TILBURG UNIVERSITY LAW SCHOOL
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act Master Thesis for the International Business Law LLM
Sintija Saurina Emp.1253925, ANR.809603
2013
Professor: Prof. dr. Erik Vermeulen Supervisor: Ms. Priyanka Priydershini
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Contents
Introduction ...... 3 1. Emergence of Crowdfunding ...... 4 1.1. Crowdfunding in Capital Formation ...... 4 1.2. Crowdfunding Platforms in Practice ...... 9 2. Legal Background of Crowdfunding ...... 13 2.1. Compliance with Securities Laws ...... 13 2.2. Development of Crowdfunding Exemption ...... 18 3. Crowdfunding Exemption under JOBS Act ...... 24 3.1. Investment Caps ...... 24 3.2. Intermediary’s Obligations ...... 29 3.3. Issuer’s Obligations ...... 37 3.3. Other Provisions ...... 41 3.4. Overview ...... 42 Conclusions ...... 44 Bibliography ...... 49
2 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Introduction On April 5, 2012, the JOBS Act was signed into law. One of the main purposes of this act is to facilitate the raise of the capital for start-up companies by creating a crowdfunding exemption. However, this exemption has raised discussions since it struggles between the protection of investors and the increase of the capital formation. Before implementing JOBS Act, the rules regarding disclosure and registration must be settled by the Securities and Exchange Commission (SEC), however, SEC has delayed the finalization of the rules, thus, precluding the possibility for new companies to use the advantages proposed by JOBS Act. While many agree that business market might only benefit from the effects of JOBS Act, criticism has been expressed about the protection of interests of investors, for example, by failing to include sufficient anti-fraud mechanisms. The middle-of-the-road for balancing the interests of the founders and the investors still should be evaluated.
The crowdfunding exemption is of a great importance for start-up companies since it offers an easier way of attracting capital for the business and lessens the burden of registration and disclosure that is required for public companies under current SEC rules. However, any significant changes should be first researched to prevent possible damage of poor legislation or to improve the mechanisms for reaching the goals of the changes. The goal of this thesis is to research the legal regulation of crowdfunding exemption under JOBS Act.
To achieve the goal of this research, firstly, in Part I the institute of the crowdfunding will be analyzed, describing the purpose of the crowdfunding, the benefits and costs of it and the use of it until now. Secondly, in Part II research of the legal background of crowdfunding exemption will be provided, including the compliance of crowdfunding with the securities laws and the development of the regulation of crowdfunding exemption. Finally, in Part III the crowdfunding exemption under JOBS Act will be analyzed, providing analyze of investment limits, intermediary’s obligations and issuer’s obligations, considering the possible positive and negative effects of this regulation and whether this regulation would execute the purpose of the crowdfunding exemption the best and what solutions could be found for preventing the disadvantages.
3 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
1. Emergence of Crowdfunding
1.1. Crowdfunding in Capital Formation
Suffered through the financial crisis, society is looking for solutions how to give economy the necessary spur. One of the most obvious solutions is to focus on developing the entrepreneurial environment, which would result in increasing GDP, created jobs to solve the unemployment, increasing state and tax income, and eventually would provide economic growth. One of the options to develop the entrepreneurial environment is encouraging the emergence of new companies. There are several ways how to improve the development of new businesses, however, the main problem for entrepreneurs still is the capital formation.
There are different ways to raise the capital at initial stages of business. The main possibilities are going public, attracting an angel investor, using the finances owned by friends and family or retained earnings, venture capital, private placements and loans. However, each of these options has some shortcomings that would exclude them from possible use in particular situations. For example, IPOs involve high administrative costs due to the registration requirements, friends and family might have limited financial means, the business idea might not be attractive for private investors or venture capital funds and small and new businesses rarely have sufficient retained earnings. Loans have been the most common mechanism for capital raising,1 however, due to the recent credit bubble of banking industry, banks are less willing to invest in risky business ideas. Being this the case, many entrepreneurs have been forced to look for new ways how to raise the capital.
One of the alternative solutions recently emerged in the field of capital raising is crowdfunding – entrepreneur approaches a large number of people who each contributes a small amount of money that in aggregate form the required capital. Crowdfunding is a blend of crowdsourcing – “small contributions from a large number of people to achieve a common goal” - and microfinance – “lending very small amounts of money, typically to poorer borrowers,” i.e., small businesses.2 This approach has been mainly used by artists collecting money from their fans to fund a tour or an album record and it is also frequently used as an instrument for political
1 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.17 2 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.28-29 4 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 fundraising. However, recently crowdfunding has also appeared in the business world as a mechanism to raise capital.3 This type of crowdfunding can be described as a mix of social media and venture capital fund. While the financial and legal aspects of crowdfunding are similar to the ones peculiar to raising the capital through venture capital funds, the mechanisms used to approach the potential investors, i.e. the crowd, usually are internet-based social media platforms such as Facebook and Twitter.4
The significant role of crowdfunding in economic development has been recognized by policy- makers in US as well as in Europe. Not only it helps to boost the emergence and development of small and new businesses, it also has an indirect impact on unemployment since small businesses are responsible for roughly half of American employment.5 Thus, establishing crowdfunding as a legally regulated capital raising mechanism could improve the economic situation and help solving the unemployment issues.
One of the most appealing benefits of crowdfunding for small and new businesses is its low costs. Currently a simple crowdfunding campaign can be launched even without any application fee, and the overall costs include small administration fee and commission fee less than 10% of the raised funds. Since the application procedure is very simple, no additional costs for legal, accounting or other services is necessary – an average entrepreneur is capable to file the application. 6 Furthermore, crowdfunding is also very time-efficient – average timeframe for crowdfunding is 9 weeks.7 The time needed for launching a crowdfunding campaign differs from one platform to another – many platforms offer an immediate launching while others have a reasonably short application period - the application period depends on whether there is some review or preapproval procedure. For example, Kickstarter offers campaigns for 1-60 days and it advises to set the deadline for 30 days or less since the previous experience has showed that after longer period of time the campaign loses the attraction of investors. It usually takes 2-3 business
3 For example, equity based crowdfunding has increased by 114% and forms 15% of all crowdfunding campaigns in 2012. Crowdfunding Growth – Infographic, May 8, 2013. Available at: http://www.crowdfundingeye.com/crowdfunding-growth-infographic/ (last visited: 21.06.2013.) 4 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.8 5 Ibid, p.18. Small businesses provide around 55% of all jobs in US. Why the JOBS Act is Great for US Economy – Crowdfunding Infographic, May 7, 2013. Available at: http://www.crowdfundingeye.com/why-the-jobs-act-is-great- for-us-economy-crowdfunding-infographic/ (last visited: 21.06.2013.) 6 See part 1.2. Crowdfunding Platforms in Practice 7 Crowdfunding Growth – Infographic, May 8, 2013. Available at: http://www.crowdfundingeye.com/crowdfunding- growth-infographic/ (last visited: 21.06.2013.) 5 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 days for approval and if changes are necessary, the while application procedure can take one week or more.8
Crowdfunding is easier to access for small and new companies since the capital is raised not from wealthy investors, which are limited in number, but from general public. In 21st century using internet platforms and social media it is very easy to access a significant part of society, diminishing the transaction costs and, thus, allowing reducing the amount of money collected from each investor individually. The significant role of internet in crowdfunding cannot be denied - with the growing use of internet crowd becomes larger, more global and easier to access. Crowdfunding is available for every entrepreneur who has a business idea. It provides with a direct link between an entrepreneur and general public, giving the entrepreneur a chance to promote his idea and offering every individual an opportunity to invest a small amount in potentially successful idea without any unnecessary burdensome registration requirements.
Furthermore, crowdfunding offers wider opportunities for trans-industry and trans-geographic investments. Crowdfunding is used in a wide range of different industries starting from entertainment and ending with scientific research. Crowdfunding platforms can be found not only in US but also in Europe, Hong-Kong, Brazil, Germany and sub-Saharan Africa.9 Therefore, crowdfunding as a mechanism has been introduced in different legal environments with a different application while at the same time the substantial concept of crowdfunding is recognized over the borders. It means that entrepreneur can easier access potential investors all over the world and they are not restricted by some industry limitations. Another aspect is that geographic distance could limit some companies from accessing the venture capital,10 while it is not an issue in case of crowdfunding since the capital is being raised through internet based platforms.
Popularity of crowdfunding has been increasing significantly – starting from estimated 283 crowdfunding platforms in 2010 to 536 platforms in 2012 worldwide.11 While each investment
8 Kickstarter website. Available at: http://www.kickstarter.com/help/faq/creator+questions?ref=footer (last visited: 14.06.2013.) 9 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.13-14 10 „Economists have found a strong correlation between the geographic proximity of the investor and the investment.” Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.17-18 11 http://www.crowdfundingeye.com/crowdfunding-growth-infographic/ 6 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 collected with crowdfunding is relatively small, the total amount of the capital can be significant. Thus, according to the information published in Kiva website, the total amount lent through Kiva is $440,433,000. 12 In 2012 2,241,475 people pledged a total of $319,786,629 through Kickstarter13 and Lending Club has issued $1,894,337,725 in loans up until now.14 The total estimated amount of funds raised has grown from $1,5 billion in 2011 up to $5,1 billion in 2013. 15 These numbers show that crowdfunding is capable of raising a large capital when necessary at the same time diverting the investment risk on a large number of investors. At the same time companies looking for larger capital might encounter some difficulties with reaching the target amount through crowdfunding. In this sense, crowdfunding might not be suitable for high-tech and other companies, requiring great financial fundament, and these companies should consider other options for capital formation.
While involving the crowd in investing has several benefits for the companies, it also means that there is no distinction between sophisticated and unsophisticated investors within the crowd. One of the main purposes of US securities law is to protect investors from illegal and fraudulent activities of entrepreneurs, and the level of protection is proportional to the level of sophistication of investor. In other words, US securities law gives more protection to the investors who are not that capable to defend themselves or to make a proper decision due to the lack of knowledge or finances. Investors who are recognized by lawmakers as sophisticated and more capable to protect their interests are defined as accredited investors16 and there are several exemptions from general rule, reducing the requirements for issuers if securities are sold to these accredited investors. Crowdfunding by its very nature breaks down the wall between accredited and unaccredited investors on the account of its approach to the crowd. In this case the crowd is a homogeneous body, consisting of a large number of individuals who are not approached individually and, thus, cannot be thoroughly examined individually, whether they fall under the scope of the term “accredited investor”.
12 http://www.kiva.org/about/stats 13 http://www.kickstarter.com/year/2012?ref=footer#overall_pledged 14 https://www.lendingclub.com/info/statistics.action 15 http://www.crowdfundingeye.com/crowdfunding-growth-infographic/ 16 The term „accredited investors” is defined in Rule 501 of Regulation D. Available at: http://www.ecfr.gov/cgi- bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2.0.1.1.12.0.46.176&idno= 17 7 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
“The crowd” factor has two sides. On one hand it is contrary to the general approach of securities laws since no additional protection can be offered to less sophisticated investors. On the other hand securities laws might be seen as overprotective and unfair since it is unreasonably assumed that certain groups of investors are not capable of making a proper decision and, thus, they are neglected and deferred from making a profit out of investing.17 While it is justified to settle some restrictions in order to protect the weaker side and to prevent fraud and other misconduct, lawmaking power should not be abused by unnecessary limiting the freedom of contract. The fundament of crowdfunding is the small amount of every particular investment and every individual should be given a freedom to decide for himself whether he wants to risk this money in investment. Instead of simply excluding a group of people from rights to invest, policy makers should work on educating the crowd and raising the awareness of the possible consequences of investing and main issues of concern.
Involving the crowd for investing can also serve the marketing –crowdfunding has been used by politicians and artists to raise money from their fans and supporters, but it can also be used the other way around too – to promote the business. Usually entrepreneur offers an idea, investor supports it and crowd consumes it. The crowd mainly is the consumer – it is the target of any business idea, and if crowd is also an investor, it provides the business with a double support. A successful crowdfunding activity not only provides business with a capital, but also promotes the business, creates a group of loyal consumers and helps to establish a place in the market. Moreover, crowdfunding procedure can help to distinguish viable ideas from the ones that are more possible to fail, i.e. give the opportunity to “test the waters”. The crowd represents the clientele of the business and if it is not interested in investing in the idea, it can be concluded that the crowd will not be interested in consuming the goods or the services of this particular company either, and, thus, it would prevent some failures and investment losses.18
However, promoting the business idea to a larger public could harm the entrepreneur in the means of competition, which would not be the case if entrepreneur would look for the capital through private placement. When launching a crowdfunding campaign, entrepreneur reveals his
17 Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.25-26 18 “Crowdfunding may actually lead to wiser decisions than a few venture capitalists. Although it may seem like comparing apples and oranges, as successful venture capitalists will doubtlessly have a business background and a strong financial acumen, but the crowd has something a single venture capitalist does not—purchasing power.” See more: Ibid, p.27-30 8 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 idea without ensuring any intellectual property protection and, thus, competitors who have financial advantages can overtake the idea and take steps to carry it out before original author of the idea has had any opportunity to do it. This publicity informs competitors about entrepreneur’s further plans and provides them with time to surpass the potential competition.
Besides the risk of fraud and competition issues, another risk of crowdfunding is that sophisticated investors, which fulfil a mentoring role for the business, such as venture capitals and angel investors could refrain from investing in companies that have raised the capital through crowdfunding since a part of ownership is distributed to the unsophisticated crowd. At the same time crowdfunding would help new companies to develop and, thus, create the competition, which would improve the market. Likewise, crowdfunding would improve the economic dynamic and would supply the market with additional finances.19 Furthermore, since crowdfunding allows entrepreneurs to take more control over offering terms, it is possible to reduce the impact of the crowd on control over the company.
Even though crowdfunding has some flaws and it is not suitable for all small and new businesses, in many cases it could work as an efficient solution for capital formation. Crowdfunding is costs and time-efficient, it creates an access to a new capital source – the crowd; it provides everyone with freedom to invest, it eliminates industrial and geographical borders and it provides support in the means of marketing. At the same time crowdfunding decreases investor protection, it eliminates the distinction between accredited and unaccredited investors, it endangers the protection of business idea, it is likely to be unsuccessful for companies seeking for a large capital and it could cause difficulties to obtain capital from other sophisticated investors. As always it is up to the company itself to decide what its best option for capital formation is, but it should be recognized that improving the crowdfunding can give a significant input in covering the currently existing capital gap.
1.2. Crowdfunding Platforms in Practice
The practical use of crowdfunding has proved its efficiency and more and more projects have been successfully funded through crowdfunding. Currently there are hundreds of crowdfunding platforms, however they differ each from other by the projects they are offering and models of
19 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.32 9 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 contributions and rewards. Thus, for example, Kickstarter20 supports creative projects exclusively and does not offer any profit to contributors – contributors do not receive a share of ownership or profit, however, they can receive a non-financial reward or a special offer for the product. The price of rewards is limited to $1-10,000 and there are certain restrictions on rewards. The platform itself receives a 5% fee if crowdfunding is successful and there is an additional 3-5% administrative fee. All-or-nothing principle applies to the funding – if the goal is not reached, project does not receive money, however, if the goal is exceeded, project receives it all. It does not cost anything to submit a project, and everyone over the age of 18, businesses, non-profit and other organizations located in US and UK can submit a project, while everyone all over the world can make a pledge. The average pledge is $75, the most common pledge is $25, the average project goal is $5,000 and so far more than 43,000 projects have successfully raised the funds.
Another example is Indiegogo.21 Contrary to Kickstarter, Indiegogo is accessible to everyone regardless the place of residence except for campaigns from countries on the U.S. OFAC sanctions list. Moreover, in addition to the Fixed Funding, when money is received only when the goal is met, it is also possible for a project to receive the money even if the goal is not met. The fee is accordingly 4% or 9%, as well as additional 3% administrative fee and $25 for non-US projects. If the project is submitted by non-profit organization registered under US law, Indiegogo offers 25% reduction of platform fees and tax-deduction in accordance with US tax law.
Crowdfunder22 is aimed at business funding and was one of the leading participants in JOBS Act legislation.23 With its branches in US and Mexico it offers not only online, but also offline support to entrepreneurs, and it creates a local community for closer interaction and networking. The services are available for persons who are at least 18 years old and legal entities registered under US law. In addition to its Contribution Platform that permits rewards for contributors, Crowdfunder also offers access to its Accredited Platform for investments. Terms of Use of Crowdfunder involves a disclaimer regarding its Accredited Platform, stating that Crowdfunder does not receive a compensation fee for securities sale, it is not a registered broker-dealer and
20 Kickstarter website. Available at: http://www.kickstarter.com/ (last visited: 21.06.2013.) 21 Indiegogo website. Available at: http://www.indiegogo.com/ (last visited 17.06.2013.) 22 Crowdfunder website. Available at: http://www.crowdfunder.com/ (last visited 17.06.2013.) 23 Barnet C. Top 10 Crowdfunding Sites For Fundraising, May 8, 2013. Available at: http://www.forbes.com/sites/chancebarnett/2013/05/08/top-10-crowdfunding-sites-for-fundraising/ (last visited 17.06.2013.) 10 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 does not offer an advice on securities offerings and offer investments, does not recommend, suggest or take part in any transaction, and transactions are not executed or negotiated on or through the platform. Furthermore, Crowdfunder does not take responsibility for the content of any information submitted to the platform and it merely provides parties with a platform for sharing and interaction. Crowdfunder prohibits any offering, selling, purchasing or otherwise acquiring securities on the site. Accredited Platform is available only for accredited investors, who have filled the questionnaire, and have warranted their status and sufficient knowledge for making a decision on investment.24
SoMoLend25 is a platform for business loans offers. The main focus of SoMoLend is local support – lenders and borrowers are mainly from the same area. The local aspect is strengthened by the fact that also cities and local governments are involved in supporting local businesses. It weakens the role of financial institutions as intermediary and focuses also on individual investors, ensuring higher chances to receive a loan. Nevertheless, while banks are more abstinent from approving loans to business ideas involving even a small amount of risk, they create a lending pool up to $50,000,000 for support of small businesses through SoMoLend. SoMoLend matches investors with small and start-up companies looking for a commercial loan between $100 and $1,000,000. Additionally, based on the information provided in the application form, borrowers are rated according to the risk involved – the higher the risk, the higher the interest rate on the loan. However, for now lenders are limited to friends and family and accredited investors (banks etc.), and crowdfunding will be launched after SEC issues the rules implementing JOBS Act.
Lending Club26 is another peer-to-peer lending platform that gives an opportunity for individuals to borrow at a more favourable terms and investors to earn profit from interest rates. This platform is focused on personal loans – borrowers are US citizens, permanent residents or subjects of long term visa who have reached the age of 18. Investors must meet “State and Financial Suitability” conditions – only residents of certain US states who have sufficient level of income are eligible to invest in peer-to-peer lending.
24 Crowdfunder website. Available at: http://www.crowdfunder.com/p/terms-of-use/ (last visited: 17.06.2013.) 25 SoMoLend website. Available at: https://www.somolend.com/Default.aspx (last vistied: 17.06.2013.) 26 Lending Club website. Available at: http://www.lendingclub.com/ (last visited: 31.06.2013.) 11 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Kiva 27 is a non-profit organization that offers microfinancing– loans from individuals are distributed to microfinancing institutions (Field Partners) all over the world. There is no interest rate set by Kiva to lenders or its Field Partners, the only interest rate is set by Field Partners to cover administrative costs and Kiva itself is funded by donations. The purpose of Kiva is to alleviate poverty and the amount of loans start from $25.
Additionally, there are several platforms connecting companies looking for capital with accredited and sophisticated investors offering the capital, such as SeedUps,28 MicroVentures29 and AngelList.30 However, while some of these use the term crowdfunding, they are doubtfully accessible to the crowd since only specific investors meeting the requirements can take part in these investments.
Thus, it can be seen that there are different variations of crowdfunding starting from non-profit and donation-based models to initial attempts of equity-based investment crowdfunding platforms. All the crowdfunding models can be categorized in 5 groups based on the return for the contribution: donation, reward, pre-purchase, lending and equity model.31 Donation model is based on investors’ generosity since no return is expected – contribution is used to fulfil the goal, either profit or non-profit, that is important to investor. Reward model offers a small, symbolic, non-financial return such as T-shirt or public acknowledgement. Pre-purchase model usually offers the product of the company for a special price or for free. With lending model investor receives a re-payment of his contribution and this model can be further divided in 2 groups based on whether the investor receives an interest or not. Equity model offers investors a share of profit as a return for the contribution.
While some crowdfunding platforms successfully keep providing their services, others have encountered difficulties regarding securities laws. For example, one of the forerunners of crowdfunding platforms for raising the capital – ProFounder – has been shut down due to the regulatory environment.32 One of the triggers for shutting down the platform has been consent
27 Kiva website. Available at: http://www.kiva.org/ (last visited 21.06.2013.) 28 SeedUps website. Available at: http://www.seedups.com/ (last visited: 17.06.2013) 29 MicroVentures website. Available at: http://www.microventures.com/ (last visited: 21.06.2013.) 30 AngelList website. Available at: https://angel.co/ (last visited 21.06.2013.) 31 See more: Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.14-27 32 ProFounder Shutting Down, February 17, 2012. Available at: http://blog.profounder.com/2012/02/17/profounder-shutting-down/ (last visited: 21.06.2013.) 12 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 order to desist and refrain for violations of broker-dealer rules,33 prohibiting uncertified broker- dealers from taking participation in purchase or sale of any security.34 The main concern of authorities regarding the crowdfunding is related to the compliance with the securities laws, more specifically – enacting public equity offerings without required registration under securities laws. Besides the compliance with legal framework, another concerning issue is policy related – the main purpose of these registration rules is investor protection, which without proper attention in regard to the crowdfunding could be harmed.
2. Legal Background of Crowdfunding
2.1. Compliance with Securities Laws To assess whether crowdfunding as a mechanism of raising the capital requires registration under SEC rules, the question that must be answered is whether the return offered for the contribution is a security under Securities Act of 1933. This question can be answered by application of Howey test to assess whether crowdfunding offer falls under the term “investment contract” as defined in Securities Act of 1933: “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”35 Thus, the Howey test involves 4 criteria when defining a security: (1) investment (2) in a common enterprise (3) with the expectation of profit (4) from the efforts of the promoter or a third party. In donation model there is no return, therefore, no profit. In reward and pre-purchasing model the difference has to be made between a consumption item and a financial return. With these models there is no financial return and, consequently, no investment contract or any other type of securities named in Securities Act of 1933 (stocks, bonds etc.), therefore, no registration with SEC is required.36 When it comes to a lending model, there is no profit if investor does not receive any interest, since he receives the re-payment of the money he contributed. However, if
33 State of California Business, Transportation and Housing Agency Department of Corporations. Consent Order to Desist and Refrain, August 31, 2011. Available at: http://www.corp.ca.gov/ENF/pdf/2011/ProFounder_CO.pdf 34 Section 25210 of Corporations Code. Available at: http://www.leginfo.ca.gov/cgi- bin/displaycode?section=corp&group=25001-26000&file=25210-25221 35 SEC v. Howey Co., 328 U.S. 293 (1946) Pp. 328 U. S. 298-299. 36 See more: Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.32 13 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 there is an interest rate, the investor can expect a profit that depends on other parties for his investment in a common enterprise, i.e., the criteria of investment contract has been fulfilled. Additionally, notes offering interest qualify as securities under the Reves37 test and the practice of SEC has approved that notes with interest should be registered as securities.38 The equity model undoubtedly falls within the scope of securities laws and, thus, requires a registration under SEC rules.39 The equity model and the lending model with interest are the ones to raise concerns about the compliance with SEC rules and protection of investors.
The registration process is long and costly and very often is not accessible for small companies and new entrepreneurs. Therefore, entrepreneurs have been looking for exemptions from registration with SEC. Besides crowdfunding exemption regulated by JOBS Act, there are several other possible exemptions: Section 4(a)(2) of Securities Act, Rule 506 of Regulation D, Section 4(a)(5) of Securities Act, Rule 504 of Regulation D, Rule 505 of Regulation D, Section 3(a)(11) of Securities Act and Regulation A.
2.1.1. Section 4(a)(2)
“The provisions of section 5 shall not apply to transactions by an issuer not involving any public offering.” 40 Private placement exemption is not applicable to public offering, such as crowdfunding. Furthermore, according to Ralston Purina and other case law, private placement exemption is limited to sophisticated investors, however, the crowd approached to with crowdfunding cannot be recognized as sophisticated.41
2.1.2. Rule 506 of Regulation D
Safe harbour exemption 42 allows derogation form general registration rule in case there is unlimited number of accredited investors and/or up to 35 non-accredited sophisticated investors. Furthermore, this exemption is not applicable if public within the meaning of Section 4(2) of
37 Reves v. Ernst & Young - 494 U.S. 56 (1990) 38 See more: Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.34-42 39 See more: Ibid, p.33-34 40 Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 41 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.45 42 Rule 506 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2.0.1.1.12.0.46.181&idno= 17 14 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Securities Act is involved, meaning, “the company cannot use general solicitation or advertising to market the securities”, 43which includes requirement for pre-existing relationship between investor and issuer. As mentioned before, the use of social media is a peculiar characteristic of crowdfunding and this requirement would restrain the access to the crowd since it allows approaching only pre-existing contacts instead of approaching the anonymous crowd through social media platforms. Therefore, this exemption is also not suitable for crowdfunding.
2.1.3. Section 4(a)(5) of Securities Act
This provision exempts “transactions involving offers or sales by an issuer solely to one or more accredited investors, if the aggregate offering price of an issue of securities offered in reliance on this paragraph does not exceed the amount allowed under section 3(b)(1) of this title, if there is no advertising or public solicitation in connection with the transaction by the issuer or anyone acting on the issuer’s behalf, and if the issuer files such notice with the Commission as the Commission shall prescribe.”44 Thus, accredited investor exemption is applicable if (1) all the investors are accredited investors within the meaning of Rule 501 of Regulation D, (2) all the investors are pre-existing acquaintances, i.e., no general solicitation or advertising is involved, and (3) the total offering price does not exceed $5,000,000. While the $5,000,000 limitation could be suitable for crowdfunding since very often small and new businesses, which would opt for crowdfunding as a mean for capital raising, are looking for a relatively small amount of capital, other two requirements do not comply with the essential characteristic of crowdfunding – approaching the crowd.
2.1.4. Rule 505 of Regulation D
Rule 505 of Regulation D includes an exemption for limited offers and sales of securities not exceeding $5,000,000. 45 Like Section 4(a)(5) this exemption limits the total offering price, however, it also prohibits the general solicitation or advertising and limits the number of unaccredited and unsophisticated investors to 35, denying again access to the crowd.
43 U.S. Securities and Exchange Commission. Rule 506 of Regulation D. Available at: http://www.sec.gov/answers/rule506.htm (last visited 21.06.2013.) 44 Section 4(5) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 45 Rule 505 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2.0.1.1.12.0.46.180&idno= 17 15 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
2.1.5. Rule 504 of Regulation D
Rule 504 or so called seed exemption is applicable to the offerings that do not exceed $1,000,000 as long as the company cannot be defined as blank check company – “a development stage company that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person”. 46 While general solicitation or advertising is not permitted under this exemption, there are certain circumstances when public offer is allowed: (1) selling is in accordance with state law requiring public filing, (2) public filing is required in another state where securities are being sold or (3) selling is in accordance with a state exemption, on condition that securities are being sold to accredited investors only. This leaves issuer with two options – either selling to accredited investors only or to register at the state level. As discussed above, restrictions on investors would deny access to the crowd, while state registration can still be too costly and burdensome for a small company.47
2.1.6. Section 3(a)(11) of Securities Act
Section 3(a)(11) of Securities Act includes an intrastate offering exemption stating that “any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory” 48 is exempted from general registration rules. It means that issuer has to (1) be organized, (2) carry out a significant amount of business and (3) offer securities only to the residents of one particular state. These requirements significantly narrow down the meaning of the term “crowd” and create some burdens for approaching the crowd since the issuer has to determine the residence of every single investor. Intrastate offering exemption could seem possible option for a small local business, although the purpose of crowdfunding is to give a space for growth and limiting the business to just one state does not fulfil this purpose. Thus, the use of intrastate offering exemption might be sufficient for crowdfunding in some cases, while it still does not provide
46 Paragraph (a)(3) of Rule 505 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2.0.1.1.12.0.46.179&idno= 17 47 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.48 48 Section 3(a)(11) of Securities Act of 1933, Available at: http://www.sec.gov/about/laws/sa33.pdf 16 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 with a sufficient legal framework to receive the best out of crowdfunding mechanism. Furthermore, if securities have been resold to a person residing outside the state within a short period of time, the exemption is lost - according to the practice, the term is nine months,49 and this means that issuer should ensure the investors will not resell the securities, which causes approaching to the crowd to be very burdensome.
2.1.7. Regulation A
Regulation A 50 provides companies with a simplified procedure for registration of public offerings. It is accessible for offerings that do not exceed $5,000,000 and Regulation A includes bad-actor disqualifications, excluding such companies as blank check companies and SEC reporting companies from application of this exemption.51 Regulation A also provides companies with a “test the water” opportunity to determine whether there is public interest in offering before actually filing the registration form. 52 However, even with a simplified registration procedure many companies can find this procedure too expensive 53 and, thus, impossible to access the necessary capital through crowdfunding. While Regulation A could work quite well in later stages of the business, it is still unavailable for start-up companies54 and, thus, does not help to achieve the goal of giving the necessary spur to economic growth.
Thus, it can be seen that even with options provided by other exemptions, the legal framework does not allow taking the most benefit out of crowdfunding and it cannot be fully used for raising the capital for small and new businesses due to restricted access to the crowd, limitations in a state level or high costs of registration. Either entrepreneur can attract investors’ attention solely with his business idea by using limited crowdfunding models, i.e. without offering any kind of profit, or it can follow the registration procedure or look for other options to raise the capital.
49 U.S. Securities and Exchange Commission. Intrastate offering exemption. Available at: http://www.sec.gov/info/smallbus/qasbsec.htm#intrastate 50 Regulation A. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&sid=20c66c74f60c4bb8392bcf9ad6fccea3&rgn=div5&view=text&node=17:2.0.1.1.12&idno=17#17:2.0.1 .1.12.0.33 51 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.13 52 U.S. Securities and Exchange Commission. Regulation A. Available at: http://www.sec.gov/info/smallbus/qasbsec.htm#rega 53 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.48 54 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.15 17 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
However, considering the current economic situation and need for entrepreneurial growth, the policy makers could reasonably opt for facilitating the access to the capital by broadening the use of crowdfunding models. Moreover, considering the fact that equity-based crowdfunding model has raised the most funds per project as compared to other crowdfunding models,55 entrepreneurs should not be kept from access to this fundraising method without reasonable research of the issue. The current regulation has developed to this form in order to provide investor protection, market stability, lower systemic risk and integrity of markets, 56 which all have been crucial aspects for existence of healthy securities market. Since facilitating the existing general registration procedure could not be sufficient and might cause too many damage to investors’ protection, and crowdfunding has naturally emerged as a new alternative capital raising mechanism, it seems as a reasonable decision to look into regulating the crowdfunding in order to give entrepreneurs a chance to use it as a capital raising mechanism while at the same time providing protection to investors’ interests. Smart lawmaker reacts to the changes and development in society and if market has found a solution for capital gap, it is more efficient to regulate this issue rather than prohibiting it due to the current legal framework or ignoring it without creating any regulation and guidelines. 57 However, investor protection is crucial in securities law due to the information asymmetry and intermediaries involved in securities trade.58Thus, when assessing and evaluating the best solutions for regulating the crowdfunding exemption, the main aspect taken into consideration must be protection of investors.
2.2. Development of Crowdfunding Exemption
2.2.1. Entrepreneur Access to Capital Act In order to balance the investor protection and the simplified capital raising procedure through crowdfunding, lawmakers considered different solutions for the regulatory framework. While
55 42% of equity-based crowdfunding projects have raised the capital exceeding $100,000 Crowdfunding Growth – Infographic, May 8, 2013. Available at: http://www.crowdfundingeye.com/crowdfunding-growth-infographic/ (last visited: 21.06.2013.) 56 See more: Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.20-24 57 “Crowdfunding needed to be either acknowledged as a potential violation of the securities laws, or, better yet, some kind of registration exemption needed to be created.” Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.4 58 Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.18-20 18 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 there have been several proposals to exempt the crowdfunding from registration with SEC,59 the first bill that actually was approved in the House was the Entrepreneur Access to Capital Act, HR, 2930 (EAC Act). The main provisions of this bill state that (1) offers involving securities transactions at the aggregate annual amount not more than $1,000,000 or $2,000,000, on condition that audited statements have been provided, are excluded from registration requirements, (2) individual investments are limited to aggregate annual amount of $10,000 or 10% of annual income, (3) transactions could be executed with or without involvement of an intermediary, (4) issuer and intermediary can rely on certifications provided by an investor to verify investor's income, (5) intermediaries and issuers are restricted from offering investment advice, (6) capital formation proceeds must be withheld till 60% of target amount have been met, (7) additional requirements for intermediaries are settled: (a) warning the investors on speculative nature of investments in start-ups, emerging businesses and small issuers, risks of illiquidity and restrictions on resale, (b) taking reasonable measures to reduce the risks of fraud, (c) requiring investors to take a questionnaire, (d) giving a notice to SEC, (8) if transaction is executed without the intermediary, issuer is responsible for fulfilling these requirements, (9) SEC should issue rules on “bad-actor” disqualification and implementation of this exemption.60 The original edition of this proposal, however, included only the investment and offering caps, later one to be set up to $5,000,000, pre-emption from the state law and shareholder cap, as well as permission to rely on the certification provided by investors about their income.61 The amendment improves the bill since it offers a little bit more detailed regulation – higher level of investor protection, more reasonable offering cap since crowdfunding is aimed for small and new businesses that usually do not require very large capital, bad-actor disqualifications and the legal acknowledgement of crowdfunding platforms as intermediaries.62
59For example, Petition for Rulemaking: Exempt securities offerings up to $100,000 with $100 maximum per investor from registration, Available at: http://www.sec.gov/rules/petitions/2010/petn4-605.pdf, SEC Government- Business Forum on Small Business Capital Formation—SBE Council Recommendation, Available at: http, Petition on Startup Exemption. Available at: http://www.startupexemption.com/petition#axzz2WaQjprt0 60 Entrepreneur Access to Capital Act, H.R.2930, 2011. Available at: http://thomas.loc.gov/cgi- bin/cpquery/?&dbname=cp112&sid=cp112IqD41&refer=&r_n=hr262.112&item=&&&sel=TOC_1144& 61 Entrepreneur Access to Capital Act, H.R.2930, 2011. Available at: http://thomas.loc.gov/cgi- bin/bdquery/z?d112:HR02930:@@@D&summ2=0& 62 Carleton W. Crowdfunding Bill Improves! October 27, 2011. Available at: http://www.wac6.com/wac6/2011/10/crowdfunding-bill-improves.html (last visited: 21.06.2013.) 19 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
2.2.2. Democratizing Access to Capital Act The Democratizing Access to Capital Act, S.1791 (DAC Act) was introduced on November 2, 2011 but it was not enacted. While the bill is similar to the EAC Act, there are few differences implemented in DAC Act that effects some improvements. Firstly, the offering limit is set to $1,000,000 raised through the issuance of securities in a 12 month period and not annually, as well as the $2,000,000 limit is eliminated.63 As noted by NASAA, if a company is seeking for capital up to $2,000,000 and is capable to provide audited statements, it should also be capable off fulfilling registration requirements through regular procedure of IPO. 64 While 12 month period is harder to monitor than annual reports and it could involve higher administrative costs, this approach is more precise and would better reach the goal to prevent big issuers seeking for high amount of capital from splitting the offer in smaller amounts in order to comply with the crowdfunding exemption, while in fact these companies would be able to bear the costs of IPO. Furthermore, in order to comply with SEC’s integration doctrine,65 it should be ensured that the use of crowdfunding exemption would not affect unfairly the use of other exemptions.66
Secondly, individual investments are limited to $1,000 annually regardless investors’ wealth.67 NASAA argues that anything higher than several hundred dollars could be too harmful for many households and, thus, it is necessary to limit the investment amount per investor. 68 While compliance with fixed investment cap would be easier to control, it is unfair and does not fulfil efficiently the aim to protect investors from overwhelming loss since for wealthier investors this loss might be insignificant while for others it could become unbearable. Furthermore, a limit for
63 Democratizing Access to Capital Act of 2011, S.1791, 2011. Available at: http://thomas.loc.gov/cgi- bin/query/z?c112:S.1791: 64 North American Securities Administrators Association, Inc. Letter to the United States House of Representatives, November 3, 2011. Available at: http://www.nasaa.org/wp-content/uploads/2011/11/NASAA-Letter-on-HR- 2930.pdf 65 According to SEC’s integration doctrine there is five-factor test, as well as the integration safe harbour regulated in Rule 502(a) of Regulation D. U.S. Securities and Exchange Commission. Rule 502(a) of Regulation D. http://www.sec.gov/rules/final/33-7943.htm#P55_11835 (last visited: 21.06.2013.) 66 Statement of Professor John C. Coffee, Jr., Adolf A. Berle at Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=d580503c-a7f3-4db5-b9f5- 968d03af374f , p.8 67 Democratizing Access to Capital Act of 2011, S.1791, 2011. Available at: http://thomas.loc.gov/cgi- bin/query/z?c112:S.1791: 68 North American Securities Administrators Association, Inc. Letter to the United States House of Representatives, November 3, 2011. Available at: http://www.nasaa.org/wp-content/uploads/2011/11/NASAA-Letter-on-HR- 2930.pdf 20 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 investment could be recognized as overprotective and unnecessarily restrictive to investors’ rights.69
Thirdly, the bill requires the transaction to be executed through registered crowdfunding intermediary, while also excluding crowdfunding intermediaries from regulation regarding brokers,70 and, thus, improving the transparency and accountability of crowdfunding while at the same time allowing escape from rules regarding brokers. This issue might be alarming considering that it could cause creation of fake crowdfunding intermediaries in order to arrogate the money. 71 A middle-of-the-road approach would be to prohibit solicitation or employing agents for these activities, leaving this advantage only to registered brokers and dealers.72
And finally, while DAC Act also pre-empts state law, this bill prescribes some circumstances when issuer is required to register in at least one state and pay fees to state authority or SEC.73 This improvement is well received by NASAA since it criticized EAC Act for the lack of state control and investment protection.74 Crowdfunding exemption most commonly will be used by new companies without a significant history of financial statements, therefore, the exemption from registration might be more beneficial for fraudulent activities, even though no exemption from anti-fraud provisions is included.75 While NASAA recognizes the need for facilitated access
69 See part 3.1.2. Investment Limits 70 Democratizing Access to Capital Act of 2011, S.1791, 2011. Available at: http://thomas.loc.gov/cgi- bin/query/z?c112:S.1791: 71 Statement of Professor John C. Coffee, Jr., Adolf A. Berle at Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=d580503c-a7f3-4db5-b9f5- 968d03af374f , p.9-10 72 Ibid, p.9-10 73 Democratizing Access to Capital Act of 2011, S.1791, 2011. Available at: http://thomas.loc.gov/cgi- bin/query/z?c112:S.1791: 74 Written Testimony of Jack E. Herstein, President of the North American Securities Administrators Association, Inc. Before the Senate Committee on Banking, Housing, and Urban Affairs “Spurring Job Growth Through Capital Formation While Protecting Investors”, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=255a1e89-30b9-4036- 9560-b4a0db5def80, p.6-7 75 Statement of Professor John C. Coffee, Jr., Adolf A. Berle at Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=d580503c-a7f3-4db5-b9f5- 968d03af374f, p.7-8 21 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 to the capital for small and new businesses, it founds state regulators to have an important role in monitoring securities transactions that could be executed under crowdfunding exemption.76
2.2.3. Capital Raising Online While Deterring Fraud and Unethical, Non-Disclosure Act of 2011 Another bill regarding the crowdfunding exemption was introduced on December 8, 2011 - Capital Raising Online While Deterring Fraud and Unethical, Non-Disclosure Act of 2011, S.1970 (CROWDFUND Act of 2011). Also this bill maintains the main regulatory issues related to the crowdfunding exemption already implemented in EAC Act and DAC Act, while adding some adjustments. While this bill has some improvements implemented, it still does not provide sufficient ex ante monitoring.77 CROWDFUND Act of 2011 preserves the limitations on the offering, however, it offers more complex regulation on investment limits. Firstly, it sets the 12 month period instead of annual limits and, thus, makes it in compliance with the offering cap. Secondly, it relates the investment limits to investor’s annual income – (1) if investor’s annual income is equal or less than $50,000, investment cannot exceed $500, (2) if the annual income is greater than $50,000 but less than $100,000, investment cannot exceed 1% of the annual income, and (3) if the annual income is greater than $100,000 – 2% of the annual income. And thirdly, the mentioned caps are set for investments in one particular issuer. In addition, the bill provides higher aggregate investment in all the issuers, accordingly, $2,000, 4% and 8% of annual income.78 As already mentioned before, the investment cap should not be the main safeguard for investor protection since it does not solve the problem of potential fraud but simply limits the investors. It would me more reasonable to decrease the offering cap, even though higher cap,
76 Written Testimony of Jack E. Herstein, President of the North American Securities Administrators Association, Inc. Before the Senate Committee on Banking, Housing, and Urban Affairs “Spurring Job Growth Through Capital Formation While Protecting Investors”, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=255a1e89-30b9-4036- 9560-b4a0db5def80, p.7-9, also letter http://www.nasaa.org/wp-content/uploads/2011/11/NASAA-Letter-on-HR- 2930.pdf 77 Testimony of Professor John C. Coates IV, John F. Cogan, Jr. Before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs United States Senate on Examining Investor Risks in Capital Raising, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1d24b42e-3ef8-4653-bfe8- 9c476740fafa, p.12 78 Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011, S.1970, 2011. Available at: http://thomas.loc.gov/cgi-bin/query/z?c112:S.1970: 22 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 especially if allowed to be adjusted according to the current economic situation, could cover a larger capital gap.79
Furthermore, CROWDFUND Act of 2011 defines the term “funding portal” and the regulation related to it.80 Including a term in such a fundamental legislation act as Securities Exchange Act of 1934 provides more fundamental base for the crowdfunding exemption and more regulated approach. 81 While SEC can be delegated to issue some rules regarding securities market, inclusion of the definition of “funding portal” in Securities Exchange Act of 1934 rather than leaving it at SEC’s discretion indicates the crucial role of crowdfunding intermediaries in application of this exemption. In addition, this regulation provides stricter requirements and, thus, prevents malicious salesmen from engaging in fraudulent transactions.82
2.2.4. Jumpstart Our Business Startups Act The development of proposals for the legal framework of crowdfunding exemptions has been gradually developed into the final proposal, implemented in JOBS Act,83 signed into law on April 5, 2012. Besides the Reopening American Capital Markets to Emerging Growth Companies Act, regulating the status of emerging growth companies, the Access to Capital for Job Creators Act, regarding the securities offers to accredit investors, the Small Company Capital Formation Act, related to Regulation A, JOBS Act also includes Title III – Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (CROWDFUND Act). However, so far JOBS Act cannot have been completely implemented since SEC has failed to provide rules and issue studies on capital formation, disclosure and registration requirements according to the
79 Testimony of Mark T. Hiraide Before The Committee on Banking, Housing, and Urban Subcommittee on Securities, Insurance, and Investment, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=348a885d-de31-4054- 8d81-2941256c9607, p.10 80 Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011, S.1970, 2011. Available at: http://thomas.loc.gov/cgi-bin/query/z?c112:S.1970: 81 Testimony of Professor John C. Coates IV, John F. Cogan, Jr. Before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs United States Senate on Examining Investor Risks in Capital Raising, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1d24b42e-3ef8-4653-bfe8- 9c476740fafa, p.15 82 Testimony of Mark T. Hiraide Before The Committee on Banking, Housing, and Urban Subcommittee on Securities, Insurance, and Investment, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=348a885d-de31-4054- 8d81-2941256c9607, p.8-9 83 Jumpstart Our Business Startups Act, 2012. Available at: http://www.gpo.gov/fdsys/pkg/BILLS- 112hr3606enr/pdf/BILLS-112hr3606enr.pdf 23 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 provisions of JOBS Act. Furthermore, there are still some concerns whether this regulation is the best solution for solving the struggle between the protection of investors and increase of capital formation, thus, the provisions of CROWDFUND Act should be analyzed considering the protection of investor and other possible consequences of this regulation.
3. Crowdfunding Exemption under JOBS Act
3.1. Investment Caps
3.1.1. Offering Limit
Crowdfunding exemption sets maximum limit for (1) aggregate investment through crowdfunding to be $1,000,000 in 12 month period84 and (2) maximum investment made by each individual investor to one issuer in a 12 month period depending on his annual income or net worth.85
Opportunity for settling higher target amounts could be considered as favourable for entrepreneurs – their options are not limited with a capital gap and it should also be kept in mind that this limit includes the offerings in last 12 month period. If entrepreneur reaches for higher amount, there are two chances – either number of investors should be significantly larger or each investor contributes higher investment and, thus, increases the risk of loss since there is no risk diversion. It is possible that good idea attracts many investors, however, it is rather believable that the target would not be met and crowdfunding campaign would fail due to the overestimated projections of investments. Not only entrepreneur risks to fail, but in case the target is met, entrepreneur loses a significant portion of ownership to the crowd. Thus, it is hardly believable that a reasonable entrepreneur would opt for raising high amount of capital through crowdfunding, even if crowdfunding gives entrepreneur more power to set the rules for ownership and control ratio.
84 Section 4(a)(6)(A) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 85 Section 4(a)(6)(B) of Securities Act of 1933. Available at:http://www.sec.gov/about/laws/sa33.pdf 24 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
The idea of crowdfunding is to raise considerably small amounts of capital. The average capital sought by start-ups is $25,000.86 While this amount might be sufficient only for low-capital companies and would not help emerging the companies in technological development and science research areas,87 if company is looking for much higher financial support, other capital raising mechanisms than crowdfunding might be more appropriate. Registrations is more inefficient for smaller offers since the capital raised does not outweigh the costs of registration, while for higher offers the registration cost would be easier to bear, therefore, the need for crowdfunding exemption for larger offerings is not so easy to justify.88 Moreover, as mentioned above higher target amounts could cause larger individual investments, which would mean more endangered investor protection in order to satisfy entrepreneur’s need for capital. While in some cases start-ups might need a large start capital, crowdfunding is aimed to support businesses that are seeking for smaller amounts of capital. Crowdfunding exemption should not cover all the possible demands but in this framing in order to implement one-size-fits-all principle investor protection is reduced and unnecessary regulatory burden is created for other entrepreneurs.
Integration doctrine, while well justified, is too complex for small entrepreneurs – they would rarely have the necessary knowledge and abilities to properly assess integration issues without any help, which would create additional costs. Thus, the integration should be applied only to all the transactions under Section 4(a)(6) of Securities Act, i.e. through crowdfunding.89
One could argue that $1,000,000 limit is set considering the 12 month period and it could be divided in smaller offerings. Moreover, this limit includes other securities transferred during the last year – also the ones complying with other exemptions and issued by company’s subsidiaries or companies with which it is commonly controlled.90 It is a common practice for venture capital
86 Why the JOBS Act is Great for US Economy – Crowdfunding Infographic, May 7, 2013. Available at: http://www.crowdfundingeye.com/why-the-jobs-act-is-great-for-us-economy-crowdfunding-infographic/ (last visited: 21.06.2013.) 87 Testimony of Professor John C. Coates IV, John F. Cogan, Jr. Before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs United States Senate on Examining Investor Risks in Capital Raising, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1d24b42e-3ef8-4653-bfe8- 9c476740fafa, p.10-11 88 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.118-119 89 Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.120-122 90 “including all entities controlled by or under common control with the issuer” Section 4(a)(6) of Securities Act of 1933, Available at: http://www.sec.gov/about/laws/sa33.pdf 25 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 funds and angel investors to provide companies with capital in rounds when certain milestones have been met in order to protect investors from losing all the money if business fails. Implementing milestone approach in crowdfunding regulation would be very advisable, since it would incentivize emerging companies to prove themselves and work harder under the scrutiny of investors to reach the goals and apply for more money through crowdfunding for further development. Considering all this, it would be more efficient to frame the regulation, setting lower maximum amount of each single offering by one issuer, for example $250,000, and separating it from maximum amount in a 12 month period, for example $500,000. Furthermore, regarding the inclusion of securities issued by subsidiaries or companies with which it is commonly controlled – crowdfunding exemption is designed for small companies acting in good faith and new start-ups, and not the large chain businesses that should be able to afford the costs of registration or entrepreneurs controlling a significant number of companies, which would usually be explained by the use of different schemes and manipulations. Smaller maximum amount would not only prevent malicious entrepreneurs from extracting large sums from the crowd that could later be channelled for their personal or third party benefit, but it would also allow to facilitate the crowdfunding procedure reducing some disclosure and registration requirements, while at the same time would completely satisfy the needs of honest entrepreneurs acting in good faith.
3.1.2. Investment Limit
Other issue is limitation for each single investment. If annual income or net worth of investor is less than $100,000, in order to comply with crowdfunding exemption requirements, investor is allowed to invest not more than 5% of the annual income or net worth or $2,000 maximum.91 If investor’s annual income or net worth is $100,000 or more, investor can invest 10% of annual income or net worth but not more than $100,000.92
In order to protect investors from damaging loss legislator has set some caps for investment made by each investor. It is impossible to completely assess and control whether each investor is able to make a reasonable decision, while it is relatively easy to assess investor’s financial status and protect him from a loss that lawmaker considers to be unbearable. It is also clear that due to the information asymmetry between issuers and investors, investors need an extra protection.
91 Section 4(a)(6)(B)(i) of Securities Act of 1933, Available at: http://www.sec.gov/about/laws/sa33.pdf 92 Section 4(a)(6)(B)(ii) of Securities Act of 1933, Available at:http://www.sec.gov/about/laws/sa33.pdf 26 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
However, the question that should be addressed is whether legislator has rights to prohibit an individual or a legal entity from freely managing its funds at its own discretion. If so, are investment limits set by JOBS Act the most appropriate?
JOBS Act entitles SEC to issue additional requirements “for the protection of investors and in the public interest”.93 There are no questions about the significance of protection of investors, however, it should be referred to disclosure requirements and other mechanisms in order to prevent information asymmetry. Limiting investors’ rights do not help to solve information asymmetry or agency problems, but it keeps investors from hurting themselves by investing too much money and, thus, protecting investors from the loss they cannot bear.94 This way lawmaker takes an overprotective, socially over-responsible role. This should not be recognized as a sufficient justification for limiting freedom of contract in a democratic country like US. It would also not be justified on the account that, firstly, Section 4A(a)(4)(C) of Securities Act already requires to ensure that investors understand the level of risk, and, secondly, if investor has proven to understand the level of risk, there is no logical ground to presume he is not capable to understand what risk he is able to take and what loss would be too overwhelming. Consequently, there is no need to set a very low individual investment cap on the basis of protection of investors – while it is reasonable to set an offering cap to protect investors from malicious issuers from channelling the high amount of invested money, there is no need to prevent investors from their own decisions, considering that there are already reasonable requirements for investor education, disclosure, transparency and accountability.
The public interest, on the other hand, might be recognized as sufficient justification for limiting investors’ rights. If too many investors due to their own erroneous decisions suffer through severe loss, it could lead to a lack of trust in crowdfunding and capital market as a whole. Therefore, in order to preserve market stability, lower systemic risk and integrity of markets, it would be justified to prevent possible investor failures by limiting their options to invest.
93 Jumpstart Our Business Startups Act, 2012. Available at: http://www.gpo.gov/fdsys/pkg/BILLS- 112hr3606enr/pdf/BILLS-112hr3606enr.pdf 94 Some specialists opt for an overprotective approach demanding a low limit for individual investment, thus, restricting potential investors from handling freely their own financial resources and possibly earn a significant profit: “Both the dollar amount and the income percentage should be low enough that most people could afford to lose that amount.” Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184, p.126-131 27 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
However, the efficiency of protective mechanism implemented by JOBS Act is questionable. It is hardly fair to assess investor’s financial abilities merely by annual income or net worth without considering average expenses and other financial commitments. If lawmaker has taken first step to assess investor’s level of wealth by reviewing the income statement, it should not stop after having done half work and neglect expenses statement. 95 Moreover, the calculations for investment limits do not resist criticism. Investor with an annual income $99,999 is allowed to invest the maximum of $2,000, while an investor receiving $1 more is allowed to invest $10,000. This example clearly shows the disproportion between investments made by each investor and asks for serious reconsidering. If it is accepted that rights of investors are limited for public interest, it should not be acceptable to set down the rules that restricts investors in such an unfair and unequal manner, especially considering that not only investments create risk, but they also provide investors with an opportunity for profit. In this way opportunity for gain is disproportionally and unfairly higher for wealthier part of society.
Another flaw of these conditions is that if one of the criteria – annual income or net worth – exceeds $100,000 threshold while the other one does not pass it, there is no certainty which part of Section 4(a)(6)(B) should be applied in order to define investment limit.96 Since compliance with this rule must be monitored by crowdfunding platforms, it is crucial to clarify the conditions rather than settling it through precedent law dragging crowdfunding platforms through unnecessary litigations.
Considering these arguments, the investment cap should be regulated similarly as proposed in EAC Act setting the limit of $10,000 or 10% of annual income or net worth, whichever is the lowest.
95 “The investor’s net worth and annual income will be calculated the same as accredited investors, which allows investors to include the net worth and annual income of their spouse. Additionally, the value of the investor’s primary residence and its mortgage are excluded, unless the mortgage exceeds the value of the residence.” Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.35 96 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.35-36 28 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
3.2. Intermediary’s Obligations
3.2.1. Mandatory Intermediaries and Registration
The transactions must be enacted through a broker or funding portal, i.e. crowdfunding platform. Every crowdfunding platform must register with SEC as a broker or funding portal and register with any applicable self-regulatory organization. 97 “The term ‘‘funding portal’’ means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others [..] that does not—
A. offer investment advice or recommendations; B. solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal; C. compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; D. hold, manage, possess, or otherwise handle investor funds or securities; or E. engage in such other activities as the Commission, by rule, determines appropriate.“98
The mandatory nature of intermediary is required in order to prevent fraud and other abusive offerings. While it is hardly believable that entrepreneurs will opt for using brokering services,99 it seems reasonable to have registered funding portals through which the crowdfunding could be ensured in order to retain some control and oversight over these transactions.100 While brokers are allowed to perform different services that funding portals are strictly restricted from, funding portals enjoy the advantages of facilitated registration requirements. 101 For example, one difference is that funding portals are prohibited from solicitation or compensating solicitation of the securities offered on the website, while crowdfunding platforms, including both – funding
97 “The term ‘‘self-regulatory organization’’ means any national securities exchange, registered securities association, or registered clearing agency, or (solely for purposes of sections 19(b), 19(c), and 23(b) of this title) the Municipal Securities Rulemaking Board established by section 15B of this title.” Section 3(a)(26) of Securities Exchange Act of 1934, Available at: http://www.sec.gov/about/laws/sea34.pdf, currently for example - the Financial Industry Regulatory Association (FINRA), Section 4A(a) of Securities Act of 1933, Available at: http://www.sec.gov/about/laws/sa33.pdf 98 Section 3(a)(80) of Securities Exchange Act of 1934. Available at: http://www.sec.gov/about/laws/sea34.pdf 99 Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.8 100 See part 2.2.2. Democratizing Access to the Capital Act 101 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.54 29 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 portals and brokers – are not,102 thus, resulting in the regulation that puts funding portals and brokers in different positions. While this inequality could be seen as unjustified,103 it arises from different registration requirements and it prevents emergence of fraudulent funding portals. Nevertheless, requirements and obligations for intermediaries might seem overly burdensome and raise concerns whether the costs of portal would outweigh the benefits of crowdfunding and whether it would not lead to extinction of many crowdfunding platforms.
Mandatory involvement of intermediaries is justified by the need for information exchange between entrepreneur and potential investors. It is more convenient for SEC to designate some intermediaries, i.e. registered funding portals and brokers, who review compliance with disclosure and other requirements, and fill the role of gatekeepers that prevent entrepreneurs and investors that are not eligible for crowdfunding exemption from executing securities transactions. It is also more convenient for entrepreneurs and investors to execute the transactions through trustworthy crowdfunding platforms that gather in one place all the interest parties, supplying entrepreneurs with potential investors, i.e. the crowd, and investors with investment opportunities that have passed certain pre-approval procedure. While any blank check company could create a campaign on social platform or specially designated website for promoting crowdfunding transactions to defraud money from uninformed individuals, relation with registered intermediary would create confidence in this offer. Finally, crowdfunding platforms have already proven their usefulness and efficiency – the growing number of crowdfunding websites and stronger position in business environment has shown that market willingly chooses available platforms for crowdfunding projects.
The registration obligation for intermediaries is reasonable in order to retain control over the intermediaries and to monitor their activities. Registration with applicable self-regulatory organizations might facilitate the fulfilment of funding portals’ obligations since these organizations can help with filling the gaps in legal regulation and assist funding portals with guidelines regarding the disclosure requirements and other rules issued by SEC.104
102 Section 3(a)(80) of Securities Exchange Act of 1934. Available at: http://www.sec.gov/about/laws/sea34.pdf 103 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.64-65 104 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.54-55 30 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
However, registration procedure for funding portals has not been approved by SEC yet. While a simple formal registration procedure, requiring statement of some basic information about funding portal, should not raise any concerns, if SEC opts for strict registration requirements or additional filings, this could have a damaging effect on crowdfunding. Unnecessary burdensome requirements could diminish the number of active crowdfunding platforms, interfering with the competition between different crowdfunding platforms and disrupting the market, which would rather harm its clients than help protecting securities market and investors. Additionally, if obligations for funding portals are too burdensome, crowdfunding platforms could rather opt for other crowdfunding models, which would mean that regulation does not fulfil its purpose and legislator has failed and has created a redundant and pointless legal framework.
3.2.2. Information Asymmetry
One of the responsibilities of crowdfunding intermediaries is to reduce information asymmetry and prevent fraud. Crowdfunding platforms as intermediaries are responsible for both sides of information exchange - providing sufficient level of information about the issuer and ensuring investor has a sufficient level of information. This must be done by providing investors and SEC with all the information submitted by issuer not later than 21 days (or other period of time determined by SEC) before securities sale and “obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person”.105
Reducing information asymmetry has to be achieved by ensuring that investors and SEC receives disclosed information provided by issuer at least 21 days before the first transaction.106 It seems as a reasonable obligation for an intermediary – funding portal acts merely as a mailman between issuer, investors and SEC. If information is not submitted or it is not sufficient, crowdfunding is not launched and transactions do not take place. Funding portal has power to automatically launch the campaign as soon as the term of 21 days has passed and prevent launching if requirements have not been fulfilled, thus, funding portal acts as a gatekeeper preventing securities transactions where investors have not been properly informed about the business. The procedure for submitting the information should be regulated. Since crowdfunding is internet-
105 Section 4A(a)(5) of Securities Act, of 1933. Available at:http://www.gpo.gov/fdsys/pkg/BILLS- 112hr3606enr/pdf/BILLS-112hr3606enr.pdf 106 Section 4A(a)(5) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 31 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 based and aims at supporting large number of start-ups, emerging businesses and small companies, in order to reduce administrative costs, all the information to SEC and to the investors should be provided electronically– either via e-mail or on the website. Crowdfunding platform should ensure that each investor has provided it with an electronic mailbox address and that all the related information is sent to corresponding recipients. Failure to deliver information in appropriate time and manner can be a reasonable ground for damage claim and if this issue is not strictly regulated and the responsibilities of each party involved are not explicitly stated, crowdfunding platforms would be open to higher risk of litigation.
However, it should be explicitly stated that crowdfunding platforms are not responsible for the content of these disclosures. The content should be responsibility of the issuer, as stated in liability provisions of Securities Act, and reviewing the content should be responsibility of SEC. Crowdfunding platform should execute formal check of submitted information and, only in case no objections have been received from SEC, launch the campaign at maturity.
JOBS Act also provides that crowdfunding platforms are obliged to review background and history of issuer’s key persons and fulfil other requirements determined by SEC.107 SEC should provide clear information on what exactly should be reviewed, since crowdfunding platforms will be competing amongst each other and potential issuers might pick those platforms, which are more favourable in revealing their particular background and other information, and this would result in unequal information exchange between issuers and potential investors.108
Since crowdfunding is mostly aimed at start-ups, emerging businesses and small companies, it is possible that most usually there would be a few key persons. If during this background review crowdfunding platform discovers information that excludes issuer from crowdfunding exemption, platform should issue a decision. In this case, there should be mechanism regulated by SEC for entrepreneur to appeal the decision in order to maintain the principle of fairness and rule of law. All the facts discovered during this review should be available to investors in order to make a considered decision about the investment. However, the liability of intermediary should be addressed properly in case no questionable facts have been discovered during the review, yet after completing securities transactions information about fraudulent or in any other way abusive
107 Section 4A(a)(5) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 108 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.59-60 32 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 activities of issuer have been discovered. Only the issuer is liable for making an untrue statement of a material fact or omitting to state a material fact required to be stated or necessary in order to make the statements not misleading. This would mean that in fact crowdfunding platforms would perform only a formal review to ensure that it has addressed this requirement with a reasonable care, while any other undisclosed information would be the responsibility of issuer since it would have omitted to provide the requested information. Meanwhile, it should be noted that crowdfunding platforms could still be found liable under Rule 10b-5,109 therefore law-maker should give a proper attention to this question in order not to drive away potential crowdfunding platforms due to the high risk of liability for the matters crowdfunding platforms do not have direct impact on.
Furthermore, SEC can determine additional requirements for crowdfunding platform in order to reduce the risk of fraud,110 however, SEC should keep in mind that crowdfunding platforms are only intermediaries and cannot have sufficient access to the information in order to prevent all the threats of fraud. Moreover, crowdfunding platforms are not public authorities entitled to investigate every case and take overly excessive actions against fraud. If SEC tries delegating too many responsibilities to crowdfunding platforms, it will have negative impact on development of crowdfunding.
3.2.3. Investor Education Regarding the level of information available to investors, crowdfunding platforms must provide investors with educational information and disclosures related to risk, as well as any other disclosures required by SEC.111 Moreover, platforms must ensure that each investor reviews this information, understands the risk of loss and affirms that he is ready to bear such loss. Each investor also has to fill a questionnaire demonstrating level of understanding of risk related to start-ups, emerging businesses and small companies, risk of illiquidity and any other matters as required by SEC.112
The duty of educating the investors is an additional obligation to the regular broker-dealer duties with the purpose to screen out investors who are not fitted to make a reasonable decision on
109 Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.10 110 Section 4A(a)(5) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 111 Section 4A(a)(3) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 112 Section 4A(a)(4) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 33 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 investing.113 While crowdfunding platforms as gatekeepers might seem the most suitable for this duty, the obligation to ensure that investors have sufficient level of knowledge and understanding in practice seems to have rather formal effect. It could be easily resolved by providing investors with educational welcome package at the registration, some check-boxes for investors to positively affirm they have reviewed the information, they understand the possible risks and can bear these risks, and a questionnaire to evaluate investors’ level of understanding – if the threshold distinguishing “sufficient level” is not reached, investor is declined to make an investment, until retaking the test after a certain period of time.
Two problems arise from this obligation – technical development and content of educational material and questionnaires. Regulation provides that investor-educating information is in accordance with standards set by SEC and that SEC is entitled to determine other matter that should be included in questionnaire, 114 however, it leaves each funding portal with its own interpretation of what information should be included in educational material and questionnaire. Moreover, the technical development of this material and questionnaire might be unnecessarily costly and time consuming.
In order to provide all the investors with equal and sufficient information and to reduce unnecessary development costs, the most efficient solution would be for SEC or self-regulatory organizations, such as FINRA, to develop the template of educational material and questionnaire that would be provided to the crowdfunding intermediary at the registration with SEC or applicable self-regulatory organization. Investor education is one of FINRA’s critical components.115 There are several educational mechanisms and materials that FINRA has already enacted and using it as a basis for centralized investor education on each crowdfunding platform would be time and cost efficient.
Firstly, this solution is more efficient since the educational material and questionnaire has to be developed only once and not by each crowdfunding platform separately. Secondly, it would
113 Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.10-11 114 Section 4A(a)(4)(A), Section 4A(a)(4)(C)(iii) of Securities Act of 1944. Available at: http://www.sec.gov/about/laws/sa33.pdf 115 FINRA. Testimony of Stephen Luparello Vice Chairman Financial Industry Regulatory Authority Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing, and Urban Affairs United States Senate, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=f79bdc28-a492-4089-8831- d1a68886178d p.9-10 34 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 ensure some uniformity in information provided to potential investors and in testing the level of investors’ understanding, and, thus, preventing any possibility of unequal treatment. Thirdly, having unified educational materials and questionnaire would reduce the costs of reviewing the compliance of every single material and questionnaire created by different funding portals with SEC standards and rules.
3.2.4. Compliance with Investment Caps
Crowdfunding platforms must also ensure that investment limits are respected – in particular investment limit for each investor in a 12 month period for all the issuers. The mechanism will be determined by SEC.116 While it is doable within one crowdfunding platform, the problems could arise for platform to ensure that investors using its services at the same time are not using services provided by other platforms, which would allow them investing in different issuers up to $100,000 through every funding portal. Another issue is that while investment limit is set for all the securities purchased from a single issuer by one investor during the last year, crowdfunding platform must oversee the sale of securities sold only through crowdfunding from all the issuers to one investor during the last year. This inconsistency could be explained as an error or as a reflection of difficulties related to this particular monitoring duty.117
Detailed mechanism how to monitor the compliance with investment limits will be determined by SEC. Two most reasonable solutions would be requiring investor to inform about investments on other portals or creating a single database for all the investors. If SEC opts for the first option, it would not definitely ensure investor has not made other investments. Investor can simply fail to inform about other investments, funding portal is responsible for preventing excess of investment limits but it cannot verify this information, and in the end enforcement of investment limitations fails. If SEC decides for a single database, it would be easier to administrate this database by a single authority, such as SEC or self-regulatory organizations. SEC should consider this when developing regulation regarding this issue.
Duty to monitor the investment limits also applies to the offering caps, since crowdfunding exemption is applicable only to the offering below $1,000,000 limit during a 12 month period. While this is certainly issuer’s responsibility, since otherwise it would offer securities without
116 Section 4A(a)(8) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 117 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.62 35 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 required registration, it is not obvious if some boilerplate provisions on the platform, through which issuer confirms compliance with this requirement would be sufficient to prevent any liability of crowdfunding platform.
3.2.5. Other Obligations
Another obligation of crowdfunding platforms is to ensure that issuer receives the proceeds only when the target has been reached. There are also some additional investor protective obligations, such as, the rights to cancel the commitment to invest,118 investor privacy issues.119 Regarding the disbursement of raised funds, rights to cancel the investment and investor privacy issues – these issues have already been implemented by crowdfunding platforms and should not cause any unnecessary burdens that could discourage crowdfunding platforms from launching equity-based crowdfunding campaigns. In practice the disbursement issue should be approached with sufficient care, since due to the rights to cancel investment and precedents regarding escrow- release,120 a possible litigation might arise. Furthermore, another mechanism for disbursement of raised funds might be necessary to implement, since funding portals are prohibited to handle issuer’s funds or securities in any way.121 Additionally, rules for adjusting target amount and deadline should be issued122 – whether issuers are allowed to make the adjustments, and, if so, the procedure for adjustments should be regulated in order to respect investor protection.
Possible conflict of interest is addressed, prohibiting platform’s key persons from having any financial interest in an issuer using crowdfunding services.123 The rules on conflict of interest between key persons of crowdfunding platform and the issuer should also be expanded to regulate more details on application of conflict of interest provisions.124
118 Section 4A(a)(7) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 119 Section 4A(a)(9) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 120 See more: Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.11-12 121 Section 12(80)[14](D) of Securities Exchange Act of 1934, Available at: http://www.sec.gov/about/laws/sea34.pdf 122 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.43 123 Section 4A(a)(1) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 124 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.65-66 36 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Furthermore, SEC is entitled to issue any other requirements it founds appropriate, 125 thus, leaving options for other obligations that could discourage crowdfunding platforms from pursuing equity-based crowdfunding campaigns, which would hinder the development of entrepreneurial environment.
3.3. Issuer’s Obligations
3.3.1. Financial Disclosure
JOBS Act also sets requirements for the issuer - issuer is required to disclose certain information in order to reduce information asymmetry. Besides basic information, such as name, legal status, contact information, description of business, business plan, description of purpose for crowdfunding, the target amount, deadline and regular updates on progress in meeting the target, price and method of evaluating the price, some additional information must be disclosed. Firstly, the financial disclosure requirements are divided according to the aggregate target offering amounts in 12 month period. If the aggregate amount does not exceed $100,000, issuer must submit income tax return filings for last year and financial statement certified by CEO. If the aggregate target amount is higher but does not exceed $500,000, financial statements must be reviewed by public independent accountant. And finally, if the target amount exceeds $500,000, financial statements must be audited. Additionally, SEC is entitled to change the threshold for audit statement requirement and issuer is obligated to file an annual report according to the rules set by SEC.126
Disclosure is one of the crucial aspects of securities laws, since it ensures higher level of investor protection from abuse of information advantages by issuer and eventually serves public interest by stabilizing securities market. Under this regulation main disclosure requirements are equal to all the issuers, while financial statement disclosures differ based on the target amount of crowdfunding. Gradual approach helps to bring out the nature of crowdfunding regulation, allowing smaller entrepreneurs to access the capital easier, while implementing stricter requirements if the target amount is higher. Three level distinction and, accordingly, approval by CEO, public accountant or auditor balances investor protection and costs of providing required disclosure.
125 Section 4A(1)(12) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 126 Section 4A(b)(1) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 37 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
While gradual approach is efficient and in accordance with the aim of the law, it has one flaw – it is based on aggregate target amount and not the amount actually raised through crowdfunding.127 Since crowdfunding exemption does not prohibit raising more capital than the target amount as long as it complies with $1,000,000 limit, it is possible that investors have invested large amount of money while issuer is required to provide only a financial statement approved by CEO. The purpose of this provision is to provide potential investors with financial information about issuer in order to help them to make a considered decision about the investment. It means that in order to fulfil this purpose, it would be necessary to adjust the phrasing of the provision so that disclosure requirements depend on the aggregate amount of securities sold in all other offerings of the issuer under section 4(6) within the preceding 12-month period and the target amount of the current offering. Since financial information is disclosed before the end of offering, it is not possible to relate disclosure requirements to the actual capital raised through the offering in question.
While proponents of crowdfunding are confident that these disclosure requirements are too demanding and too overwhelming for small companies and start-ups,128 defenders of investors’ rights argue that disclosure requirements are not sufficient. 129 It must be noted that these requirements are stricter than the ones under other securities exemptions.130 While there are only some eligibility requirements for other exemptions, crowdfunding exemption requires a comparably complicated financial report. These additional requirements can be justified by additional risk that comes with the crowdfunding exemption – crowdfunding exemption involves public solicitation and, thus, “the crowd”. It is possible that financial statements might be more useful for sophisticated investors rather than the crowd, however, since the crowd needs higher level of protection than sophisticated investors, these additional requirements help to improve transparency and allows SEC overseeing the performance of companies using crowdfunding. Moreover, logically companies that cannot afford higher disclosure costs are seeking for lower
127 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.40-41 128 For example, see: Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.11-12 129 For example, see: Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744 , p.41-43 130 Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.11 38 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 target amount, and this is where gradual approach comes in handy – the more money is at stake, the higher are the costs. As mentioned before, average crowdfunding campaign would fall within the lower level of disclosure requirements and, thus, would not cause unreasonable costs.
At the same time, the accounting standards only allow accountants to give negative assurances that nothing to indicate lack of completeness or accuracy has been found, since there is no procedure for accountants to give a positive assurance for unaudited statements, and CEO approval does not give enough credibility, giving more opportunities for fraud and scams.131 While it is true that crowdfunding exemption exposes investors to higher risk of misstatements and omissions, there are still mechanisms for civil and criminal liability. It should be kept in mind that “the securities laws are about economic tradeoffs that are realized politically by balancing constituent interests. It remains impossible to foster economic growth without taking some measure of risk.”132 It is the market that should prevail and determine the law, and not the other way around – if market signals that it is ready and willing to implement crowdfunding, legislator should adapt and give space for crowdfunding to develop, while at the same time stay alarmed in order to react if abuse of regulation appears. The current approach is a good solution to balance transparency - and thus, the protection of investors - with transaction costs, i.e. the interests of entrepreneurs.
Information asymmetry and control over issuer is also mitigated by annual reports to SEC, which help to prevent misconduct after securities transactions. Request for a financial report once in a year is reasonable since it does not distract issuer from its main business and does not require excessive consumption of resources, while it puts a pressure on entrepreneur to act in order not to leave a negative impact on the report and it provides transparency and gives investors opportunity to review company’s performance. However, SEC is entitled to issue the rules requiring more often reports, and while monthly or quarterly reports would increase the transparency, it would not outweigh the effort required from the entrepreneur to fill these reports. Likewise, SEC should not exempt any issuers from these reports 133 since it would give more opportunities for arbitrariness by entrepreneurs since no accountability can be demanded and verified. Similarly,
131 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.41-43 132 Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.34 133 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.49 39 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
SEC has power to either improve the crowdfunding exemption by issuing reasonable annual report requirements or to nullify its effect by creating burdensome regulation that would overwhelm small and new businesses.
3.3.2. Other Disclosures and Promotion Restriction
Furthermore, issuer must disclose description of ownership and capital structure, including the names of directors, officers and other persons with a similar status, as well as the owners of at least 20% of shares, terms of securities and description of possible risks and other negative impacts. 134 The question raising concerns is that description of possible risks might be too complex for entrepreneurs and it would be impossible to develop them without the help from lawyers and accountants. Since hiring lawyers and accountants would increase the costs and create unnecessary burdens, especially for companies with single-class shares, SEC could facilitate this procedure by providing issuers with guidelines regarding risk disclosures or standard language for these disclosures. Another option would be to delegate these functions to intermediaries or self-regulatory organizations, however, it would be better to have a centralized approach in order to avoid unnecessary reviews and different interpretations of what is recognized as sufficient disclosure of potential risks.135
Additionally, SEC is entitled to require disclosure of any other information for the purpose of protection of investors and public interest. Again, this is a chance for SEC to either support or to bury the crowdfunding exemption by overwhelming regulations.
Besides disclosure requirements, JOBS Act sets some restrictions on advertising and promotion of the offer, as well as empowers SEC to prescribe other requirements for the protection of investors and public interest.136 Furthermore, JOBS Act restricts issuer from advertising the offer without directing the potential investor to the intermediary. There are some uncertainties how this direction should be ensured, thus, SEC should issue rules to regulate in more details the advertising of the offer. The same applies to the compensations of promoters.137
134 Section 4A(b)(H) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 135 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.45-46, 56-57 136 Section 4A(b)(1)(I) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 137 Section 4A(b)(2) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf, Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.46-47 40 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
3.3. Other Provisions It should be noted that securities sold through crowdfunding are restricted and cannot be transferred within one year of purchasing, except for special circumstances, i.e. transferring back to issuer, an accredited investor or member of family and transferred in relation to death or divorce or as part of an offering registered with SEC, as well as other circumstances set at SEC’s discretion.138 Crowdfunding exemption is applicable to the transactions and not the securities, thus, there is a one year restriction on resale of securities. This restriction is also common for other exemptions, 139 and it does not prohibit secondary market of securities older than one year, 140 although it is possible that secondary market for securities obtained through crowdfunding might not be very dynamic and active.
Crowdfunding exemption is not applicable to SEC reporting companies and investment companies, as well as if decided by SEC.141 JOBS Act also sets liability to issuers for (1) making an untrue statement of a material fact, (2) omitting to state a material fact required to be stated or necessary in order to make the statements not misleading, on condition that purchaser did not know of such untruth or omission, unless issuer in the exercise of reasonable care could not have known of such untruth or omission.142 Liability under Section 4A(c) is similar as the one in section 12(a)(2), therefore, most probably the same case law will apply. However, there is a small difference in wording that distinguishes the object of the provision – issuer or any person that sells or offers the securities, and this issue will be most probably settled by case law, which might not be favourable for crowdfunding platforms.143
Some other adjustments have been made in relation to crowdfunding exemption, i.e. excluding investors acquiring securities through crowdfunding from shareholder cap,144 excluding funding
138 Section $A(e) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 139 Rule 504, 505 and 506 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&sid=20c66c74f60c4bb8392bcf9ad6fccea3&rgn=div5&view=text&node=17:2.0.1.1.12&idno=17#17:2.0.1 .1.12.0.42.179 140 Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.13 141 Section 4A(f) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 142 Section 4A(c) of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 143 Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744, p.68-69 144 Section 12(g)(6) of Securities Exchange Act of 1934. Available at: http://www.sec.gov/about/laws/sea34.pdf 41 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 portals from requirement to register as a broker or dealer,145 and set the rules regarding state law.146
3.4. Overview
These requirements might be seen as too burdensome for crowdfunding platforms and the effort needed to comply with all the requirements would not be worth the remuneration crowdfunding platforms could obtain by commission fees and advertising.147 However, crowdfunding platforms would serve a large number of entrepreneurs and while some of them would not be capable of bringing in a significant profit, others would provide quite generous commission fee. Moreover, crowdfunding platforms, such as ProFounder, had shut down before signing into law the JOBS Act and it is not a result of the new regulation but the lack of any regulation at all. JOBS Act sets the general framework of intermediary’s duties and as for now, except for some issues, for example regarding the investment limits, it is reasonable. It only depends on SEC, whether it will choose the approach to lead this framework towards establishing a successful entrepreneur- friendly capital raising mechanism that would also protect investors and the market in a sufficient level, or it will override the positive direction started by JOBS Act regulation by implementing an impractical and unusable procedure for crowdfunding. If SEC opts for the first option, crowdfunding platforms would be able to create an efficient mechanism with reasonably small transaction costs and, thus, it would not hinder even small companies seeking for relatively small target amount. On the other hand, if SEC focuses on high target amounts up to $ 1,000,000 that according to JOBS Act is now available through crowdfunding and pushes on investor protection and more transparency, the crowdfunding exemption will not fulfil its intention. Meanwhile, it should be bore in mind that crowdfunding exemption is not supposed to be only in favour of entrepreneurs – it is supposed to balance the investor protection and facilitate the capital raising for new and small companies.148
145 Section 3(a)(80) of Securities Exchange Act of 1934. Available at: http://www.sec.gov/about/laws/sea34.pdf 146 Section 18 of Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 147 “At least one crowdfunding site committed to small business development, Profounder, shut down as a result of the new regulations.” See more: Cohn. S.R. The New Crowdfunding Registration Exemption : Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016, p.10,13 148 “These disclosures represent a compromise between the business industry and investor protection advocates—it will no longer be cost-prohibitive to issue crowdfunding securities, but the fundamental safeguards will be there.” Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953, p.33 42 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
The question remains – whether the potential risk of fraud and other misconduct is worth the possible economic growth and development. While the amount of investment by each investor through crowdfunding would be considerably small, in aggregate it would create a large amount that in case of fraud would have a serious impact on the market as a whole. However, even with the stiffest regulations and strongest requirements it is impossible to eliminate a potential risk.149 People have their own will and it is impossible to prohibit all the actions that could lead to a potential harm. It is true that one of the purposes of law is preventive function, however, even regarding more important matters, such as person’s life, health and humanity, the law sets the punishment for the crime itself and not the actions that could possibly lead to the crime. An example could be used to describe the overprotective approach of crowdfunding opponents – it is possible that the use of knife could lead to a murder, however it would be unreasonable to prohibit people from holding a kitchen knife only because it could cause harm. Crowdfunding exemption could be used for fraud, but it does not necessarily mean that it is a sufficient reason to eliminate it with burdensome regulation. Moreover, the crowd is a specific player in the market and the transparency and accountability could probably be better ensured by some other self- policy mechanisms – similar as the ones already implemented in crowdsourcing platforms such as eBay and Amazon or the Crowdfunding Accreditation for Platform Standards (CAPS) for self- reviewing the crowdfunding platforms.150
149 Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051, p.30-32 150 PROTECTING THE CROWD AND RAISING CAPITAL THROUGH THE JOBS ACT, p.33-34 43 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Conclusions
In order to overcome the consequences of economical step-back, policy-makers are looking for ways to boost economy, one of the solutions to be facilitating the capital formation for small and new businesses. Capital can be raised through several options, however, very often these options might not be suitable for small and new businesses, therefore, crowdfunding – a blend of crowdsourcing and microfinance – has emerged as a new capital formation mechanism, mixing the characteristics of venture capital and social media.
Crowdfunding is costs and time-efficient, it creates an access to a new capital source – the crowd; it provides everyone with freedom to invest, it eliminates industrial and geographical borders and it provides support in the means of marketing. At the same time crowdfunding decreases investor protection, it eliminates the distinction between accredited and unaccredited investors, it endangers the protection of business idea, it is likely to be unsuccessful for companies seeking for a large capital and it could cause difficulties to obtain capital from other sophisticated investors. It is up to the company itself to decide what its best option for capital formation is, but it should be recognized that improving the crowdfunding can give a significant input in covering the currently existing capital gap.
There are different variations of crowdfunding. All the crowdfunding models can be categorized in 5 groups based on the return for the contribution: donation, reward, pre-purchase, lending and equity model. The issue in question is compliance of crowdfunding with the securities laws and investor protection.
According to the securities laws the equity model and the lending model with interest should be registered with SEC unless exemption is applicable. Legal framework without implementation of crowdfunding exemption does not allow taking the most benefit out of crowdfunding and it cannot be fully used for raising the capital for small and new businesses due to restricted access to the crowd, limitations in a state level or high registration costs.
Lawmaker must react to the changes in society and provide necessary regulation instead of ignoring or prohibiting the issue without adequately analyzing it. One of the mains aspects that must be taken into consideration when analyzing the regulation for crowdfunding exemption is the level of protection of investors.
44 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
The legal framework of crowdfunding exemption has gradually developed and it is implemented in JOBS Act, signed into law on April 5, 2012, however, crowdfunding exemption still cannot be put to use die to the lack of rules that must be issued by SEC for implementation of this exemption.
There are three main issues regulated by crowdfunding exemption implemented by JOBS Act: investment limits, intermediaries’ obligations and issuers’ obligations.
Larger offerings could increase risk for issuer and investors, and thus, result in either additional disclosure requirements for the issuer or insufficient protection of investors. Crowdfunding exemption is designated for businesses seeking for smaller amounts of capital, and implementing one-size-fits-all principle to cover larger capital gap would cause unjustified harm for investors and other entrepreneurs. Furthermore, integration should be limited only to the securities offered under crowdfunding exemption and milestone approach should be implemented in order to reduce the costs, to reduce the amount of money at stake and to incentivize entrepreneurs to improve their performance. It would be more efficient to set lower maximum amount of each single offering by one issuer, for example $250,000, and to separate it from maximum amount in a 12 month period, for example $500,000.
Limits for the size of individual investments could be justified with protection of investors or public interest. Since regulation also requires investors to prove their level of understanding of the possible risks, it is undemocratic to restrict potential investors from freely managing their funds. Investment caps can be justifies with public interest – investors are limited to invest in order to preserve market stability, lower systematic risk and integrity of markets.
Current investment cap creates disproportional inequality between potential investors and does not reflect investor’s actual ability to bear the loss. Moreover, there is no clarity which provision is applicable if investor’s net worth and annual income falls within the scope of different provisions, which could cause unnecessary litigations to crowdfunding platforms. Possible solution would be to regulate the investment caps similarly as proposed in EAC Act by setting the limit of $10,000 or 10% of annual income or net worth, whichever is the lowest.
Crowdfunding exemption prescribes mandatory use of intermediaries – funding portals or brokers. Mandatory involvement of intermediaries benefits in different ways: improves monitoring, transparency, accountability and efficiency, ensures proper information exchange
45 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 between issuer and investors, prevents fraud and reviews the compliance with requirements and prevents ineligible participants from using crowdfunding exemption.
Registration with self-regulatory organizations can also provide intermediaries with support and fill the caps of legal regulation. Registration of funding portals with SEC is facilitated by excluding from regulations regarding brokers, however, it also includes restrictions on services allowed to be provided by funding portals in order to prevent emergence of fraudulent crowdfunding platforms. However, registration procedure is not approved by SEC yet, and SEC should approach this issue with sufficient care since overly burdensome requirements could have a damaging effect on crowdfunding.
Procedure for providing information should be regulated by SEC in more details in order to avoid potential litigation on the grounds of failure to deliver information in appropriate time and manner. Considering that crowdfunding is internet-based and to reduce administrative costs, all the information should be provided to the corresponding parties electronically. The content of the information provided should be responsibility of the issuer and reviewing the content should be responsibility of SEC. Intermediary should execute formal check of submitted information and, only in case no objections have been received from SEC, launch the campaign at maturity.
Regarding the background review and history check performed by intermediaries, firstly, in order to maintain the principle of fairness and rule of law there should be a mechanism regulated by SEC for entrepreneur to appeal the decision of crowdfunding platform if it discovers information that excludes issuer from crowdfunding exemption. Secondly, if no questionable facts have been discovered during the review, yet after completing securities transactions information about fraudulent or in any other way abusive activities of issuer have been discovered, law-maker should give a proper attention to the liability of intermediaries in order not to drive away potential crowdfunding platforms due to the high risk of liability for the matters crowdfunding platforms do not have direct impact on. Thirdly, if SEC issues more requirements for intermediaries on this matter and, thus, delegates too many responsibilities to crowdfunding platforms, it will have negative impact on development of crowdfunding.
Two problems arise from the obligation of intermediaries to educate the investors – technical development and content of educational material and questionnaires. The most efficient solution would be for SEC or self-regulatory organizations, such as FINRA, to develop the template of
46 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 educational material and questionnaire that would be provided to the crowdfunding intermediary at the registration with SEC or applicable self-regulatory organization. Firstly, it would reduce the overall costs of development of these materials since materials should be developed only once for every intermediary, secondly, it would ensure uniformity in the content and, thus, prevent unequal treatment, and thirdly, it would reduce the costs of reviewing the compliance of every single material and questionnaire created by different funding portals with SEC standards and rules.
Monitoring the compliance with investment limits is unclear under current regulation since there is no mechanism to verify investors’ investments through other crowdfunding platforms and intermediary’s obligation differs from the investment cap rules. This could be solved either by investor’s verification about his other investments, however, it would not be reliable and it could cause liability of intermediaries, or by creating a single database for all the investments made by the potential investors under crowdfunding exemption. This database should be best administrated by SEC or self-regulatory organizations.
Crowdfunding exemption prescribes stricter disclosure rules than other exemptions, which is justified by additional risk that comes with public solicitation and, thus, “the crowd”. The crowd needs higher level of protection than sophisticated investors, and these additional requirements help to improve transparency and allow SEC overseeing the performance of companies using crowdfunding. Crowdfunding exemption involves higher risk of misstatements and omissions, however, economic growth is not possible without reasonable measure of risk and there are still mechanisms for civil and criminal liability.
JOBS Act prescribes gradual approach for disclosure requirements regarding financial statements, which reasonably balances protection of investors and the costs of disclosure. However, in order to provide potential investors with financial information about the issuer to help them to make a considered decision about the investment, financial disclosure requirements should be related to the aggregate amount of securities sold in all other offerings of the issuer under section 4(6) within the preceding 12-month period and the target amount of the current offering. Information asymmetry and control over issuer is also mitigated by annual reports to SEC, which help to prevent misconduct after securities transactions. While more often reports would increase the transparency, it would not outweigh the effort required from the entrepreneur to fill these reports, thus SEC should not eliminate them but also it should not require more 47 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013 frequent reports. SEC has power to either improve the crowdfunding exemption by issuing reasonable annual report requirements or to nullify its effect by creating burdensome regulation that would overwhelm small and new businesses.
Disclosure of possible risks might be too complex for entrepreneurs and it would be impossible to develop them without the help from lawyers and accountants that would increase the costs and create unnecessary burdens. SEC could facilitate this procedure by providing issuers with guidelines regarding risk disclosures or standard language for these disclosures or by delegating these functions to intermediaries or self-regulatory organizations. The first option would be preferable since it would ensure centralized approach that would prevent unnecessary reviews and different interpretations of law.
Furthermore, the costs of all the requirements for intermediaries would be evened out by the average income from different issuers. The transparency and accountability could probably be better ensured not by the disclosure requirements that ask for time and knowledge to draw proper conclusions but some other self-policy mechanisms. It is true that crowdfunding exemption could be used for fraud, but it does not necessarily mean that it is a sufficient reason to prohibit it or to create a regulation that would eliminate the possible implementation of crowdfunding.
In conclusion, JOBS Act sets the general framework of intermediary’s duties and as for now, except for some issues that requires adjustments it is reasonable. It only depends on SEC, whether it will choose the approach to lead this framework towards establishing a successful entrepreneur-friendly capital raising mechanism that would also protect investors and the market in a sufficient level, or it will override the positive direction started by JOBS Act regulation by implementing an impractical and unusable procedure for crowdfunding.
48 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
Bibliography
1. Bradford C.S. Crowdfunding and the Federal Securities Laws, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184 2. Cohn. S.R. The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2066016 3. Fink A. Protecting the Crowd and Raising Capital Through the JOBS Act, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2046051 4. FINRA. Testimony of Stephen Luparello Vice Chairman Financial Industry Regulatory Authority Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing, and Urban Affairs United States Senate, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=f79 bdc28-a492-4089-8831-d1a68886178d 5. Martin T.A. The JOBS Act of 2012: Balancing Fundamental Securities Law Principles With the Demands of the Crowd, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2040953 6. North American Securities Administrators Association, Inc. Letter to the United States House of Representatives, November 3, 2011. Available at: http://www.nasaa.org/wp- content/uploads/2011/11/NASAA-Letter-on-HR-2930.pdf 7. Statement of Professor John C. Coffee, Jr., Adolf A. Berle at Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=d58 0503c-a7f3-4db5-b9f5-968d03af374f 8. Testimony of Mark T. Hiraide Before The Committee on Banking, Housing, and Urban Subcommittee on Securities, Insurance, and Investment, December 14, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=348 a885d-de31-4054-8d81-2941256c9607 9. Testimony of Professor John C. Coates IV, John F. Cogan, Jr. Before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs United States Senate on Examining Investor Risks in Capital Raising, December 14, 2011. Available at: 49 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1d2 4b42e-3ef8-4653-bfe8-9c476740fafa 10. Whitbeck J.B. The JOBS Act of 2012: The Struggle Between Capital Formation and Investor Protections, 2012. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2149744 11. Written Testimony of Jack E. Herstein, President of the North American Securities Administrators Association, Inc. Before the Senate Committee on Banking, Housing, and Urban Affairs “Spurring Job Growth Through Capital Formation While Protecting Investors”, December 1, 2011. Available at: http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=255 a1e89-30b9-4036-9560-b4a0db5def80 12. AngelList website. Available at: https://angel.co/ 13. Barnet C. Top 10 Crowdfunding Sites For Fundraising, May 8, 2013. Available at: http://www.forbes.com/sites/chancebarnett/2013/05/08/top-10-crowdfunding-sites-for- fundraising/ 14. Carleton W. Crowdfunding Bill Improves! October 27, 2011. Available at: http://www.wac6.com/wac6/2011/10/crowdfunding-bill-improves.html 15. Crowdfunder website. Available at: http://www.crowdfunder.com/ 16. Crowdfunding Growth – Infographic, May 8, 2013. Available at: http://www.crowdfundingeye.com/crowdfunding-growth-infographic/ (last visited: 21.06.2013.) 17. Indiegogo website. Available at: http://www.indiegogo.com/ 18. Kickstarter website. Available at: http://www.kickstarter.com/ (last visited: 21.06.2013.) 19. Kiva website. Available at: http://www.kiva.org/ 20. Lending Club website. Available at: http://www.lendingclub.com/ 21. MicroVentures website. Available at: http://www.microventures.com/ 22. Petition for Rulemaking: Exempt securities offerings up to $100,000 with $100 maximum per investor from registration. Available at: http://www.sec.gov/rules/petitions/2010/petn4- 605.pdf 23. Petition on Startup Exemption. Available at: http://www.startupexemption.com/petition#axzz2WaQjprt0 24. ProFounder Shutting Down, February 17, 2012. Available at: http://blog.profounder.com/2012/02/17/profounder-shutting-down/ 50 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
25. SEC Government-Business Forum on Small Business Capital Formation—SBE Council Recommendation. Available at: http://www.sec.gov/info/smallbus/gbfor29.pdf 26. SeedUps website. Available at: http://www.seedups.com/ 27. SoMoLend website. Available at: https://www.somolend.com/Default.aspx 28. U.S. Securities and Exchange Commission. Regulation A. Available at: http://www.sec.gov/info/smallbus/qasbsec.htm#rega 29. U.S. Securities and Exchange Commission. Rule 502(a) of Regulation D. http://www.sec.gov/rules/final/33-7943.htm#P55_11835 30. U.S. Securities and Exchange Commission. Intrastate offering exemption. Available at: http://www.sec.gov/info/smallbus/qasbsec.htm#intrastate 31. U.S. Securities and Exchange Commission. Rule 506 of Regulation D. Available at: http://www.sec.gov/answers/rule506.htm 32. Why the JOBS Act is Great for US Economy – Crowdfunding Infographic, May 7, 2013. Available at: http://www.crowdfundingeye.com/why-the-jobs-act-is-great-for-us-economy- crowdfunding-infographic/ (last visited: 21.06.2013.) 33. Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011, S.1970, 2011. Available at: http://thomas.loc.gov/cgi-bin/query/z?c112:S.1970: 34. Democratizing Access to Capital Act of 2011, S.1791, 2011. Available at: http://thomas.loc.gov/cgi-bin/query/z?c112:S.1791: 35. Entrepreneur Access to Capital Act, H.R.2930, 2011. Available at: http://thomas.loc.gov/cgi- bin/cpquery/?&dbname=cp112&sid=cp112IqD41&refer=&r_n=hr262.112&item=&&&sel= TOC_1144& 36. Jumpstart Our Business Startups Act, 2012. Available at: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf 37. Regulation A. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&sid=20c66c74f60c4bb8392bcf9ad6fccea3&rgn=div5&view=text&node=17:2.0. 1.1.12&idno=17#17:2.0.1.1.12.0.33 38. Rule 501 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2 .0.1.1.12.0.46.176&idno=17
51 | P a g e
Crowdfunding Exemption Under the Jumpstart Our Business Startups (JOBS) Act 2013
39. Rule 505 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2 .0.1.1.12.0.46.180&idno=17 40. Rule 506 of Regulation D. Available at: http://www.ecfr.gov/cgi-bin/text- idx?c=ecfr&SID=694a3ca5db5ca62e3dbb11126b401725&rgn=div8&view=text&node=17:2 .0.1.1.12.0.46.181&idno=17 41. Section 25210 of Corporations Code. Available at: http://www.leginfo.ca.gov/cgi- bin/displaycode?section=corp&group=25001-26000&file=25210-25221 42. Securities Act of 1933. Available at: http://www.sec.gov/about/laws/sa33.pdf 43. Securities Exchange Act of 1934. Available at: http://www.sec.gov/about/laws/sea34.pdf 44. Reves v. Ernst & Young - 494 U.S. 56 (1990) 45. SEC v. Howey Co., 328 U.S. 293 (1946) Pp. 328 U. S. 298-299 46. State of California Business, Transportation and Housing Agency Department of Corporations. Consent Order to Desist and Refrain, August 31, 2011. Available at: http://www.corp.ca.gov/ENF/pdf/2011/ProFounder_CO.pdf
52 | P a g e