When the JOBS Act was passed, a lot of people hoped that it would de-regulate startup finance, resulting in a boom of new startups being funded. By repealing the ban on general solicitation, allowing online angel investment platforms, creating the new “Regulation A+,” and allowing equity crowdfunding, the JOBS Act was supposed to make funding startups considerably easier. But there have been some significant bumps in the road. First, in my view, the equity crowdfunding exemption that was included in the bill was unworkable from the beginning. That continues to be true under the crowdfunding regulations proposed by the SEC and of course, the SEC has yet to adopt final equity crowdfunding regulations (which means that equity crowdfunding is still largely prohibited for non-accredited investors). While the SEC finally did implement the lifting of the ban on general solicitation by creating the new Rule 506(c), it also has proposed new onerous rules governing its use (as well as the use of the existing Rule 506(b)). The SEC has proposed implementing regulations for Regulation A+, but has not adopted final regulations, which means that the exemption still cannot be used. In addition, the SEC is getting pushback from state securities regulators on the proposed Regulation A+ on the issue of preempting state registration requirements, which may result in the removal of preemption from the final regulations (which would make the exemption considerably less useful). Furthermore, since Regulation A+ investors would be counted as shareholders for purposes of triggering reporting under the Securities Exchange Act of 1934 (the “Exchange Act”), as the proposed rules are currently written, any use of the exemption would also likely trigger expensive Exchange Act reporting requirements.
Because of all of these issues with the implementation of the JOBS Act, some members of Congress have decided to once again get involved. Three pieces of proposed legislation, all intended to retool parts of the JOBS Act that have proved unworkable, have recently been introduced or are in the draft stage:
- The Equity Crowdfunding Improvement Act of 2014;
- The Startup Capital Modernization Act of 2014; and
- A Bill to direct the Securities and Exchange Commission to revise its proposed amendments to Regulation D, Form D, and Rule 156.
Following is a summary of each of these bills.
The Equity Crowdfunding Improvement Act of 2014 (H.R. 4564)
The Equity Crowdfunding Improvement Act of 2014, introduced on May 6, 2014 (available here), was proposed in response to concerns that the JOBS Act makes crowdfunding difficult and costly for small businesses to implement. It would repeal Title III of the JOBS Act and replace it with new provisions amending the federal securities laws to allow crowdfunding. It would amend the Securities Act of 1933 (the “Securities Act”) by adding securities transactions with the following characteristics to the list of securities transactions exempted from federal securities registration requirements:
- The issuer is a corporation
- The total amount sold per year under the exemption is up to $3 million, or $5 million if investors receive audited financial statements (caps to be adjusted for inflation annually)
- The total amount sold to any non-accredited investor per year does not exceed the greater of—
- $5,000 (adjusted for inflation annually); or
- 10% of the investor’s annual income or net worth
- If funds are raised from non-accredited investors, an intermediary that complies with Section 4A(a) (discussed below) must be used
- Issuer provides potential investors with financial statements that have been certified or reviewed in accordance with certain procedures
It would also amend the Securities Act by adding a new Section 4A that sets forth requirements for intermediaries in crowdfunding transactions, comprising the following:
- Register with the SEC as a broker or an intermediary who does not (i) offer investment advice; (ii) explicitly solicit purchases, sales, or offers to buy particular securities on its website or portal; (iii) directly compensate anyone for direct sale of securities on its website or portal; or (iv) handle investor funds or securities
- Warn investors of the speculative nature of investments in startups, emerging businesses, and small issuers
- Warn investors that they are subject to restrictions on resale
- Take reasonable measures to reduce the risk of fraud
- Provide the SEC with its address, website, and names of the intermediary, its chief officer, and any employee responsible for compliance with securities laws
- Provide the SEC with continuous investor-level access to its website
- Require each potential investor to answer questions demonstrating an understanding of risks and other areas the SEC determines appropriate
- Require the issuer to state a target offering amount and a deadline to reach it and ensure a third-party custodian withholds offering proceeds until 100% of the target is raised and the issuer has complied with all requirements
- Perform a background check on the issuer’s officers, directors, and shareholders with 15% or more voting control to ensure they haven’t committed any of the “bad acts” that are excluded from Rule 506 offerings under the Dodd-Frank Act
- Provide the SEC and potential investors with notice of the offering including certain information
- Outsource cash functions to a qualified third-party custodian
- Maintain certain books and records
- Offer on its website a method for the issuer and investors to communicate
- Provide the SEC with notice of completion of the offering
- Do not offer investment advice
Other provisions that would apply to intermediaries include the following:
- An intermediary may rely on a certification by an investor of its status as an accredited investor or its annual income, net worth, and the aggregate amount of securities sold to it within the previous year
- Securities purchased in an exempt crowdfunding transaction may not be resold for one year unless to the issuer or an accredited investor
- An issuer may only enter into an exempt crowdfunding transaction with an unaccredited investor through the use of an intermediary, and any resale of a security originally issued in reliance on the crowdfunding exemption may only be made with an unaccredited investor through the use of an intermediary
- An intermediary in a transaction either made pursuant to the crowdfunding exemption or involving the resale of a security originally issued pursuant to a crowdfunding exemption is not required to register as a broker
- An intermediary may select which transactions to be involved in, and this is not considered investment advice [1]
- An intermediary may review a transaction and terminate it at any time if termination is appropriate in doing due diligence, it is able to return all funds, and the custodian has not transferred the offering proceeds to the issuer
The bill would require the SEC to issue rules for Section 4A within 120 days of enactment. The bill would also require the SEC to establish disqualification regulations prohibiting an issuer from using the crowdfunding exemption based on its history or that of its related persons and disqualifying intermediaries, within 120 days of enactment.
The bill would provide for federal law to preempt state law by adding securities sold under a crowdfunding exemption to the statutory list of “covered securities.” However, it clarifies that this amendment relates only to registration, documentation, and offering requirements and does not limit state enforcement authority.
The crowdfunding exemption proposed in this bill is far simpler, and I believe, far superior to the one that was included in the original JOBS Act. By allowing portals to select which transactions they are involved in (i.e. curating) and also allowing for larger capital raises, the new proposed crowdfunding exemption addresses many of the issues that make the original JOBS Act crowdfunding exemption unworkable.
The Startup Capital Modernization Act of 2014 (H.R. 4565)
The Startup Capital Modernization Act, also introduced on May 6, 2014 (available here), is intended to reform and improve Regulation A securities offerings. It would increase the maximum amount of a single public offering under the original Regulation A exemption (now often referred to as a “Tier 1” offering) from $5 million to $10 million. The bill would provide for federal law to preempt state law by adding securities sold in a Tier 1 Regulation A exempt offering to the statutory list of “covered securities.” [2] However, it would clarify that this amendment relates only to registration, documentation, and offering requirements and preserves state enforcement authority.
The bill would direct the SEC to exempt securities acquired under Regulation A offerings from Section 12(g) of the Exchange Act, which requires registration of an issuer’s securities when a certain number of shareholders is reached, if the issuer has filed audited financial statements with the SEC and is in compliance with all required periodic disclosures. The bill would require the SEC to issue a rule to carry this out within 180 days of enactment.
The bill would also allow for a more streamlined process for the resale of restricted securities (e.g., securities sold in a Rule 506 offering) if the resale meets the following conditions:
- Each purchaser is an accredited investor, as defined in Rule 501
- If any securities are offered by means of any general solicitation or general advertising, the seller takes reasonable steps to verify that each purchaser is an accredited investor
- The seller is not an issuer, its subsidiaries, or its parent; an underwriter acting on behalf of the issuer, its subsidiaries, or its parent that receives compensation from the issuer; or a dealer.
The bill would provide for federal law to preempt state law by adding securities sold under this exemption to the statutory list of “covered securities.”
As I’ve pointed out before, the fact that use of Regulation A or A+ would trigger Exchange Act reporting requirements is a major deterrent to the use of the exemption. This bill addresses this problem. In addition, I have long thought that there should be a simpler way to resell restricted securities to accredited investors, as the existing Rule 144 requirements are quite cumbersome.
A Bill to direct the Securities and Exchange Commission to revise its proposed amendments to Regulation D, Form D, and Rule 156
Title II of the JOBS Act required the SEC to make rules allowing general solicitation and advertising for certain private securities offerings under Rule 506 of Regulation D. These rules were adopted in July 2013 (see discussion here). The SEC issued separate proposed amendments not required by the JOBS Act that would impose a number of new requirements in connection with Rule 506, including the submission of Form D to the SEC before and at the completion of an offering and the filing of written general solicitation materials. Under the proposed rules, an issuer could be disqualified from using Rule 506 for one year if it failed to comply with the additional Form D filing requirements. The SEC has received over 500 comment letters but has not adopted a final rule.
The bill, which is in the discussion draft phase and has not yet been introduced (the draft is available here), would require the SEC to revise its proposed amendments to Regulation D, Form D, and Rule 156 in the following ways:
- The SEC may not adopt any requirement to file Form D before the sale of securities under Rule 506 of Regulation D or after the offering has ended
- The SEC may not condition the availability of the Rule 506 exemption on the filing of Form D
- The SEC may not condition the availability of the Rule 506 exemption on the steps taken to verify that purchasers are accredited investors, as required under section 201(a) of the JOBS Act and Rule 506(c)
- The SEC may not extend Rule 156 requirements covering investment company sales literature to private funds
- The SEC must revise Regulation D to permit issuers to sell securities to their employees (with this phrase in brackets in the draft: “[who are not otherwise accredited investors]”)
- The SEC may not require issuers to submit written general solicitation materials any earlier than 60 days after the closing of the Rule 506 offering, and may not require more than one filing
I have opposed the SEC’s proposed rules on Form D filing requirements, which I believe have the potential to be very burdensome and destructive to emerging businesses. However, this bill also takes an additional step and changes Rule 506(c) so that a failure to take steps to verify that purchasers are accredited investors does not invalidate the exemption. I’m not sure that is necessary, as it seems to me to be an essential part of the bargain that if general solicitation is used, then the accredited investor verification provisions kick in.
In general, I think all three bills are a step in the right direction and address squarely some of the disappointments that have occurred in the implementation of the JOBS Act.
Footnotes
[1] This provision is badly needed. One of the worst features of the proposed SEC rules is that attempts to curate offerings on crowdfunding sites are considered prohibited “investment advice.” This means that the SEC is literally mandating that crowdfunding portals not remove deals that they consider bad for their customers(!)
[2] Congress may also want to consider removing the language which limits Regulation A preemption solely to securities offered or sold on a national securities exchange or offered or sold to a qualified purchaser. While the SEC, in its proposed rule, has deemed all offers and purchasers of Regulation A+ securities to be qualified purchasers, the state regulators have objected to this. By leaving this language in the JOBS Act, if Congress’ goal is to ensure that preemption of state registration requirements applies to Regulation A, it risks the SEC caving into state regulators’ pressure and thwarting that goal by creating a more narrow definition of “qualified purchaser.”
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
