Start-up companies and investors eagerly await SEC final rules implementing the JOBS Act’s crowdfunding provisions. The SEC, however, must ensure investors are adequately protected. Achieving this goal will help validate crowdfunding as a viable investment and capital raising tool.
The Jumpstart Our Business Startups Act (“JOBS Act”, or “the Act”), enacted on April 5, 2012, made significant changes to the ways small companies can raise capital. Title III of the JOBS Act provides for an exemption from regular securities registration in specific circumstance, referred to as crowdfunding. The passage of these provisions has created a great deal of excitement for potential funding for new start-up companies. But the new regulatory exemption doesn’t become effective until the Securities and Exchange Commission issues final rules implementing Title III. Although the Act directed the SEC to issue the rules not later than 270 days after enactment, because of the complexity of the provision and the need to ensure investor protection, proposed rules weren’t issued until October 23, 2013. A comment period closed on February 3, 2014. Although eagerly awaited, there is no set timetable for when the SEC might issue final rules.
The concept of crowdfunding is explained in the introduction to the SEC’s proposed rules: Crowdfunding is a new and evolving method to raise money using the Internet. Crowdfunding serves as an alternative source of capital to support a wide range of ideas and ventures. An entity or individual raising funds through crowdfunding typically seeks small individual contributions from a large number of people. A crowdfunding campaign generally has a specified target amount for funds to be raised, or goal, and an identified use of the funds. (SEC Release Nos. 33-9470; 34-70742; File No. S7-09-13)
The JOBS Act included rules and restrictions on the use of the crowdfunding regulatory exemption, directed at the issuers, investors, and intermediaries connecting issuers with investors, and the issuers.
The more notable of these rules include:
• An issuer cannot issue more than $1 million in any 12-month period and must comply with specific rules.
• Companies issuing securities under the crowdfunding provisions must provide specified information to the SEC and meet other specified rules, must be organized within the U.S. and cannot be existing reporting filers with the SEC. Required disclosures would range from tax returns and financial statements certified by the principal executive officer for issuers offering 100,000 or less, to audited financial statements for issuers offering more than $500,000 in a 12-month period.
• Limitations are placed on the amount an investor can purchase from an issuer in any one-year period. Under the original JOBS Act the limits ranged from $2,000 for the smallest of investors to $100,000 for investor’s with annual income or net worth equal to or greater than $100,000.
• An investor cannot transfer acquired securities for one year except in limited circumstances.
• Transactions must be conducted through qualifying brokers or funding portals that follow specific requirements.
The original crowdfunding provisions in the JOBS Act took up about nine pages. Included was a direction to the SEC to issue “such rules as the Commission determines may be necessary or appropriate for the protection of investors.” As an indicator how serious the SEC is taking this charge, the October 2013 proposed rules to implement those provisions total almost 600 pages. The SEC made some interpretations and adjustments to the original JOBS Act provisions, while asking for general comments, and answers to about 300 questions. The full text of the proposed rules is available here.
Approximately 300 comment letters have been posted to the SEC’s website. The response that has received the most attention, however, is a recommendation from the SEC’s Investor Advisory Committee (the “IAC”.)
The Investor Advisory Committee was created by Dodd-Frank to “advise and consult with the Commission” on issues such as “initiatives to protect investor interest; and … promote investor confidence and the integrity of the securities marketplace.” The IAC issued its recommendation on the crowdfunding proposed rules on April 10, 2014, and can be viewed here. The document notes many of the risks of investing in early-stage start-up companies, and then provides six recommendations to the SEC.
1. Tighter restrictions on amounts investors can invest.
2. Strengthening of enforcement of the investor investment restrictions.
3. Stronger requirements on intermediaries with regards to ensuring issuer compliance.
4. Increased SEC oversight of educational materials provided by intermediaries to investors, done in conjunction with other regulatory bodies.
5. Changes to proposed electronic delivery requirements for investor materials.
6. Application of integration doctrine, requiring applicability of regulatory exemption for crowdfunding offerings be considered in light of other offerings by the issuer.
Consideration by the SEC of the IAC’s recommendations, along with the other comments received, are likely to take some time. As the SEC noted in April 2012, the exemption is not available until final rules are issued.
Various parties have expressed concern that the SEC’s proposed rules are too cumbersome and will result in high issuance costs for issuers. But the SEC’s mission, as stated on its website, “is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.” The SEC’s Investor Advisory Committee’s recommendations highlight the significant risks from crowdfunding. Therefore, the SEC cannot be rushed or pushed into issuing “easy” rules. Investors don’t need to be entirely protected from risk – risk is an important component of an investor’s return. But the SEC needs to ensure that investors aren’t blinded by the potential for large returns.
Investors need to fully understand the risks of a potential investment, and how these investments impact the volatility and realizability of their entire investment portfolio. Protecting the small investor from unscrupulous ventures can validate crowdfunding as a viable investment and capital-raising tool, but with transparent and understandable risks.