Brian Korn November 15, 2013

Equity Crowdfunding Legal Landscape: What’s Allowed and What’s Not

Midwest CrowdfundingChicago, Illinois

• Equity Crowdfunding – What is it? How does it compare to other crowdfunding?

• Legal status of equity crowdfunding

• SEC Proposed Rules• New Private Placement

Rules• Bad Actor Disqualification

Agenda

Crowdfunding After the SEC Rules Proposal

JOBS Act Overview

• Crowdfunding – online fundraising…but there’s a catch• Regulation A+ - from $5mm to $50 mm• Private Placement Reforms

− General Solicitation relaxed – effective Sept. 23

− Enhanced verification of Accredited Investors if Soliciting

• “Go Public” Shareholder Thresholds Increased• IPO On-Ramp and Emerging Growth Companies• Relaxation on Research Restrictions• Decimalization – move to $.09 tick increments?• Prospective Issuer Outreach• Signed into law April 5, 2012

“To increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.”

• Comprises Title III of the JOBS Act • Originated from two perceived

needs:− that smaller retail investors did not

have access to early stage investment opportunities

− that start-up companies did not have adequate access to available capital, particularly online capital raising

• Adds exemption from SEC registration for crowdfunding transactions in the form of new Section 4(6) of the Securities Act

Crowdfunding background

• Capital• Raising• Online• While • Deterring• Fraud and• Unethical• Non-• Disclosure

Backdrop: Current Crowdfunding Landscape – Five* Varieties

Type Rewards/Donation-Based

Equity to Accredited Investors

Equity to the Public

Peer-to-Peer Lending

*Advertised Private Placements/Title II

Examples Kickstarter, Indiegogo, Rockethub, Youcaring

FundersClub, AngelList, Ourcrowd

??? Lending Club, Prosper, Zopa (UK)

Private Placements using advertising and general solicitation

Securities Reg Status

Not sales of “securities”

Sales of securities to accredited investors

Sales of securities to the general public

Registered borrower-payment dependent notes

Exempt private placements under Rule 506(c)

Regulation State-level antifraud only; not SEC-regulated

SEC-regulated, no-action letters protect website solicitations from being public offerings

Extensive SEC regulation; currently illegal until SEC rules are finalized

SEC-registered securities, not really crowdfunding; banking regulations, not legal in several states

Extensive SEC regulation and proposed regulation; enhanced investor verification

Bad Actor Disqualification

Not applicable Applies for all issuers and for the crowdfunding sites themselves

Not applicable under JOBS Act, but SEC has said it will apply

Not applicable Yes

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Public Equity Crowdfunding

Information Regarding the Use of the Crowdfunding Exemption in the JOBS Act

On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law.

The Act requires the Commission to adopt rules to implement a new exemption that will

allow crowdfunding. Until then, we are reminding issuers that any offers or sales of

securities purporting to rely on the crowdfunding exemption would be unlawful under the

federal securities laws.

• Deadline for SEC rulemaking was due December 31, 2012

Issuers Not Eligible to Crowdfund

• Non-US companies• Public reporting companies (only required filers are

excluded, not “voluntary filers”)• Investment companies, including companies excluded

from the definition of Investment Company by 3(b) or 3(c) of the Investment Company Act of 1940, including:− Mutual Funds

− Private Equity Funds

− Asset Management Vehicles

− Business Development Companies

Crowdfunding vs. Other Exemptions

Feature Public Crowdfunding Regulation A+ Regulation D Rule 506 (4(a)(2))

Maximum Total Raised $1 million per 12 month period $50 million per 12 month period

Unlimited

Number of Investors Unlimited but subject to maximum total raised

Unrestricted

Unlimited accredited investors; up to 35 non-accredited investors unless soliciting

Investment Per Investor Restricted by income/net worth Unrestricted

Unrestricted

Investor Disclosure Required, must be filed with SEC

Required, must be filed with SEC

Not required if all accredited investors; Form D filing proposed

Intermediary Required Yes – broker/dealer or funding portal

No

No

Subject to ongoing SEC reporting following raise

Yes, at least annually, possibly more frequently

Yes; at least audited financials filed annually

No

Crowdfunding vs. Other Exemptions

Feature Crowdfunding Regulation A+ Regulation D Rule 506 (4(a)(2))

Disclosure Liability Yes, full disclosure liability with a knowledge exception

Yes, full disclosure liability with a knowledge exception

Only anti-fraud liability

Shares restricted Yes, for one year No

Yes, for public companies most can sell under Rule 144 after six months

State Filing Possibly, depends on future rules by state

No, if securities sold are listed on a national securities exchange or if sold only to “qualified investors”

Usually no if only offering to accredited investors

Advertising and general solicitation

Not allowed Allowed

Allowed if sales are made only to accredited investors and issuer takes reasonable steps to verify accredited status

Can public cos., foreign issuers, investment companies and exempt inv. companies issue

No Yes

Yes

Crowdfunding Requirements

• Investment limitations (per trailing 12 month period)− Company: Can receive up to $1 million

− Investor:• Less than $100K: greater of $2,000 or 5% of annual income

or net worth

• $100K or more: 10% of annual income or net worth

• Must be conducted through broker or “funding portal”• Must file with the SEC and provide to broker/funding

portal and investors extensive disclosure, including tax returns ($100K or less), reviewed financial statements ($100K-$500K) or audited financial statement (>$500K)

Crowdfunding Requirements

• Must not advertise except to direct investors to broker/portal

• Must not pay promoters except as SEC allows• Must file annual or more frequent reports with the SEC• Prospectus liability for disclosures with knowledge out• 1 year holding period on shares sold except to issuer,

accredited investor, family member or through registered offering

• Crowdfunded shares do not count towards the 2,000 shareholder rule to force a company public, but see above re SEC reporting

Funding Portals

• Created by Crowdfunding rules• Must be used as “publicity intermediary” in all

crowdfunding transactions• Exempt from broker-dealer regulation, but must

register with FINRA; FINRA can only enforce and examine rules specifically written for funding portals

• Prohibited from:− Offering investment advice or recommendations

− Soliciting purchases, sales or offers to buy the securities

− Compensating employees based on sales

− Holding, managing or possessing investor funds or securities

More Funding Portal Requirements

• Register with the SEC and any applicable SRO

• Provide disclosures related to risks and other investor education materials as the SEC shall require

− Must ensure that each investor reviews investor education materials

− Obtain investor representation that he or she understands:

• that entire investment is at risk

• that investing in start-ups and emerging companies is risky

• that crowdfunding investments are illiquid

• Must obtain background check on officers, directors and 20% or greater shareholders

• File with SEC and distribute disclosure materials at lest 21 days prior to first sale date

• Ensure offering proceeds are only provided to issuer when raise has met target; allow investors to cancel orders

• Make efforts to ensure no investor exceeds individual crowdfunding cap across all transactions

• Protect investor privacy

• Not compensate promoters, finders or lead generators who direct investors to the portal

• Not work with issuers where a portal officer, director or partner has a financial interest

New Private Placement Rules

New Structure of Rule 506

• Rule 506 now has two alternatives: (b) and (c)− 506(b) is the traditional rule

• no general solicitation or advertising permitted• offers and sales must be to either accredited or financially

sophisticated investors• up to 35 non-accredited investors permitted• information requirements for non-accredited investors• unlimited accredited investors permitted• unlimited dollar amount of offering

− 506(c) is the new rule• general solicitation or advertising is permitted• sales must be to accredited investors only• unlimited accredited investors permitted• unlimited dollar amount of offering

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• Historically, Regulation D’s prohibition against general

advertising/solicitation generally restricted funds and issuers

from utilizing any kind of article, advertisement, seminar,

meeting or notice to promote their Rule 506 offering• Under the JOBS Act amendments, private fund advisers may

now publicly advertise their funds, discuss funds in interviews

and informal investor settings, conduct capital raising meetings,

etc.− No limitation to “friends and family”; no more pre-existing

arrangements required

− The risk of “foot faults” (where too much information about a private

fund is unintentionally disclosed) should largely be eliminated

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Can Advertising Be Private?

• The lifting of the solicitation restrictions can be of special benefit

to emerging or growing funds that lack name recognition• Solicitations, advertisements and similar communications will

remain subject to the anti-fraud provisions of the Advisers Act,

which include prohibitions against the use of testimonials, past

specific recommendations, and restrictions on the presentation

of performance data• Web sites no longer need to be “password protected,” but they

still must be truthful and not misleading

•  

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Advertising (cont.)

• One practical advantage of the lifting of the solicitation

restrictions is the ability to get a group of investors in

a room and just talk to them about a fund offering• Another practical advantage is the ability to cross-

market with fund managers in unrelated sectors or

strategies to gain exposure to new sources of

investors• The ability to speak freely about fund offerings in

informal settings may be the most significant near-

term advantage of new Rule 506(c)

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Advertising (cont.)

• The fund or issuer must be satisfied that purchasers (regardless of to whom a private fund is advertised) are at least accredited investors

• New Rule 506(c) requires that the issuer take “reasonable steps” to verify that the investor fits within an accredited investor category

• The SEC suggested several “non-exclusive and non-mandatory” methods by which an issuer may meet the requirement to “take reasonable steps” to verify that a purchaser is accredited – unless the issuer has actual knowledge that the investor is not an accredited investor

• Funds are still limited to 100 investors in 3(c)(1) funds

• Funds with performance fees or allocations must still only sell to persons meeting the “qualified client” requirements

• Funds relying on Section 3(c)(7) must still only be sold to qualified purchasers

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Investments Still Effectively Limited to Accredited Investors

Verification of Accredited Status

• The proposed new rules require the issuer to take “reasonable steps to verify” that the purchasers of the securities are accredited investors, considering the following factors:− nature of purchaser / category of accredited investor

− amount and type of information issuer has concerning the purchaser

− nature of offering• manner in which purchaser was solicited

• term of the offering

• minimum investment amount, if any

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Accredited Investors: Natural Persons

• Natural persons meeting (or reasonably believed to meet) the following requirements are “accredited investors”:− Net Worth Test: individual net worth, or joint net worth with

spouse, exceeds $1 million, excluding net equity in primary residence

− Income Test: individual income in excess of $200,000 in each of the two most recent years, or joint income with spouse in excess of $300,000 in each of those years, with a reasonable expectation of reaching the same income level in the current year

− Insider Status: Director, executive officer or general partner of the issuer, or director, executive officer or general partner of a general partner of the issuer

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Verification Methods

• Publicly available information in governmental filings, such as:− registration of the investor with the SEC as a broker-dealer,

investment company or business development company

− public company proxy statement listing the investor as an executive officer or director, along with compensation information

− Form 990 tax return for a 501(c)(3) organization investor verifying at least $5 million in total assets

• Reasonable documentation− verification of an investor’s status as an accredited investor by a third

party, such as a broker-dealer, attorney or accountant

− copy of investor’s individual tax returns, Forms W-2, Forms 1099, or pay stubs demonstrating satisfaction of “income test”

− specific publicly available information about the average compensation earned at the investor’s workplace by persons at the level of the investor’s seniority

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Verification Methods (Cont’d)

• How the investor was solicited− Open web site solicitation, accompanied by a mere “check-the-

box” affirmation of accredited status, is insufficient

− Database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer, is sufficient

• Terms of the offering− High minimum investment (i.e. $1 million for an individual), not

financed by the issuer or a third party, can provide reasonable evidence of accredited status

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• If you choose to gather tax return information or forms, you now must have a way to safeguard the most confidential of information; it also makes you a potential third-party record keeper

• This is very different from subscription information, which is self-provided

• Some funds and issuers may turn to third-party verification services

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Possible Consequences of Self-Verification

Bad Actor Disqualification from Rule 506

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History of Bad Actor Disqualification

• Mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010− Requires the SEC to adopt rules that disqualify securities

offerings involving certain “felons and other bad actors” from reliance on Rule 506 of Regulation D

− Rules must be substantially similar to Securities Act Rule 262, which contains disqualifications for Regulation A offerings (up to $5 million; soon-to-be up to $50 million under Section 401 of JOBS Act)

• SEC proposed rules on May 25, 2011; approved on July 10, 2013; effective on September 23, 2013

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• To whom does disqualification apply?− Issuers, underwriters, placement agents and any other “compensated solicitor”

− …and their directors, officers and significant shareholders, members or beneficial owners of voting securities (20 percent of voting power)

− For pooled investment funds, the funds’ investment managers and their principals and officers• Includes GPs and managing members of funds, and their GPs and MM, and principals

and officers participating in the private placement

• All officers? − No, just executive officers and officers working on the transaction

− Point of contention for investment banks in the proposal

• Timing of disqualifying acts?− Only events after enactment

− But, disclosure is required

• SEC confirms crowdfunding and Reg A+ will have their own bad actor disqualifications

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New Rule 506(d) of Securities Act

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What are the Disqualifying Events?

Bad Act  Look-Back Period

Criminal convictions in connection with the sale of securities or making false statements to the SEC 

Issuers – 5 yearsAll others (including issuer executive officers and directors) – 10 years

Court orders, judgments or decrees in connection with the purchase or sale of securities or in connection with the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor 

5 years

Final orders of certain regulators, including state securities commissions, state banking authorities, state insurance commissions, federal banking agencies or the National Credit Union Association, which bar the person from:

association with an entity regulated by such commission

engaging in the business of securities, insurance or banking, or

engaging in saving association or credit union activities

 

Longer of duration of final order or 10 years from final order based on violation of fraudulent, manipulative or deceptive conduct, if applicable

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Disqualifying Events (cont.)

Bad Act Look-Back Period 

CFTC orders (bar or final orders) relating to violations of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct 

Longer of duration of final order or 10 years from final order

SEC disciplinary orders under Sections 15(b) or 15B(c) of the Securities Exchange Act of 1934, as amended (the Securities Exchange Act), or 201(e) or (f) of the Investment Advisers Act of 1940, as amended, that: suspends or revokes such person’s

registration as a broker, dealer, municipal securities dealer or investment adviser

limits such person’s activities function or operations, or

bars person from association with any entity or from participating in an offering of penny stock

 

Duration of order

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Disqualifying Events (cont.)

Bad Act Look-Back Period

SEC orders prohibiting future violations of any scienter-based anti-fraud provision, including Sections 5 and 17(a) of the Securities Act, and Sections 10(b) of the Securities Exchange Act 

5 years from date of order

Suspension or expulsion from membership in or bar from association with a member of a national securities exchange or registered national securities association (currently FINRA is the only registered national securities association) 

Duration of suspension or expulsion

Regulation A bad-actor stop-orders 

5 years

U.S. Postal Service false representation orders 

Longer of 5 years or duration of order

Questions & Answers

Speaker Biography

Brian Korn

212.808.2754kornb@pepperlaw.com

Corporate and Securities practice group, based in New YorkHands-on transaction execution and market expertise across product categories, including equity capital markets, debt capital markets, leveraged finance and private equityFormer in-house counsel at Barclays and Citigroup investment banksSpecialist in IPOs, the JOBS Act and SEC compliance, as well as early-stage fundraising, high yield debt and swaps/derivativesMedia Appearances: Fox Business Television, Bloomberg, NPR, CCTV AmericaPublished or Quoted: Forbes, CNBC, MSNBC, New York Law Journal, Law360, Philadelphia Inquirer, Pittsburgh Post-Gazette, The Financier, Review of Securities & Commodities RegulationSeasoned 16 year securities expert and frequent speaker: PLI, NYC Bar faculty member; Speaker at national securities and crowdfunding conferences J.D. Northwestern University School of Law

− Northwestern Journal of International Law & Business

B.A. with Honors and Distinction, University of California, Berkeley

For more information, visit www.pepperlaw.com.

Pepper Hamilton LLPThe New York Times Building

620 Eighth AvenueNew York, New York 10018

Brian Korn, Esq.(212) 808-2754kornb@pepperlaw.com