June 12, 2012
Title III — Crowdfunding
Title III of the Act provides a crowdfunding exception to the registration requirements of the Securities Act of 1933. The crowdfunding exception will allow issuers to raise, subject to substantial regulation, up to $1 million a year in small increments from ordinary investors through a registered funding portal. State Blue Sky laws regarding registration and qualification are preempted. This aspect of the Act has the potentially to transform small firms access to capital provided that the regulatory framework adopted by the Commission does not unnecessarily impede either issuers or funding portals.
$1 million Limitation
New section 4(6) permits offerings under the crowdfunding exemption up to an aggregate of $1 million in a twelve-month period. The statutory language is not a model of clarity regarding whether the $1 million limitation pertains only to offerings under Section 4(6) of the Act or includes all exempt offerings. NSBA supports the $1 million limitation applying only to crowdfunding offerings. In any event, the Commission should clarify its position.
Self-Regulatory Organizations and Registration as a Broker
New section 4A(a )(2) requires funding portals to register with any applicable self-regulatory organization (as defined in section 3(a)(26) of the Securities Exchange Act of 1934). Section 304(a) of the Act provides that the Commission shall, by rule, exempt, conditionally or unconditionally, a registered funding portal from the requirement to register as a broker or dealer.
The Commission must designate with which SRO a funding portal should register. Nor is it clear what the funding portal should register as. The Act makes it clear that a funding portal is distinct from a broker or dealer from a regulatory standpoint. The difficulty is that the current stance of the Commission is, effectively, that almost anyone no matter how tangentially involved in a securities transaction may be a dealer (see, e.g., the SECs Guide to Broker-Dealer Registration http://www.sec.gov/divisions/marketreg/bdguide.htm#II). It is clear that the state of SEC guidance in this area is not clear.
For example, the SEC Guide to Broker-Dealer Registration states that (1) finding investors for "issuers" (entities issuing securities), even in a "consultant" capacity, (2) engaging in, or finding investors for, venture capital or "angel" financings, including private placements or (3) persons that operate or control electronic or other platforms to trade securities can trigger registration. That, of course, is what funding portals will be doing and what both Congress and the President intend for them to do.
Given the highly expansive interpretation of current SEC guidance, any funding portal would presumably be required to register as a dealer. Yet this clearly is not consistent with Congressional intent and would impose an unreasonable burden on funding portals. In fact, it would defeat the primary purpose of the legislation, to wit, to allow investors to invest and small issuers to raise capital without being required to cut Wall Street in for a large piece of the company.
NSBA does not believe that registration as a dealer should generally be required of organizations that are only funding portals for crowdfunding and/or Regulation D offerings. It is imperative that the Commission guidance adopt this position and makes this clear. It is important that the Commission make it clear that funding portal fees set, in whole or in part, as a percentage of the amount raised do not trigger dealer registration requirements. It is also important that the Commission designate the crowdfunding SRO as soon as possible so that it can be created (if necessary) or can begin adopting the rules necessary to accept funding portal registrations.
New section 4A(a)(3) requires an issuer to provide such disclosures, including disclosures related to risks and other investor education materials, as the Commission shall, by rule, determine appropriate. To eliminate uncertainty and ensure that the information deemed by the Commission to be necessary is conveyed to prospective investors, we strongly urge the Commission to provide model language that it wants in the disclosures and educational materials or, as necessary, to provide detailed templates.
New section 4A(a)(5) requires an issuer to take such measures to reduce the risk of fraud with respect to such transactions, as established by the Commission, by rule, including 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.
We would urge the Commission to indicate what behavior uncovered by a background check is disqualifying, which needs to be disclosed and which does not. For example, is a 15 year old DUI or marijuana possession felony conviction disqualifying? Does it need to be disclosed? Are the requirements limited to crimes of moral turpitude? Is the background check requirement limited to a criminal background check and, if not, what other types of background check will be required? For example, is it mandatory to disclose tax liens, judgments, bad debts or similar issues and if so, how is such a background check to be conducted? Liens and judgments, for example, are often not on a central database. Guidance on the parameters of this requirement is very important.
Section 15(b)(4) of the Securities Exchange Act could be used as the template for a rule regarding disqualification but would not necessarily be appropriate for a mandatory disclosure standard.
We would also advise the Commission of the recent EEOC revised Enforcement Guidance on the Consideration of Arrest and Conviction Records in Employment Decisions under Title VII of the Civil Rights Act of 1964. It is clear that the EEOC and SEC are pursuing very different policy agendas in this area and we would ask that SEC and EEOC guidance be consistent since our membership cannot comply with conflicting legal requirements issued by two different agencies.
New section 4A(a)(8) of the Act requires intermediaries to ensure that no investor in a twelve-month period has purchased crowdfunding securities that, in the aggregate, from all issuers, exceed the Section 4(6) investment limits. It is unclear how an intermediary will be able to verify whether an investor had exceeded these limits unless it is entitled to rely upon the representation of an investor regarding prior investments in such securities.
New section 4A(b)(1)(G) requires an issuer to offer investors a reasonable opportunity
to rescind the commitment to purchase the securities. Dovetailing this provision with the Truth in Lending Act (TILA) provisions contained in 15 USC 1635 and many state consumer protection statutes seems appropriate since the policy goals are substantially similar and it is less likely to lead to consumer confusion. The TILA statute provides consumers the right to rescind the transaction until midnight of the third business day following the consummation of the transaction or the delivery of the information and rescission forms required under this section together with a statement containing the material disclosures required under this subchapter, whichever is later. The period should commence upon the investor entering into a binding initial commitment.
It should also recommence if the issuer makes a change in the investment terms or provides a new material adverse disclosure before the offer is closed (and should not terminate until substantially after the issuer provides actual notice of the change or adverse disclosure). In our judgment, in these two cases, the period should be much longer than three days.
Offering Notices or Announcements
New section 4A(b)(2) provides that an issuer shall not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker. The Commission should provide guidance as to what information is permitted in the notice. At a minimum, the issuer should be allowed to provide the following information in the notice:
(1) The name of the issuer
(2) The name and web site of the funding portal or portals
(3) The type of security being offering
(4) The offering amount
(5) The opening and closing date of the offering and
(6) The line of business that the issuer is in (or will be in if the offering will fund a new line of business).
Issuer and Intermediary Liability
New section 4A(c) provides a cause of action to an investor in a crowdfunding offering against the issuer, a director or partner of the issuer, the principal executive officer or officers of the issuer, or the principal financial officer, controller or principal accounting officer of the issuer to recover damages for material misstatements and omissions by the issuer. Although it is Congressional intent that the issuer and its executives be legally responsible for material misstatements and omissions in the offering documents, the Commission should provide guidance as to whether an intermediary will be required to confirm any information presented by the issuer during the course of the offering (and if so, which information and to what extent) or will be subject to liability for any violations by the issuer of its Section 4(6) obligations. The Commission should provide guidance as to whether intermediaries will be permitted to request issuers to provide greater disclosure of information to the public than required by the Act and whether this additional disclosure would result in any liability to the intermediary in the event of fraud or negligent misrepresentation by the issuer.
Given the combination of a large number of potential investors making small investments and potentially risky investments, class action or shareholder derivative lawsuits (both warranted and unwarranted) are likely to be reasonably common. In order for this risk not to pose a major barrier to those wishing to maintain funding portals, it is important that the scope of intermediary duties be set forth with reasonable specificity. Moreover, it is our belief that a funding portal attempting to impose stricter standards than the minimum required by the Commission should not give rise to liability. Finally, a funding portal that complies with Commission requirements should not be co-liable for material misstatements and omissions by an issuer – otherwise, they are, in effect, being asked to become an insurer and the costs and risk of maintaining a portal will become prohibitive.
Section 3(a) of the Securities Exchange Act as amended by new subsection 80 defining a funding portal prohibits an intermediary from offering investment advice or recommendations. However, the Act does not provide a definition of what constitutes investment advice or a recommendation. The commission should clarify whether the following actions would constitute either investment advice or a recommendation: (1) removing an offering before its offering period has expired for lack of sufficient investor commitments (2) preventing an issuer from offering its securities on the funding portals website because of failure to provide documents responsive to a the portal due diligence/disclosure standard (3) establishing disclosure standards or qualification standards (e.g. prohibiting felons from being in issuer management) that are higher than the standards specified by the Commission (4) assuming a funding portal allows investors to comment or submit questions to an issuer on the funding portals website, deleting a third partys statements that are false, obscene, defamatory or irrelevant (5) defining the layout, format or positioning of the offering on the funding portals website (6) providing market and news updates and (7) declining to post an offering due to the offering not fitting into the type of offering that the funding portal seeks to limit itself to offering (e.g. small businesses, businesses in a specific geographical area, prohibiting certain lines of business (e.g. gambling establishments), etc.)
A funding portal may not hold, manage, possess, or otherwise handle investor funds or securities (new section 3(a)(80)) but must ensure that ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount, and allow all investors to cancel their commitments to invest, as the Commission shall, by rule, determine appropriate (new section (4A(a)(7)). Thus, a funding portal must effectively ensure that funds are held in escrow but may not do so itself. The Commission should provide guidance as to what sort of institutions may provide this service, what the funding portals responsibilities regarding this requirement are, who should bear the cost of this service, who should bear the risks associated with providing this service and what the escrow agents duties are and to whom.