Introduction of Regulation Crowdfunding
August 2016 | FEATURE | FINANCE & INVESTMENT
Financier Worldwide Magazine
For startups and small businesses, the signing into law of the Jumpstart Our Business Startups Act (JOBS Act) in April 2012 was a momentous, game changing moment. More than four years after the Act’s introduction, the final set of rules adopted by the Securities and Exchange Commission (SEC) with respect to Title III of the Act has finally come into effect.
In mid May, a new federal law called Regulation Crowdfunding became effective with the aim of opening up investment in private companies beyond the usual wealthy ‘accredited’ investors. The implementation of Regulation Crowdfunding has been designed to democratise modern investing in the US. Under Regulation Crowdfunding, ordinary people will be able to invest as little as $100 in startups and small businesses. While this may not seem significant, it represents a serious about-face for securities legislation not only in the US, but in most other notable jurisdictions.
The next step in crowdfunding regulation
The passing of Regulation Crowdfunding is a significant development, but it is not the first time that regulators have made efforts to harness crowdfunding as a means of capital generation. The SEC previously opened the door to a type of securities crowdfunding with Regulation D, which allowed public advertising of ‘private’ offerings. However, the SEC’s previous crowdfunding attempt was somewhat undercooked in comparison to Regulation Crowdfunding. Under Regulation D, the sales of securities were limited to “accredited investors”. Regulation Crowdfunding, by comparison, will go much further, engaging the general public. Though there is still some uncertainty about the efficacy of the new regulation, it is likely to be hugely influential. “Only time will tell how effective Crowdfunding will be, but it holds tremendous promise,” says Christopher J. Rogers, an associate at Jennings Strouss. “A lot depends on the licensed web-portals that will manage the offerings. One of the key challenges for any offering will be breaking through all the competition and earning investor attention. There are a lot of great businesses that are going to embrace the new rules, but the question is whether investors are going to be able to find them through the noise of all the others.”
For those within the crowdfunding industry, Regulation Crowdfunding has been a long time coming. Yet some critics have claimed that the final version of the rule is not fit for purpose. Some analysts have suggested that, at least initially, the appeal of the new regulation may be limited. Given that the Regulation contains a number of requirements and restrictions, including portal registration requirements, investment amount limits and issuer disclosure and reporting obligations, issuers may be reluctant to use this capital raising method.
It is also possible that the investing public may, in the short term, be sceptical about investing in unknown and possibly unproven enterprises, particularly given that there is lack of a secondary trading market which would enable investors to liquidate their investment. Combined, these factors may dilute the appeal of crowdfunding, although nothing is certain. For some, including Douglas Ellenoff, a partner at Ellenoff Grossman & Schole LLP, the implementation of the new rules is a considerable step in the right direction. “There are only positives that can result from the new rules. Companies now have many new approaches to pursuing raising capital and that is all for the good, but understanding the differences and their actual applicability to the companies circumstances is very, very important. Just because you can avail yourselves of these meaningful changes to US securities laws does not mean that you will actually raise the necessary funds or that accepting funds from the crowd will not be intrusive. Like many other alternative finance programmes, crowdfunding will take years to establish itself and should not be judged too quickly.”
Facets of the Act
The most important aspect of Regulation Crowdfunding is the change allowing small and start up companies to access the capital markets through low dollar amount online securities offerings directed to the ‘crowd’. The maximum aggregate amount that a company may raise through Regulation Crowdfunding during a 12 month period is $1m. The maximum aggregate amount that individual investors (whether non-accredited or accredited) may purchase depends on their annual income and net worth. For those with either annual income or net worth below $100,000, the limit is the greater of $2000 or 5 percent of the lesser of their annual income and net worth. For those with both annual income and net worth over $100,000, the limit is 10 percent of the lesser of their annual income or net worth, up to a maximum of $100,000.
Though previously capital funding was only really restricted to bigger players through public offerings or via private listing securities with exemptions, the arrival of the new regulations has opened the door to smaller investors and smaller companies and is a sea change from the previous regime. “Regulation Crowdfunding is a significant departure from 80 years of securities laws in the US and truthfully most established capital markets,” says Mr Ellenoff. “The presumption under the securities laws are that securities must be registered with the SEC if you want to offer those securities – particularly if they are offered through what is commonly referred to as a general solicitation. By definition, at least up until the new provisions under the Jobs Act, a private offering of securities, was just that: private. If you wanted to conduct a compliant private placement you had to have a pre existing and substantive relationship between the company and all investors.”
Despite the general optimism, there are still a number of questions lingering over the possible effectiveness of Regulation Crowdfunding. For some, including Eliza Fromberg, counsel at Day Pitney LLP, the efficacy of the regulation is in doubt given the restrictions in place. “Although it has captured the public’s imagination, I do not believe that Regulation Crowdfunding will have a significant impact on capital raising activity unless and until the $1m limit is increased significantly. However, the current regulation is a starting point, and if this experiment goes smoothly, and the SEC is able to adequately protect investors from fraudulent offerings, we may see regulatory interest in expanding this ‘pilot programme’.”
Criticisms and caveats
A number of parties have been quick to dismiss the potential effectiveness of the new regulations. “The SEC has really created a credibility crisis for crowdfunding,” said Patrick McHenry, Republican vice-chairman of the House Financial Services Committee, in an interview with the Financial Times. “It’s as if regulators don’t have trust and confidence that this marketplace can work. It seems like they have no trust that we can successfully invest in each other.”
There have been suggestions that the complexity and uncertainty generated by the new regulations will impact both investors and companies alike, many of whom will be reluctant to utilise the new system as a means of raising funds. The rules may create a two-tier investment landscape which would allow smaller companies to only be able to turn to crowdfunding as a means of raising funds.
Furthermore, in order to raise capital under the auspices of Regulation Crowdfunding, a company must provide a number of disclosures both at the time it sells its securities and on an ongoing basis. Should the company miss a filing it may be required to register the offering – in the form of a particularly expensive IPO – or risk violating securities laws. This may be an expensive and difficult process to complete, if not impossible.
As with any new process or financial measure, the uptake among companies and investors will likely be slow to begin with, particularly as many firms and would-be investors attempt to understand the new regulations, on which little guidance has been offered to date. Given that the regulation itself is over 500 pages long, it may take some time for parties to interpret and acclimatise.
In many respects, the criticisms levelled at Regulation Crowdfunding are in keeping with overarching attitudes toward all forms of crowdfunding. Since equity crowdfunding first attracted the public’s attention a few years ago, many critics have been quick disparage the practice as a bureaucratic burden and a disaster waiting to happen. Nevertheless, crowdfunding continues to go from strength to strength, and evolves to meet new needs, a task which will be facilitated by the enactment of Regulation Crowdfunding.
In reality, investors and companies are becoming increasingly accustomed to the application of significant new financial policies. Regulation A+, which revamped existing securities regulation, has been a notable measure which made capital raising much more efficient. There are lessons to be learned from Regulation A+, which has some parallels with the new crowdfunding regulation. “While both Regulation Crowdfunding and Regulation A+ permit companies to raise money from non-accredited investors, a Regulation A+ offering requires the company to draft offering documents for submission to and review by the SEC,” explains Ms Fromberg. “Tier 1 offerings also require review by state regulators for the states in which the offering is made. The regulatory qualification process is typically expensive, due to legal and accounting fees, and time consuming as regulatory approval takes several months. In contrast, no regulatory approval is required before seeking funds pursuant to Regulation Crowdfunding – the only gatekeeper is the intermediary facilitating the offering, meaning the broker-dealer or funding portal. In a Regulation A+ offering, the issuer can raise up to $20m via Tier 1 or $50m via Tier 2, in contrast to crowdfunding. Also, Regulation A+ shares are fully transferable immediately, although there is not currently a liquid secondary market for such shares, while crowdfunded securities are subject to a one year holding period.”
The differences between the regulations can, as Mr Rogers notes, be attributed to the different stages of a company’s development. “Regulations A+ and Crowdfunding primarily cater to companies at different stages of development. They differ in the amount of money that can be raised, the level of ongoing disclosure requirements, and the resale restrictions attached to the security. A startup or early stage company looking to raise $400,000 is a more likely candidate for crowdfunding than it is for Regulation A+, where companies are more likely seeking $4m-$40m. Furthermore, a Regulation A+ offering goes through a much more rigorous review process at the SEC which may involve several rounds of back and forth comments before the offering can officially start. In contrast, a Crowdfunding campaign need only complete and file the required form and could begin the offering in earnest, through a licensed intermediary,” he says.
For many commentators, the final version of regulation crowdfunding is too restrictive and may result in companies who might otherwise have struggled to attract investment engaging with investors in this manner. The Act offers little protection for investors should the offering company fail. Accordingly, efforts must be made to educate investors about participating in a crowdfunding campaign if fraud and malfeasance is to be avoided.
Regulation Crowdfunding is now a part of the investment fabric in the US and it could be a considerable benefit to both issues and investors, though there is much to be concerned about for both.
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