Andrew Ledbetter

Like other capital formation bills we’ve discussed, the House of Representatives has overwhelmingly approved (by a vote of 407-17) the “Entrepreneur Access to Capital Act,” H.R. 2930.  Subject to certain limitations, H.R. 2930 would allow businesses to raise money selling unregistered securities using “crowdfunding.”

Crowdfunding generally involves raising funds from large numbers of people typically in small amounts, often using social networks.  Crowdfunding has been used successfully for charitable purposes, where participants donate funds, but the public nature of most crowdfunding solicitations limits the ability of businesses to raise investment funds using crowdfunding. 

The main provisions of the crowdfunding exemption set forth in H.R. 2930 include:

  • Aggregate Offering Cap – in any 12-month period, issuers could only use the exemption to raise $1 million, or $2 million if the issuer provides “potential investors” with audited financial statements. 
  • Per Investor Cap – the aggregate annual limit that may sold to “any investor” is the lesser of $10,000 or 10% of the investor’s annual income.  The issuer or intermediary may rely on certifications as to annual income provided by the person to whom the securities are sold to verify the investor’s income.
  • Investor protection measures – A variety of detailed protective measures are included.  The party tasked with ensuring compliance with such measures varies based on whether an intermediary is used or the issuer raises funds directly.  These measures include:
    • Warning investors of certain risks associated with the issuer and the investment.
    • Warning investors that resales are restricted, as described below.
    • Taking “reasonable measures to reduce the risk of fraud.”  
    • Providing certain information to the SEC.
    • Providing the SEC with “continuous investor-level access” to website information.
    • Requiring each “potential investor” to answer questions regarding various risks.
    • Requiring a “target offering amount” and a deadline for achieving it, and holding amounts raised with a third party custodian until at least 60% of the target amount is raised.
    • Providing the SEC and potential investors with a notice of offering, not later than the first day securities are offered to potential investors.
    • Outsourcing “cash-management functions” to a “qualified third party custodian,” such as a registered broker-dealer or an insured depository institution.
    • Maintaining books as records as the SEC determines appropriate.
    • Making available on the intermediary’s website a method of communications that permits the issuer and investors to communicate with one another.
    • Providing the SEC with a notice of completion of the offering.
    • Not offering investment advice.
    • If an issuer sells directly without an intermediary, requiring disclosure to potential investors, on the issuer’s website, that the issuer has an interest in the issuance.
    • If an intermediary is used, conducting background checks on the issuer’s principals.
  • Restricted Securities – an investor may not transfer the securities acquired for one year from the date of purchase, unless resold to the issuer or to an accredited investor.
  • Preemption of State Registration – States would be preempted from requiring registration of crowdfunding offerings, but states would retain their authority to bring enforcement actions with regard to persons using the exemption.
  • Information Available to States – the SEC must make available to the States the notices of sale, notices of completion, and contact information.
  • Intermediary not Broker – an intermediary used for this exemption would not be required to register as a broker under Section 15(a)(1) of the Securities Exchange Act of 1934.
  • Bad Actor Disqualifications – the SEC shall establish “bad actor” disqualification provisions for issuers and intermediaries based on disciplinary history.

In addition, investors who purchase securities under the crowdfunding exemption would not count toward the 500-shareholder threshold for SEC registration in Section 12(g) of the Securities Exchange Act of 1934, as amended.  We have previously discussed the attention this rule has received from the SEC, as well as in recent proposed bills.

SEC Rulemaking Would be Needed

The bill would require SEC rulemaking to carry out these provisions within 180 days.  This seems wise, since it is easy to imagine numerous topics that are critical to understanding how to safely use this exemption.  Here are just a few notable questions off of the top of my head:

  • How is annual income calculated?  Does it include income from spouses or other adult members living in the same house?  If a wife has chosen not to work and her husband makes $190,000 per year, is the wife unable to invest in her own name?  If a wife makes $60,000 a year and her husband makes $60,000 a year, may the wife invest only $6,000 or up to the $10,000 maximum in light of her household income?  Does it matter if her husband also invests? 
  • What audited financial statements are needed in offerings up to $2 million?  Just balance sheet and statement of operations, or also cash flows and changes in equity?  How many years must be covered?  May they be prepared in accordance with local GAAP or IFRS, without reconciliation to U.S. GAAP?  Are interim statements necessary in any circumstances?
  • Who is a “potential investor”?  This undefined term is used throughout the bill.  Does it refer to any person offered securities (sometimes referred to in the securities laws as an “offeree”), or perhaps to a prospect who has demonstrated more of a meaningful intent to invest?  Obviously, knowing when a person has become a “potential investor” is critical to understanding how to comply with the exemption, such as the obligation that “potential investors” complete an investor questionnaire.  Can you solicit potential investors without 100% of those who access the solicitation completing investor questionnaires?  In other words, is pre-screening of potential investors required?
  • What is an adequate “target offering amount”?  The bill’s inclusion of the concept seems to imply that a meaningful target must be established, as opposed to a target of $0.01, $10, or some other unreasonably low amount that is tantamount to having no target.  But how should the target be selected?  Must it bear a relationship to a particular business goal?  Can risk disclosure justify what might otherwise be regarded as a lower-end target amount?
  • What happens to funds being held by a qualified third party intermediary?  Who benefits from any interest or other time-value of the funds while they are on deposit?  Do investors get account statements, or notices that the target has been met?
  • How do the resale provisions work?  The bill only says that, subject to a few limited exceptions, investors “may not transfer” securities acquired under the crowdfunding exemption in the year after they are purchased.  The negative implication is that after one year the securities are freely re-saleable, but that is not what the bill expressly says.  Is there still a need for an exemption for the resale, such as Rule 144?  What if the securities were acquired by an insider and are thus “control” securities under other SEC interpretations? 
  • Can crowdfunding offerings be “integrated” with other offerings?  Will there be any safe harbors, such as those provided in Rule 502 of Regulation D?

What’s Next?

The concept of removing legal restrictions to permit businesses to accept small investments via crowdfunding seems simple.  However, as H.R. 2930’s surprising detail demonstrates, it can be difficult to set policy that balances the goals of capital formation and investor protection, particularly in the context of public solicitations of investors.  Indeed, H.R. 2930 has materially changed since its original form.  It remains to be seen whether the Senate will move quickly on this issue, with or without material changes.  But the overwhelming bipartisan support in the House of Representatives implies this idea may move quickly.  Interestingly, President Obama has also endorsed the concept of crowdfunding in his proposed American Jobs Act

We will keep you posted on this interesting topic.