Congress Already Considering Improvements to Title III Crowdfunding

Although Title III equity crowdfunding finally, after much delay, has finally gone into effect this week, Title III itself and the related regulations adopted by the Securities and Exchange Commission have long been criticized for putting too much restriction on the companies that are likely to use Title III. However, members of Congress are already putting forward new legislation intended to address some of the widely-perceived shortcomings of Title III.

Congressman Patrick McHenry, a sponsor of one of the original bills that ultimately became the JOBS Act, has introduced the Fix Crowdfunding Act (H.R. 4855), which seeks to increase the utility of Title III equity crowdfunding and address some of the grey areas in the law and regulations, particularly where it comes to the responsibilities of the funding portals that will host equity crowdfunding offerings. Among the Fix Crowdfunding Act’s provisions:

Funding Cap: Title III currently limits companies to raising no more than $1 million in any 12 month period using equity crowdfunding (the cap is not exclusive to other exemptions, so companies can also raise additional money via Regulation D or Regulation A exemptions). The Fix Crowdfunding Act would raise the cap to $5 million in any 12 month period. 

Funding Portal Liability: Title III imposes liability for material misstatements or omissions on an “issuer” that cannot show that it could not have known of the misstatement or omission despite the exercise of reasonable care. However, in its regulations the SEC declined to clarify whether funding portals would be considered “issuers” for the purpose of misstatement or omission liability. As a result, funding portals are currently liable for any misstatements or omissions made by issuers that use their platform; it is specifically this grey area that has dissuaded crowdfunding sites such as Indiegogo and EarlyShares from setting up Title III platforms. The Fix Crowdfunding Act clarifies that a funding platform is not considered an issuer, and has no liability unless the platform itself makes a material misstatement or omission or knowingly engages in fraudulent conduct; under this scheme, in order to make a portal liable for an issuer’s misstatement or omission, a plaintiff would have to prove that the funding portal had knowledge the issuer’s misstatement or omission.

Section 12(g) Investor Cap: While the JOBS Act raised the cap on shareholders to 2000 (including 500 non-accredited shareholder) before a company triggers reporting obligations under the Exchange Act, and specifically directed the SEC to conditionally or unconditionally exempt shareholders who purchase in a Title III offering, the SEC chose to impose a condition on this exemption, providing that a company with more than $25 million in assets could not exempt crowdfunding shareholders from the 12(g) cap. The Fix Crowdfunding Act would overrule this condition.

Special Purpose Vehicles: Some platforms, such as AngelList and OurCroud, use special purpose vehicles as part of their fund-style investment process — individuals place their money in a SPV, which bundles investors’ money that is then invested in a startup. SPVs have the benefit of streamlining startups’ cap tables, as there is legally only one investor. The Fix Crowdfunding Act would remove the exclusion on SPVs. 

Testing the Waters: Finally, the Fix Crowdfunding Act would enable companies to “test the waters” — that is, to obtain non-binding investor interest in a potential equity crowdfunding offering without having to undertake the effort and expense of making the required regulatory filings with the SEC prior to soliciting interest.

The Fix Crowdfunding Act has been referred to the House Committee on Financial Services; keep an eye on the legislation to see if it makes it out of committee to the full House of Representatives.

New “Exit” Securities Exemption In New Transportation Bill

 Last month, Congress passed a transportation bill called the Fixing America’s Surface Transportation Act (or FAST Act), signed into law by President Obama. However, buried in the bill was an addition to the Securities Act of 1933. The addition codifies an “unwritten” exemption from the registration requirement for the resale of securities, called “Section 4(a)(1-1/2)” because it combined the exemptions of both Section 4(a)(1), which exempted securities transactions by any person or entity other than an issuer, underwriter, or dealer, and Section 4(a)(2), which exempted transactions by an issuer not involving a public offering.

The new exemption, which is inserted into the Securities Act as Section 4(a)(7), exempts resales of restricted securities so long as the transaction meets several requirements: 

1) The securities must be resold to an accredited investors

2) There can be no general solicitation for the resale 

3) If the company that originally issued the securities is not subject to reporting requirements, then the seller and prospective purchaser must have access to reasonably current information about the company, including the equity structure, the directors and officers, and financial records

4) The seller is not a subsidiary of the issuer

5) Neither the seller nor anyone being paid in connection with the transaction is a bad actor as defined under Regulation D

6) The original issuing company is not a blank check, blind pool, or shell company 

and 7) The class of securities involved in the resale have been outstanding for at least 90 days prior to the transaction.

Section 4(a)(7) provides another statutory resale exemption, in addition to Rule 144, the traditional codified resale exemption. Section 4(a)(7) provides greater flexibility than Rule 144, including having no cap on the amount of securities that can be resold in any one transaction, no holding period for the seller to qualify with, no requirement to report the transaction, and most importantly, an preemption from state registration requirements pursuant to NSMIA. 

However, Rule 144 has benefits over Section 4(a)(7), including allowing resales to any person or entity, unlike Section 4(a)(7)’s requirement that the purchaser be an accredited investor. Moreover, securities resold under the Section 4(a)(7) exemption remain restricted securities, unlike in a Rule 144 transaction which unrestricted the securities.Therefore, a purchaser who acquires securities in a Section 4(a)(7) transaction must find an exemption if they wish to resell.

SEC Considering Revising Accredited Investor Standard

Just before the holidays, the SEC released a report detailing a review conducted by the SEC staff of the accredited investor standard. As a quick recap, the accredited investor standard is, for individuals, a net worth of at least $1 million (either alone or in conjunction with one’s spouse) or an annual income of at least $200,000 for the past 2 years with a reasonable expectation of such income in the current year (or $300,000 in conjunction with one’s spouse); for companies, trusts, and other legal entities, the accredited investor standards typically require assets of at least $5 million.

The purpose of the review, conducted pursuant to the Dodd-Frank Act, is to determine whether the accredited investor standard should be modified in order to achieve the securities regulations’ objectives of protection of the investing public. The report published in 2015 is the first report drafted under Dodd-Frank, and is the first meaningful review of the accredited investor standard since its adoption in 1982. In particular, the review looks at whether the financial standards of the accredited investor rule are still effective to protect the investing public, given the changes in the economy, and whether other standards should be adopted in addition to or in place of the financial limitations. The report’s proposed standards include consideration of an investor’s investment history, current investments, professional and educational background, and the use of an “accredited investor” examination to qualify investors. The report addresses many criticisms of the accredited investor rule as being solely focused on an investor’s financial ability to absorb risk of loss, instead of whether the investor is actually capable of evaluating the merits and risks of a potential investment.

The SEC’s report discussing the review of the accredited investor standard, and suggested revisions to the rule, can be read here: http://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-of-accredited-investor-12-18-2015.pdf. The SEC is also seeking public comment on the proposals contained in the report, as well as general comments on the accredited investor standard, which can be submitted at the following link: http://www.sec.gov/cgi-bin/ruling-comments?ruling=4692&rule_path=/comments/4-692&file_num=4-692&action=Show_Form&title=Report%20on%20the%20Review%20of%20the%20Definition%20of%20%27Accredited%20Investor%27 

SEC Issues Clarifications on General Solicitation

Earlier in the summer, the SEC issued several statements in response to inquiries about different aspects of general solicitation with respect to Regulation D (particularly Rule 506) offerings. The first statement concerned the ability of angel groups to provide a “preexisting relationship” between issuer and prospective investors for the purpose of the Reg D rules. The SEC clarified that angel investors in a particular group who may have a preexisting relationship with a company can introduce that company to other angels in the group, and rely on the group to have a reasonable belief that its members have the requisite financial sophistication necessary for some of the Reg D rules. The SEC further noted that the greater number of persons in an “angel” group without financial sophistication and the more impersonal, non-selective the methods of introduction in the group are, the more likely the SEC will be to deem such communications general solicitation.

The SEC also provided guidance with respect to demo days. The SEC’s statement clarified that as long as a pitch at a demo day did not involve an offer of a security, then the Securities Act and its regulations were not implicated. However, where any communication at a demo day could be considered to be an offer of a security or alerting persons to the potential offer of securities, the Securities Act could be implicated, and whether or not such communications at a demo day constituted general solicitation depended on the type of invitation to the event — if the event is limited to persons whom the issuer or organizer had a preexisting relationship, then it would not be considered general solicitation, but if members of the general public are invited to the event, then the communications may be deemed general solicitation.

Finally, the SEC also issued a no-action letter where it approved the use of a a password-protected website in order to permit issuers and sophisticated investors to develop a preexisting relationship prior to the offer of any securities, so that the use of a website to make an offer of securities would not constitute general solicitation.