JOBS Act 2.0: Congressman McHenry’s Cure for the “Six Deadly Sins” of Crowdfunding Regulation

Patrick McHenry Fixing the JOBS Act

For those of you who were too busy to notice, U.S. Congressman Patrick McHenry introduced three draft bills into the House Financial Services Committee last week.  One of them, if it were to become law, would open up the U.S. equity crowdfunding world in ways which only a true visionary could imagine.  Though its passage into law in the 2014 election year is far from certain, according to fellow Congressman David Schweikert, in an interview with him the day following the introduction of the far reaching draft crowdfunding bill, there is not a better “pilot” to navigate the choppy Congressional waters than Congressman McHenry.

Hitting the Crowdfunding Reset Button

One of the bills, entitled “Startup Capital Modernization Act of 2014”, is primarily directed towards fixing some of the potentially fatal defects and ambiguities embedded in the original JOBS Act bill – largely a result of last minute drafting changes in the 2012 legislative process – and compounded by proposed SEC rules –  which together threaten to kill equity crowdfunding before it even gets off the ground.

Sins of Excessive RegulationsFor those of you who read my earlier article, “SEC’s Proposed Crowdfunding Regulations: Six Deadly Sins,” outlining what I considered to be the major impediments in the JOBS Act rulemaking to a successful crowdfunding regimen,  the McHenry bill grants absolution for these past crowdfunding regulatory and legislative sins – and then some.  As the U.S. and the rest of the world look impatiently to Washington, D.C. for leadership in the emerging crowdfunding capital markets,. Congressman McHenry has once again stepped up to provide the type of leadership that our small businesses  (and would-be small businesses) crave.

Specifically, Congressman McHenry’s proposed Title III redo accomplishes a great deal.  Here are some of the highlights:

  • Raises crowdfunding limits from $1 million to up to $5 million.
  • Allows self –certified financials for raises under $500,000 – and independently reviewed financials statements for raises between $500,000 and $3 million – leaving the more onerous audited financials for raises above $3 million.
  • Eliminates the requirement that the SEC promulgate rules requiring detailed, registration statement-like non-financial disclosure resembling a public company report.
  • Eliminates the need for ongoing annual reporting in perpetuity.
  • Allows non-broker-dealer intermediaries (funding portals) to register only with the SEC, avoiding registration with FINRA and compliance with its rules.
  • Allows intermediaries which are not licensed broker-dealers to “curate” crowdfunded transactions, screening out those not deemed suitable for their portal.
  • Removes the more onerous liability provisions for intermediaries and issuers.

Żmurko_Sinner's_past SinThough some may debate the wisdom of raising the current $1 million crowdfunding dollar limit before this nascent ecosystem is even open for business, it certainly underscores headline grabbing successes with heftier raises in the rewards based crowdfunding domain – Oculus being the crowdfunding success du jour. (Kudos to the brave and lucky Oculus lawyer who took his fees in Oculus stock!)

Perhaps less apparent, however, is the impact the proposed bill could have on intrastate crowdfunding. If the McHenry JOBS Act 2.0 were to become law, it would dwarf, and in many instances make largely superfluous, the developing intrastate crowdfunding ecosystem.  Though states would remain free to create their own crowdfunding ecosystems within their borders, the McHenry bill would generally provide a more attractive alternative – its reach extending well beyond state borders.

A Quiet Assault on Small Business by the SEC – The Seventh Deadly Sin

The proposed McHenry crowdfunding bill, though far reaching, would leave untouched a recent informal pronouncement by the SEC Staff, issued below the radar of Congress and crowdfunding supporters (and perhaps even the SEC Commissioners) -which, from my point of view, is questionable on its merits and goes against the grain of the of the entrepreneurial spirit which crowdfunding exemplifies.  Even more troubling, the ruling suggests a “backdoor” approach to SEC rulemaking – at least where the interests of small business are concerned.

Specifically, until April 10, 2014, it would appear by all accounts that a state legislature would be free to fashion a crowdfunding regime within its borders which would allow an issuer to throw up a crowdfunding campaign on its own internet site – without the need to utilize an intermediary – be it a licensed broker-dealer or otherwise.

However, on April 10, 2014, the SEC Staff put a chill on any thoughts a state legislature might have to craft an intrastate crowdfunding structure which would permit an issuer to conduct its own crowdfunding campaign – on its own website.

SEC Headquarters in DCOn April 10, 2014, the Staff of the SEC’s Division of Corporation Finance quietly issued a tersely worded interpretive ruling, which sent a chilling message to the 50 states and their legislatures: in the opinion of the Staff of the SEC Division of Corporation Finance, an issuer would be violating the Securities Act of 1933, which regulates the sale of securities by an issuer of securities, if it conducted an otherwise lawful intrastate crowdfunded offering on its own website, bypassing a licensed intermediary.   However, the Staff ruled, the same activity by a licensed broker-dealer would not invalidate an otherwise lawful intrastate sale of securities. This SEC ruling, if valid, would trump any state crowdfunding legislation to the contrary.

It seems that the Staff at the SEC Division of Corporation Finance is not (yet) willing to allow small business crowdfunders to disintermediate a licensed broker-dealer intermediary – a Staff goal undoubtedly shared by organizations such as the North American Securities Administrators Association, Inc. (NASAA), a powerful national lobbying organization of state securities administrators which derives a portion of its financial support from FINRA administered state broker licensing exams. Yes, that’s right – an international lobbying organization inclusive of Canada and Mexico which derives direct financial support from these state exams.

However, what is most perplexing, indeed disturbing, is that this informal ruling by the SEC Staff represents a 180 degree about face from a lengthy, well reasoned interpretive release issued by the SEC in 1998 in a parallel situation involving cross-border international offerings on the internet by U.S. companies – to the effect that any limitations on internet solicitations by an issuer would be less Megaphonerestrictive than those faced under federal law for a licensed broker-dealer.  So it seems the Staff quietly took a major step backwards on April 10, 2014, when faced with an analogous situation involving U.S. intrastate crowdfunded offerings.

So while the crowdfunding world is keenly focused on a much delayed 585 page SEC release, and the SEC publicly bemoans a more than five year rulemaking backlog, the Staff at the SEC’s Division of Corporation Finance has found the time to gratuitously issue a ruling which interferes with a state’s ability to fashion its own crowdfunding regime.  And perhaps even more perplexing – no one outside the SEC had even asked for this ruling – at least not through formal, transparent channels.

So what prompted this Staff ruling – and what can and should be done to avoid further informal, intrusions which threaten to hijack state legislative measures such as intrastate crowdfunding,  at the expense of small business, by circumventing more transparent rulemaking processes?

Fat Lady PaintingThis is precisely the question I intend to ask Commissioner Daniel Gallagher in a meeting I have formally requested with him – to discuss the procedures which led up to this ruling under the noses of five SEC Commissioners– and what can and should be done to prevent future missteps.  I have my theory as to what prompted this ruling– which, if accurate, does not bode well for small business capital formation in matters going beyond the scope of the April 10 ruling.

Stay tuned.  The fat lady is just getting warmed up.   Hopefully Washington will be listening.

__________________________________

 Samuel S. GuzikSamuel S. Guzik, a recognized authority on the JOBS Act including Regulation D private placements, investment crowdfunding and Regulation A+, writes a regular column, The Crowdfunding Counselorfor Crowdfund Insider.  A consultant on matters relating to the JOBS Act, he recently led a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy.   He is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience.  He is admitted to practice before the SEC and in New York and California. Guzik has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  He also frequent blogger on securities and corporate law issues at The Corporate Securities Lawyer Blog.

 

  • Paul Spinrad

    Under which Section and Question is that interpretive ruling listed, on that page of interpretations that you link to?

    If this official interpretation would invalidate some or all of the many new intrastate exemptions, that’s a major plot point– and I think the issue needs to be broken out under a headline and dedicated post of its own, rather than embedding (burying) it in an article on McHenry’s new bill!

    Thank you Sam for bringing this to people’s attention!

    • Paul Spinrad

      Specifically, there’s no need to even rewrite anything– just start the post with “[A] recent informal pronouncement by the SEC Staff, issued below the radar…” and leave the rest of the article exactly the same. Give it a headline like “Recent SEC Interpretive Ruling Invalidates State Exemptions.”

      Apologies for the back-seat editing, I just wanna help, hope it’s not annoying.

      • Samuel S. Guzik

        Paul,

        Thanks for inquiring.

        As for the headline – you are correct. It does not tell the whole story. We live in a world dominated by search engines that read no more than 60 characters in a title.

        Also, as for the headline – the spotlight deserves to be on Congressman McHenry – and his new bill – at least for today.

        As for your astute observation that the headline does not clue the reader to the second part of the article, you are correct – But the point to be made is that it takes more than one act of Congress to fix what needs to be fixed in the world of small business capital formation regulation.

        The story will not be “buried”, I can assure you. I have provided a great amount of detail to Commissioner Gallagher’s office this morning. And there will be at least two or three more articles forthcoming addressing the subject matter in the second part of the article.

        So as the article says, “stay tuned.”

        The CDI’s being discussed are CDI 141.04 and 141.05 – easy to find from the link – they are in numerical order – just keep scrolling.

        And thank you for reading the entire article – and taking the time to think about it – and respond.

        • Paul Spinrad

          Thanks Sam– that all sounds good, and I’m so glad you’re on this! I will for sure stay tuned, and agree about McHenry’s bill being the big story today.

          IANAL, but 141.04 and 141.05 don’t sound so bad to me, especially if you assume a WordPress plug-in (or equivalent) that makes it easy to add state or zipcode self-certification to any page on your website– kinda like the ones out now that can add an “Are you over 18?” popup.

          • Samuel S. Guzik

            Paul,

            Here’s the problem. The plug-in works well, but according to the Staff at the SEC Division of Corporation Finance, only if you are a licensed Broker-Dealer (or perhaps a licensed/registered funding portal).

            But if you are an issuer who wants to go it alone without a licensed third party portal in an intrastate crowd fund, you are “SOOL” and in violation of federal securities laws – at least according to the “not so bad” CDIs – That’s exposing the company to up to 5 years in federal prison and a six figure fine.

            More puzzling, the SEC juxtaposed the positions it took in a lengthy interpretive release in 1998.

            Why the change? And why now? Stay tuned . . .

          • Paul Spinrad

            That’s a problem…

            Yes, we need answers.

            Thanks again!

    • CuriousCollaborator

      Paul, these interpretations do not invalidate any of the new intrastate exemptions. All they do is clarify how the SEC understands the obligations of companies using the internet and social media to sell securities under the intrastate exemption.

      Also, these are SEC interpretations, not law or administrative rules. A court could decide the SEC is wrong in its interpretation.

      • Paul Spinrad

        Thank you, I’m glad, that’s good to know!

  • CuriousCollaborator

    I don’t understand how you reached your conclusion that broker-dealers are required for intrastate offers over the internet. CD&I 141.04 applies to the use of third party sources to disseminate offering information — that could be LinkedIn, Facebook, Twitter, etc. There is nothing there about broker-dealers.

    CD&I 141.05 does not say anything about a company not being able to use its own website, it just needs to restrict access to intrastate prospective investors. If the information is unrestricted and can be accessed by anybody anywhere, then it needs to be done in a way that is not an “offer” of securities.

    • Samuel S. Guzik

      To “Curious Collaborator”: It’s not my conclusion. It’s the conclusion of the Staff of the Division of Corporation Finance. That’s my opinion, based upon 35 years of private practice in SEC matters.

      If you are going to proffer opinions, and expect them to carry any weight, I suggest you disclose to readers your name and qualifications in the area of securities law – so they can better assess the strength of your opinions.

      • CuriousCollaborator

        If it is the conclusion of Corp Fin, then where in CD&I 141.04 does the SEC say brokers are required for intrastate offerings over internet? In fact, the SEC says “use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory.”

        In this context, “portal” does not have any sort of restricting language that would indicate only broker-dealers may apply.

        • Paul Spinrad

          FWIW I also see no such restricting language in 141.04 and 141.05 themselves, but am assuming that the full context (with broker-dealer requirement) is some kind of non-obvious law thing from some other, related source that Sam will be explaining in due time– which will be super helpful.

    • Samuel S. Guzik

      As I indicated below: No name + no credentials = no response.

      These are the same rules the SEC has proposed, and will require, when Titie III crowdunding goes into effect.

      Only then can the crowd decide.

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