Crowdfunding Under Title III: Building an SEC-Compliant Funding Portal

November 30, 2015

Regulation Crowdfunding
Crowdfunding continues to garner more and more attention as the SEC pushes forward implementing the 2012 JOBS Act.  On October 30, 2015 the SEC adopted Regulation Crowdfunding pursuant to Title III of the JOBS Act, which will permit startups and small businesses to offer and sell securities through online crowdfunding.

Regulation Crowdfunding, which will become effective in May 2016, permits non-accredited investors to participate in securities-based (i.e. equity) crowdfunding transactions.  The rules establish limits as to how much a company can raise and how much an individual can invest, require to companies to disclose certain information, and create a regulatory framework for the intermediaries facilitating crowdfunding transactions.

While securities offered pursuant to Regulation Crowdfunding will be exempt from registration, the new rules mandate that intermediaries facilitating securities transactions must be registered with the SEC and FINRA.  Under Regulation Crowdfunding, the newly-created “funding portal” entities will be able to register as such on January 29, 2016.

Unlike the more complex and expensive Regulation A+ offerings, where companies can raise up to $50 million from investors, offerings under Title III are capped at $1 million, involve less stringent disclosure requirements and are targeted towards early-stage startups and small businesses.  Another key distinction is that offerings made under Title III must be made through an SEC-registered intermediary, either a broker-dealer or a funding portal.  On the other hand, an issuer seeking to conduct a larger, Regulation A+ offering need not engage an intermediary.

Although unlikely to be as demanding as Regulation A+, host of regulations will apply to issuers and intermediaries seeking to participate in the equity crowdfunding boom under Regulation Crowdfunding.  In addition to facilitating the offer and sale of securities, funding portals will be required to perform various investor-protection related functions, such as providing investors with educational materials, taking fraud-reduction measures, and encouraging communication and discussion about offerings on the platform.

The extent to which intermediaries will rely on issuer and investor representations is crucial for funding portals to comply with the anti-fraud provisions of Regulation Crowdfunding.  Because companies that will engage in Title III offerings are likely to be early-stage startups with limited financial resources, the bulk of the regulatory burden is likely to be shouldered by funding portals – not issuers.

Funding portals will need to work closely with securities attorneys to build legal compliance into their technical infrastructures, automating SEC regulations such as investment limits and issuer disclosure requirements.  Automated regulatory compliance will allow both issuers and funding portals to mitigate the risk of running afoul of newly-adopted SEC rules.

Limitations on Offerings and Investor Accreditation
Pursuant to Regulation Crowdfunding, a company would be allowed to raise a maximum amount of $1 million through crowdfunding offerings in a 12-month period.  An investor with an annual income and net worth exceeding $100,000 may invest 10% of their annual income or net worth (whichever is less).  An investor with an annual income or net worth less than $100,000 is permitted to invest $2,000 or 5% of their annual income or net worth, whichever is less.  During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.  Securities purchased in a crowdfunding transaction will generally be subject to a one-year holding period where they cannot be resold.

Funding portals should develop easy-to-use investor education and accreditation tools for potential investors, where investor input, such as annual income and investment experience, establishes whether and to what extent the investor may participate in crowdfunding offerings pursuant to Title III.

Issuer Disclosure Requirements
As with a traditional IPO, companies offering their securities to crowdfunding investors must make certain disclosures.   Third-party funding portals will serve as intermediaries between investors and entrepreneurs, facilitating negotiation, communication and the sale of securities.

Under Regulation Crowdfunding, companies must disclose certain information, including the offering price of the securities, the deadline to reach the target offering amount, the company’s financial condition (which may include audited tax returns), information about directors, officers and owners of the company and certain third-party transactions. In addition, companies relying on the crowdfunding exemption would be required to file an annual report with the Commission and provide it to investors, make amendments to offering documents under certain conditions and provide updates on the issuer’s progress toward reaching the target offering amount.

Startups and small businesses are unlikely to have access to the capital necessary to engage securities attorneys to ensure compliance with disclosure requirements.  If Regulation Crowdfunding is to succeed, funding portals will need to develop SEC-approved mechanisms to collect, organize and distribute issuer information to investors.  Successful funding portals will be those that develop an SEC-compliant architecture that facilitates issuer disclosure and compliance.  Funding portals should build disclosure mechanisms into their platform, whereby issuers would be automatically prohibited from offering or selling securities on the platform if they were deficient in their reporting requirements.

The information in this article is for general, educational purposes only and should not be taken as specific legal advice.

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Cass Sanford
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