Securities Regulation Update

Transcription

1 November 2013 SEC Proposes Crowdfunding Rules The SEC has published for comment proposed Regulation Crowdfunding (the Proposal ), which is intended to enable entrepreneurs and start-up companies to solicit investments over the Internet from the general public through SEC-registered intermediaries. 1 This 300-plus page Proposal would establish rules governing the offer and sale of securities in crowdfunding transactions under new Section 4(a)(6) of the Securities Act of 1933 (the Securities Act ). It would also provide a framework for the regulation of registered funding portals and broker-dealers that issuers would be required to use as intermediaries in the offer and sale of securities in reliance on Section 4(a)(6). Comments on the Proposal are due by February 3, The SEC s crowdfunding proposal is intended to implement the requirements of Title III of the Jumpstart Our Business Startups Act (the JOBS Act ), which was designed to alleviate the funding gap and accompanying regulatory concerns faced by startups and small business in connection with raising capital in relatively low dollar amounts. The Proposal would provide the public i.e., the crowd with an opportunity to invest in an idea or a business by permitting individuals to make such investment decisions after sharing information about the idea or business with each other. At the same time, the Proposal would implement investor protections, including individual investment limits; required disclosures by issuers; and the use of intermediaries. The Proposal is divided into five subparts. Subpart A sets out the general crowdfunding exemption and requirements. Subpart B sets out the requirements applicable to issuers that engage in crowdfunding transactions. Subpart C governs the intermediaries, both broker-dealers and funding portals, through which crowdfunding transactions would be effected. Subpart D sets out requirements for funding portals, and Subpart E contains miscellaneous provisions, including a one-year prohibition on transferring shares purchased in a crowdfunding transaction. The Issuer Exemption Subpart A of the Proposal, specifically, Rule 100, would exempt securities sold pursuant to Section 4(a)(6) from the securities registration requirements of Section 5 of the Securities Act and Section 12(g) of the Securities Exchange Act of 1934 (the Exchange Act ). To qualify for the exemption under Section 4(a)(6), crowdfunding transactions would be subject to the following limitations and requirements: (1) the issuer could not raise more than $1 million in a 12-month period; (2) individual investments in a 12-month period would be limited to the greater of $2,000 or 5 percent of annual income or net worth for an investor with annual income or net worth of less than $100,000, and 10 percent of annual income or net worth (not to exceed an aggregate investment of $100,000) if annual income or net worth is $100,000 or more; 2 and (3) transactions would have to be conducted through an intermediary that either is registered as a broker under the Exchange Act or as a new type of entity 1 Crowdfunding, Exchange Act Release No (Oct. 23, 2013), 78 FR (Nov. 5, 2013), available here. 2 The SEC would be required to adjust these dollar amounts at least every five years based on the Consumer Price Index. If both annual income and net worth are less than $100,000, the limit of $2,000 or 5 percent of annual income or net worth, whichever is greater, would apply. If either annual income or net worth exceeds $100,000, then the limit of 10 percent of annual income or net worth, whichever is greater, would apply. Total investment, however, could not exceed $100,000, as noted.

2 called a funding portal. A natural person s annual income and net worth would be calculated in accordance with the SEC s rules for determining accredited investor status, as set out in Rule 501 under the Securities Act. An investor s annual income and net worth could be calculated jointly with the income and net worth of the investor s spouse. Amounts raised through other exempt transactions, i.e., not pursuant to Section 4(a)(6), would not be aggregated for purposes of the $1 million annual limit. Thus, under the Proposal, an issuer could conduct an offering under Section 4(a)(6) that is made simultaneously with, or that is preceded or followed by, an offering made under another exemption from registration under the Securities Act. 3 The SEC stated that it believes that the overall intent of providing the exemption under Section 4(a)(6) was to provide an additional mechanism for capital raising for startup and small businesses and not to affect the amount an issuer could raise outside of that exemption. Moreover, amounts raised through methods that do not involve the offer or sale of securities (such as donations received from a separate, non-securities-based crowdfunding effort, contributions from family and friends, gifts, grants or loans), would not be aggregated for purposes of the $1 million annual limit. Any amounts raised by securities sold in reliance on Section 4(a)(6) by any predecessor entity, or any other entity controlled by or under common control with the issuer, however, would be aggregated in determining the total amount of crowdfunding securities sold during the preceding 12-month period. The meaning of control for Section 4(a)(6) purposes would be as defined in Rule 405 under the Securities Act. The following categories of issuers could not rely Section 4(a)(6) to engage in crowdfunding transactions: (1) issuers that are not organized under the laws of a state or territory of the United States or the District of Columbia; (2) issuers that are subject to Exchange Act reporting requirements; 4 (3) investment companies as defined in the Investment Company Act of and companies excluded from the definition of investment company under Section 3(b) or 3(c) of the Investment Company Act; and (4) any other issuer that the Commission, by rule or regulation, determines appropriate. The Proposal would also exclude issuers that are disqualified from relying on Section 4(a)(6) pursuant to the disqualification provisions of Section 302(d) of the JOBS Act. Any issuer that has sold securities in reliance on Section 4(a)(6) but has not filed with the Commission and provided to investors required ongoing annual reports during the two years immediately preceding the filing of the required new offering statement would be excluded from being able to further solicit crowdfunding investments pursuant to Section 4(a)(6). Also excluded would be any issuer that has no specific business plan or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies. Requirements for Issuers Disclosures. Issuers would be subject to disclosure, reporting, filing and other requirements and limitations as set out in Subpart B of the Proposal, which would be comprised of Rules 201 through If the exempt offering being made concurrently with the offering made under Section 4(a)(6) did not permit general solicitation, the issuer would need to satisfy itself that the purchasers were not being solicited in the non- Section 4(a)(6) offering by means of the offering made in reliance on Section 4(a)(6). 4 These are issuers who are required to file reports with the Commission pursuant to Exchange Act Sections 13(a) (15 U.S.C. 78m(a)) or 15(d) (15 U.S.C. 78o(d)) U.S.C. 80a-1 et seq. November 2013 Page 2

3 The Proposal would require an issuer offering or selling securities in reliance on Section 4(a)(6) to file specified disclosures, including financial disclosures, with the SEC; provide the disclosures to investors and the broker or funding portal through which the securities would be sold or offered; and make the disclosures available to potential investors. The disclosures would include: (1) the name, address and Website address of the issuer; (2) a description of the business and a business plan; (3) the names of the directors and officers of the issuer, and persons holding more than 20 percent of the shares of the issuer; (4) a description of the financial condition of the issuer; (5) a statement of the intended use of the proceeds sought with respect to the target offering amount, which also must be identified; (6) the deadline to meet the target amount and updates regarding progress towards meeting the target; (7) the price of the securities to the public or the method for determining that price; (8) a description of the ownership and capital structure of the issuer; and (9) such additional disclosures as the SEC may require. Issuers would be subject to tiered financial disclosure requirements, depending on the amount of the offering. For an offering of $100,000 or less, the issuer would need to file with the SEC, provide to investors and the relevant intermediary, and make available to potential investors, tax returns filed by the issuer for the most recently completed year, and financial statements that are certified by the principal executive officer of the issuer to be true and complete in all material respects. Issuers offering more than $100,000 up to $500,000 would need to file with the SEC, provide to investors and the relevant intermediary, and make available to potential investors, financial statements reviewed by a public accountant that is independent of the issuer. With respect to offerings of more than $500,000, issuers would need to file with the SEC, provide to investors and the intermediary, and make available to potential investors, audited financial statements. The issuer would also need to include a narrative discussion of its financial condition. Filings. An issuer would file disclosures on proposed Form C. The issuer would need to amend its disclosure to reflect any material change in the terms of the offer or in a disclosure previously provided. Amendments would be filed by checking Form C-A: Amendment on proposed Form C. Progress updates would be filed by checking Form C-U: Progress Update on proposed Form C. An issuer also would be required to file annually with the SEC and provide to investors reports of the results of operations and financial statements. The issuer would file the annual report on by checking Form C- AR: Annual Report on proposed Form C. Issuers terminating their reporting obligations would file Form C-TR: Termination of Reporting using Form C. Intermediaries As noted above, an issuer effecting a crowdfunding transaction in reliance on Section 4(a)(6)(C) would have to conduct the offering through an intermediary, specifically, a broker or a funding portal. Intermediaries would be subject to the requirements set out in Subpart C of the Proposal, Rules 300 through 305. A broker is defined in Section 3(a)(4) of the Exchange Act. Section 3(a)(80) of the Exchange Act defines funding portal as any person acting as an intermediary in a transaction involving the offer or sale of securities for the accounts of others solely pursuant to Section 4(a)(6). A person acting as an intermediary in crowdfunding transactions would register either as a broker under Section 15(b) of the Exchange Act or as a funding portal under Section 4A(a)(1) of the Securities Act and proposed Rule 400 of Regulation Crowdfunding. Both a broker and a funding portal would have to register with a self-regulatory organization ( SRO ). A funding portal would specifically November 2013 Page 3

4 be required to register with a national securities association, the only one of which currently is the Financial Industry Regulatory Authority, Inc. ( FINRA ). 6 Obligations with Respect to Issuers. The Proposal would impose certain obligations on an intermediary with respect to issuers that wish to carry out crowdfunding transactions on the intermediary s platform. The intermediary would have to have a reasonable basis to believe that the transaction would be exempt under Section 4(a)(6) of the Securities Act. It would also have to have a reasonable basis to believe that the issuer had implemented a system to keep accurate records of the holders of securities that the issuer offered and sold through the intermediary s platform. An intermediary could comply with each of the preceding obligations by obtaining a representation of the issuer concerning compliance, unless the intermediary has reason to question the reliability of the representations. The intermediary would have to deny an issuer access to its platform if the issuer or any of its officers, directors or 20 percent-plus beneficial owners is disqualified from relying on the exemption set out under Section 4(a)(6). Disqualification would arise, among other reasons, if such persons had been convicted of felonies or misdemeanors in connection with securities transactions or had been enjoined or restrained from engaging in a securities business. The intermediary would also have to deny access to its platform if it believed an issuer otherwise presents the potential for fraud or raises investor protection concerns. Investor Account Opening. An investor seeking to invest in an offering made via a crowdfunding transaction would need to open an account with an intermediary. Among other things, the investor would be required to consent to the electronic delivery of materials related to the investment. The Proposal would require the intermediary to deliver disclosure and educational materials to investor that, among other things, describe: (1) the process for the offer, purchase and issuance of securities through the intermediary; (2) the risks associated with investing in securities sold through a crowdfunding transaction; (3) restrictions on resale of such securities; (4) cancellation rights; and (5) limitations on amounts that the investor may invest. Under the Proposal, the intermediary would be responsible for determining that an investor complied with the limitations on investment described above. Obtaining representations from the investor, e.g., as to his or her annual income, net worth and total investment made over the preceding 12 months, generally would suffice for purposes of meeting the intermediary s obligation to monitor the investment limitations. Similarly, before accepting an investment commitment, the intermediary would need to obtain a representation from the investor that the investor (1) has reviewed and understood the educational materials, (2) is aware that entire amount of his or her investment may be lost and is in a financial condition to bear such loss, (3) understands that there are restrictions on the ability to cancel his or her investment and obtain the return of that investment, (4) is aware that it may be difficult to resell his investment, and (5) understands that he or she should not invest in any crowdfunding transaction unless he or she can afford to lose the entire investment (this requirement is quite similar to requirement (2)). Intermediary Disclosures. The Proposal would require disclosures with respect to persons who promote the issuer s offering ( Promoters ), whether for compensation or otherwise. At the account opening stage, the intermediary would be required to inform investors that (1) a person who promotes the issuer s offering for compensation, or (2) any person who is a founder or employee of the issuer that 6 See FINRA Regulatory Notice (October 2013). November 2013 Page 4

5 engages in promotional activities on behalf of the issuer on the intermediary s platform, would have to disclose clearly in all communications on the platform the receipt of the compensation and the fact that he or she is engaging in promotional activities on behalf of the issuer. This provision is intended to allow investors to monitor an issuer s compliance with its obligation to disclose that it compensates persons to promote its offering. The intermediary would likewise have to disclose, when establishing an account for an investor, that the intermediary will be compensated in connection with offerings and sales made in reliance on Section 4(a)(6). The provision is intended to alert the investor to any potential conflicts of interest that the intermediary may have arising out of the nature of its compensation. Intermediaries would need to disclose to the SEC and potential investors information that an issuer provides to the intermediary. The intermediary would make this information publicly available on its platform, in a manner reasonably accessible to the public and that permits the downloading, saving or other type of storing of such information, no later than 21 days before the first day on which the securities are sold to any investor, and during which time the intermediary may accept investments. The information would have to remain publicly available on the platform until the offer and sale of securities is completed or canceled. Access to this information could not be contingent upon a person establishing an account with the intermediary. The intermediary would have additional disclosure obligations to investors. Upon receipt of an investment commitment the intermediary would need to send the investor notification disclosing: (1) the dollar amount of the investment; (2) the price of the security, if known; (3) the name of the issuer; and (4) the date and time by which the investor may cancel the commitment. The intermediary also would have to provide a confirmation of the transaction at or before the completion of the transaction. The confirmation would need to disclose (1) the date of the transactions; (2) the type of security involved; (3) the identity, price and number of securities purchased by the investor, as well as the number of securities sold by the issuer in the transaction and the price; (4) specified terms of the security (e.g., debt or callable); and (5) any remuneration received by the intermediary, other than from the issuer. An intermediary that provides this confirmation would be exempt from the confirmation requirements of Rule 10b-10 under the Exchange Act. Communication Channels. The Proposal would require intermediaries to provide channels that would allow investors to communicate with one another and with representatives of the issuer about offerings made available on the intermediary s platform. Investors could also communicate outside the intermediary s channel; however, communications by an investor with a crowdfunding issuer or its representative about the terms of the offering would be required to occur only through this channel. An intermediary that is a funding portal could not participate in communications made through its channels, other than to establish communications guidelines and to remove abusive or fraudulent communications. An intermediary that is a broker, by contrast, could participate in such communications. Communications channels would be available for public viewing, although only investors with accounts could post comments. Any person posting a comment would have to clearly and prominently disclose with each post whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated to promote the issuer s offering. Investment Commitments. Under the Proposal, an investor could cancel any investment commitment until the final 48 hours of the offering. If an issuer hit its target amount earlier than anticipated, it could close the offering early so long as the offering was open at least 21 days, the issuer November 2013 Page 5

6 provided notice of the new offering deadline at least five business days before that deadline, investors could cancel their investment commitment until 48 hours before the new offering deadline, and at the time of the new offering deadline, the issuer continued to meet or exceed the target offering amount. If an issuer changed the material terms of an offer after potential investors made commitments, the issuer would be required to send notice of the material change to the investors. The notice would provide that if the potential investors did not reconfirm his or her commitment within five business days of receipt of the notice, the issuer would notify the investors that their commitments were canceled and direct the refund of the investors funds. If an issuer did not a complete an offering, either because it did not reach the target amount or decided to terminate the offering, the intermediary, within five business days, would have to notify each investor who made an investment commitment of the cancellation, the reasons for the cancellation and the amount to be returned to the investor; direct the refund of investor funds; and prevent investors from making commits for the canceled offering on the intermediary s platform. Protection of Investor Funds. The Proposal would impose requirements on intermediaries for the transmission and maintenance of investor funds. The Proposal would require an intermediary that is a broker to comply with Rule 15c2-4 under the Exchange Act, which governs the transmission or maintenance of payments received in connection with underwritings. Consistent with the requirements of Rule 15c2-4, a broker would need to deposit promptly in a separate bank account investor money or other consideration that the broker receives for payment of securities to be purchased in a crowdfunding transaction as agent or trustee for the persons who have a beneficial interest in the assets in the account. Once the relevant contingency occurs, which would either be reaching the minimum target offering amount, or cancelling the offering, the funds would be released to the issuer or returned to the investors, as applicable. Rather than be transferred to the broker, funds could be transmitted directly to a bank that has agreed in writing to holds such funds in escrow for persons with a beneficial interest in them, and to transmit the funds to the issuer or return them to the beneficial owner upon the occurrence of the relevant contingency. Intermediaries that are funding portals would be subject to separate requirements with respect to investor funds. A funding portal could not receive investor funds because it would not be a broker. It therefore would have to instruct investors to transmit money or other consideration directly to a qualified third party, meaning a bank, that has agreed in writing to hold the funds for the benefit of the investors and the issuers. The funding portal would promptly direct the bank to transmit the funds to the issuer if investor commitments from all investors equal or exceed the target amount of the offering and the cancellation period had expired (but no earlier than 21 days after the funding portal made information required to be provided by the issuer publicly available on its platform). The funding portal would also promptly direct the bank to return funds to an investor if an investment commitment had been canceled or the issuer had failed to complete the offering. Additional Provisions Applicable to Intermediaries. An intermediary would be prohibited from having any financial interest in an issuer using its services. This would include receiving an interest in the issuer as compensation for the intermediary s services. Financial interest would include direct or indirect ownership of, or economic interest in, any class of the issuer s securities. The Proposal would prohibit an intermediary from compensating any person for providing it with personally identifiable information, which would include any information that could be used to distinguish or trace an individual s identity, either alone or when combined with other personal or November 2013 Page 6

7 identifying information that is linked or linkable to a specific individual (e.g., name, social security number or date of birth). An intermediary could pay a person for directing issuers or potential investors to the intermediary s platform if the person does not provide personally identifiable information, and the compensation, unless paid to a broker-dealer, is not based, directly or indirectly, on the purchase or sale of a security offered in reliance on Section 4(a)(6) on or through the intermediary s platform. Additional Funding Portal Regulation Subpart D of the Proposal, Rules 400 through 404, would impose requirements specific to funding portals, i.e., not applicable to brokers. The SEC notes in the Proposal that because a funding portal would be engaged in the business of effecting securities transactions for the accounts of others through crowdfunding, it would be a broker within the meaning of Section 3(a)(4) of the Exchange Act, but is subject to an exemption under the JOBS Act. Unlike a broker, moreover, a funding portal could not: (1) offer investment advice or recommendations; (2) solicit purchases, sales or offers to buy the securities offered or displayed on its platform or portal; (3) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed or referenced on its platform or portal; (4) hold, manage, possess or otherwise handle investor funds or securities; or (5) engage in such other activities as the SEC, by rule determines appropriate. Associated Persons. The Proposal would apply the concept of associated persons to funding portals. The Proposal would define person associated with a funding portal or associated person of a funding portal to mean (1) any partner, director, officer or manager of a funding portal (or person occupying a similar status or performing similar functions); (2) any person controlling or controlled by a funding portal; or (3) any employee of a funding portal, excluding persons whose functions are solely clerical or ministerial. Funding Portal Registration. Under the Proposal, a funding portal would register with the SEC by completing Form Funding Portal, which would be similar to Form BD. Registration would become effective the later of 30 calendar days after the registration is received by the SEC, or the date that FINRA or any other registered national securities association approves the portal for membership. A funding portal would have an obligation to amend its Form Funding Portal within 30 days of the form becoming inaccurate for any reason. Information contained on Form Funding Portal would be publicly available through the SEC s Website, subject to the redaction of personally identifiable information and other information with a significant potential for misuse. Upon ceasing operation, a funding portal would need to file a withdrawal of registration on Form Funding Portal. A funding portal could operate multiple Website addresses under single funding portal registration, provided all Website addresses are disclosed on Form Funding Portal. This approach would allow a funding portal to customize Websites to appeal to certain industries or investors. Nonresident Funding Portals. The Proposal would permit nonresident funding portals, subject to specified criteria. There would need to be an information sharing arrangement between the SEC and the competent regulator in the jurisdiction in which the funding portal is organized or has its principal place of business. The nonresident funding portal also would need to: (1) provide written consent and power of attorney appointing an agent in the United States to accept service of process or papers in any action; (2) furnish the SEC with the name and address of the service of process agent; and (3) certify, and provide an opinion of counsel, that it can, as a matter of law, provide the SEC and the national November 2013 Page 7

8 securities association of which it is a member with prompt access to its books and records and can, as a matter of law, submit to onsite inspection and examination by the SEC and the national securities association of which it is a member. Compliance Obligations. A funding portal would have specified compliance obligations. It would have to establish, implement, maintain and enforce policies and procedures reasonably designed to achieve compliance with federal securities laws and regulations, and the rules of the national securities association of which it is a member, relating to its business as a funding portal. The Proposal, moreover, would require that a funding portal comply with the anti-money laundering provisions of Chapter X of Title 31 of the Code of Federal Regulations. Similarly, funding portals would be subject privacy requirements, specifically, Regulation S-P (protection consumer financial information and personal information), Regulation S-AM (limitations on affiliate marketing) and Regulation S-ID (identity theft red flags). A funding portal would be subject to examinations and inspections by representatives of the SEC and of the registered national securities association of which it is a member. Recordkeeping. The Proposal would impose books and records requirements on funding portals. A funding portal would be required to make and preserve specified books and records for five years, the first two years in an easily accessible place. With respect to investors, a funding portal would have to keep records of educational materials provided and materials related to account openings and transactions (including notices of investment commitments and reconfirmations). Records relating to issuers that offer and sell, or attempt to offer and sell, securities through the funding portals, and relating to persons having control over those issuers, would also have to be kept. The funding portal would have to retain records of all communications that occur on or through its platform. The Proposal would also broadly require a funding portal to keep all records it has created in the course of its business in order to comply with Regulation Crowdfunding, but would not require the creation of any records or prescribe any recordkeeping format in that regard. Similarly, a funding portal would be required to maintain records of all written agreements (or copies thereof) entered into by a funding portal relating to its business as such, as well as copies of its organizational documents. The Proposal would require a funding portal to create and maintain daily, monthly and quarterly summaries of transactions effected through it. It would also have to make and keep a log of each offering, reflecting the progress of each issuer toward raising its targeted offering amount. Miscellaneous Provisions Subpart E of the Proposal, Rules 501 through 503, contains miscellaneous provisions. Of particular consequence, the Proposal would prohibit a person who purchases a security through a crowdfunding transaction from transferring that security for a period of one year from the date of purchase, except in limited circumstances. Specifically, a purchaser could transfer, less than a year after the offering date, the securities: (1) to the issuer; (2) to an accredited investor; (3) as part of an offering registered with the SEC; or (4) to a member of the purchaser s family or the equivalent (meant to capture in-laws and adoptive relationships, among others), to a trust established by the purchaser, to a trust created by the for the benefit of a member of the purchaser s family or the equivalent, or in connection with the death or divorce of the purchase, or similar circumstances. November 2013 Page 8

9 Conclusion The Proposal leaves a number of important questions unanswered. For example, although a funding portal cannot pay a third party that is not a broker-dealer transaction-based compensation for referring issuers to the portal s platform, the Proposal does not address whether a portal can make a referral payment contingent upon the issuer referred to the portal actually offering securities through the portal. Similarly, the Proposal notes that an issuer must maintain records of accountholders. It does not address, however, whether transfer agents or clearing corporations, whether registered or not, could hold securities, in book entry form, after they have been issued. The Proposal also does not indicate whether, and how, a broker-dealer could hold securities issued in a crowdfunding transaction on behalf of a customer. To discuss these matters further, please contact any of the following Murphy & McGonigle lawyers: Matthew Comstock mcomstock@mmlawus.com Larry Bergmann lbergmann@mmlawus.com Andrew Beresin aberesin@mmlawus.com For more information about our firm or our regulatory practice, please visit our website at Murphy & McGonigle PC. Murphy &McGonigle is providing this communication solely for educational and informational purposes, and receipt of this publication does not create an attorney-client relationship. The distribution of this publication does not constitute an offer by Murphy & McGonigle or the attorneys listed above to provide legal advice or other service. This publication is not intended to and does not provide legal or other advice.to comply with IRS regulations, we advise you that any discussion of Federal tax issues in this publication was not intended or written to be used, and cannot be used by you, (i) to avoid any penalties imposed under the Internal Revenue Code or (ii) to promote, market or recommend to another party any transaction or matter addressed herein. November 2013 Page 9