SENATE PASSES CROWDFUND ACT, ADDS PROTECTIONS FOR LESS SOPHISTICATED INVESTORS, REQUIRES RECONCILIATION WITH HOUSE BILL

 

With a 73-26 vote, the U.S. Senate brought my dream of a bonsai pet business one step closer to reality today. The bill added some much-needed requirements to the JOBS Act that passed in the House of Representatives, giving the SEC more authority to protect the less sophisticated investors who might want to help fund a new business venture.

In the Senate version known as the CROWDFUND Act (S. 2190) crowds looking to fund new business ideas will have to do so through approved portals, many of which have been been gearing up to funnel cash into new companies once this law is fully passed. Here are the major provisions of the Senate version.  

• Maximum Funding Companies - Companies can receive up to $1 million in funding from the crowd.
• Maximum Investment By Individual Investors - The amount each person can give will be capped based on their income. The limits range between $2,000 and $10,000 dollars.

But not everyone is convinced the JOBS Act is for the best. David Marlett from Crowd9, which works with crowdfunded securities, still sees a lot of room for fraud.

He writes on his blog.

“Regardless of how this is stated, it will be almost impossible to enforce.  If an investor wants to invest, they will simply claim their income or net worth to be above the required threshold.  Spend time in the boiler rooms, listening to the schemes, trying to counsel against those exhaustively exaggerated claims, and you get a sense for how truly ineffective such a provision will be. Once a potential investor is spotted, any huckster worth his huckst will make sure they ‘meet’ whatever threshold is required.”

Marlett also talks about the absurdity of performing financial audits on newborn companies who might spend as little as a few hundred dollars on each line item involved in forming a startup.

A number of other important provisions in the legislation will dramatically impact the startup landscape. The biggest one is probably the death of the 500-shareholder rule, which will allow private companies far more leeway to put their shares onto platforms like SecondMarket, giving the company, especially early investors and employees, much needed liquidity without the major hurdle of having to take the company public.

COMMENTARY:    I have been covering crowdfunding since the very first crowdfunding sites were launched in 2010 and even predicted that this could revolutionize how capital is raised by startup entrepreneurs and could even make angel investors obsolete.  If you are not familiar with crowdfunding, please read my blog post dated November 19, 2011.  

Crowdfunding has been in the legislative crosshairs since the end of 2010 due to concerns over the potential for fraud, compliance with SEC regulations governing the sales of securities, and offering individual investors firm guidelines and protections.     

Startups are currently prohibited from selling stock or other securities via crowdfunding sites or social networking sites; they may, however, accept donations.  This is because of federal and state securities laws which have been in place (in one form or another) since the 1930’s, including the following:

• A prohibition against advertising or “general solicitation” – which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor (see “Can I Raise Money For My Startup Via Twitter?” );
• Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering of securities too costly and onerous for a startup (see “Ask the Attorney – Securities Laws”);
• A requirement that any intermediaries (including websites) must be registered with the SEC and applicable state securities commissions as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities (see “Ask the Attorney – Beware of Finders”); and
• A requirement that any company that has 500 or more shareholders and total assets exceeding $10 million must register with the SEC and file periodic reports.

To following Federal Crowdfunding Bills Timeline will give you a quick overview of the legislative process and bills proposed and passed since August 2010:

Click Image To Enlarge

In a  blog post dated November 30, 2011, I covered the passage of the House's Entrepreneur Access To Capital Act, H.R. 2930, on November 4, 2011. 

As passed, the House version of the crowdfunding legislation includes the following requirements and limitations on crowdfunding:

• "The [issuer] may only raise a maximum of $1 million, or $2 million if the [issuer] provides potential investors with audited financial statements.
• Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.
• The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.” 

Senate bill S. 1790, the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (or the “CROWDFUND Act”), was originally introduced by Senator Merkley on December 8, 2011.   S. 1790 later became S. 2190   In researching the Senate's CROWDFUND Act, there were a total of eight amendments pertaining specifically to Title III - CROWDFUNDING.

The key amendment provisions to S. 1790 (now S.2190)  are as follows:  

SEC 302 - Crowdfunding Exemption to the Securities Act of 1933.--Section 4 of the Securities Act of 1933 (15 U.S.C. 77d),  The key points of SEC 302 are summarized below:

1. The aggregate amount sold to all investors by the issuer during the 12-month period preceding the date of such transaction, is not more than $1,000,000;
2. The aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided under this paragraph during the 12-month period preceding the date of such transaction, does not exceed--
   1. The greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
   2. 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;
3. The transaction is conducted through a registered broker/dealer or Funding Portal (See SEC 304 below).

SEC 303 Exclusion of Crowdfunding Investors From Shareholder Cap as provided in the Securities and Exchange Act of 1934 (15 U.S.C. 78l(g)) which placed a cap of 499 individual investors for unregistered corporations.

SEC 304 Funding Portal Regulation which amended Section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c) .  This amendment says that "the Commission (SEC) shall, by rule, exempt, conditionally or unconditionally, a registered funding portal from the requirement to register as a broker or dealer under section 15(a)(1), provided that such funding portal--

(A) remains subject to the examination, enforcement, and other rulemaking authority of the Commission;

(B) is a member of a national securities association registered under section 15A; and

(C) is subject to such other requirements under this title as the Commission determines appropriate under such rule. 

The term `funding portal' means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 1933 (15 U.S.C. 77d(6)), that does not--

(A) offer investment advice or recommendations;

(B) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;

(C) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal

(D) hold, manage, possess, or otherwise handle investor funds or securities; or 

(E) engage in such other activities as the Commission, by rule, determines appropriate.''.

If my interpretation of SEC 304 Funding Portal Regulation is correct, the Senate crowdfunding legislation will exempt crowdfunding sites like Kickstarter, Crowdcube,etc. from registering with the SEC as registered securities dealers or brokers provided they meet several conditions.       

I assume that securities offered through a crowdfunding site by a corporation to small individual investors will require a prospectus and disclosures that the investors are or are not fully-accredited investor or unsophisticated investors.     

The Senate's JOBS Act, S. 2190, still needs to be reconciled with the House's bill and a final bill prepared for President Obama's signature before it becomes law.  I much prefer the Senate's version of the crowdfunding bill because it sets a $1 million maximum limit that can be raised by an individual corporation through a crowdfunding site, and sets limits on individual investors based on income or net worth.   I assume that the crowdfunding provisions of the JOBS Act will not enacted for several months to give all parties affected time to make the necessary preparations.  

Let's hope that Congress can get their act together and pass a bill that protects all the parties. 

Courtesy of an article dated March 22, 2012 appearing in VentureBeat