On March 22, 2012, the Senate passed the Jumpstart Our Business Startups (JOBS) Act by a vote of 73-26. The House of Representatives passed the JOBS Act on March 8, 2012 by a vote of 390-23. The Senate bypassed its typical committee process to rush the bill to a floor vote. Legislators in both parties and the President have adopted the JOBS Act as an election-year demonstration of their commitment to small businesses and entrepreneurialism, and they have paid little heed to strongly-worded opposition from SEC Chairman Mary Schapiro, state regulators and organizations ranging from the Council for Institutional Investors to the AARP.
The approved Senate bill contains an amendment authored by Sen. Jeff Merkley (D-OR) which replaces the “crowd-funding” exemption contained in Title III of the House version. Senate Democrats were unsuccessful in attempts to amend other provisions of the JOBS Act.
As we blogged following the House’s passage of the JOBS Act, this bill represents a watershed change to the laws and regulations governing capital raising for private companies, in addition to creating a scaled regulatory compliance pathway, referred to as an “IPO on-ramp,” for companies going public and newly public companies. Please see our prior blog for a more complete description of the JOBS Act, including many provisions not discussed in this post.
What does the Senate bill say about crowdfunding?
The Senate version of the JOBS Act replaces most of Title III of the House version of the bill. Title III establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act. The Senate version of the crowdfunding exemption has the following parameters:
- The aggregate proceeds from all investments in the issuer, including amounts sold under the crowdfunding exemption during the preceding 12 months, must be less than $1,000,000.
- The aggregate amount invested by any investor in all issuers pursuant to the crowdfunding exemption must not exceed a limit determined on a sliding scale based on net worth or annual income. The limit is 5% of net worth or annual income that is less than $100,000 (or $2,000, if greater than the 5% calculation), and 10% of net worth or annual income that is $100,000 or more. No investor may invest more than $100,000 in an issuer pursuant to the crowdfunding exemption. Income and net worth are to be calculated in the same fashion as the tests for accredited investors. Accordingly, equity in a principal residence will be excluded from net worth.
- The transaction must be conducted through an intermediary that is either a registered broker-dealer or “funding portal.”
- Funding portals will not be required to register as broker-dealers, but will be subject to SEC registration and must be members of a national securities association, such as FINRA.
- The intermediary must provide disclosures, including disclosures related to risks and other investor education materials, as determined by SEC rules.
- The intermediary must ensure that investors review investor-education information (as determined by SEC rules).
- The intermediary must ensure that investors answer questions demonstrating that they understand the risks of investing in startups, including the risk of loss of the entire investment, and that each investor can afford such loss.
- The intermediary must provide the disclosures to the SEC and to investors at least 21 days prior to accepting any investments.
- The intermediary must take fraud-prevention measures to be determined by SEC rules, including background checks of officers, directors and 20% holders.
- The intermediary must ensure that proceeds are not released to issuers until a set target amount is reached and must allow investors to withdraw their commitment in accordance with SEC rules.
- The intermediary must take steps to be determined by SEC rules to ensure that each investor has not exceeded its crowdfunding limit in a 12-month period, which as noted above applies to all investments in all issuers under the crowdfunding exemption.
- The intermediary must take steps to ensure the privacy of information collected from investors in accordance with SEC rules.
- Intermediaries cannot pay finders fees.
- Directors, officers and partners of the intermediary may not have a financial interest in the issuer.
- The issuer must make the following mandatory disclosures to the SEC, the intermediary and investors:
- identifying information about the issuer, including its website
- the names of officers, directors and 20% shareholders
- a description of the business and the anticipated business plan
- a description of the financial condition of the issuer, with scaled requirements depending on the target amount of the offering.
- For offerings of $100,000 or less, the income tax return for the last completed year and financial statements certified by the principal executive officer to be true and correct
- For offerings of $100,000 to $499,999, financial statements reviewed by an independent public accountant
- For offerings over $500,000, financial statements audited by an independent public accountant
- the intended use of proceeds
- the target offering amount, the deadline to meet the target offering amount, and regular updates regarding the progress of the issuer toward the target
- the price or the method of determining the price, and if the price is not fixed, a reasonable opportunity for the investor to rescind its commitment once the price is determined
- detailed information about the capital structure of the issuer, the securities being offered and the risks associated with those securities
- how the securities being offered are being valued, and how they might be valued in the future in connection with a corporate transaction
- Issuers may not advertise the terms of the offering except for notices which direct investors to the intermediary.
- Issuers may not compensate finders except in accordance with SEC rules that will ensure the recipient clearly discloses such compensation.
- Issuers must file annual reports of results of operations and financial statements with the SEC and provide to investors, in accordance with SEC rules.
- No resales are permitted for one year except to the issuer, an accredited investor, a member of the investor’s family or pursuant to a registered offering.
- The exemption is available only for U.S. issuers that are not investment companies and are not subject to periodic reporting under the Exchange Act.
- The issuer and its directors, partners, principal executive officer, principal financial officers and controller/principal accounting officer will be liable to investors for any material omissions or misstatements unless they can sustain the burden of proof that they did not know, and in the exercise of reasonable care, could not have known, of such untruth or omission.
It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.
Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.
Within 270 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.
How is the Senate version different from the House version?
Key differences from the House version of the JOBS Act are:
- The House bill’s general limit is also $1,000,000, but the House bill’s limit increases to $2,000,000 if audited financial statements are provided.
- The House bill dollar limits apply to the amount of securities sold under the crowdfunding exemption. The Senate bill’s limit is based on all funds raised by an issuer in the prior 12 months. Accordingly, under the Senate bill, the amount an issuer could raise under the crowdfunding exemption would be reduced by the amount of all investments taken in during the prior 12 months.
- The House bill limits the investment of any one person in a crowdfunding offering by a single issuer to the lesser of $10,000 or 10% of annual income. The Senate bill’s limits, described above, apply to all crowdfunding investments by a person in all issuers during a 12-month period.
- The House bill does not require issuers to make financial disclosures in connection with the offering. The Senate bill requires detailed disclosures, including financial statements and for larger offerings, assurance from an accounting firm.
- The House bill does not contain explicit provisions creating liability for issuers or control persons, though such persons would be subject to liability under other provisions of the securities laws.
- The House bill does not require the use of intermediaries, and if intermediaries are used, they are exempt from oversight based solely on their crowdfunding activities. The Senate bill requires intermediaries and provides for a new oversight regime for those that are not broker-dealers.
- The House bill allows offerings to close when 60% of the target is met, and does not provide for any other waiting periods. The Senate bill requires 100% of the target to be met, allows investors to withdraw their commitment and requires a minimum of 21 days to elapse following the delivery of required disclosure.
- The House bill does not restrict paid promotion of investment opportunities. The Senate bill prohibits finder’s fees paid by intermediaries, and requires SEC rulemaking on finder’s fees paid by issuers, including disclosure of payments.
- The House bill has no requirement for ongoing financial reporting after the offering. The Senate bill requires annual financial reports and statements following the offering.
- The House bill exemption is available for any issuer. The Senate bill exemption is not available for foreign issuers, SEC-reporting companies or investment companies.
- The House bill requires intermediaries or issuers to facilitate communications among investors. The Senate bill contains no such requirement.
How is the Senate version different from Regulation D, Rule 504?
The Senate version of the crowdfunding exemption is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not preempted from state regulation.
The Senate’s version of the crowdfunding exemption appears more restrictive than Rule 504 in every respect except:
- the $1,000,000 limit in the Senate’s crowdfunding exemption may not be subject to integration with future offerings, whereas the Rule 504 limit is subject to integration with future offerings;
- Rule 504 offerings are subject to state regulation, so offerings need to be qualified or determined to be exempt in each state in which the offering will occur; and
- shareholders who purchase securities under Rule 504 are included in the count of record holders for mandatory Exchange Act registration.
In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the Senate’s version of the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.
Did the Senate tighten any other provisions of the JOBS Act?
No. In particular, the Senate did not change Title II, which permits general solicitation for Rule 506 offerings provided that all purchasers are accredited. Rule 506 may therefore serve as a type of “crowdfunding” exemption for accredited investors without any of the limitations in Title III related to the new Section 4(6) exemption for crowdfunding. The unlimited nature of the Rule 506 exemption may prove to be troublesome for investments targeted to seniors and other vulnerable persons who may meet the net worth test for accredited investors but not be suitable investors for early stage businesses.
As required to be amended or replaced by the Title IV of the JOBS Act, Regulation A will also be available as a type of crowdfunding exemption, and may prove to be more appealing to issuers and intermediaries and more satisfactory from an investor protection standpoint.
What will happen next?
The Senate version of the bill will go back to the House of Representatives for consideration. House Majority Leader Eric Cantor (R-VA) has said he plans to hold the final vote early in the week of March 26. President Obama has said he will sign the bill Congress approves.
What should I do now?
The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.
Regardless of the outcome of reconciliation of the House and Senate versions of the crowdfunding exemption, the changes that appear all but certain to be implemented by the JOBS Act will fundamentally alter the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the crowdfunding exemption or the new Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.
Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.
What if you have questions?
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.
John Tishler (858-720-8943, firstname.lastname@example.org), Louis Lehot (650-815-2640, email@example.com), Edwin Astudillo (858-720-7468, firstname.lastname@example.org), Jason Schendel (650-815-2621, email@example.com), Camille Formosa (650-815-2631, firstname.lastname@example.org) and Nina Karalis (858-720-7466, email@example.com) participated in drafting this posting.
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.