers already subject to the periodic reporting requirements of the Exchange Act
• Investment companies
• Issuers not having a specific business plan or having indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies
• Issuers that have sold securities in reliance of the crowdfunding exemption during the previous two years but have not filed with the SEC and have not provided to investors the annual reports required by the crowdfunding regulation
• Issuers that are otherwise disqualified because they are associated with felons or other “bad actors”

Limitations for Investors

The original petition to create a crowdfunding securities exemption was submitted to the SEC in 2010 prior to the JOBS Act. Under the terms outlined in the petition, investors would have been allowed the opportunity to help entrepreneurs raise capital by creating an exemption from the federal filing requirements as long as the investors did not invest more than $100 per security offering. Although this petition did not succeed, it did spark an interest in the subject that was realized in the JOBS Act.

Under the JOBS Act and the proposed rules, individual investors who wish to invest in crowdfunded investments would be permitted to invest up to $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.

Investors with annual income or net worth that is more than $100,000 would be allowed to invest up to 10% of their annual income or net worth, whichever is greater but with an annual cap of $100,000.

Investors would not be able to resell the securities for one year.

Investors have an unconditional right to cancel an investment commitment within 48 hours after making it. However, a cancellation during the final 48 hours of the crowdfunded offering is only permitted if there is a material change to the offering terms or to other information provided by the issuer with respect to the offering.

The annual income and net worth limitations have made the maximum allowable investments under the JOBS Act much higher than the cap of $100 per offering that was in the original petition. Perhaps Congress equates success with converting a simple idea to something much more complex? The increase in the investment amount has substantially increased the possible risk to investors. Given that the mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation, this might explain the length of the proposed rules.

In my next blog, we will look at the use of intermediaries and the reporting and disclosure requirements associated with securities offered through crowdfunding.