Applications and Problem Areas of New NJ Crowdfunding Law

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1 As Seen In Law360 December 8, 2015 Applications and Problem Areas of New NJ Crowdfunding Law Crowdfunding has been a popular securities law topic since the Jumpstart Our Business Startup Act of 2012 (Jobs Act) required the U.S. Securities Exchange Commission to create a new regulatory regime to facilitate capital raising by small companies. After several years of discussion and a certain amount of hand-wringing, on Oct. 30, 2015, the SEC adopted final rules to permit equity crowdfunding under Title III of the Jobs Act. Under the new rules, companies are now permitted to raise up to $1 million in crowdfunding offerings during any 12-month period from all investors, including unaccredited investors, subject to compliance with the prescribed offering requirements. Following closely on the heels of the SEC, on Nov. 9, 2015, New Jersey Gov. Chris Christie signed a bill that creates an exemption from New Jersey State blue sky registration for certain securities offerings by New Jersey businesses only to New Jersey residents. The new law does not, however, provide an exemption from registration under federal securities law. It in fact requires that the offering and sales be exempt from federal registration under the so-called intrastate offering exemption of Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act). More on that topic below. What is Crowdfunding Crowdfunding is the process by which companies raise capital with relatively small individual investments from a large number of investors, typically through the Internet and social media. Over the past few years, there has been a lot of activity and discussion about crowdfunding, and according to industry sources the crowdfunding industry is now expected to surpass venture capital as a major source of financing for businesses. Technically however, crowdfunding is a very limited mechanism to raise Bruce Czachor, Esq. Bruce Czachor is a counsel in Sills Cummis Newark, New Jersey, office. He represents companies in a variety of corporate matters, including capital markets, mergers and acquisitions, securities law and general corporate advice. The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

2 [ 2 ] capital when you consider the cost of compliance, and the risk of noncompliance, with all of the governing rules and limitations. A primary goal of the Jobs Act was to facilitate capital raises for smaller companies by easing the regulatory burdens imposed by federal securities laws and regulations. Other reforms under the Jobs Act have already relaxed some of those burdens, including allowing general solicitation in private placements to accredited investors pursuant to new Rule 506(c) of Regulation D under the Securities Act. The popularity of this exemption has caused some confusion in the press since many commentators refer to those deals as crowdfunding, even though they are really just a new exemption to the private placement rules. In addition, new rules also allow companies to raise up to $50 million in mini initial public offerings pursuant to new provisions under Regulation A under the Securities Act (commonly referred to as Regulation A+), although the utility of Regulation A+ is also limited by the reporting, audit and other requirements set forth in the new provisions. While there has been a great deal of expectation relating to crowdfunding rules, I do not believe that they will be particularly useful to small companies seeking to raise capital. The new federal crowdfunding rules and New Jersey s intrastate exemption place far too many burdens and costs on small companies when compared to traditional private placements or the more relaxed rules under new Section 506(c) of Regulation D. Federal Crowdfunding Title III of the Jobs Act creates an exemption from registration under a new Section 4(a)(6) of the Securities Act for crowdfunding offerings. The rules set forth limitations on the amount of funds that companies can raise in a crowdfunding offering and the type of companies that are eligible to commence an offering. The rules also prescribe the manner in which such an offering must be conducted and the reporting and disclosure obligations with which a company must comply during and following an offering, all as summarized below. Limitations on Funds Raised. Individual investors, over the course of a 12-month period, are limited to investing in the aggregate across all crowdfunding offerings up to: the greater of (a) $2,000 or (b) 5 percent of the lesser of their annual income or net worth, if either of their annual income or net worth is less than $100,000; and 10 percent of the lesser of their annual income or net worth, if both their annual income and net worth are at least $100,000. In both cases, the aggregate amount of securities sold to an investor through all crowdfunding offerings during any 12-month period may not exceed $100,000. Company Eligibility. The exemption is not available to non-u.s. companies, public companies, investment companies and companies affiliated with any person that is subject to certain federal and state bad-actor disqualifications.

3 [ 3 ] Additionally, if a company conducts subsequent crowdfunding offerings after its initial crowdfunding offering, then the company must have complied with all annual reporting requirements during the preceding two years. Constraints on Transfer. Securities purchased in a crowdfunding offering generally cannot be resold for a period of one year. In addition, investors will have difficulty selling their investment even after one year if there is no active market for the securities. Unless and until a market for these securities develops or the company is acquired, investors could be holding their investment for a long time. Disclosure and Reporting Obligations. A company that conducts a crowdfunding offering will be required to prepare and distribute an offering document that: discloses information about its officers and directors, and the owners of 20 percent or more of its securities; describes its business and the use of proceeds from the offering; discusses its financial condition; and provides financial statements (which can be unaudited for the first offering). In addition, a company will be required to: amend the offering document during the offering period to reflect any material changes and provide updates on their progress toward reaching the target offering amount; and file an annual report (including updated financial statements) with the SEC after the offering is completed. This ongoing reporting requirement terminates if (1) the company is acquired, (2) the company has filed at least one annual report and has fewer than 300 holders of record, or (3) the company has filed at least three annual reports and has total assets that do not exceed $10 million. Funding Portals. All crowdfunding offerings under Title III must take place exclusively through a broker-dealer or a funding portal registered with the SEC. Crowdfunding portals will facilitate the offer and sale of crowdfunded securities and are required to take measures to reduce the risk of fraud. Under the final rules, portals are prohibited from offering investment advice or soliciting sales of securities displayed on their platforms. Portals can neither compensate promoters for solicitations or based on the sale of securities, nor hold or handle any investor funds or securities. Proposed Changes to Intrastate Offering Rules. In connection with adopting final crowdfunding rules, the SEC also proposed changes to facilitate intrastate crowdfunding offerings under Rule 147 of the Securities Act. The proposed changes would eliminate the prohibition on a company advertising its intrastate crowdfunding offerings to out-of state residents, which effectively prevented companies from using their website or social media to attract investors. However, the laws that many states have adopted to permit intrastate crowdfunding still contain similar prohibitions against marketing offerings to out-of-state residents. Assuming that the proposed changes to Rule 147 are enacted, many states may amend their laws to remove this requirement. Until such time, companies conducting an intrastate crowdfunding offering need to confirm what marketing activities are permitted in their particular state.

4 [ 4 ] The New Jersey Intrastate Offering Exemption What follows is a brief description of what will become permissible under the new New Jersey law and some observations about its potential applications and problem areas. Exclusively New Jersey Intrastate Offerings. The exemption is available for use only by business entities organized under New Jersey law and authorized to do business in New Jersey, for sales only to New Jersey residents. The offering must also meet the requirements for the federal intrastate offering exemption. The intrastate offering exemption requires that not only sales of securities, but the offers of securities, be confined to a single state. Because offers includes a wide range of selling activities, the intrastate offering exemption has long been used only sparingly because it is too difficult to restrict offers to in-state residents, and any out-of-state offers cause the loss of the exemption. It remains to be seen whether internet solicitations are offers that can be confined within New Jersey lines. If the SEC does adopt changes to Rule 147 as discussed above, this concern may be ameliorated. In addition, the issuer must have the substantial part of its business located in New Jersey, in addition to being formed under New Jersey law. Limitations on Amounts Invested. Accredited investors are defined under the SEC s Regulation D as meeting certain financial tests based on assets or income. Individuals must have a net worth (excluding their personal residence) of at least $1 million, or income of at least $200,000 for the two preceding years and an expectation of at least $200,000 in the current year ($300,000 in each case if measured jointly with their spouse). The maximum amount that a business can raise from New Jersey nonaccredited investors under the new law is $1 million in the aggregate. No single nonaccredited investor can invest more than $5,000. Amounts invested by accredited investors are not subject to the $5,000 individual cap and are excluded from the $1 million aggregate maximum. The new law does not address how an issuer can assure compliance with the accredited investor tests. Those familiar with Regulation D private placements know that it is often difficult to establish whether an investor can satisfy the accredited investor tests. The new federal rules discussed above that allow for general solicitation require that the issuer takes reasonable steps to verify that an accredited investor meets the tests, which is a higher standard than self-certification by the investors. Internet Site Operators. The offering must be made exclusively through a qualifying Internet site. To qualify, the Internet site operator must itself be a business organized under New Jersey law and authorized to transact business in New Jersey, and must itself file a registration with the New Jersey Bureau of Securities. The Internet site operator does not have to be a broker-dealer registered in New Jersey, but if it is not, then it must satisfy some fairly rigorous requirements, such as not giving investment advice and not being compensated based on the amount of securities sold, among other things, to assure that broker-dealer regulations are not being violated by its activities. Issuer s Required Disclosure. The issuer must post on the Internet site written disclosure materials relating to the offering and the business, such as the issuer s business plan, use of proceeds, identification of major equity holders,

5 [ 5 ] description of material agreements, pending legal proceedings, identification and qualifications of directors, officers and managers, capital structure and the terms of the securities offered. There is a requirement that financial statements be included, but no requirement of an audit report or other attestation from independent public accountants. Escrow. The issuer must give a minimum offering amount sufficient to fund its business plan and specify a date and time by which the minimum must be raised. Investors funds must be held in escrow with a third-party bank or financial institution, also based in New Jersey, until the minimum offering amount is raised. Notice Filing. The issuer must make a notice filing (i.e., there is no review period) of this information with the New Jersey Bureau of Securities at least 10 days before commencement of the offering and pay a fee. Final Thoughts The New Jersey crowdfunding bill is part of a wave of state law attempts to liberalize private placement restrictions and permit, within limits, the use of the Internet to match capital potentially available from the crowd with small companies. Its limitations are many, including its geographical restriction to New Jersey residents, which seems to run counter to how information is disseminated in the 21st century. Further, there are numerous compliance costs, including preparation of disclosure documents, financial statements and corporate legal documentation, compliance with accredited investor tests, retaining an Internet site operator, and engaging a bank as escrow agent to hold investor funds pending completion. Finally, since the SEC finally acted to adopt regulations required by the Jobs Act to implement crowdfunding at the federal level, the New Jersey intrastate exemption seems to be even less useful.