Reviewing the CROWDFUND Act

The JOBS Act (backronymed to “Jumpstart Our Business Startups Act”), which has passed both houses of Congress and is awaiting signature by President Obama, contains a provision known as the CROWDFUND Act (also backronymed to “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act”), which provides an exemption to federal securities registration for business that sell equity through the crowdfunding method to raise capital.

Here’s a breakdown of the provisions in the CROWDFUND Act portion in the JOBS Act:

  • Issuers cannot raise more than $1 million from the sale of securities in a 12-month period
  • Investors are limited during any 12 month period in the amount they can invest in crowdfunding companies, depending on their net worth and annual incomes:
    • The greater of $2000 or 5% of the annual income or net worth of investors with an annual income or net worth less than $100,000
    • The lesser of $10,000 or 10% of the annual income or net worth of investors with an annual income or net worth equal to or greater than $100,000
  • Crowdfunding transactions must be conducted through a broker or funding portal that complies with several provisions:
    • Be registered with the SEC as a broker, or be an exempt funding portal
    • Register with a self-regulatory organization
    • Provide investor education materials and disclose risks of investment (including risk of loss, illiquidity of shares, etc.)
    • Perform background and securities regulatory enforcement checks on issuers, their officers, directors, and persons holding more than 20% of the equity in an issuer
    • Provide to the SEC and potential investors any and all information provided by the issuer at least 21 days before the sale of securities
    • Only permit distribution of proceeds once capital raised hits target amount; allow investors to cancel commitments to purchase pursuant to conditions as to be determined by the SEC
    • Ensure that no investor has exceeded their investment limits
    • Avoid compensation for solicitation of or leads on potential investors
    • Prohibit investment or other financial interest in issuers using its services
    • Funding portals are exempt from having to register with the SEC as a broker or dealer so long as it:
    • Remains subject to examination, enforcement, and authority of the SEC
    • Is a member of a national securities association
    • Does not engage in the following activities:
      • Offer investment advice or recommendations
      • Solicit purchases, sales, or offers to buy securities
      • Compensate individuals for solicitation or otherwise based on the sale of securities
      • Hold investor funds or securities
  • Issuers must also comply with numerous provisions:
    • Provide the SEC with the following information:
      • Name, legal status, physical and website address of the issuer
      • Names of offers and directors (or anyone acting in a like capacity)
      • Description of the business and anticipated business plan
      • Description of financial condition:
        • For offerings less than $100,000, the latest tax return for the business, and financial statements certified by a corporate officer to be true and complete
        • For offerings between $100,000 and $500,000, financial statements reviewed by an independent public accountant
        • For offers above $500,000, audited financial statements
      • Description of the intended use of the capital sought
      • The target offering amount, the deadline for reaching the target, and regular progress reports in meeting the target
      • The price of the securities or the method for determining the price (prior to final sale, investors must be provided the final price in writing along with all required disclosures, with an opportunity to rescind commitment to purchase)
      • Description of the capital structure and ownership of the issuer:
        • Terms of the security being offered, and the terms of all other classes of securities
        • How terms may be modified and a summary of differences between classes of securities
        • Descriptions of how the securities being offered may be materially limited, diluted, or qualified by any other class of securities
        • How the rights of principal shareholders may negatively affect purchasers of the securities being offered
        • The names and equity positions of each person holding more than 20% equity
        • How the securities are being valued and how they may be valued by the issuer in the future
        • The risks to purchasers relating to minority ownership, the issuance of additional securities, a sale of company assets, or a sale of the company
    • Issuers must not advertise terms of the offering, except to direct potential investors to the broker or funding portal
    • Avoid compensation for promotion of offerings through the broker or funding portal without adequately disclosing such compensation
    • File with the SEC and provide to investors annual (or more frequently as the issuer may choose) reports of operations and financials
  • Purchasers may bring a cause of action against an issuer to rescind a transaction for any material misstatement or omission (issuer’s agents are also liable)
  • Purchasers may not transfer securities within one year of the date of purchase, except to the issuer, an accredited investor, as part of a public offering, or to a family member in connection with death or divorce
  • Issuers may be disqualified based on conditions to be determined by the SEC, including any individual who has been convicted of securities laws violations

With almost each of these provisions, the CROWDFUND Act gives the SEC the authority to promulgate additional rules as necessary.

The ultimate crowdfunding legislation turned out much more complicated than Congressman Patrick McHenry’s original bill in the House, largely due to Senate Democrats’ fears that crowdfunding exemptions would erode important investor protections and lead to a return of so-called “boiler room” operations and increased securities fraud. The CROWDFUND Act contains multiple provisions regarding information issuers must provide to the SEC and potential investors and rules funding portals or brokers must comply with in order to provide a crowdfunding service, aimed largely at assuaging the fears of crowdfunding opponents. What is troublesome about the CROWDFUND Act is its creation of a cause of action for material misstatements or omissions, akin to Section 10b-5 liability. However, 10b-5 liability applies to registration statements — the CROWDFUND Act is an exemption to registration — and doesn’t hold issuer agents, such as attorneys, who don’t necessarily provide the figures and opinions contained in a registration statement, whereas the CROWDFUND Act’s liability provision appears to do so. The CROWDFUND Act also doesn’t appear to address how it will operate with state securities laws (ideally, a crowdfunding exemption would have a Rule 502 offering-like preemption of state securities registration requirements).

It remains to be seen over the next six to nine months what additional rules and regulations the SEC adopts pursuant to the CROWDFUND Act, particularly if they address the Act’s relationship to state securities laws, and whether they adopt safeharbor provisions for things like purchaser qualifications or the Act’s liability provision.