Our Venture Capital & Emerging Companies practice group analyzed the SEC’s recently released equity crowdfunding rules (referred to by the SEC as “Regulation Crowdfunding”) in a concise and easy-to-digest article authored by Sam Effron and Kristin Gerber.

The article does a great job of highlighting some of the regulation’s shortcomings, such as the limits it places on amounts that can be raised (at both the company and investor level); the requirement that companies complete and file a new Form C; and certain ongoing reporting obligations for companies.  In all, the added costs, burdens, and risks associated with complying with this regulation means that in most cases there are better alternatives (such as raises under Rule 506) for start-up companies looking to access the capital markets.

Securities Matters readers are invited to join Kristin Gerber and me at the Cambridge Innovation Center this Thursday, April 16, starting at 4:30, for an update on the status of equity crowdfunding rules at both the federal and state levels. Given that it has been 18 months (and counting) since the SEC first proposed rules to implement the JOBS Act’s directive to make crowdfunding a reality, we will take a look not just at the SEC’s rulemaking but also the increasing activity at the state level (including crowdfunding rules passed in January 2015 right here in Massachusetts). We’ll also discuss other means of capital-raising for the small, scrappy start-up that may have greater practical, near-term application. The program is free to attend, so we hope to see you there.

 

The Massachusetts Securities Division has recently joined a number of other states in adopting a “crowdfunding” exemption from securities registration requirements for certain offerings made within the Commonwealth, with the stated purpose of enabling startups and entrepreneurs to more easily use the Internet to raise capital.  Adopted as an emergency regulation that took effect immediately, the exemption permits companies that are incorporated in Massachusetts to raise capital from Massachusetts investors.

Much has been written about crowdfunding at the federal level, which was addressed by the Jumpstart Our Business Startups Act in 2012, but for which the SEC has indicated it is in no hurry to adopt the final regulations that would allow the practice to proceed. Impatient to release the purported floodgates of investor interest in funding local businesses, several states have taken matters into their own hands in passing regulations allowing intrastate crowdfunding, using rules similar to the ones just adopted in Massachusetts.

Under the new rules, a Massachusetts company may use the exemption for offerings of up to $1 million in securities in a one-year period, and up to $2 million in securities in a one-year period if the company has made audited financial statements available to each prospective investor.  The regulations also impose restrictions on the investors in these offerings.  Investors with annual incomes and net worth of less than $100,000 are limited to purchases of the greater of $2,000 or 5% of their annual income or net worth.  Investors with incomes or net worth of $100,000 or more may purchase up to the greater of 10% of their annual income or net worth, with an investment limit of $100,000.  An investor’s annual income and net worth are to be calculated in accordance with the accredited investor calculation under Rule 501 of Regulation D.  The company must also establish a minimum offering amount and, if such amount is not met, the company must return all funds to investors.

Furthermore, offerings must be made in accordance with the requirements of Section 3(a)(11) of the Securities Act of 1933, as amended, commonly known as the intrastate offering exemption, and Rule 147 under the Securities Act, a safe harbor that issuers may use to ensure that they meet the requirements for the intrastate offering exemption.

Certain companies may not use the exemption, including investment companies; hedge funds, commodity pools or similar investment vehicles; reporting companies under the Securities Exchange Act of 1934; companies engaging in blind pool or blank check offerings; or any company involving petroleum exploration or production, mining or other extractive industries.  Certain “bad boy” exceptions also apply.

While we continue to wait patiently for the crowdfunding wheels to turn at the federal level, these rules may provide some flexibility to the small, scrappy Massachusetts startup looking to raise much-needed capital.

On November 10, 2014, the SEC announced a settlement with Eureeca Capital SPC, which is a crowdinvesting portal incorporated in the Cayman Islands.  Eureeca’s website seeks to match foreign-based issuers with investors interested in making equity investments.  The website provides information about various issuers and their offerings.  This information was accessible to U.S. residents, despite the fact that the securities offered through the site were not registered with the SEC.  In alleging that Eureeca violated Section 5 of the Securities Act by offering unregistered securities for sale, the SEC noted that Eureeca took no steps to comply with the exemption from registration found in Rule 506(c).  Specifically, the SEC alleged that Eureeca took insufficient steps to confirm that the U.S. investors were accredited investors.  The SEC also alleged that Eureeca was acting as an unregistered broker-dealer by, among other things, (i) encouraging investments in the offerings on its site, (ii) completing the final legal requirements for the transaction (i.e. accommodating the swap of funds for equity), and (iii) receiving a percentage of the funds from all fully funded offerings as a fee.

The Eureeca settlement demonstrates that the SEC is closely scrutinizing crowdinvesting sites to see if they are acting as broker-dealers, and highlights how it is may be increasingly difficult to divorce the benefits gained from promoting Rule 506(c) offerings from the burdens of having to register as a broker-dealer.  Andrew Stephenson from CrowdCheck, a provider of due diligence and disclosure services for online alternative investments, explains that crowdinvesting sites that are not registered as broker-dealers are likely relying on the SEC’s October 25, 1996 No Action Letter to Angel Capital Electronic Network (“ACE-NET”).  In that No-Action Letter, the SEC’s Division of Market Regulation stated that it would not recommend enforcement action against ACE-NET for failing to register as a broker-dealer so long as ACE-NET met six separate criteria that it claimed it would meet.  One of these criteria was that ACE-NET would not “provide advice about the merits of particular opportunities or ventures.”  Mr. Stephenson describes how complying with this criterion could potentially cause the most difficulty for current crowdinvesting sites.  This could be especially true if potential investors increasingly seek out crowdinvesting sites that provide more information about an offering than simply listing information provided by an issuer.   Furthermore, given the vagaries of what constitutes “providing advice,” the SEC still has considerable discretion in instituting proceedings against crowdinvesting sites it believes has crossed this indeterminate line.