Legal Insights

At Last Exempt Crowdfunding is (Almost) Here

By: , February 17, 2016

Finally, starting-May 16, 2016, businesses can raise up to $1 million every 12 months by crowdfunding–or targeting the public with low dollar, internet-based securities investment offerings-without general public registration.

Why the Wait? Congress gave the SEC 270-days to finalize rules upon implementation of the JOBS Act in April 2012. Those days came and went with the New Year. The 2013 New Year, that is. Proposed rules were not even approved until October 2013. To which the SEC received hundreds of response letters before the 90-day comment period ended. A speech by SEC Chair White left people expecting final rules in October 2014. However, an SEC agenda published shortly after, set a target adoption time of October 2015-making SEC’s crowdfunding rules creation a 24 month process.

The misnomer of naming the act the “JOBS Act” when in fact no new jobs were guaranteed (directly at least), left skeptics feeling this was merely an attempt to avoid transparency and to increase the likeliness of fraud on unsuspecting investors. Legislation faced serious opposition to rolling back Securities Act disclosure and investor protection provisions. Past SEC Chair Schapiro, even submitted an opposition letter, sparking debate over audited financial statement requirements. The SEC was not pleased with Congress’ haste to craft bipartisan legislation without sufficient time to formulate it. However, proponents urged Congress to pass legislation to democratize access to capital without cumbersome restrictions.

Considering the SEC rose out of the great depression, its weariness of fraudulent offerings targeting vulnerable consumer is not surprising. Let’s face it, smaller businesses are more apt to fail than succeed, highlighting the need to reduce risk when non-accredited investors are involved. To address concerns, the Commission balanced financial integrity against stifling capital formation. In theory, low dollar offerings and investment amounts protect all investors because it curbs the risk borne by any one investor. Still regulators worry people will not be self-accountable, or will too easily fall victim to fraud. The idea that people lack sophistication to properly vet potential investment opportunities is, however, short sided. Like the ‘call before you dig’ PSA, maybe regulators should make a campaign like ‘Q&A before you pay.’ Or maybe regulators will take comfort in knowing the low dollar amounts susceptible investor can actually lose are minimal (based on a lesser of salary or net worth for annual max contribution calculations). Instead of playing Chicken Little, regulators may consider protecting investors with education on how to analyze an investment opportunity. We cannot forget the intent of Congress that the crowd would network and share facts to, in essence, make a popularity contest where the issuer with the best presence prospers.

What Are the Benefits? On the bright side, at least audit requirement are out for company’s raising less than $500,000 a year. First-time crowdfunding issuers will be required to submit accountant reviewed financial statements (not audited statements) when raising between $500,000 and $1,000,000. Many commentators voiced concerns about burdensome requirements that would limit the ability of businesses already lacking capital to spend large amounts of money for audited financials. Another positive – issuers can conduct simultaneous offerings without running afoul of integration (presuming proper exemptions are followed).

In short, this isn’t an “either/or” proposition. This is good because having a limitation on raising other money for a full year could have chilled companies desire to participate in crowdfunding at all. It also would have prevented private equity funds from making larger investments in successfully crowdfunded companies for an entire year. Capping all investment at $1 million is obviously contrary to the underlying purpose of the law: to make it easier for smaller and startup companies to raise money. To some, the small stream of investment obtained by a crowdfunding offering will only provide limited opportunities for business growth at best.

Another benefit is that the SEC recognized challenges with monitoring individual investment amounts, and suggested investors “self-report” income and net worth, as well as their annual crowdfunding investments (not to completely relieve portals of monitoring requirements, though). This is also good news; without self-reporting of previous investments, it would be near impossible to track cross-portal activity.

Additionally, the delay allowed state petri dishes to enact their own versions of more flexible crowdfunding rules without pre-emption of Federal rules because of certain safe harbors or exemptions. In practice, however, the problem remains that by virtue of having funding portal listings online, the audience becomes difficult to control.

Of course fretting may prove wasteful at the end of the day. Investment capital will likely come primarily from people directly involved in the issuer, as it does in rewards based crowdfunding initiatives. There are always exceptions. But the critical mass of investors funding a campaign will likely be those closest to the issuer and therefore in the best position to evaluate whether they are comfortable with making an investment. In sum, crowdfunding is a catchy idea to spark consumer loyalty and raise awareness that may fizzle before reaching full potential.

To read all 685 pages of the final rules go to: http://www.sec.gov/rules/final/2015/33-9974.pdf.