CROWDFUNDING FAQS. Paul Blumenstein. February 11, Q: What methods of crowdfunding are currently permitted under federal securities regulations?

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1 CROWDFUNDING FAQS Paul Blumenstein February 11, 2015 Q: What is crowdfunding? A: Crowdfunding refers to various means of raising of capital from large numbers of small investors, usually via the Internet. Crowdfunding today can consist of securities offerings effected within the existing regulatory structure, or fundraising activities that do not involve the issuance of securities, such as that conducted by Kickstarter. In recent years, through laws such as the JOBS Act, federal and state legislators have sought to relax the securities laws to facilitate crowdfunding and provide entrepreneurs with easier and cheaper access to capital. The JOBS Act, however, is not self-executing but requires implementation by the SEC. Q: What methods of crowdfunding are currently permitted under federal securities regulations? A: The SEC has yet to finalize most of its regulations implementing the JOBS Act. However, there are other federal exemptions available to issuers seeking to engage in crowdfunding. Crowdfunding structures that currently available include (i) offerings to accredited investors under Regulation D Rule 506, (ii) small public offerings under Regulation D Rule 504 or Regulation A, and (iii) intrastate offerings under Section 3(a)(11) of the Securities Act and the related Rule 147 safe harbor. The two leading peer-to-peer lending platforms, LendingClub and Prosper, issue securities primarily through registered public offerings. Q: What types of crowdfunding methods are covered by the JOBS Act? A: The JOBS Act facilitates three types of crowdfunding. Title II mandates revisions to Rule 506 to permit general solicitation under certain circumstances. Title III creates a new type of crowdfunding structure through which issuers may sell securities in limited amounts to nonaccredited investors, without registration through online intermediaries such as a funding portal or a broker-dealer. Title IV provides for revisions to Regulation A to increase the offering limit from $5 million to $50 million, among other things. As of this time, the SEC has implemented Title II through the creation of Rule 506(c), but has not adopted final rules implementing Titles III and IV. Whereas Titles II and IV represent an evolution of existing regulations, Title III contemplates an entirely new type of offering regulation; it remains to be seen, however, whether the advantages it offers issuers are sufficient to overcome its limitations, as discussed below. Q: What are the key advantages and disadvantages of Rule 506(c)? A: Rule 506(c) is similar to the old Rule 506 in that it permits an issuer to offer securities to accredited investors without any limit in the aggregate offering amount or the amounts purchased by any single investor. An issuer relying on Rule 506(c) may engage in general solicitation, provided that the issuer must take reasonable steps to verify that each purchaser of securities is an accredited investor. As with other offerings under Rule 506, securities issued in reliance on

2 Rule 506(c) are covered securities under NSMIA,1 such that sales of such securities are exempt from registration under state blue sky laws. By permitting general solicitation, Rule 506(c) enables a crowdfunding issuer to cast a much wider net in search of investors than the issuer in a traditional private placement. However, sales under Rule 506(c) are restricted to accredited investors, which significantly limits the population of eligible investors. Moreover, whereas an issuer relying on Rule 506(b) need only have a reasonable belief that each purchaser is accredited (which often involves nothing more than obtaining appropriate representations from each purchaser), under Rule 506(c) the issuer must take affirmative steps to verify that each purchaser is accredited. Q: In an offering under Rule 506(c), what steps must an issuer take to verify that each investor is accredited? A: Rule 506(c) requires that the issuer take reasonable steps to verify accreditation. The rule includes a list of nonexclusive steps that are deemed to constitute reasonable steps so long as the issuer does not have knowledge that an investor is not in fact accredited. These steps include the following: 1. Review of tax returns, W-2s, or similar IRS forms that report income for the last two years and receipt of a written representation from the investor that he or she has a reasonable expectation of reaching the necessary income level during the current year. 2. Verification of net worth through review of bank statements, brokerage statements and the like to determine assets, and review of a credit report from a nationwide consumer reporting agency to determine liabilities, provided that such documents are dated within the last three months and the investor provides a written representation that all liabilities necessary to determine net worth have been disclosed. 3. Receipt of written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney or CPA that such person has taken reasonable steps within the past three months to determine that the investor is accredited and has determined that the investor is in fact accredited. Except where the investor can provide tax returns that clearly demonstrate income in excess of the required thresholds, applying these verification methods can be time-consuming and may not be cost-effective in offerings in which investors are permitted to invest small amounts, as is often the case with crowdfunding. Eventually, the verification process is likely to become streamlined through the services of third-party verification services and offering platforms such as AngelList. 1 National Securities Markets Improvement Act of 1996, codified as Section 18 of the Securities Act of Under this law, certain federal registration exemptions are deemed to preempt state registration requirements. 2 See the SEC s Compliance and Disclosure Interpretations, Questions through

3 Q: What are the key advantages and disadvantages of Rule 504? A: Rule 504 permits issuers to offer up to $1 million in securities to investors regardless of income or net worth, so long as the issuer (i) registers the offering in at least one state that requires public filing and delivery of a disclosure document and (ii) delivers such disclosure document to all investors prior to sale, regardless of which state they reside in. General solicitation is permitted under Rule 504. Thus, Rule 504 allows issuers to target a much wider investor audience than Rule 506. Because securities offered under Rule 504 are subject to registration under state blue sky laws, however, an offering under Rule 504 can involve significant regulatory burdens. Moreover, given the $1 million annual cap on offerings, Rule 504 may be of little use for commercial-scale project financing. Q: What are the key advantages and disadvantages of intrastate offerings under Section 3(a)(11)? Section 3(a)(11) provides an exemption for securities offered exclusively to residents of a single state, so long as the issuer is incorporated in that state and doing business in the state. Issuers seeking to effect intrastate offerings may rely on a safe harbor set forth in SEC Rule 147, discussed in greater detail below. Intrastate offerings are not subject to restrictions regarding the size of the offering and are not restricted to accredited investors, although they may be subject to registration at the state level, through which the offering may be subject to investor qualifications based on income or net worth. General solicitation is permitted so long as it s targeted at investors within the state.2 The territorial restriction, however, can impose a significant burden on the issuer s fundraising efforts. Moreover, the issuer needs to take special caution to ensure that each purchaser is in fact a resident of the state. That said, Section 3(a)(11) may be a good fit for many renewable energy projects, particularly those located in large states such as California, in light of the local nature of the enterprise and the interest it is likely to generate among investors in the area who appreciate the social benefits of renewable energy. Q: In an intrastate offering, what is required for an issuer to satisfy Rule 147? A: In general, Rule 147 requires that (i) the issuer be organized in the state where the offering takes place, (ii) the issuer derive at least 80% of its gross revenues (on a consolidated basis) from the operation of a business or real property in, the purchase of real property located in, or the rendering of services within the state,3 (iii) at least 80% of the issuer s assets (on a consolidated basis) be located in the state, (iv) the issuer intend to use at least 80% of the net offering proceeds in connection with the operation of a business or real property in, the purchase of real property located in, or the rendering of services within, the state, and (v) the issuer s principal office is located within the state. In addition, under the rule, offers and sales of securities may be made only to persons resident in the issuer s state, and the issuer must prohibit resales of the 2 See the SEC s Compliance and Disclosure Interpretations, Questions through Based on (a) revenues for the most recent fiscal year, if the initial offer of securities occurs during the first six months of the current fiscal year, or (b) revenues for either the first six months of the current fiscal year or the 12-month period ending with such six-month period, if the initial offer occurs during the last six months of the current fiscal year. This requirement does not apply to any issuer that has not had gross revenues in excess of $5,000 from the conduct of its business during its most recent 12-month period. 3 3

4 securities to any nonresidents from the commencement of the offering until nine months following the completion of the offering. An individual is deemed to be a resident of the state of his or her principal residence, and an entity is deemed to be a resident of the state where its principal office is located. Q: If the issuer fails to satisfy one of the requirements of Rule 147, does it lose the intrastate exemption? A: No. Rule 147 is a nonexclusive safe harbor. It provides greater certainty that the issuer qualifies for the Section 3(a)(11) exemption, but if it is not satisfied, the issuer may still claim the exemption based on the statute itself. Q: What are the key advantages and disadvantages of Regulation A? A: Regulation A is often viewed as registration-lite. The process is similar to registration on Form S-1, but the issuer is not required to file audited financial statements (unless it has prepared them for other purposes) and does not become subject to the 1934 Act reporting requirements. To many issuers, however, Regulation A may seem like the worst of all worlds: offerings are capped at $5 million for any 12-month period, the securities are subject to state law registration requirements, and the SEC review process can be just as burdensome as when a company is registering securities. In addition, securities sold under Regulation A are not exempt from state blue sky registration. However, for an issuer that wishes to raise more than $1 million from nonaccredited investors in multiple jurisdictions, Regulation A may offer the only viable alternative. In Title IV of the JOBS Act, Congress adopted a new Regulation A structure, commonly referred to as Regulation A+, under which the annual offering limit would be increased to $50 million and securities issued under the rule would be covered securities under NSMIA and thus exempt from state law registration. In return, issuers would be required to file audited financial statements and would become subject to ongoing periodic reporting obligations. For issuers seeking to raise large sums of money through crowdfunding, Regulation A+ offers the most promise of all of the available regulatory pathways. Although the SEC approval process is similar to federal registration, the ability to avoid the state law registration removes an enormous potential hurdle, particularly for any issuer seeking to launch a broad-based crowdfunding campaign that reaches beyond a small number of states. The issuer s periodic reporting obligation may be terminated after the end of the next fiscal year if the securities it has sold in the offering are held by fewer than 300 holders of record. Q: Will the crowdfunding landscape change significantly when Title III of the JOBS Act is implemented? A: Through Title III of the JOBS Act, Congress set out to create an entirely novel registration exemption specifically aimed at crowdfunding. However, in light of some of the limitations and conditions set forth in Title III and the related regulations proposed by the SEC, it remains to be seen whether this new regulatory scheme will represent the sea-change that was originally intended. Under the exemption created by Title III, companies may sell securities online without registration via funding portals or registered broker-dealers, subject to an annual limit of 4

5 $1 million in securities sold under the exemption. Securities may be sold to both accredited and non-accredited investors, provided that purchases by each investor are limited to an annual amount that is based primarily on a percentage of the investor s annual income or net worth. (This limit applies to all securities purchased by an investor in the aggregate pursuant to the crowdfunding exemption.) Issuers are not permitted to engage in advertising or general solicitation but are permitted to issue notices, similar to tombstone ads, directing investors to the designated online offering platform, through which an issuer may then communicate with investors. Securities sold under the crowdfunding exemption are covered securities under NSMIA and thus exempt from registration under state blue sky laws. The funding portal or other intermediary is required to police the offering process and furnish educational materials to ensure that the issuer complies with the applicable requirements and that investors understand the investment process and the risks of investing. The intermediary must take steps to ascertain that no purchaser is exceeding his or her investment limits and must ensure that each investor reviews and understands the educational materials. Each investor must answer questions so as to demonstrate an understanding of the risks associated with investing in startups. An issuer relying on the crowdfunding exemption must file a disclosure form with the SEC similar to the form that is filed in connection with a Regulation A offering and must make the form available to investors via the offering platform. The disclosure form is not subject to review by SEC staff; however, in light of the oversight responsibility imposed on intermediaries, intermediaries may adopt the practice of reviewing issuers disclosure forms and requesting changes before proceeding with an offering. Different levels of financial disclosure are required depending on the size of the offering. For offerings not exceeding $100,000, the issuer is only required to file its most recent tax return. For offerings of between $100,000 and $500,000, the issuer must file tax returns that conform to GAAP and are reviewed (but not audited) by an independent public accountant. For offerings in excess of $500,000, audited financial statements are required. Although Title III and the accompanying SEC rule proposal that accompany it represent an effort to loosen the restrictions on capital formation by small businesses, the long-term practical utility of the new exemption remains uncertain. In light of the $1 million annual cap on securities sold pursuant to the crowdfunding exemption, this exemption may be better-suited to seed financings by early-stage startups than to project financing for energy projects. Moreover, the requirements imposed on intermediaries, particularly those relating to verifying that investors understand the investment risks, are likely to introduce significant friction and cost into the offering process. Q: How great an advantage is there in avoiding blue sky registration? A: In many ways, state blue sky requirements can be more burdensome than the requirements imposed under federal securities laws. Unlike the SEC, many blue sky regulators do not limit their review process to disclosures but engage in merit review, through which they can require substantive changes to the terms of the offering or the issuer s corporate governance policies. A blue sky regulator could make demands that appear disproportionately burdensome, or it could 5

6 refuse to approve an offering altogether due to concerns about the issuer s financial condition. 4 Most states that engage in such merit review follow the NASAA Statement of Policy, which sets forth model standards for evaluating securities offerings. Apart from the substantive burdens associated with merit review, being subject to state registration can subject an issuer to significant procedural burdens, particularly in the case of an issuer that seeks to engage in a broad-based multi-state crowdfunding campaign under Regulation A or Rule 504. The issuer must register its securities with multiple states and respond to comments from the securities regulators in each state. (Most states permit coordinated filing and review, through which one state takes the lead in acting on behalf of several states in a geographic region, but each state is still permitted to submit its own comments.) Moreover, the blue sky regulators often require issuers to file copies of any advertising materials, which creates an ongoing burden for issuers seeking to use social media to promote their offerings. Other things being equal, it is far preferable to rely on a federal exemption that treats the issued securities as covered securities under NSMIA than one that requires the issuer to comply with state blue sky laws, unless it is feasible to limit the offering to a small number of large states. Q: Are any crowdfunding initiatives happening at the state level? A: Several states have adopted registration exemptions that enable companies to engage in intrastate crowdfunding. These exemptions are aimed at intrastate offerings and often have requirements that mirror Section 3(a)(11) and Rule 147. They generally require an offering process that resembles that contemplated by Title III of the JOBS Act. Most such exemptions are limited to offerings of up to $1 million, although a few states raise this cap to $2 million for issuers that file audited financial statements. CrowdCheck, a company that provides services to crowdfunding platforms, has posted a useful chart summarizing the status of intrastate crowdfunding exemptions throughout the U.S. 4 Examples of requirements imposed by blue sky regulators are (a) that the issuer elect a certain number of independent directors, (b) that the founders agree to lock up their shares for several years and place them in escrow, or (c) that the issuer meet certain financial ratios as a condition to proceeding with the offering. 6