Two types of investment crowdfunding

Today's post is the text of prepared remarks I plan to give later today as part of a public policy and national ACA update panel at the 2013 Angel Capital Association Northwest Regional Meeting. The panel will cover several other current policy issues important to angel investing, but part of my role is to take the lead on a crowdfunding update.

Here's an update on crowdfunding.

Accredited Crowdfunding

There is one kind of crowdfunding law already in effect today, not waiting on SEC rulemaking.

That's an exemption from federal broker-dealer registration requirements, designed for angel investing platforms, including AngelList, CircleUp, Gust, and the like.

This exemption for angel platforms became law in April 2012, when President Obama signed the JOBS Act. Unlike other recent Congressional reforms to securities regulations that impact angel investing, this reform did not ask the SEC to do anything; instead, Congress changed a statute and we do not need to wait on rulemaking in order to rely on this exemption.[1]

The exemption[2] in pertinent part says this:

“With respect to securities offered and sold in compliance with Rule 506 of Regulation D under this Act, no person who meets the conditions set forth in [this law] shall be subject to registration as a broker or dealer pursuant to [the Securities Exchange Act of 1934], solely because  . . . that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means[.]”

Now, you might pick up on the term "general solicitation" in the legislative language. It's probably fair to say Congress anticipated the exemption would work hand-in-hand with the lifting of the ban on general solicitation in Rule 506 offerings that are limited to accredited investors. That’s because the lifting of the ban on general solicitation is written up in the same Title of the JOBS Act, Title II.[3]

However, the lifting of the ban on general solicitation doesn’t go into effect until the SEC amends Regulation D.[4] Why would Congress make one piece effective right away, and outsource a companion piece to the SEC for rulemaking? Hard to say, although Congress may have supposed there wouldn’t be a gap for too long, as it mandated that the SEC complete the implementing rules within 90 days of enactment of the law. That works out to have been July 2012. The SEC has missed and continues to miss that deadline.

Fortunately, there are existing legal doctrines to support the position that, when a site is walled off and protected by a password so only accredited investors are participating, and maybe also when there is some kind of cooling off period between registering on the site and investing, that in such cases, there is no “general solicitation,” or there is indicia of a pre-existing business relationship that negates the generality of any solicitation. At this point in the evolution of our securities laws, words have lost their plain meanings and become terms of art. But this convoluted jurisprudence is the basis on which the most prominent angel platforms are addressing the question of general solicitation, at least for now. 

The interim position is best reflected in a legal opinion that sports the candid title, “K&L Gates Opinion as to Why AngelList Does Not Need To Register as a Broker and Why Companies Posting Information to Accredited Investors on the AngelList Website are Not Engaged in a General Solicitation.”[5]

Two typesAll the same, we will breathe more easily when the exemption for angel platforms can be married with a lifted ban on general solicitation. Assuming the angel verification requirements are not too onerous![6]

Facilitating accredited investor crowdfunding is arguably the most important feature of the JOBS Act.

Title III Crowdfunding for Everyone

While there is one type of investment crowdfunding[7] already in effect – crowdfunding where the crowd is limited to those who are accredited investors – most people who refer to crowdfunding under the JOBS Act are talking about Title III, crowdfunding for everyone. Title III crowdfunding is not yet legal. Here again, Congress chose to require the SEC to first implement rules.

A nascent investment crowdfunding industry is eagerly awaiting these rules. Promoters of would-be non-accredited crowdfunding sites are meeting with the SEC, and with FINRA. Some are reconciling themselves to becoming registered broker-dealers, as the sense emerges that the constraints Title III imposes on funding portals are too restrictive.

The JOBS Act gave the SEC 9 months to come up with rules to implement Title III. That deadline was missed, and I’ve heard secondhand that SEC staff is signaling it may take all of 2013 to come up with final rules.

Now, if you are one of those angels who thinks investment crowdfunding for non-accredited investors is a bad idea, take comfort: it won’t prove workable. It won’t be the SEC’s fault, either; it will be because Title III is too much of a grab bag of conflicting imperatives.

Contrary to what is popularly supposed, Title III isn’t the original, standalone McHenry crowdfunding bill that the White House supported and got huge bipartisan support when it first passed the House. As, months later, the the JOBS Act was being cobbled together from disparate bills, Senators threw into Title III almost every investor protection from the past 80 years that any regulator could think of. Lost was the core idea that crowdfunding was supposed to be a simple, limited exemption for very small offerings.

The Senate’s essential problem with crowdfunding, as it turned out, was that it might involve a crowd.

Below are listed just some of the prohibitions, conditions and mandates in Title III of the JOBS Act.

For companies raising money:

  • No advertising, other than to direct people to the funding portal or broker-dealer
  • Financial statement requirements, including a requirement for audited financials if raising more than $500,000
  • Requirement for a business plan, to be filed with the SEC, with liability for omissions extending to officers, directors, and any seller
  • Annual SEC reporting requirements

For funding portals:

  • No solicitation of purchases, sales, or offers to buy securities displayed or offered on the portal
  • Ensure that no investor has exceeded her annual crowdfunding limit, across all platforms, with reference to how the sliding scale applies to her, all while ensuring her privacy
  • Requirement to educate and test investors
  • Obtain background checks and securities enforcement regulatory history checks on each officer, director and person holding more than 20% ownership
  • Ensure proceeds are not distributed before the offering target is hit
  • Have no interest in any company raising money through the portal

NONE of the requirements referenced above apply to crowdfunding on angel investing platforms.[8]

Photo: Problemkind / Flickr.


ENDNOTES

[1] SEC staff recently concurred with this view in an FAQ dated February 5, 2013, “Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act.” Here is the pertinent question and answer:

Question 1.

Can I rely on the exemption from broker-dealer registration in Securities Act Section 4(b) before the SEC adopts rules to eliminate the ban in Rule 506 on general solicitation?

Answer.

Yes. The exemption from broker-dealer registration in Section 4(b) does not require the SEC to issue or adopt any rules. You cannot permit an issuer to conduct a general solicitation of a Rule 506 offering on your platform, however, until the SEC’s rules permitting those activities for a Rule 506 offering are adopted.

[2] Here’s the exemption in fuller context from Section 201(c) of the JOBS Act:

(1)          With respect to securities offered and sold in compliance with Rule 506 of Regulation D under this Act, no person who meets the conditions set forth in paragraph (2) shall be subject to registration as a broker or dealer pursuant to section 15(a)(1) of this title, solely because--

(A)          that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means;

(B)          that person or any person associated with that person co-invests in such securities; or

(C)          that person or any person associated with that person provides ancillary services with respect to such securities.

(2)          The exemption provided in paragraph (1) shall apply to any person described in such paragraph if--

(A)          such person and each person associated with that person receives no compensation in connection with the purchase or sale of such security;

(B)          such person and each person associated with that person does not have possession of customer funds or securities in connection with the purchase or sale of such security; and

(C)          such person is not subject to a statutory disqualification as defined in Section 3(a)(39) of this Title and does not have any person associated with that person subject to such a statutory disqualification.

(3)          For the purposes of this subsection, the term `ancillary services' means--

(A)          the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and

(B)          the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.

[3] To be quite precise, both the lifting of the ban on general solicitation and the broker-dealer registration exemption for angel platforms are contained within Section 201 of the JOBS Act. Even so, the statute is quite clear that the lifting of the ban on general solicitation will require rulemaking before being effective, but the broker-dealer registration exemption will not. SEC staff have concurred in this view. See Endnote 1, above.

[4] Congress didn't have to do it this way. When Congress changed the accredited investor definition, even though that definition was itself an innovation of administrative regulation and not statute, Congress itself changed the definition, to state that, in calculating the net worth threshold, one should exclude the value of the principal residence.  Although the SEC followed up with rulemaking on how to deduct the value of the principal residence from net worth, that gloss did not delay implementation of the Congressionally reformed accredited investor definition. 

[5] The K&L Gates opinion, dated August 30, 2012, is available on the web at https://angel.co/documents/AngelList%20Legal%20Opinion%20-%20Aug%2030%202012.pdf.

[6] A Congressional quid pro quo for lifting the ban was that the SEC’s implementing rules “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” JOBS Act, Section 201(a)(1).

[7] For purposes of our discussion I am not addressing rewards- or donation-based crowdfunding, the poster child for which is Kickstarter.

[8] If time permits, we should discuss the implications of the February 2013 SEC staff FAQ on the question of what compensation will be permissible in connection with running an angel platform. See in particular Questions 5, 6 and 8 and the corresponding answers. Reference: http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm.


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