CROWDFUNDING WHAT IS CROWDFUNDING?

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1 CROWDFUNDING PBI Business Lawyers Institute 5 November 2015 G. Philip Rutledge, Partner Bybel Rutledge LLP, Lemoyne, PA rutledge@bybelrutledge.com WHAT IS CROWDFUNDING? Much over used term to describe a multitude of permutations similar to use of the term hedge fund Current crowdfunding efforts include Kickstarter style efforts where company provides products/services in exchange for contribution Rule 506(c) private offerings where issuers use websites/social media to sell securities directly to persons they verify as Accredited Investors 2 CROWDFUNDING UNDER THE JOBS ACT OF 2012 Established a registration exemption under the Securities Act of 1933 for offerings where: Amount sold in last 12 months does not exceed $1 million Limits on amount of securities that can be purchased Effected solely by a single broker dealer or funding portal Without physical interaction between issuer and investors Without effective SEC rules, it is currently illegal to engage in equity or debt crowdfunding in interstate commerce in the US 3 1

2 FINAL SEC RULES Adopted October 30, 2015 as 350 page SEC Release No Effective 180 days after publication in the Federal Register Approximate effective date of May 2016 Includes new Forms C, C A, C U, C AR and C T to be filed with the SEC 4 STATUTORILY INELIGIBLE TO USE THE CROWDFUNDING EXEMPTION Section 4A(f) states that these issuers are ineligible to use the Crowdfunding exemption Non US companies SEC reporting companies Investment companies as defined in the Investment Company Act of 1940 (1940 Act) Persons excluded from definition of investment company under Sections 3(b) or 3(c) of the 1940 Act (eg private pooled investment vehicles) 5 OTHER ISSUERS INELIGIBLE TO RELY ON CROWDFUNDING EXEMPTION By rule, SEC will prohibit the following from relying on the Crowdfunding exemption Issuers that would be subject to a bad actor disqualification similar to SEC Rule 506(d) Issuers that have no specific plan or business or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company Issuers that previously relied on the Crowdfunding exemption but failed to provide ongoing annual reports during the two years prior to a new offering 6 2

3 RELATED SECURITIES LAW ISSUES Crowdfunding offerings are not subject to the SEC s policy on integration of offerings One year restriction on resale (which applies to any purchaser, including non initial purchasers in secondary transactions) beginning with the date the securities were first issued, except to: An Accredited Investor Member of the family of the purchaser or a trust for the benefit of the purchaser s family or controlled by the purchaser Upon death or divorce of the purchaser 7 INVESTMENT LIMITATIONS IN CROWDFUNDING OFFERINGS If net worth <$100,000, maximum purchase is the greater of $2,000 or 5% of the lesser of the investor s annual income or net worth If net worth is >$100,000, maximum purchase is 10% of the lesser of the investor s annual income or net worth not to exceed $100,000 Limitations apply to all investments in all Crowdfunding offerings within 12 months and to Accredited Investors and non US investors Issuer may rely on calculations by intermediary 8 MANNER OF CONDUCTING CROWDFUNDING OFFERING All transactions for a Crowdfunding offering are conducted through a single registered broker dealer or funding portal (ie no offering can be listed on multiple platforms) These broker dealers and funding portals must comply with the requirements of Section 4A of the 1933 Act in effecting Crowdfunding transactions 9 3

4 WHAT IS A FUNDING PORTAL? A financial intermediary that engages only in effecting transactions under the Crowdfunding exemption and does not: Offer investment advice or recommendations Solicit purchases, sales or offers to buy securities offered on its website Compensate employees, agents or other persons for soliciting sales of securities on its website Hold, manage possess or otherwise hold investors funds or securities Registered with the SEC and the Financial Industry Regulatory Authority (FINRA) 10 A NON US ENTITY MAY ACT AS A FUNDING PORTAL IF.. Information sharing agreement exists between the SEC and the regulator of the jurisdiction under which the funding portal is organized Funding portal obtains the written consent and power of attorney appointing an agent in the US (other than the SEC) upon whom may be served any process, pleading or papers Funding portal provides the SEC with the name of the person who is the agent for service of process Funding portal certifies that it can provide SEC and FINRA with access to its books and records and submit to an onsite examination with an opinion of counsel confirming the same 11 OBLIGATIONS OF INTERMEDIARIES Provide risk disclosures to investors Regulatory history check on each officer, director and beneficial owner of 20% or more of any outstanding voting equity security Ensure that offering proceeds are provided to the issuer when aggregate capital raise equals or exceeds the target amount and allow investors to cancel commitments Direct investors to deposit subscription funds with an insured bank or credit union subject to an escrow agreement 12 4

5 OBLIGATIONS OF INTERMEDIARIES Reasonable belief that the issuer is in compliance with the conditions of the Crowdfunding exemption but SEC advises that relying solely on a written representation may not be sufficient Denies access to its platform if it believes the issuer or offering would present potential for fraud Adopt written policies and procedures reasonably designed to achieve compliance with federal securities laws related to its business 13 OBLIGATIONS OF INTERMEDIARIES SEC rules prohibit the intermediary and its officers and directors from possessing any financial interest in an issuer using its services or in connection with the offer and sale of a security except: An intermediary may accept, as compensation for services provided in a Crowdfunding transaction, securities of the issuer if they are the same securities and subject to the same terms and conditions as those offered in the Crowdfunding offering 14 OBLIGATIONS OF INTERMEDIARIES Provide to SEC and investors information required to be furnished by issuer 21 days before a sale is made Not effect any sale of a security until an investor opens an account and gives consent to electronic delivery of all documents 15 5

6 OBLIGATIONS OF INTERMEDIARIES Intermediary must ensure that each potential investor Reviews investor education material information as required by the SEC Receives Risk Factor disclosure Answers questions demonstrating an understanding of liquidity risks and risks generally applicable to investing in a start up business Intermediary must obtain an affirmation that the investor understands that there is the risk of loss of the entire investment and he can bear such loss 16 WHAT INTERMEDIARIES MAY DO Compensate third parties for providing nonpersonally identifiable information on investors if compensation is not based, directly or indirectly, upon the purchase or sale of a security Provide advice to the issuer about the structure and content of the offering and assist the issuer in the preparation of disclosure documentation Highlight in a non discriminatory manner offerings on the platform by offering amount, type of security offered, industry segment, geography or percentage of proceeds raised 17 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Provide a disclosure document on Form C containing certain mandated information which will be made available by the intermediary to potential investors (Form C includes an optional Q&A format) General information Information about officers, directors and persons who beneficially own 20% or more of outstanding voting equity securities for the past three years Description of the business and business plan Description of the intended use of proceeds 18 6

7 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Terms of the offering The total offering amount (target amount) Public offering price If offering price is determined by a formula, describe the method used to determine the offering price and provide investor with a reasonable opportunity (eg 48 hours) to rescind the purchase commitment Permit investors to rescind their commitment until 48 hours prior to the offering deadline 19 ISSUER FINANCIAL INFORMATION REQUIREMENTS If offering during preceding 12 months is $100,000 or less, redacted income tax returns ( or alternatively, a statement of total income, taxable income and tax paid certified by a principal executive officer as true and complete in all material respects) and financial statements certified as true and complete in all material respects by a principal executive officer. However, if have reviewed or audited financial statements, must provide them 20 ISSUER FINANCIAL INFORMATION REQUIREMENTS If offering during preceding 12 months is more than $100,000 but not more than $500,000, reviewed financial statements of independent public accountant unless audited financial statements are otherwise available 21 7

8 ISSUER FINANCIAL INFORMATION REQUIREMENTS If offering during preceding 12 months is more than $500,000, financial statements are to be audited by independent public accountant except, if the issuer has not previously relied on the Crowdfunding exemption, the issuer may use reviewed financial statements unless audited financial statements are available 22 FINANCIAL INFORMATION REQUIREMENTS Provide investors a complete set of financial statements for the shorter of two most recently completed fiscal years or inception of the business Must be for most recently completed fiscal year unless offering is within 120 days of the most recent fiscal year end, then the prior fiscal year is sufficient Must conform to US GAAP Signed audit or review report must be filed with SEC and given to investors and the intermediary Issuer must notify public accountant of intended use of a review or audit report in a Crowdfunding offering 23 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Financial condition narrative in the disclosure document wherein the issuer discusses Historical results of operations Are historical earnings and cash flows representative of future expectations Description of liquidity and capital resources If a start up, define financial milestones and operational, liquidity and other challenges How the proceeds from the offering will affect liquidity and whether additional funds are required Other potential sources of capital (eg bank lines) 24 8

9 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Discussion of capital structure Terms of the offering and if they can be modified Summary of differences between the securities being offered and other classes of securities How rights of securities being offered may be limited, diluted or qualified by the rights of another class of security holders in any material respect How exercise of rights held by principal shareholders could negatively impact purchasers in the offering 25 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Names and ownership level of each existing shareholder beneficially owning 20% or more of any class of voting equity securities How the securities being offered have been valued and examples of the methods the issuer may use to value such securities in future Risks to purchasers relating to minority ownership Issuance of additional shares Sale of the issuer or assets of the issuer Transactions with related parties 26 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Risk factor disclosure Discussion of material factors that make an investment in the issuer speculative or risky Additional disclosures Name, SEC file number and CRD number of the broker dealer or funding portal Amount of compensation paid to the intermediary for conducting the offering Current number of employees 27 9

10 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Description of material terms of any indebtedness of the issuer, including amount, interest rate, maturity date and other material terms Discussion of all exempt offerings conducted by the issuer in the past three years Disclosure of all transactions between the issuer and a person affiliated with the issuer, including the terms of such transactions and whether the terms were similar to those that would have been available in an arm s length transaction 28 REQUIREMENTS OF ISSUERS RELYING ON CROWDFUNDING EXEMPTION Disclosure of compensated activities At the account opening, must disclose receipt of compensation to promoters for the fact that he or she is engaging in promotional activities on behalf of the issuer Applies to all persons acting on behalf of an issuer regardless of whether or not the compensation they receive is for promotional activities Intermediary may pay third parties for general advertising, web search engine direction or other internet techniques if the compensation is not based, directly or indirectly, upon the purchase or sale of a security 29 ADVERTISING No advertising by issuers permitted but issuer may publish notices limited to: Notice that the issuer is conducting an offering Name of the intermediary and web address Terms of the offering, including the amount of securities offered, type of securities, price of the security and closing date of the offering period Name, address, phone number and website of issuer and address of an issuer representative Brief description of the issuer s business 30 10

11 SEC FILING AND INITIAL REPORTING REQUIREMENTS All filings must be made electronically Issuers must file the required disclosure document and financial statements Progress reports must be filed with the SEC or issuer may rely on intermediary to make such filings within five business days of the offering reaching specified intervals (eg 25%, 50%, 75%) Issuer (vice intermediary) must file final report within five business days after termination of the offering disclosing the amount of securities sold 31 SEC POST OFFERING REPORTING REQUIREMENTS Annual reports to SEC and investors which includes results of operations and financial statements of the issuer Financial statements must be certified by a principal executive officer as true and complete in all material respects Reports must be completed within 120 days of the issuer s fiscal year end Issuers may provide this report to investors by posting it on the issuer s website 32 TERMINATION OF ANNUAL REPORTING OBLIGATION Requirement to file annual reports is terminated if the issuer: Has filed at least one report and has fewer than 300 security holders Has filed three annual reports and does not have total assets exceeding $10 million Is required to filed reports under the Exchange Act Acquires all the securities issued in the Crowdfunding offering or all such securities are acquired by another party Is liquidated or dissolved under state law 33 11

12 COUNTING OF SECURITY HOLDERS FOR EXCHANGE ACT REPORTING For purposes of determining the number of shareholders under the Securities Exchange Act of 1934, purchasers of securities in a Crowdfunding offering are excluded if: The issuer is current in its annual reports The issuer has assets as of its last fiscal year end of not greater than $25 million The issuer engages a registered transfer agent 34 CIVIL LIABILITY OF ISSUERS Issuer liability Liable to a purchaser for making an untrue statement of material fact or omitting to state a material fact required to be stated or necessary in order to make the statements, in light the circumstances under which they were made, not misleading, provided the purchaser did not know of the untruth or omission Issuer has affirmative defense that he did not know, and in the exercise of reasonable care could not have known, of the untruth or omission 35 CIVIL LIABILITY OF AFFILIATES OF THE ISSUER For purposes of civil liability, issuer is defined to include Directors, principal executive officers, principal financial officer, controller or principal accounting officer who offers or sells a security in a Crowdfunding transaction Any person who offers or sells a security in a Crowdfunding transaction Statute of limitations is one year after discovery or three years after the sale 36 12

13 CIVIL LIABILITY OF INTERMEDIARIES SEC takes the view that intermediaries (including funding portals) may be viewed as an issuer for purposes of civil liability Although they will also have the benefit of the statutory affirmative defense, they should: Exercise discretion to limit the offerings and issuers allowed on their platforms Establish policies and procedures to achieve compliance with Crowdfunding regulations Conduct a review of an issuer s offering documents prior to posting them to evaluate whether they contain materially false or misleading information 37 PREEMPTION OF STATE SECURITIES LAW With respect to securities offered in reliance on the Crowdfunding exemption, state securities laws (including any notice filing or fee requirement) are preempted, except A notice filing and filing fee could be imposed by a state where purchasers of 50% or more of the aggregate offering are resident States make take enforcement action against the issuer or its control persons (eg fraud) 38 PREEMPTION OF STATE SECURITIES LAW With respect to funding portals, state securities laws are preempted, except Actions relating to fraud or deceit Examinations of a funding portal which has its principal place of business in the state but only to the extent that the state laws and regulations being enforced with regard thereto are not different from, or in addition to, SEC rules 39 13

14 INTRASTATE CROWDFUNDING Due to significant delay in adoption of SEC rules, 22 states and District of Columbia have created crowdfunding exemptions based upon an exemption from SEC registration under Section 3(a)(11) of the 1933 Act and therefore are limited to: Issuers residing in a single state Offerees and purchasers residing in a single state Funding portals operating within in a single state 40 INTRASTATE CROWDFUNDING Must comply with SEC intrastate exemption Issuer formed under the laws of the state Authorized to do business in the state Derive at least 80% of its gross proceeds in most recent fiscal year prior to offering from the state 80% of its assets in the state as of the most recent semi annual report prior to the offering Use 80% of net proceeds of offering in the state Has its principal place of business in the state 41 PROPOSED CHANGES TO SEC RULE 147 Simultaneously with adoption of Regulation Crowdfunding, SEC proposed changes to Rule 147 to make it more compatible with existing intrastate crowdfunding exemptions Rule 147 is proposed to go from a safe harbor of the Section 3(a)(11) statutory exemption to a separate exemption Statutory exemption in Section 3(a)(11) will remain available (but without a safe harbor?) 42 14

15 MAJOR PROPOSED CHANGES Rule 147 offering must: Be registered with the state securities regulator of the state; or Rely upon a state exemption from registration in the state that limits the amount of securities an issuer may sell under the state exemption to no more than $5 million and imposes an investment limitation on investors (ie Intrastate Crowdfunding Exemptions) 43 MAJOR PROPOSED CHANGES Only sales (not offers) must be made to residents of a single state Only require issuer to have principal place of business in the state Only meet one of the 80% tests or that the majority of the issuer s employees are located in the state 9 month resale restriction to non residents is from the time of sale, not from the end of the offering 44 INTRASTATE CROWDFUNDING Some states require use of an intrastate funding portal while others will permit offerings through an issuer s website If use of a funding portal is required, the funding portal must be registered with the state and Include disclaimers that access to crowdfunding offerings is limited to residents of the state Maintain security procedures that only persons who affirm residency in that state may obtain access to crowdfunding offerings 45 15

16 DISQUALIFICATIONS AND PROHIBITIONS The intrastate crowdfunding exemption may not be available to issuers where the issuer or its affiliates have a disqualification Intrastate crowdfunding exemption also is generally not available to: Companies subject to the reporting requirements of the Exchange Act Blank check/blind pool companies 46 MAXIMUM OFFERING AMOUNT Each state can set its own maximum offering Some have $1 million within a 12 consecutive month period while others opt for six months Some exclude from the maximum offering amount purchases by officers, directors and 10% owners Some increase the maximum offering amount if the issuer has a financial audit which it will give to investors 47 MAXIMUM PURCHASE AMOUNT States set their own maximum purchase limits Tend not to follow the SEC model and opt for a specific maximum dollar amount $5,000 in Texas and Indiana but $10,000 in Wisconsin Accredited Investors can purchase any amount of securities in a crowdfunding offering Wisconsin has a Certified Investor category which is less than the Accredited Investor definition who may purchase any amount in a crowdfunding offering 48 16

17 ESCROW OF SUBSCRIPTIONS Issuers must require that all funds to purchase securities in an intrastate crowdfunding offering be deposited into escrow governed by a separate escrow agreement Some states require the escrow agent to be a depository financial institution while others permit a non depository trust company to be an escrow agent Funding portals cannot handle investor funds 49 MANDATORY LEGENDS AND NOTICES Generally these disclosures advise that Offers and sales may be made only to bona fide residents of the state Resale restrictions required by SEC Rule 147 apply (ie no sales to non state residents for nine months from the last sale in the offering) Securities have not been registered under federal or state securities laws There is no ready market for the securities and it may be impossible to dispose of the investment 50 MANDATORY LEGENDS AND NOTICES The purchaser may have to bear the financial risks of the investment indefinitely No federal or state regulatory agency has reviewed, approved or confirmed the accuracy and adequacy of any disclosure statement or other information appearing on the website of the funding portal 51 17

18 MANDATED DISCLOSURE DOCUMENTS Similar to SEC proposed rules, intrastate crowdfunding exemptions require the issuer to provide a disclosure document to investors via a website posting Issuers are under an affirmative obligation to provide all information that a reasonable person would deem to be material in making an informed investment decision Providing only the information cited in the exemption may not be sufficient 52 MANDATED DISCLOSURE DOCUMENTS Disclosure document must be filed with the state regulator prior to sale of a security Texas requires filing 21 days prior to sale Wisconsin and Indiana require 10 days Disclosure document may be subject to regulatory review Staff provide comments to issuer Issuer must respond to comments and update disclosure document as necessary 53 INTRASTATE FUNDING PORTALS These funding portals must Be organized under the laws of the state and authorized to do business in the state Engage exclusively in offers and sales in the state Not use a facility of a national securities exchange Not operate or facilitate a secondary market in securities Limit its activities to operating a website used solely to sell securities in an intrastate crowdfunding offering 54 18

19 INTRASTATE FUNDING PORTALS Registration with state securities regulator Subject to a registration application process with the state securities regulator Subject to periodic examination by the state securities regulator States may require the funding portal to maintain a surety bond of a certain amount (eg Indiana requires $50,000) Funding portals rely on an intrastate brokerdealer exemption under federal law 55 INTRASTATE FUNDING PORTALS State funding portals cannot Offer investment advice or recommendations Hold or manage investor funds or securities Be affiliated with an issuer whose offering is on the funding portal s platform Hold or receive a financial interest in any issuer whose securities are displayed on the funding portal s platform Pay unregistered persons for soliciting offers or sales of securities displayed on the platform 56 MANDATORY REPORTING State reporting requirements may differ Indiana requires a quarterly report to investors Describing cash compensation received by each officer and director since the last report and on an annual basis as well as any bonuses, stock options or other rights to receive securities of the issuer or an affiliate Analyzing the business operations and financial condition of the issuer Wisconsin requires quarterly reports only as to the progress of the offering 57 19

20 UK CROWDFUNDING Currently operational Regulated by the UK Financial Conduct Authority (FCA) Regulation divided between Debt crowdfunding portals Equity investment crowdfunding portals 58 UK CROWDFUNDING Purchase limitation: < 10% of investor s net assets in illiquid securities unless: Retail investor who is advised; High net worth investor (annual income of 100,000 or 250,000 net worth); Sophisticated investor Member of business angel network Invested in an unlisted company within last two years Director of a company with 1 million turnover 59 UK CROWDFUNDING FCA has not established minimum due diligence standards on platforms in reliance on current voluntary practices of UK funding portals relating to: Screening for fraud Conducting background checks of the company, management team and financial backers Examining financial disclosures Assessing marketability of the company 60 20

21 UK CROWDFUNDING Offering amount is limited by EU Prospectus Directive which provides an exemption for offerings of less than 5 million in a 12 month period Unlike proposed SEC rules, the FCA prohibits portals from engaging in advertising beyond what is posted on the portal but allows the issuer to engage in advertising 61 THANK YOU G. Philip Rutledge, Esq. rutledge@bybelrutledge.com Bybel Rutledge LLP 1017 Mumma Road, Suite 302 Lemoyne, PA (717) phone (717) fax The information in this presentation should not be construed as legal or other professional advice or opinions on specific facts or matters. Distribution hereof shall not constitute an attorney client relation. Questions regarding information in this presentation may be directed to the presenter or another attorney at Bybel Rutledge LLP