EQUITY CROWDFUNDING HAS FINALLY ARRIVED – SEC ADOPTS FINAL RULES ON CROWDFUNDING

On October 30, 2015, the Securities and Exchange Commission (“SEC”), in a 3-1 vote of the SEC Commissioners, approved final rules to adopt Regulation Crowdfunding, which sets forth the framework by which companies can “equity crowdfund” – sell small amounts of securities (typically for a small purchase price) to a large number of investors over the Internet. The final rules, which will become effective 180 days after they are published in the Federal Register, follow the SEC’s adoption of proposed rules in October 2013 (which we previously blogged about). The SEC’s proposed rules were widely criticized as unworkable and elicited more than 480 comment letters that raised a host of concerns regarding, among other things, the effectiveness of the proposed rules in promoting capital formation and protecting investors.

Issuers and investors, particularly in the startup community, have been abuzz about equity crowdfunding since the Jumpstart Our Business Startups Act (“JOBS Act”) was enacted in April 2012.  Title III of the JOBS Act added Section 4(a)(6) to the Securities Act of 1933 (the “Securities Act”) to provide an exemption for equity crowdfunding transactions from the registration requirements of the Securities Act.  After seeing the success of non-equity crowdfunding – the Kickstarter fundraising campaigns of Pebble (~$20M raised) and Pono (~$6M raised) come to mind – it is understandable why issuers and investors have placed so much hope in the promise of equity crowdfunding.  With the SEC’s final rules in place, equity crowdfunding, with its numerous limitations and requirements, will shortly become a reality.

Under the final rules, an issuer may raise up to $1 million in a 12-month period in a crowdfunding offering conducted via a single intermediary – either a broker-dealer or a funding portal registered with the SEC.  An issuer engaging in a crowdfunding offering must complete and file with the SEC a newly-created Form C (similar to the Form 1-A offering statement under Regulation A, but with fewer required disclosures), which will require the disclosure of certain business and financial information including  financial statements of the issuer. Depending on the amount sought in the crowdfunding offering and whether an issuer has previously conducted a crowdfunding offering, the final rules will require that an issuer provide audited or reviewed financial statements.  For example, an offering of more than $500,000 of securities will require reviewed financial statements unless the issuer is not a first time issuer, in which case audited financial statements will be required.

The final rules also limit the amount of funds that an individual investor may invest in all crowdfunding offerings over a 12-month period, based on an investor’s annual income and net worth. Interestingly, despite criticism on the workability of the investment limitations set forth in the proposed rules, the final rules have more stringent limitations than those included in the proposed rules.  An investor with either annual income or net worth less than $100,000 can invest up to 5 percent of the lesser of annual income or net worth, or $2,000, whichever is greater, every 12 months. An investor with both annual income and net worth greater than $100,000 can invest up to 10 percent of the lesser of annual income or net worth every 12 months, subject to a cap of $100,000 in a 12-month period.   One effect of the limits will be that crowdfunding issuers may end up with numerous investors providing small investments – for example, an issuer raising $1 million would have 500 shareholders if the $2,000 limitation applied to those investors.

Only time will tell whether the regulatory environment created by the final rules will allow equity crowdfunding to reach the heights envisioned by many proponents. Among other reasons, the costs and compliance burden for issuers and the potential returns to investors are difficult to forecast at this time.  Regardless, many issuers, especially startups, now have an additional tool to raise capital in the United States. A more detailed summary of the final rules is provided below.

Sales Limitations

The following sales limitations apply to a crowdfunding offering:

  • An eligible issuer (see below for a description of ineligible issuers) is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period. In addition, entities controlled by, or under common control, with the issuer are aggregated for purposes of determining compliance with the offering ceiling.
  • Individual investors, over the course of a 12-month period, are permitted to invest in the aggregate across all crowdfunding offerings up to:
    • If either their annual income or net worth is less than $100,000, then the greater of: (1) $2,000, or (2) 5% of the lesser of their annual income or net worth.
    • If both their annual income and net worth are equal to or more than $100,000, then 10% of the lesser of their annual income or net worth, subject to a cap of $100,000 in a 12-month period.
  • The JOBS Act requires that the SEC adjust the issuer sales limitation and investor investment limitations not less than every five years to account for changes in the CPI.

Ineligible Issuers

The following issuers are not eligible to utilize a crowdfunding offering:

  • Non-U.S. companies.
  • Reporting companies under the Securities Exchange Act of 1934 (the “Exchange Act”).
  • Certain investment companies.
  • Companies that are disqualified under Regulation Crowdfunding’s disqualification rules (i.e., bad actors).
  • Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement (i.e., Form C).
  • Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Disclosure Requirements

An issuer conducting a crowdfunding offering is required to file certain information with the SEC on new Form C and to provide this information to investors and the applicable crowdfunding portal facilitating the offering. Among other things, in its offering documents, the issuer is required to disclose:

  • Information about officers and directors as well as owners of 20 percent or more of the issuer;
  • A description of the issuer’s business and the use of proceeds from the offering;
  • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the issuer will accept investments in excess of the target offering amount;
  • Certain related-party transactions;
  • A discussion of the issuer’s financial condition; and
  • Financial statements of the issuer that are, depending on the amount offered and sold during a 12-month period:
  • If $100,000 or less, based on information from the issuer’s tax returns and certified by the principal executive officer,
  • If more than $100,000 and but not more than $500,00, reviewed by an independent public accountant, and
  • If more than $500,000, audited by an independent auditor, except that an issuer engaging in a crowdfunding offering for the first time would be permitted to provide reviewed rather than audited financial statements.
  • In any case, if audited financial statements of the issuer are available, then they must be provided.

Issuers are required to amend the offering document during the offering period to reflect material changes and provide updates on the issuer’s progress toward reaching the target offering amount.

In addition, issuers relying on the Regulation Crowdfunding exemption are required to file an annual report with the SEC and provide it to investors.  The reporting requirements will continue until:

  • the issuer is required to file reports under the Exchange Act;
  • the issuer has filed at least one annual report and has fewer than 300 holders of record;
  • the issuer has filed at least three annual reports and has total assets that do not exceed $10 million;
  • the issuer or another party purchases or repurchases all of the securities issued pursuant to the crowdfunding exemption), including any payment in full of debt securities or any complete redemption of redeemable securities; or
  • the issuer liquidates or dissolves in accordance with state law.

Crowdfunding Platforms

Each crowdfunding offering must be conducted exclusively through a single platform operated by an “intermediary” which is either a registered broker or a funding portal – a new type of SEC registrant. The rules require that such an intermediary:

  • Provide investors with educational materials;
  • Take measures to reduce the risk of fraud;
  • Make available information about the issuer and the offering;
  • Provide communication channels to permit discussions about offerings on the platform; and
  • Facilitate the offer and sale of crowdfunded securities.

The rules also prohibit a crowdfunding portal from:

  • Offering investment advice or making recommendations;
  • Soliciting purchases, sales or offers to buy securities offered or displayed on its platform;
  • Compensating promoters and others for solicitations or based on the sale of securities; and
  • Holding, possessing, or handling investor funds or securities.

The final rules provide a safe harbor under which crowdfunding portals can engage in certain activities, consistent with these restrictions.

Miscellaneous Restrictions

Securities acquired in a crowdfunding offering are generally subject to a one year holding period before they can be resold, subject to certain exceptions. Holders of securities acquired in a crowdfunding offering do not count toward the threshold that requires an issuer to register its securities with the SEC under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligation, retains the services of a registered transfer agent and has less than $25 million in assets.

The SEC Approved PCAOB Rules on Communications with Audit Committees

On December 17, 2012, the SEC approved PCAOB proposed rules on Auditing Standard No. 16, Communications with Audit Committees.  Auditing Standard No. 16 supersedes PCAOB’s interim standards AU section 380, Communication with Audit Committees, and AU section 310, Appointment of the Independent Auditor.  Auditing Standard No. 16 is effective for audits of financial statements for fiscal years beginning on or after December 15, 2012 and applies to the audits of all issuers, including emerging growth companies established under the JOBS Act and foreign private issuers.

It is interesting to note that, among other matters, Auditing Standard No. 16 expands the inquiries of the audit committee required by Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, which requires the auditor to inquire of the audit committee regarding its knowledge of the risks of material misstatements, including fraud risks.  The inquiry required by Auditing Standard No. 16 goes beyond material misstatements and fraud risks and provides that the auditor “should inquire of the audit committee about whether it is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations.” 

 In light of this inquiry, audit committees will need to discuss procedures for evaluating violations, including possible violations, of laws and regulations, especially considering the fact that this requirement does not include any materiality threshold.

SUBMISSIONS OF DRAFT REGISTRATION STATEMENTS TO THE SEC VIA EDGAR REQUIRED BEGINNING OCTOBER 15TH

We previously blogged about the Securities and Exchange Commission’s announcement that starting October 1, 2012, certain emerging growth companies and foreign private issuers would be able to voluntarily submit to the SEC draft registration statements for non-public and confidential review via a modified EDGAR system instead of via the current secure e-mail submission process.  Filing such draft registration statements via EDGAR will become mandatory when the new EDGAR Filer Manual becomes effective next Monday, October 15, 2012. Therefore, beginning October 15, 2012, draft registration statements and amendments as well as related correspondence must be submitted or filed via the EDGAR system.

Financial Reporting Manual Has Been Updated

Yesterday, the SEC posted its updated Financial Reporting Manual, which was revised as of June 30, 2012 (search for the date tag, “Last updated: 6/30/2012,” to view the changes).   The SEC added a note regarding Title I of the Jumpstart Our Business Startups Act (JOBS Act) to the manual, but the note did not add any new guidance regarding the financial reporting and other requirements for emerging growth companies and just referred to the existing SEC guidance regarding the JOBS Act at http://www.sec.gov/divisions/corpfin/cfjobsact.shtml.

The remaining revisions to the Financial Reporting Manual clarify the following matters:

  • proxy statement requirements for the disposal of a business;
  • auditor association with amounts from inception in development stage companies;
  • application of PCAOB auditor requirements in connection with  a reverse merger; and
  • reporting requirements in a reverse acquisition with a domestic registrant that is not a shell company.

SUBMISSIONS OF DRAFT REGISTRATION STATEMENTS TO THE SEC VIA EDGAR TO GO LIVE ON OCTOBER 1

On September 26, 2012, the Securities and Exchange Commission announced that starting October 1, 2012, certain emerging growth companies and foreign private issuers would be able to submit to the SEC draft registration statements for non-public and confidential review via a modified EDGAR system instead of via the current secure e-mail submission process.  Once the EDGAR Filer Manual for EDGAR Release 12.2 becomes effective, eligible issuers desiring to take advantage of the confidential review process will be required to use the new EDGAR system. 

To assist issuers with the use of the new confidential filing procedures, the SEC posted a set of detailed instructions on how to prepare an electronic submission of a draft registration statement, or an amendment.  In addition, issuers that file via the new EDGAR system will no longer need to file copies of previously submitted draft registration statements as exhibits to their publicly-filed registration statements to comply with the JOBS Act’s mandate that the drafts become publicly available at least 21 days prior to the start of the road show.  The new EDGAR system will allow issuers to direct the EDGAR system to publicly file the drafts as individual documents on EDGAR.

The new EDGAR system is part of the SEC’s efforts to meet the requirements of Section 106(a) of the JOBS Act mandating that certain pre-IPO emerging growth companies be provided an opportunity to submit draft registration statements to the SEC for confidential review.  In addition, the new EDGAR system will support the SEC’s policies and procedures allowing certain foreign private issuers that are not emerging growth companies to submit registration statements to the SEC for non-public review.

New PCAOB Standard for Communications with Audit Committees

On August 15, 2012, the Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 16, Communications with Audit Committees.  This standard sets forth matters that the auditor should discuss with audit committees prior to the issuance of the auditor’s report.  Standard No. 16 supersedes PCAOB’s interim standards AU sec. 380, Communication with Audit Committees, and AU sec. 310, Appointment of the Independent Auditor.  The PCAOB expects Standard No. 16, which is subject to the SEC approval, to be effective for audits of fiscal years beginning on or after December 15, 2012.  In addition, the PCAOB will request, subject to the SEC’s separate determination, that this standard apply to the audits of emerging growth companies established under the JOBS Act.

Standard No. 16 enhances certain existing auditor communication requirements and adds new communication requirements that provide the audit committee with additional information about the audit, including the following:

  • an overview of the overall audit strategy, including timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or identified risks;
  • information about the nature and extent of specialized skill or knowledge needed in the audit, the extent of the planned use of internal auditors, company personnel or other third parties, and other independent public accounting firms, or other persons not employed by the auditor that are involved in the audit;
  • the basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors;
  • situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting;
  • difficult or contentious matters for which the auditor consulted outside the engagement team;
  • the auditor’s evaluation of going concern;
  • departure from the auditor’s standard report; and
  • other matters arising from the audit that are significant to the oversight of the company’s financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor’s attention during the audit.

SEC Updates Procedures for Non-Public Submission of Registration Statements by Foreign Private Issuers

On May 30th, the SEC updated its procedures for foreign private issuers wishing to make non-public submission to the SEC of draft registration statements for review by the SEC.  Prior to the enactment of the JOBS Act, domestic issuers filing initial registration statements with the SEC were required to file publicly through the EDGAR system.  Under certain limited circumstances, however, foreign private issuers had the option of submitting to the SEC registration statements and amendments on a non-public basis for SEC review in connection with their first-time registration of securities with the SEC.   

Pursuant to Section 106(a) of the JOBS Act, any emerging growth company (EGC), in connection with its initial public offering, may submit to the SEC a draft registration statement for confidential, non-public review.  Section 106(a) of the JOBS Act also requires that the EGC file publicly the initial confidential submission and all amendments at least 21 days prior to the date the company starts its road show.  In addition, SEC policy requires EGCs to submit on EDGAR all company responses to SEC comment letters on confidential draft registration statements at the time the EGC first files its registration statement publicly on EDGAR.  The SEC will then publicly release its comment letters and company responses no earlier than 20 business days following the effective date of the registration statement, which is the same time frame the SEC uses for non-confidential filings.

Pursuant to the updated procedures, the process for non-public submission of initial registration statements by foreign private issuers that are not EGCs now tracks the process applicable to EGCs.  When a foreign private issuer utilizing the SEC’s non-public submission policy first publicly files its registration statement, it is also required to file publicly all previously submitted draft registration statements and to resubmit all previously submitted responses to SEC comment letters.  Thereafter, the SEC will publicly release its comment letters and company responses in accordance with its policy described above.  A foreign private issuer that both qualifies as an EGC and meets the SEC’s requirements for non-public submission of registration statements by foreign private issuers can elect to submit its initial draft registration statement confidentially to the SEC as an EGC or non-publicly as a foreign private issuer.  The new filing and submission requirements set forth in the SEC’s May 30th update apply to foreign private issuers seeking non-public review (as opposed to confidential review as an EGC) only where the initial draft registration statement was submitted after May 30, 2012.

JOBS Act – What People Are Talking About

The JOBS Act continues to be a hot topic.  Yesterday, the Practicing Law Institute presented its continuing legal education seminar on the JOBS Act.  Some discussion highlights from the seminar include:

  • Under Section 105(c) of the JOBS Act, an issuer that qualifies as an emerging growth company can engage in oral or written communications, prior to or after filing the registration statement with the SEC, with qualified institutional buyers and institutional accredited investors to determine whether they might have an interest in a contemplated securities offering, also known as “testing the waters.”   The panel discussed the SEC’s recent requests, in connection with reviews of issuers’ registration statements, that the issuers provided on a supplemental basis any written materials used by issuers in connection with such testing the waters.  It appears that the SEC is requesting these materials to determine if the materials are consistent with the issuer’s registration statement.  The fact that the SEC is requesting copies of such materials, combined with the general reluctance on the part of issuers and investment bankers to engage in testing the waters process due to liability concerns, probably means that most issuers and investment bankers will not be using written materials to test the waters, at least in the near term. 
  • The SEC is asking emerging growth companies to indicate on the cover of their registration statements that they are an emerging growth company and to include in the registration statement disclosure regarding how and when emerging growth company status may be lost, the various exemptions available to the issuer as an emerging growth company, such as exemptions from Section 404(b) of the Sarbanes-Oxley Act, and the issuer’s election under Section 107(b) of the JOBS Act.  Unless an issuer that is an emerging growth company opts out, under Section 107(b) of the JOBS Act, the issuer will be subject to any new or revised financial accounting standards on the effective dates applicable to private companies, rather than the effective dates applicable to public companies.  Historically, the effective dates for private companies have been later than the effective dates for public companies.  If the emerging growth company elects to opt out of the extended transition period, the SEC requests the issuer to state that such election is irrevocable.  If the emerging growth company chooses to be subject to the later effective dates for new or revised financial accounting standards, the SEC is requesting issuers to include a risk factor (as well as disclosure in the critical accounting policies section of the MD&A) explaining that the issuer’s financial statements may not be comparable to companies that comply with the public company effective dates.  There are at least a few SEC comments letters publicly available requesting this information.
  • Under the JOBS Act, once SEC rules are in place, general solicitation or advertising will be permitted in connection with Rule 506 offerings so long as the issuer sells securities only to accredited investors.  Interestingly, the definition of the term “accredited investor” provides that an accredited investor is not only someone that is actually an accredited investor, but also someone the issuer “reasonably believes” is an accredited investor.  The general consensus was that the SEC will likely not seek to change the definition of “accredited investor,” but will seek to provide for fairly stringent steps issuers will have to take in order to satisfy the JOBS Act requirement that an issuer take “reasonable steps to verify” accredited investor status in connection with Rule 506 offerings that use general solicitation or advertising.   
 

SEC Issues Additional FAQs on JOBS Act

The SEC today issued additional Jumpstart Our Business Startups Act (JOBS Act) frequently asked questions (FAQs 18-41).  These FAQs address questions relating to emerging growth company status,  treatment of comment letters on confidential submissions of draft registration statements and issuer responses to such comment letters, financial accounting standards and restatement of financial statements, foreign private issuers’ compliance with the JOBS Act, and disclosures required in registration statements and periodic reports filed by emerging growth companies.  The new FAQs represent helpful additional guidance for emerging growth companies considering whether to take advantage of “IPO on Ramp” provisions of the JOBS Act.