Brian Korn - Equity Crowdfunding Legal Aspect
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This document summarizes the key points of a presentation on equity crowdfunding regulations. It discusses the various types of crowdfunding and their securities regulations status. It then outlines the requirements and regulations for public equity crowdfunding under the JOBS Act, including investment limits, required use of funding portals, and disclosure requirements. It also summarizes the new rules around private placements, including the addition of Rule 506(c) which allows general solicitation and advertising when selling to accredited investors.
Brian Korn - Equity Crowdfunding Legal Aspect
- 1. Equity Crowdfunding Legal Landscape: What’s Allowed and What’s Not Midwest Crowdfunding Chicago, Illinois Brian Korn November 15, 2013
- 2. Agenda • Equity Crowdfunding – What is it? How does it compare to other crowdfunding? • Legal status of equity crowdfunding • SEC Proposed Rules • New Private Placement Rules • Bad Actor Disqualification
- 3. Crowdfunding After the SEC Rules Proposal
- 4. JOBS Act Overview “To increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.” • Crowdfunding – online fundraising…but there’s a catch • Regulation A+ - from $5mm to $50 mm • Private Placement Reforms − General Solicitation relaxed – effective Sept. 23 − Enhanced verification of Accredited Investors if Soliciting • • • • • • “Go Public” Shareholder Thresholds Increased IPO On-Ramp and Emerging Growth Companies Relaxation on Research Restrictions Decimalization – move to $.09 tick increments? Prospective Issuer Outreach Signed into law April 5, 2012
- 5. Crowdfunding background • Comprises Title III of the JOBS Act • • • • • • • • • Capital Raising Online While Deterring Fraud and Unethical NonDisclosure • Originated from two perceived needs: − that smaller retail investors did not have access to early stage investment opportunities − that start-up companies did not have adequate access to available capital, particularly online capital raising • Adds exemption from SEC registration for crowdfunding transactions in the form of new Section 4(6) of the Securities Act
- 6. Backdrop: Current Crowdfunding Landscape – Five* Varieties Type Equity to Accredited Investors Equity to the Public Peer-to-Peer Lending *Advertised Private Placements/Title II Examples Kickstarter, Indiegogo, Rockethub, Youcaring FundersClub, AngelList, Ourcrowd ??? Lending Club, Prosper, Zopa (UK) Private Placements using advertising and general solicitation Securities Reg Status Not sales of “securities” Sales of securities to accredited investors Sales of securities to the general public Registered borrower-payment dependent notes Exempt private placements under Rule 506(c) Regulation State-level antifraud only; not SECregulated SEC-regulated, noaction letters protect website solicitations from being public offerings Extensive SEC regulation; currently illegal until SEC rules are finalized SEC-registered securities, not really crowdfunding; banking regulations, not legal in several states Extensive SEC regulation and proposed regulation; enhanced investor verification Bad Actor Disqualification 6 Rewards/ DonationBased Not applicable Applies for all issuers and for the crowdfunding sites themselves Not applicable under JOBS Act, but SEC has said it will apply Not applicable Yes
- 7. Public Equity Crowdfunding Information Regarding the Use of the Crowdfunding Exemption in the JOBS Act On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. The Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws. • Deadline for SEC rulemaking was due December 31, 2012
- 8. Issuers Not Eligible to Crowdfund • Non-US companies • Public reporting companies (only required filers are excluded, not “voluntary filers”) • Investment companies, including companies excluded from the definition of Investment Company by 3(b) or 3(c) of the Investment Company Act of 1940, including: − Mutual Funds − Private Equity Funds − Asset Management Vehicles − Business Development Companies
- 9. Crowdfunding vs. Other Exemptions Feature Public Crowdfunding Regulation A+ Regulation D Rule 506 (4(a)(2)) Maximum Total Raised $1 million per 12 month period $50 million per 12 month period Unlimited Number of Investors Investor Disclosure Required, must be filed with SEC Unlimited accredited investors; up to 35 non-accredited investors unless soliciting Unrestricted Unrestricted Restricted by income/net worth Unrestricted Investment Per Investor Unlimited but subject to maximum total raised Required, must be filed with SEC Not required if all accredited investors; Form D filing proposed Intermediary Required Yes – broker/dealer or funding portal Yes, at least annually, possibly more frequently No Subject to ongoing SEC reporting following raise No Yes; at least audited financials filed annually No
- 10. Crowdfunding vs. Other Exemptions Feature Crowdfunding Regulation A+ Regulation D Rule 506 (4(a)(2)) Disclosure Liability Yes, full disclosure liability with a knowledge exception Yes, full disclosure liability with a knowledge exception Only anti-fraud liability No Yes, for public companies most can sell under Rule 144 after six months Shares restricted Yes, for one year State Filing Advertising and general solicitation Possibly, depends on future rules by state Not allowed No, if securities sold are listed on a national securities exchange or if sold only to “qualified investors” Usually no if only offering to accredited investors Allowed Allowed if sales are made only to accredited investors and issuer takes reasonable steps to verify accredited status Can public cos., foreign issuers, investment companies and exempt inv. companies issue No Yes Yes
- 11. Crowdfunding Requirements • Investment limitations (per trailing 12 month period) − Company: Can receive up to $1 million − Investor: • Less than $100K: greater of $2,000 or 5% of annual income or net worth • $100K or more: 10% of annual income or net worth • Must be conducted through broker or “funding portal” • Must file with the SEC and provide to broker/funding portal and investors extensive disclosure, including tax returns ($100K or less), reviewed financial statements ($100K-$500K) or audited financial statement (>$500K)
- 12. Crowdfunding Requirements • Must not advertise except to direct investors to broker/portal • Must not pay promoters except as SEC allows • Must file annual or more frequent reports with the SEC • Prospectus liability for disclosures with knowledge out • 1 year holding period on shares sold except to issuer, accredited investor, family member or through registered offering • Crowdfunded shares do not count towards the 2,000 shareholder rule to force a company public, but see above re SEC reporting
- 13. Funding Portals • Created by Crowdfunding rules • Must be used as “publicity intermediary” in all crowdfunding transactions • Exempt from broker-dealer regulation, but must register with FINRA; FINRA can only enforce and examine rules specifically written for funding portals • Prohibited from: − Offering investment advice or recommendations − Soliciting purchases, sales or offers to buy the securities − Compensating employees based on sales − Holding, managing or possessing investor funds or securities
- 14. More Funding Portal Requirements • Register with the SEC and any applicable SRO • Provide disclosures related to risks and other investor education materials as the SEC shall require − Must ensure that each investor reviews investor education materials − Obtain investor representation that he or she understands: • that entire investment is at risk • that investing in start-ups and emerging companies is risky • that crowdfunding investments are illiquid • Must obtain background check on officers, directors and 20% or greater shareholders • File with SEC and distribute disclosure materials at lest 21 days prior to first sale date • Ensure offering proceeds are only provided to issuer when raise has met target; allow investors to cancel orders • Make efforts to ensure no investor exceeds individual crowdfunding cap across all transactions • Protect investor privacy • Not compensate promoters, finders or lead generators who direct investors to the portal • Not work with issuers where a portal officer, director or partner has a financial interest
- 15. New Private Placement Rules
- 16. New Structure of Rule 506 • Rule 506 now has two alternatives: (b) and (c) − 506(b) is the traditional rule • no general solicitation or advertising permitted • offers and sales must be to either accredited or financially sophisticated investors • up to 35 non-accredited investors permitted • information requirements for non-accredited investors • unlimited accredited investors permitted • unlimited dollar amount of offering − 506(c) is the new rule • general solicitation or advertising is permitted • sales must be to accredited investors only • unlimited accredited investors permitted • unlimited dollar amount of offering 16
- 17. Can Advertising Be Private? • Historically, Regulation D’s prohibition against general advertising/solicitation generally restricted funds and issuers from utilizing any kind of article, advertisement, seminar, meeting or notice to promote their Rule 506 offering • Under the JOBS Act amendments, private fund advisers may now publicly advertise their funds, discuss funds in interviews and informal investor settings, conduct capital raising meetings, etc. − No limitation to “friends and family”; no more pre-existing arrangements required − The risk of “foot faults” (where too much information about a private fund is unintentionally disclosed) should largely be eliminated 17
- 18. Advertising (cont.) • The lifting of the solicitation restrictions can be of special benefit to emerging or growing funds that lack name recognition • Solicitations, advertisements and similar communications will remain subject to the anti-fraud provisions of the Advisers Act, which include prohibitions against the use of testimonials, past specific recommendations, and restrictions on the presentation of performance data • Web sites no longer need to be “password protected,” but they still must be truthful and not misleading • 18
- 19. Advertising (cont.) • One practical advantage of the lifting of the solicitation restrictions is the ability to get a group of investors in a room and just talk to them about a fund offering • Another practical advantage is the ability to cross-market with fund managers in unrelated sectors or strategies to gain exposure to new sources of investors • The ability to speak freely about fund offerings in informal settings may be the most significant near-term advantage of new Rule 506(c) 19
- 20. Investments Still Effectively Limited to Accredited Investors • • New Rule 506(c) requires that the issuer take “reasonable steps” to verify that the investor fits within an accredited investor category • The SEC suggested several “non-exclusive and non-mandatory” methods by which an issuer may meet the requirement to “take reasonable steps” to verify that a purchaser is accredited – unless the issuer has actual knowledge that the investor is not an accredited investor • Funds are still limited to 100 investors in 3(c)(1) funds • Funds with performance fees or allocations must still only sell to persons meeting the “qualified client” requirements • 20 The fund or issuer must be satisfied that purchasers (regardless of to whom a private fund is advertised) are at least accredited investors Funds relying on Section 3(c)(7) must still only be sold to qualified purchasers
- 21. Verification of Accredited Status • The proposed new rules require the issuer to take “reasonable steps to verify” that the purchasers of the securities are accredited investors, considering the following factors: − nature of purchaser / category of accredited investor − amount and type of information issuer has concerning the purchaser − nature of offering • manner in which purchaser was solicited • term of the offering • minimum investment amount, if any 21
- 22. Accredited Investors: Natural Persons • Natural persons meeting (or reasonably believed to meet) the following requirements are “accredited investors”: − Net Worth Test: individual net worth, or joint net worth with spouse, exceeds $1 million, excluding net equity in primary residence − Income Test: individual income in excess of $200,000 in each of the two most recent years, or joint income with spouse in excess of $300,000 in each of those years, with a reasonable expectation of reaching the same income level in the current year − Insider Status: Director, executive officer or general partner of the issuer, or director, executive officer or general partner of a general partner of the issuer 22
- 23. Verification Methods • Publicly available information in governmental filings, such as: − registration of the investor with the SEC as a broker-dealer, investment company or business development company − public company proxy statement listing the investor as an executive officer or director, along with compensation information − Form 990 tax return for a 501(c)(3) organization investor verifying at least $5 million in total assets • Reasonable documentation − verification of an investor’s status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant − copy of investor’s individual tax returns, Forms W-2, Forms 1099, or pay stubs demonstrating satisfaction of “income test” − specific publicly available information about the average compensation earned at the investor’s workplace by persons at the level of the investor’s seniority 23
- 24. Verification Methods (Cont’d) • How the investor was solicited − Open web site solicitation, accompanied by a mere “check-thebox” affirmation of accredited status, is insufficient − Database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer, is sufficient • Terms of the offering − High minimum investment (i.e. $1 million for an individual), not financed by the issuer or a third party, can provide reasonable evidence of accredited status 24
- 25. Possible Consequences of Self-Verification • If you choose to gather tax return information or forms, you now must have a way to safeguard the most confidential of information; it also makes you a potential third-party record keeper • This is very different from subscription information, which is self-provided • Some funds and issuers may turn to third-party verification services 25
- 26. Bad Actor Disqualification from Rule 506 26
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- 28. History of Bad Actor Disqualification • Mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 − Requires the SEC to adopt rules that disqualify securities offerings involving certain “felons and other bad actors” from reliance on Rule 506 of Regulation D − Rules must be substantially similar to Securities Act Rule 262, which contains disqualifications for Regulation A offerings (up to $5 million; soon-to-be up to $50 million under Section 401 of JOBS Act) • SEC proposed rules on May 25, 2011; approved on July 10, 2013; effective on September 23, 2013 28
- 29. New Rule 506(d) of Securities Act • To whom does disqualification apply? − Issuers, underwriters, placement agents and any other “compensated solicitor” − …and their directors, officers and significant shareholders, members or beneficial owners of voting securities (20 percent of voting power) − For pooled investment funds, the funds’ investment managers and their principals and officers • Includes GPs and managing members of funds, and their GPs and MM, and principals and officers participating in the private placement • All officers? − No, just executive officers and officers working on the transaction − Point of contention for investment banks in the proposal • Timing of disqualifying acts? − Only events after enactment − But, disclosure is required • 29 SEC confirms crowdfunding and Reg A+ will have their own bad actor disqualifications
- 30. What are the Disqualifying Events? Bad Act Look-Back Period Criminal convictions in connection with the sale of securities or making false statements to the SEC Issuers – 5 years All others (including issuer executive officers and directors) – 10 years Court orders, judgments or decrees in connection with the purchase or sale of securities or in connection with the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor 5 years Final orders of certain regulators, including state Longer of duration of final order or 10 years from securities commissions, state banking authorities, final order based on violation of fraudulent, state insurance commissions, federal banking manipulative or deceptive conduct, if applicable agencies or the National Credit Union Association, which bar the person from: association with an entity regulated by such commission engaging in the business of securities, insurance or banking, or engaging in saving association or credit union activities 30
- 31. Disqualifying Events (cont.) Bad Act CFTC orders (bar or final orders) relating to violations of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct Look-Back Period Longer of duration of final order or 10 years from final order SEC disciplinary orders under Sections 15(b) or Duration of order 15B(c) of the Securities Exchange Act of 1934, as amended (the Securities Exchange Act), or 201(e) or (f) of the Investment Advisers Act of 1940, as amended, that: suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser limits such person’s activities function or operations, or bars person from association with any entity or from participating in an offering of penny stock 31
- 32. Disqualifying Events (cont.) Bad Act Look-Back Period SEC orders prohibiting future violations of any scienter-based anti-fraud provision, including Sections 5 and 17(a) of the Securities Act, and Sections 10(b) of the Securities Exchange Act Suspension or expulsion from membership in or bar from association with a member of a national securities exchange or registered national securities association (currently FINRA is the only registered national securities association) Duration of suspension or expulsion Regulation A bad-actor stop-orders 5 years U.S. Postal Service false representation orders 32 5 years from date of order Longer of 5 years or duration of order
- 35. Brian Korn • • Hands-on transaction execution and market expertise across product categories, including equity capital markets, debt capital markets, leveraged finance and private equity • Former in-house counsel at Barclays and Citigroup investment banks • Specialist in IPOs, the JOBS Act and SEC compliance, as well as early-stage fundraising, high yield debt and swaps/derivatives • Media Appearances: Fox Business Television, Bloomberg, NPR, CCTV America • 212.808.2754 kornb@pepperlaw.com Corporate and Securities practice group, based in New York Published or Quoted: Forbes, CNBC, MSNBC, New York Law Journal, Law360, Philadelphia Inquirer, Pittsburgh Post-Gazette, The Financier, Review of Securities & Commodities Regulation • Seasoned 16 year securities expert and frequent speaker: PLI, NYC Bar faculty member; Speaker at national securities and crowdfunding conferences • J.D. Northwestern University School of Law − Northwestern Journal of International Law & Business • B.A. with Honors and Distinction, University of California, Berkeley
- 36. For more information, visit www.pepperlaw.com. Brian Korn, Esq. (212) 808-2754 kornb@pepperlaw.com Pepper Hamilton LLP The New York Times Building 620 Eighth Avenue New York, New York 10018