On May 16, 2016, the Securities and Exchange Commission’s rules implementing Title III of the JOBS Act will come into effect, allowing companies to raise funds under Section 4(a)(6) of the Securities Act. The SEC made some important improvements over the proposed rules that will make Regulation Crowdfunding more accessible for small issuers. However, there are a few outstanding areas where issuers would benefit if the SEC or Congress revisits its regulatory and statutory language.
Allowing Single Purpose Funds
Many commenters wrote to the SEC requesting that it allow single purpose funds when investing in issuers conducting offerings under Section 4(a)(6). This would assist issuers by having cleaner capitalization tables and provide benefits to investors because this structure would permit a single fund manager or adviser who could ensure that the issuer respects the rights granted to those investors.
However, when crafting the exclusionary language regarding the eligibility to rely on Section 4(a)(6), Congress seemingly followed the exclusionary language contained in Rules 504 and 505, the previously existing federal exemptions for small capital raises. Those exemptions expressly exclude SEC reporting companies and investment companies. So, too, with the statutory language for Section 4(a)(6) crowdfunding.
Given the specific statutory exclusion, the SEC had no room to maneuver to allow single purpose funds. Interestingly, Congress went even further and prohibited those investment companies that are exempted from Investment Company Act registration from being eligible to use Section 4(a)(6). Without that language, the SEC could have been creative and allowed for single purpose funds that are exempt from the definition of investment companies under Section 3(c)(7) of the Investment Company Act by defining purchasers in a transaction in compliance with Regulation Crowdfunding as “qualified purchasers”, in much the same way the SEC did for providing the benefits of state preemption to qualified purchasers in offerings taking place under Tier 2 of Regulation A.
To allow for single purpose funds, Congress will need to revisit the statutory language authorizing crowdfunding under Section 4(a)(6) Securities Act and possibly the statutory language of Section 3 of the Investment Company Act as well.
Testing the Waters
Securities professionals and issuers know that raising capital can be expensive. The expense is worth it if the issuer is able to raise the funds it needs. Still, there is no guarantee that the issuer will be successful. That is the role of “testing the waters”. The SEC has allowed for testing the waters in larger offerings, and could have done so for Regulation Crowdfunding.
The standard concern for allowing testing the waters is that unscrupulous issuers will use testing the waters to create undue excitement about the offering prior to any disclosure information being filed publicly. Without the protection of the public filing, issuers may more easily use selective disclosures or overly enthusiastic language to create investor interest. With unsophisticated issuers, there is also the concern that after a successful testing the waters campaign, the issuer would not properly issue the securities in a transaction in compliance with the Securities Act.
This concern could be overcome with a properly structured testing the waters provision that works with the remainder of Regulation Crowdfunding. For instance, any testing the waters could be required to be done through a single crowdfunding platform, just as offers and sales are under the rules. The platform hosting the testing the waters campaign would be responsible for ensuring that any issuer, prior to posting its testing the waters materials, is in satisfaction of the platform’s policies and procedures to prevent the dissemination of materially false or misleading information.
Such a testing the waters provision would allow for issuers to determine whether it makes sense to move forward. As it stands, initiating an offering under Regulation Crowdfunding will be a gamble for any issuer.
Exchange Act Reporting
In an apparent tradeoff of reporting requirements, the SEC reduced the ongoing reporting requirements for smaller issuers whose assets do not exceed $10 million while on the other hand made the proposed exemption from full reporting under the Exchange Act conditional as opposed to absolute. In order to rely on the new conditional exemption from full reporting, an issuer must be current in its ongoing annual reports, have total assets not in excess of $25 million, and have engaged a transfer agent to maintain records of the securities issued.
While it is understandable that the SEC would have concerns about large numbers of freely tradable securities floating about the marketplace without regular reporting by the underlying issuer, the conditionality of the exemption sets an unreasonable bar for a small company looking to grow. Recall, full reporting under the Exchange Act requires, at minimum, the filing of an annual 10-K, quarterly 10-Qs, and current reports on Form 8-K. The SEC has previously estimated the time burden for the 10-K as 1,998.78 hours, 187.43 hours for each 10-Q, and an additional 5.71 hours for each 8-K. Those hours assume the use of professionals to prepare the forms and having employees dedicated to the task by the company. Even with the two-year grace period contained in the final rules, Exchange Act registration and reporting would sap any available time and resources and prevent that company from pursuing the interests of its crowdfunding investors – namely, being a growing, successful enterprise.
Bear in mind, the conditional exemption from Exchange Act reporting is only necessary if the company meets the trigger under Section 12(g) of the Exchange Act, which happens when the company reaches 2000 equity holders of record, no more than 500 of which may be non-accredited investors, and $10 million in assets. Companies may opt to engage a broker that will be the single holder of record for securities issued under Section 4(a)(6). That broker would hold the securities for the benefit of the investors and provide important services to the issuing company and investors by ensuring records are kept correctly and facilitating communication between the issuer and the investors.
Like many other participants in this space that have watched as securities crowdfunding went from a legislative proposal, to enacted statute, and finally to effecting regulations, I am excited for the potential of crowdfunding under Section 4(a)(6) of the Securities Act. Still, there are areas that Congress or the SEC should return to in order to make the underlying statute and rules better for issuers and investor alike.
Andrew Stephenson serves as VP of Product Management and Strategy for CrowdCheck, one of Entrepreneur Magazine’s 100 Brilliant Companies of 2015. Andrew has a wealth of experience assisting companies with understanding and taking advantage of the new landscape of online capital raising — including reward-based crowdfunding, securities crowdfunding, offerings to accredited investors, and exempt public offerings of securities under Regulation A. Andrew leads a team of CrowdCheck due diligence analysts and regularly contributes to the national dialog surrounding innovation in capital formation.