Previous, I summarized the Entrepreneur Access to Capital Act (H.R. 2930), a bill which provides for a crowdfunding exemption to the registration requirements of federal and state securities laws. The bill was recently passed by the U.S. House of Representatives, and now awaits U.S. Senate action. In this post, I’ll provide some of my thoughts on what is to come.
Will it pass?
Predicting the future is usually a futile effort, but I do believe that this bill (or something like it) has a good chance of becoming law. If you had asked me this same question a year ago, or even six months ago, I would have told you that it had no chance. The political climate over the last few years has favored the tightening of securities laws, not their deregulation, due in no small part to the perceived excesses of the securities industry in the events leading up to the financial crash in 2008. What I hadn’t counted on was the cumulative effect of three years of high unemployment on the political process. Politicians are desperate for a solution to reduce unemployment and consequently legislation that promises to reinvigorate the entrepreneurial sector has found rare bipartisan support. Of course, the Republican gains in the Congress in 2010 helped significantly as well, given that the need for business deregulation is an article of faith within the Republican party. As a result of these factors, the House passed the bill overwhelmingly in a rare bipartisan vote. The White House has also signaled that it supports the effort. The only remaining piece to the puzzle is Senate passage.
The U.S. Senate could choose to take up H.R. 2930 itself, or proceed with its own version, the Democratizing Access to Capital Act of 2011 (S. 1791), which is sponsored by Sen. Scott Brown (R – MA). S. 1791 is remarkably similar to the House bill. Given the bipartisan support for the concept, I think it is highly likely that a crowdfunding bill will pass the Senate, though it will likely differ in small or major ways from the House legislation. These differences will need to be reconciled in conference committee, and then the reconciled bill will need to be passed again by each house. However, neither political party has drawn a line in the sand about any of the particular differences and most of them are rather technical. Therefore, there currently aren’t any major impediments to a final bill being passed before the end of 2012. My prediction, therefore, is that we will see a crowdfunding exemption passed into law by the end of next year.
How will its implementation affect its usefulness?
Assuming the bill passes, it must also be implemented by SEC regulations. It is crucial to understand that the SEC has significant power to determine how useful a crowdfunding exemption could be. If the SEC’s regulations make it difficult to use, then no one will use it and the effort will be for naught. If the SEC issues regulations that are friendlier to issuers, then the exemption could be highly useful. For instance, here are some open issues that will need to be addressed and could drastically affect the ability of companies to use the exemption effectively:
- How will income be measured? The bill requires that investors invest no more than the lesser of $10,000 or 10% of their annual income. It further provides that an issuer or intermediary may rely on a certification of annual income provided by an investor. This leaves several unanswered questions: (1) How will income be measured? By the previous calendar year? By an average of several of the previous calendar years? (2) Will the investor’s spouse’s income be included? (3) Is the limit subject to each of the spouses separately or are the amounts invested by each spouse considered in aggregate towards the limit? (4) Will the certification ask for any kind of documentation to establish the income of the investor or does the investor merely provide a number which the issuer or intermediary can accept without question? If so, is it reasonable for an issuer to accept that someone in a low paying field claims he or she makes $150,000 a year? All of these questions will need to be addressed by SEC regulations, and the more specifically it does so, the more beneficial it is for issuers and intermediaries because bright-line tests remove business uncertainty.
- What will be the permissible activity of intermediaries? The bill establishes a new category of participant in the capital markets called an “intermediary.” No definition of an “intermediary” is provided in the legislation, but presumably an intermediary would operate a website which administers the crowdfunding offering. The bill specifically exempts intermediaries from the broker-dealer registration requirements under the Securities Exchange Act of 1934. There are a number of unresolved questions: (1) What activities may an intermediary engage in? Are they simply passive participants, or may they engage in active sales efforts? (2) How may they be compensated? Are their fees limited to flat fees to use their platform or can compensation be varied depending on the success of the offering (i.e. a success fee or a fee in proportion to the amount of securities actually sold)? (3) Finally, how will state broker-dealer registration requirements apply? Will they be required to register as broker-dealers and their employees as broker-dealer agents with the states they operate within?[1]
- Will issuers also be permitted to conduct a simultaneous offering under Rule 506 of Regulation D to accredited investors? The bill itself says that use of the crowdfunding exemption does not prevent an issuer from raising capital through other methods. Therefore, a simultaneous Rule 506 offering will not preclude the use of a crowdfunding offering. Unfortunately, the use of a crowdfunding offering may preclude the use of Rule 506. Regulation D provides that other offerings conducted near in time to a Regulation D offering are considered part of the Regulation D offering (i.e. they are integrated). Since a crowdfunding offering would not be in compliance with Rule 506 (because it was conducted via a general solicitation and the securities were offered to non-accredited investors), the Rule 506 exemption relied upon for the offering would be invalidated. Unless the SEC alters the integration provisions of Regulation D, companies may be unable to conduct an angel financing round near the same time as a crowdfunding offering.
- The bill requires issuers or intermediaries to “take reasonable measures to reduce the risk of fraud.” It will be up to the SEC to spell out what those reasonable measures are. The SEC could leave it with a relatively subjective standard, or they could provide a safe harbor which contains a number of measures an issuer or intermediary can take that will assure it that it has complied with this requirement. A safe harbor would be far more preferable to an open-ended standard, since certainty is required for any securities registration exemption to be truly useful. The bill also requires that the issuer or intermediary require potential investors to answer questions demonstrating their understanding of the level of risk involved with investing in a startup. It also requires an intermediary to conduct a background check on the issuer’s principals. Both of these requirements could also jeopardize the usefulness of the exemption if the SEC does not provide a safe harbor or otherwise objective criteria for meeting these obligations.
As you can see, even if the crowdfunding exemption bill passes as is, there will still be any number of issues unresolved until the SEC fills in the gaps in the legislation through interpretive regulations. These regulations could greatly facilitate the usefulness of this new exemption, or could eviscerate its usefulness, causing it to be used as often as Rules 504 and 505 of Regulation D.[2]
Footnotes
[1] This issue of whether state registration requirements apply to intermediaries is very complex and merits its own post. This issue has been around for some time, because there is an analogous situation pertaining to Rule 506 offerings. Some states require the officers who conduct a Reg. D offering to register as “issuer agents,” but such requirements may be preempted by federal law.
[2] Rules 504 and 505 are other exemptions contained within Regulation D. They tend not to be used very often because, unlike Rule 506, there is no federal preemption of state registration requirements, subjecting offerings conducted under this rule to numerous state regulations.
