The Securities and Exchange Commission (SEC) took a giant step in fulfilling its rulemaking obligation under the 2012 Jumpstart Our Business Startups (JOBS) Act last week when it released proposed Regulation Crowdfunding.  Although these rules are long overdue (Congress gave the SEC nine months to implement the Section 4(a)(6) exemption by January 2013), once they are adopted in final form, Regulation Crowdfunding will implement the newly created exemption from registration for offers and sales of securities in "crowdfunded" offerings under Section 4(a)(6) of the Securities Act of 1933.  Given the period the SEC has set for public comment, which is 90 days from the date the rules are published in the Federal Register, we do not expect the SEC to adopt final rules until 2014.  This update highlights key aspects of the proposed rules.

Summary of Proposed Regulation Crowdfunding

What is a Crowdfunded Offering? 

Perkins Coie's update on the JOBS Act from March 30, 2012 outlines the JOBS Act's requirements for a crowdfunded offering within the Section 4(a)(6) exemption: a securities offering facilitated by an intermediary (either a registered broker or a "funding portal" registered with the SEC) and conducted publicly over the Internet.  Issuers can only raise a limited amount of money in crowdfunded offerings — $1,000,000 every 12 months — and retail investors (the "crowd") may only purchase securities in limited amounts.

Proposed Regulation Crowdfunding Imposes Disclosure Obligations

The proposed Regulation Crowdfunding subjects crowdfunded companies to rules that are analogous to those applicable to public companies, albeit on a much less onerous scale.  Like public companies, crowdfunded companies will have to file a disclosure document with the SEC and make it available to the public.  Crowdfunded companies are also subject to annual reporting obligations.  A new Form C has been proposed that companies will use both for securities offerings and annual reporting.

The Crowdfunding Exemption 

The proposed rules clarify and provide details regarding the new exemption from registration.  Highlights include:

• No Integration With Other Offerings.  The proposed rules clarify that non‑crowdfunded offerings and sales will not count toward the $1,000,000 transaction limitation.  They further clarify that the public nature of the transactions will not preclude issuers from selling to investors with which it has a pre-existing relationship, in private offerings in reliance on exemptions that prohibit general solicitations.
• Available to Almost Any Business.  Subject to a number of disqualification provisions based on conduct, the proposed rules decline to add to the list of issuers who cannot use crowdfunding — the JOBS Act itself precludes use by foreign companies, public companies and investment companies.  The sole new proposed exception prohibits companies with no specific business plan, or with a business plan to merge with or acquire an unidentified company, from relying on this exemption.
• Additional Disclosure Requirements.  The proposed rules provide details regarding mandatory disclosure requirements, including new requirements relating to compensation to the intermediary, number of employees of the issuer, risk factors, debt, prior securities offerings and related-party transactions. 

Proposing Release Outlines Three Key Themes for Crowdfunded Offerings 

Three key premises emerge from the SEC's commentary on the proposed rules. 

1.  The Crowd's Capacity to Share Information and Evaluate Ideas Reduces the Risk Associated With Unregistered Securities Offerings.  The SEC recognizes that Congress contemplated as the "central tenet" of crowdfunding that the crowd, through its collective wisdom, has the capacity to sort out good investments from bad ones.  The SEC has tailored the proposed rules to make it easier for crowds to coalesce around individual offerings.  The following proposed rules highlight this policy:

• Crowdfunded Offerings May Only Be Conducted Over the Internet, Through a Single Intermediary.  An issuer offering securities under the crowdfunding exemption may only offer and sell its securities through one intermediary at a time.  All offers and sales of securities under the crowdfunding exemption must occur on that intermediary's online platform.  These rules will have a channeling effect of driving all potential investors in a security to the same place — the intermediary's platform — to ensure that there is no disparity of information among potential investors.
• Issuers and Investors May Only Communicate With Each Other Regarding the Offering Through Communication Channels on the Intermediary's Platform.  Though not explicitly required by the JOBS Act, the SEC's proposed rules require intermediaries to provide communication channels on the Internet-based platforms through which they effect securities offerings.  Requiring intermediaries to construct such channels — and requiring that all communications occur through them — will have the effect of centralizing the available information about the offering.  This centralization will enable the crowd to better evaluate potential investments.  Issuers are encouraged to participate in the discussion regarding the offering so long as agents of the issuer clearly identify their interest in the transaction.  In addition, although only those with accounts with the intermediary may post to the communication channels, the proposed rules require that intermediaries provide accounts to all who apply and make the content visible to the public.  This could have the effect of expanding the collective information available to the crowd by attracting new participants to it.
• Investors Can Cancel Participation up to 48 Hours Prior to the Closing.  In order to permit investors to take full advantage of the wisdom of the crowd, issuers are required to permit investors to cancel commitments until 48 hours in advance of the closing.  This permits an investor to monitor the discussion on the portal regarding the offering and change his or her investment decision based on late-breaking information.

2.  Regulations Should Be Tailored to Avoid Inhibiting Capital Formation Through Crowdfunding.  The SEC’s proposed rules seek to clarify the JOBS Act to eliminate obstacles to capital raising through crowdfunded offerings.  Recognizing that intermediaries and issuers in the new crowdfunding marketplace may be especially sensitive to the uncertainty of a new market, the SEC included proposed rules such as the following:

• Safe Harbor From Prohibition on Investment Advice.  The JOBS Act prohibits funding portals from giving investment advice.  To avoid confusion, the proposed rules clarify that portals would not contravene this prohibition just by limiting the types of issuers it permitted to conduct offerings on its platform, or by highlighting certain offerings or issuers, so long as it did so based on objective criteria.  Funding portals will also be permitted to advise issuers on the structure of their offerings, and engage in advertising, limited to certain types of content.
• Issuers Will Not Lose the Crowdfunding Exemption for "Insignificant" Deviations From Regulation Crowdfunding's Requirements.  The SEC has proposed providing protection for issuers whose offerings do not strictly comply with the requirements of Regulation Crowdfunding.  The offering will still be exempt from registration under Section 4(a)(6) if the issuer shows that:
• • • the noncompliance was insignificant;
    • the issuer did not know of any non-compliance by an intermediary; and
    • the issuer made a good faith and reasonable attempt to comply with the regulation's requirements.

This "exception" should make issuers less hesitant to conduct crowdfunded offerings due to the risk that all the detailed requirements for such an offering will not be satisfied.

• Issuers Will Not Be Disqualified for Conduct That Predates the Effective Date of Regulation Crowdfunding.  Issuers may rely on the crowdfunding exemption, even if disqualifying events (which are largely drawn from existing financial industry regulations) occurred prior to the effective date of Regulation Crowdfunding.  Although issuers must disclose such events in their offering materials, this carve out will make the crowdfunding market immediately available to more issuers.

3.  Although Crowdfunded Securities Are Exempt From Registration Under the Securities Act, Crowdfunding Will Be a Closely Regulated Part of the Securities Industry.  No market for crowdfunded offerings exists in the United States because such offerings have not been possible under the existing domestic regulatory scheme.  Anticipating that the crowdfunding exemption's implementation will give birth to a new industry of such offerings, the SEC included several rules to facilitate oversight:

• Issuers Successfully Selling Securities Under the Crowdfunding Exemption Will Incur Ongoing Reporting Requirements.  The SEC's proposed rules clarify that issuers who successfully sell securities, rather than only offering them as the text of the JOBS Act seems to require, in a crowdfunded offering must file annual reports with the SEC.  Such an issuer is required to file such reports as long as the securities remain outstanding and the company has not become a public company.  Although Congress did not specify in the JOBS Act the level of detail required in such reports, the SEC opted to require issuers to make extensive ongoing disclosures, like those they must make at the time of the offering, including audited financial statements for issuers who seek to raise more than $500,000 in the offering.
• Funding Portal Intermediaries Must Provide Detailed Disclosures in SEC Filings and Register With FINRA.  The JOBS Act mandated that intermediaries register with the SEC whether functioning as a broker or as a funding portal, but did not specify the form or content of that registration.  Because funding portals are a creature of the JOBS Act, the SEC included extensive requirements for the types of information funding portals must disclose in the regulation.  These disclosure requirements reflect the SEC's view that funding portals are actually "brokers" that Congress has exempted from the usual broker registration requirements.  Additionally, the SEC relied on its plenary rulemaking power to require funding portals to join the Financial Industry Regulatory Authority (FINRA), or another national securities association (although none currently exists) and to obtain a fidelity bond with a minimum coverage amount of $100,000.
• Intermediaries Must Provide and Verify Investor Education.  The proposed rules provide details regarding the JOBS Act's requirement that portals educate investors regarding crowdfunding.  While the proposed rules do not provide any specific process for portals to verify the efficacy of their investor education, they indicate that merely requiring investors to acknowledge the education materials is insufficient.  Instead, intermediaries will need to implement a process, such as a multiple choice or true/false test, to verify that investors understand the materials before making an investment commitment.
• Regulation Crowdfunding Connects With Existing Regulatory Schemes Where Possible.  Both Congress and the SEC appear to recognize that although the crowdfunding exemption will create a new securities marketplace in the United States, the regulatory landscape for that market need not be created out of whole cloth.  Many concepts that appear in Regulation Crowdfunding are imported from existing financial industry regulatory schemes.  Additionally, the SEC's release clarifies where, in its view, existing regulations would apply to participants in crowdfunded offerings.  Specifically, funding portals will be subject to money laundering, and to a certain extent, privacy regulations like registered brokers, or those who are required to be registered as brokers, and will have to comply with all requirements of the Bank Secrecy Act.
• Funding Portals Must Implement Written Policies for Complying With Regulation Crowdfunding's Rules.  Although Congress did not require it, the SEC requires funding portals to document their policies for ensuring compliance with the agency's rules.  Although this requirement will present another hurdle to the establishment of intermediaries, who are essential to the functioning of the new crowdfunding marketplace, it is understandable given the SEC's lack of experience regulating the funding portal industry.
• Funding Portals Must Keep Detailed Records of Investors, Issuers and Hosted Offerings and Sales.  The SEC relied on its plenary authority to require each funding portal to maintain records related to offerings it has hosted on its platform for five years.  As a result, funding portals will be required to document information related to issuers, investors, offerings, communications and daily, monthly and quarterly logs of transactions effected through its platform.  The SEC's express purpose for requiring portals to maintain this information is to create an audit trail that will facilitate oversight of this new industry.  Consequently, these records will be subject to review by the SEC or FINRA at any time. 

Additional Information

This client update provides a summary of key provisions in Regulation Crowdfunding.  When the SEC releases final rules, we plan to provide further updates discussing Regulation Crowdfunding in greater detail.  You can read the full text of the SEC's release here.  You can find more information about the JOBS Act and discussions of other recent cases, laws, regulations and rule proposals of interest to emerging companies on our website.

© 2013 Perkins Coie LLP