The “crowdfunding” of securities is poised to democratize the financing of startups, small businesses, farmers and others. Securities crowdfunding, defined as the sale of unregistered securities over the Internet to large numbers of retail investors, each of whom contributes a small amount, had previously been banned by federal law, but this prohibition was overturned by Congress in 2012. This new marketplace will go live once the SEC issues regulations to govern it. Although those rules were officially due in late 2012, they were just proposed on Oct. 23, 2013, and are likely to go into effect in 2014.
Securities crowdfunding has its origins in “reward” crowdfunding, practiced on websites like Kickstarter and IndieGoGo. In reward crowdfunding, artists, entrepreneurs and others ask “the crowd” to contribute capital to their ventures, generally in exchange for the fruits of the project, such as a book or CD. The investors never receive stock, bonds or other securities, however, because federal securities law effectively banned the crowdfunding of securities.
This all changed in 2012, when Congress amended the federal securities laws to overturn this prohibition. In Title III of the Jumpstart Our Business Startups (JOBS) Act—the “CROWDFUND Act”—Congress established a new exemption from the registration requirement for crowdfunded securities. President Obama signed the JOBS Act into law in April 2012, and it will go into effect once the SEC completes its rulemaking process.
The purpose of the CROWDFUND Act is twofold. First, it is designed to liberate startup companies, small businesses and others to use peer networks and the Internet to obtain modest amounts of business capital at very low cost. Second, Congress sought to democratize the market for financing speculative startup companies by allowing investors of modest means to make investments that had previously been offered solely to wealthy, “accredited” investors.
The new CROWDFUND Act has important limitations and places significant obligations on participants in this new marketplace. Under the statute, issuers may only raise up to $1,000,000 annually via securities crowdfunding. Issuers also must state a minimum amount and can only collect the proceeds of the offering if they reach or exceed that target.
Issuers must provide some very basic disclosures to the SEC, designated intermediaries, and potential investors. The financial disclosures depend on the size of the offering: For offerings of $100,000 or less, income tax returns for the last fiscal year and unaudited financial statements certified as accurate by the principal executive officer are required. For offerings of between $100,000 and $500,000, financial statements reviewed by an independent public accountant must be provided. And for offerings of between $500,000 and the maximum of $1 million, audited financial statements are mandated. Finally, following a crowdfunding round, an issuer must annually file with the SEC, and make available to investors, a report on the results of operations.
As for investors, the maximum annual aggregate amount of crowdfunded securities that any one investor may purchase depends on her wealth and income: If an investor’s net worth or annual income is under $100,000, she can invest the greater of $2,000, or five percent of her annual income, in crowdfunded securities each year. If her net worth or annual income is over $100,000, she can invest 10% of her annual income each year.
The Act provides that crowdfunding transactions may not be consummated directly between issuer and investor. Rather, they must be executed via a financial intermediary registered with the SEC as either a broker-dealer or a “funding portal,” a creation of the Act. The Act imposes a number of serious obligations on these financial intermediaries, such as a requirement that they take measures to reduce the risk of fraud, including obtaining a background check on officers, directors and substantial investors in crowdfunding issuers.
As for a secondary market, the Act provides that crowdfunded securities may not be transferred or sold by investors for one year after the date of purchase, unless being transferred to the issuer, an accredited investor, a family member of the purchaser, or as part of an offering registered with the SEC.
The CROWDFUND Act expressly pre-empts state law regarding registration or qualification of securities. That said, states must be provided with notice of crowdfunded offerings, and they retain the right to bring enforcement actions for fraud or other violations of state securities law not relating to registration.
To police fraudulent behavior, the Act expressly authorizes civil actions against an issuer, its directors and officers, if they make an untrue statement of a material fact. In addition, the SEC is granted examination, enforcement and other rulemaking authority over funding portals, and presumably retains authority to enforce the various statutory and regulatory mandates for both issuers and intermediaries.
How securities crowdfunding will play out in practice remains to be seen, and depends greatly on the rules that the SEC just proposed on October 23, 2013. Those proposed rules, called “Regulation Crowdfunding,” are available online, and the SEC invites comments from the public before they become final.
In short, the CROWDFUND Act represents an opportunity for enterprising and creative practitioners to shape a brand new market for securities.
Editor’s Note: This article originally appeared in the October 2013 CBA Business Law Section newsletter.