Imagine if you would a crisp autumn morning with horses lined up at the starting gate, excited and skittish. Hundreds of horses of all breeds, ages and conditions. No racing experience is required. In this event, the jockeys are blindfolded and the type of track, distance and conditions under which they will be racing has not been revealed to them. Although the event is almost guaranteed to be chockfull of fouls, the stewards are only informed of the rules immediately before the opening of the gates, or perhaps even after the race is underway.
Add to this absurdly farcical scenario the promise of immensely high winnings for the leaders, and you have entered into a new world that resembles the unfolding of crowdfunding investing.
With bipartisan support but severe criticism by the Securities and Exchange Commission (SEC), on April 5, 2012, President Barack Obama signed into law Title III of the JOBS Act, known as the Capital Raising Online While Deterring Fraud and Unethical Disclosure Act of 2012 (Crowdfund Act).1 The purpose of the Crowdfund Act is to amend Section 4 of the Securities Act of 19332 to exempt issuers from the requirements of Section 5 of that act when offering or selling securities in amounts up to $1,000,000. As originally contemplated, crowd-funding was created to permit entrepreneurs access to the broad marketplace of an Internet ‘crowd’ to fund their ventures with smaller, individual investments. The exempt status would reduce the costly compliance obligations that act as a barrier to smaller ‘Main Street’ businesses seeking to raise capital.
Crowdfunding sites on the Internet have been divided into five models, distinguished by what an issuer seeks to provide to its investors in return for their contributions: 1) the donation model; 2) the reward model, 3) the pre-purchase model; 4) the lending model; and 5) the equity model.3 Any single model, or amalgam thereof, reflects the target of the issuer’s appeal for investments.
The Crowdfund Act, as enacted, requires the use of an intermediary that is either a broker registered with the SEC or a “funding portal” registered with the SEC,4 which is also registered “with any applicable self-regulatory organization.”5 A funding portal is defined as “any person acting as an intermediary in a transaction involving the offer and sale of securities for the account of another…that does not: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (iv) hold, manage, possess, or otherwise handle investor funds or securities; or (v) engage in such other activities as the SEC, by rule, determines appropriate.”6
At the time of the enactment of the Crowdfund Act, Congress provided the SEC with 270 days (until Dec. 31, 2012) to develop rules “necessary and appropriate for the protection of investors.”7 Due to the enormity of the task and a vacant director position caused by the resignation of Mary Shapiro, the SEC was unable to meet the Crowdfund Act’s deadline. Even with the appointment of Mary Jo White as the new director, many now speculate the agency, which was steadfastly opposed to enactment of the law, may now need until the end of 2013 to develop regulations. Others question whether the regulations will ever be completed.
As a foundation for investor protection, the Crowd-fund Act contains provisions requiring an issuer to disclose certain minimum information. The amount of information to be disclosed is determined by the amount of capital sought to be raised. However, regardless of the amount to be raised, the issuer is required to provide: 1) the name, legal status, physical address, and website address of the issuer; 2) the names of the directors and officers (and any persons occupying a similar status or performing a similar function), and each person holding more than 20 percent of the shares of the issuer; 3) a description of the business of the issuer and the anticipated business plan of the issuer; 4) a description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount; 5) the target offering amount, the deadline to reach the target offering amount, and regular updates regarding the progress of the issuer in meeting the target offering amount; 6) the price to the public of the securities or the method for determining the price, provided that, prior to sale, each investor shall be provided in writing the final price and all required disclosures, with a reasonable opportunity to rescind the commitment to purchase the securities; and 7) a description of the ownership and capital structure of the issuer.8
In addition to this base information, the issuer is also required to provide certain financial disclosures. For capital raise amounts of $100,000 or less, the issuer must release its income tax returns for the most recently completed year, along with financial statements certified by a principal executive officer. For raise amounts of between $100,000 and $500,000, the issuer is required to provide financial statements reviewed by an independent public accountant. For amounts sought in excess of $500,000, the issuer must produce audited financial statements.9
Eliminating the accredited investor requirement, the Crowdfund Act also limited the amount any person could invest in any single year. Individuals whose net worth or annual income is under $100,000 could invest the greater of $2,000 or five percent of their net worth. All others could invest up to 10 percent of their net worth or annual income.10
The Crowdfund Act also imposes other investor protection obligations on the intermediary. These include: 1) “investor-education information” yet to be developed by the SEC, 2) the obtaining of an affirmative statement from the investor that such investor “is risking the loss of the entire investment, and that the investor can bear that loss,” 3) obtaining a statement that the investor understands the risk associated with start-up, emerging and small enterprises and 4) other matters which the SEC may determine as appropriate.11
Intermediaries are also required to “take such measures to reduce the risk of fraud” as shall be established by the SEC, but inclusive of background and regulatory history checks for each officer, director and person holding greater than 20 percent of the outstanding equity of the issuer. Also imposed on the intermediaries are other obligations such as providing access to the requisite information to the SEC 21 days prior to the offering, reserving any invested funds until the target offering amount has been met, ensuring investor privacy, restricting compensation to “promoters, finders or lead generators,” and such other rules as may be devel-oped by the SEC for investor protection. Importantly, an intermediary may not have any financial interest in any issuer using its services.12
The Crowdfund Act has also mandated a restriction on the transfer of shares for a period of one year after issuance other than: 1) to the issuer, 2) to an accredited investor; 3) as part of an SEC registered offering; 4) to a member of the family of a purchaser or in connection with death or divorce; and 5) such other situations as established by the SEC.13
As noted earlier, to date the SEC has not issued its rules or regulations. Without this guidance, issuers, intermediaries, and investors are poised at the ready with-out any firm direction. Although Congress has provided a limited structure, the devil remains in the details.
One such detail is the requisite ‘cooling off’ period. The Crowdfund Act establishes that no sale to an investor may take place prior to the passing of 21 days (or such other period of time as established by the SEC) after an intermediary makes available the mandatory disclosure information.14 However, there is no discussion about what happens to that period if the information has been amended or updated. Nor is there any discussion of permitted due diligence on the part of an investor. In a letter to the SEC, the Crowdfund Intermediary Regulatory Advocates (CfIRA) have suggested that with any material amendment to the mandated disclosures, the 21-day period should recommence.15 Interestingly, the Crowdfund Act takes no position on what may happen during this 21-day period, nor does it state the purpose of this period. CfIRA has suggested that during the original period or any extension thereof, an investor be permitted to rescind any commitment that investor may have made.
The National Crowdfunding Association (NCA) has taken a different viewpoint on rescission. Understanding the ability to rescind may lend itself to fraud, the NCA urges that rescission be permitted only within the first 48 hours after commitment or after any amendment to the disclosure materials, stating, “this will prevent commitments being made initially just to attract attention to a project then being withdrawn after new investors join.”16 Of course, the treatment of interest on a rescinded investment is a consideration under either scenario.
Another critical issue is defining how an intermediary may be compensated and whether the SEC will impose any limitations on that compensation. The Crowdfund Act is silent on fees, other than to state that an intermediary is unable to maintain an ownership interest in an issuer. A literal reading would imply that an intermediary may be unable to receive shares as compensation, and that compensation would be limited to monetary remuneration only. The NCA has opposed this reading and has suggested the SEC adopt regulations permitting compensation in shares of the issuer but that the intermediary have no shares at the time of the offering.17
Still remaining open is whether the SEC will seek to regulate the amount and manner of any monetary fees an intermediary may charge, and whether the intermediary can require upfront fees or initial service fees, as well as breakup or minimum undertaking fees. Likewise open is whether the intermediary may charge, either through monetary payment or shares, and either directly or through related entities, for ancillary services such as transfer agent, management, marketing, or structuring services. Presumably, as long as there is transparency and accuracy in reporting, the flexibility to enter into a structure that is acceptable to both the issuer and the investor should be left to market forces.
The extent of liability for misstatements or omissions also needs to be more fully defined through future regulation. The Crowdfund Act’s specifically preempts any state laws related to actions against intermediaries but leaves the issuer and its directors, principal officers and financial officers liable for actions against them. The NCA has questioned whether an intermediary who requires the disclosure of information, beyond that which an issuer provides under the Crowdfund Act, opens itself up to liability.18
Logic would dictate that as long as the intermediary takes no part in the development of the information, exceeding the minimum level of information should not expose the intermediary to liability. One of the areas that may plague the SEC the most is defining the Crowdfund Act’s prohibition against an intermediary providing investment advice. Would the creation and administration of a forum for discussions monitored or edited by the intermediary constitute advice? Would the establishment of a page layout do so? The providing of market updates or news? Or the involvement in development of a debt interest rate? The establishment of safe harbors by the SEC as part of its regulations is needed to ensure innocent violations are not committed by well-intentioned portals.
The open issues are almost limitless, including: 1) restrictions on compensation to intermediaries’ employees; 2) the limitations on advertising by an issuer and the manner by which that advertisement may direct investors to the portal; 3) the permitted involvement of social media; 4) the scope of the requisite background checks imposed upon the intermediaries and the manner in which the dissemination of that discovered information is made; 5) the extent of the information required to be provided under the education mandate and whether the intermediary is required to verify the review of that information by the investor; 6) the ability to combine accredited and non-accredited investors in order to raise an amount in excess of $1,000,000; 7) the safeguarding of deposited funds; 8) the manner of transition from a successful capital raise to distribution of shares; and 9) which self-regulatory organization would be deemed acceptable for registration. Examining these questions will likely lead to more questions.
The naysayers to crowdfunding abound, and perhaps for good reason. It is likely that crowdfunding’s initial startup years will be replete with fraud, bankruptcies, shareholder derivative claims, and widespread litigation. Despite the educational and disclosure requirements, many investors will enter blindly into a crowdfunding investment and then complain of their losses. It will be incumbent upon the SEC to strike a balance between opening a nimble and cost-effective means of injecting capital into Main Street businesses, and at the same time providing investor protection.
Returning to our original analogy, once the race begins we will quickly come to learn that some of the horses will be seasoned, well-conditioned thoroughbreds while the others will be nothing other than lame nags. However, one thing remains certain, it will be a very intriguing spectator sport.
Bruce E. Baldinger is the managing member of The Law Office of Bruce E. Baldinger, LLC in Morristown. He is a 1984 graduate of the University of Miami Law School and focuses his practice on commercial and securities litigation.