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By Popular Demand: New Crowdfunding Rules and the Tantalizing Alternative of Regulation A+

MSBA Business Law Section 2016 Business Law Institute

Penny Somer-Greif

Gregory T. Lawrence

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Raising Capital by Selling Stock Every offer or sale of a security

must be registered or exempt SEC and state regulators

SEC registration of offering means Company becomes subject to Exchange Act reporting SEC review and comment Expense/delay

Raising capital through an exempt offering avoids Exchange Act reporting, SEC review

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Two types of Exemptions

Exempt Securities Municipal and

federal government securities §3(a)(2)

Commercial paper §3(a)(3)

Securities of non-profit issuers §3(a)(4)

Insurance policies and annuities §3(a)(8)

Exempt Transactions Private placements under

Securities Act§4(a)(2)

Limited offerings under Securities Act§3(b)

Regulation D (Securities Act Rules 504, 505 and 506)

Intrastate offerings §3(a)(11) and Rule 147

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Rule 506(b) of Regulation D (Traditional)

Most private placements are conducted in accordance with Rule 506 Safe harbor exemption under §4(a)(2) of

the Securities Act

No limit on number or dollar amount of securities sold

Unlimited number of accredited investors

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Rule 506(b) of Regulation D, continued

Up to 35 non-accredited but “sophisticated” investors

Prescribed disclosure for non-accredited

Private placement memo generally used even if all accredited

State registration pre-empted

Notice filing and payment of filing fee only

Accredited-only offerings common

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Accredited Investors

Net worth $1 million

Must deduct value of primary residence

Annual income $200,000/$300,000 w/spouse

Last two years, reasonable expectation of reaching in current year

Net worth and annual income limits will be updated for inflation at some point

Director, executive officer or general partner of the issuer

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Accredited Investors, continued

Certain entities including banks, insurance companies, registered investment companies, certain employee benefit plans, and charitable organizations, corporations or partnerships with assets exceeding $5 million not formed for specific purpose of acquiring the securities offered

Person who comes within, or who the issuer reasonably believes, comes within any of these categories

Typically, issuers rely on self-certification

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“Sophisticated” Investor

“Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.” (Rule 506(b)(ii)(2))

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Rule 506(b): No General Solicitation or General Advertising Permitted

Radio, newspaper, television or similar media advertisements, notices or articles Meeting where invitees invited via

general solicitation or general advertising Mass mailings/emails Distribution of flyers

Statements on a public Web site No substantive, pre-existing

relationship (membership lists)

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General Solicitation Issues

Issuer or others acting on its behalf must have reasonable criteria for selecting offerees

Pre-existing substantive relationship: Issuer and/or its agents should have prior contact and “sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication in determining his or her status as an accredited investor.”

Self-certification of accredited investor status standard in Rule 506(b) offerings

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Rule 506(c) Offerings Permit General Solicitation/General Advertising

• All investors are accredited investors

• The issuer takes “reasonable steps” to verify that all purchasers in the offering are accredited investors

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Verification of Accredited Investor Status

Facts and circumstances determination

Nature of purchaser

Type of accredited investor (which category)

Amount and type of information issuer has about the purchaser

Nature of the offering High minimum investment

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Types of Information to Verify Accredited Status

Publicly available information in regulatory filings

Reliable third-party information Pay stubs

Public information about average compensation earned by like persons

Third-party verification

Self-certification (check-the-box) alone will not be sufficient

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Additional Provisions - Rule 506 Offerings

Securities restricted as to resale

Issuer must take reasonable care to limit resales Restrictive legend

Notice to purchasers

Form D filing with SEC within 15 days of first sale Generally filed with states in Rule 506 offerings

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Crowdfunding (Section 4(a)(6))

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The SEC on “What is Crowdfunding?”

Relatively new and evolving method of using the Internet to raise capital

Serves as an alternative source of capital to support a wide range of ideas and ventures

A crowdfunding campaign generally has a specified target amount for funds to be raised, or goal, and an identified use of those funds

Typically seeks small individual contributions from a large number of people

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The Simpsons on Crowdfunding

“If there’s anything that has true wisdom it’s crowds.”

-Homer J. Simpson

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Crowdfunding Exemption Effective May 16, 2016

Sections 4(a)(6) and 4A of the Securities Act, as added by the Jumpstart Our Business Startups (JOBS) Act

Exempt from Section 5 registration requirements

Exempt from state registration requirements States may require filing of documents filed with

SEC

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Basic Requirements (This is NOT Kickstarter)

Limits on amount raised in 12-month period By issuer

From any one investor (across all crowdfunded offerings)

Conduct through registered intermediary

Disclosure requirements

Ongoing reporting

Compliance with other requirements set forth in proposed rule

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$1 Million Offering Limit

Issuer cannot raise more than $1 million in any 12-month period under crowdfunding exemption

Amounts raised through other methods do not count towards the limit Non-securities based crowdfunding

Exempt private placements under Regulation D

Not integrated with other exempt offerings Must ensure persons participating in offering prohibiting

general solicitation were not solicited by crowdfunding offering

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Limits per Investor over a 12-Month Period

Greater of (i) $2,000 or (ii) 5% of the lesser of the investor’s annual income or net worth, if the investor’s annual income or net worth are below $100,000; or

10% of the lesser of the investor’s annual income or net worth, not to exceed $100,000, if the investor’s annual income and net worth are at least $100,000

Calculated consistent with Rule 501 definition of accredited investor

No other purchaser requirements

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Must Use a Registered Intermediary

Cannot use more than one

Offering conducted solely through intermediary’s Internet or similar electronic “platform” Limited off-line notice/advertising permitted

Potential investors must consent to electronic delivery

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Intermediary: Registered Broker or “Registered Funding Portal” Registered Funding Portals Must register with the SEC, FINRA

FINRA has own compliance requirements (FINRA funding portal rules became effective January 29, 2016)

Cannot offer investment advice, solicit purchases, handle investor funds/securities, or take certain other prohibited actions

Subject to SEC examination and enforcement

Must implement policies and procedures to comply with applicable laws and regulations

Must comply with certain recordkeeping, other requirements

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Permitted Actions of Registered Funding Portals

Advise issuer about structure and content of the issuer’s offering, including preparation of offering documentation

Provide, but not participate in, communication platforms

Pay compensation to a registered broker or dealer for services in connection with the offer or sale of securities on its platform

Accept investment commitments on behalf of issuer

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Role of Intermediary Investor education materials

Affirm investor understands risks

Make information required to be provided by the issuer available on its platform 21 days before securities sold

Take steps to reduce the risk of fraud

Background checks

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Role of Intermediary, continued

Reasonable basis for believing investor satisfies investment limits (investor rep)

Before allowing an investment, confirm the investor has reviewed the education materials and understand the risks, right to cancel, resale limitations

Note: All information provided to and received from investors is done electronically

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Role of Intermediary, continued

Provide communication channels Cannot participate but for guidelines, removal of

abusive/fraudulent communications

Comply with rules for the maintenance and transmission of investor funds Funding portals must have arrangement with a bank

Provide investors with confirmation of the investment, purchase/transaction Identity, price and number of securities purchased/sold

Type, terms of security sold

Source, amount and form of remuneration

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Disclosure Requirements – New Form C

Filed with SEC through EDGAR, provided to intermediary and to investors/potential investors through intermediary’s platform

Issuer and officers, directors, 20% stockholders

Business and business plan, Web site

Purpose/use of proceeds

Target offering amount, deadline to reach, acceptance over target, over-subscriptions

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Form C Disclosure Requirements, continued

Offering price or method for determining, terms of offering, ownership and capital structure

Factors that make an investment speculative or risky

Indebtedness

Description of the issuer’s financial condition, “including, to the extent material, … the issuer’s historical results of operations, liquidity and capital resources.”

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Form C Disclosure Requirements, continued

Investors may cancel until 48 hours prior to deadline

Intermediary will notify when target reached

Offering may close early if target reached

Need to reconfirm for material change

Offering cancelled if target not reached

Resale restrictions

Certain legends

Regular updates

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Form C – Financial Information

Up to $100,000: total income, taxable income and total tax from federal income tax returns, financial statements certified by CEO

Up to $500,000 or first crowdfunding offering: Financial statements reviewed by independent CPA

Over $500,000 and not first crowdfunding offering: Financial statements audited by independent CPA

Two years or period since inception if shorter

Accountant’s review or audit report

If audited or in case of up to $100,000, reviewed financial statements are available, use those instead

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Advertising

Limited to “tombstone” notices that provide limited information about the offering/issuer and direct potential investor’s to the intermediary’s platform Statement issuer conducting offering, terms

Name of intermediary, link to platform

Certain factual information about legal identity, business location; brief description of business

Issuers/founders/employees/promoters can use intermediary’s communication channels, but must identify themselves, disclose compensation

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Compensation

Intermediaries may not compensate any person for providing it with “personally identifiable information” of any investor or potential investor

Can compensate persons to direct potential investors to platform if not transaction-based

Directors, officers, partners of intermediary cannot have or receive as compensation a financial interest in issuer using its platform Intermediary may receive the same securities sold in the

offering as compensation

Intermediary’s compensation must be pursuant to written agreement with the issuer

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Completion, Amendment, Cancellation and Reconfirmation May cancel until 48 hours after expiration date

Issuer can close early if target reached and offering open at least 21 days, and intermediary provides notice of new deadline/continue to meet target

Material change requires intermediary to provide notice, investors to reconfirm

Intermediary must provide notice of cancellation, return investors funds if offering cancelled

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Cannot Resell/Transfer for One Year, Except:

Issuer

Accredited Investor

Registered offering

Family member

Trust controlled by initial purchaser or for benefit of family member

Death/divorce of purchaser, similar

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Other

Annual Reports on Form C-AR Substantially similar to Form C but for offering-

specific information

Do not count towards record holder limitation for Exchange Act registration/reporting under Section 12(g) (compliance requirements)

Insignificant deviations safe harbor Failure to comply was insignificant

Good faith/reasonable attempt to comply

Issuer did not know of failure when result of failure of intermediary to comply

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Ineligible Issuers

Not a U.S. company

Subject to Exchange Act’s reporting requirements

Investment companies

Companies excluded from the definition of investment company under certain exclusions Hedge funds, other private funds

Failed to file annual report required in prior two years if used exemption previously

No specific business plan/plan to merge or acquire unidentified company or companies

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Disqualification of Felons, Other “Bad Actors”

Issuer, predecessor, affiliated issuer

Director, officer, general partner, managing member

20% stockholder (voting securities)

promoter connected with the issuer at the time or sale

Compensated solicitor

General partner, director, officers or managing members of any such solicitor

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Disqualification Events

Convictions and orders, judgments and decrees

Courts or federal or state regulatory agencies

Securities sales/business

False filings/bars

Suspension/expulsion (SROs, etc.), revocation of registration

Fraudulent, manipulative or deceptive conduct

Violation of certain securities or other laws

SEC stop orders or suspensions , U.S. Postal Service false representation orders

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Date of Triggering Event

Disqualification does not apply if event was prior to May 16, 2016, but

Disclosure of such events in offering statement

Look-back period generally is either five or ten years, but some orders will result in a disqualification if the applicable person or entity remains subject to the order at the time of sale

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Disqualification Considerations

Disqualification not applicable if SEC so determines, upon good cause, or issuer establishes “it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.”

Requires due diligence/factual inquiry by issuer

Disqualification does not apply if authority issuing order/judgment/decree advises disqualification should not be a consequence

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Crowdfunding in Maryland

Intrastate exemption – Maryland purchasers only

Do not have to use a funding portal

Look-back for “bad actor” disqualification events will not begin on effective date of order

Otherwise, similar to federal crowdfunding exemption

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Regulation A

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Regulation A - General

Exempt public offering Non-SEC reporting U.S./Canadian companies Up to $20 million (Tier 1) or $50 million (Tier 2) in

any 12-month period Equity securities, debt securities, debt convertible

into equity No purchaser qualifications No restrictions on general solicitation/ advertising No restrictions on resale of securities purchased

in a Regulation A offering Limits on registered resales

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Regulation A – General, continued

“Bad Actor” disqualifications Offering statement must be distributed to

potential investors Must be filed and “qualified” with SEC Subject to SEC review and comment

Regulation A not available to: Registered investment companies (or required) Blank check companies Issuers of fractional undivided interests in oil or

gas rights or similar interests in other mineral rights

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Tier 1 Regulation A Offerings

Up to $20 million in any 12-month period

Form Z exit report filed no later than 30 days after termination or completion of offering

Number of securities qualified and sold, price, fees, net proceeds

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Regulation A Offering Statement

Filed with the SEC through EDGAR

Basic information about the issuer, offering (Part I)

Boxes/drop-down menus

Financial statement information

Disclosure document and financial statements (Part II Offering Circular)

Narrative disclosure

Can follow Form S-1 requirements instead

Exhibits/signatures (Part III)

No filing fees

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Offering Circular – Part II Disclosure Document

Basic information about the company and offering Underwriters, underwriting discounts/commissions

Most significant risks

Plan of distribution

Material terms of securities being offered

Use of proceeds

Description of business, material properties

Directors, executive officers, significant employees Family relationships, business experience

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Offering Circular – Part II Disclosure Document (continued) Management’s discussion and analysis of financial condition

and results of operations, liquidity and capital resources

Plan of operations for 12 months if no revenues from operations in each of last three years – Whether necessary to raise additional funds in next six

months

Executive/director compensation (most recent fiscal year)

Beneficial ownership of voting securities by executive officers, directors, 10% owners

Transactions with related persons, promoters, control persons

Financial statements, two years (Tier I may be unaudited)

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Tier 2 - “Regulation A+”

Up to $50 million in any 12-month period “Test the waters” to solicit interest permitted Full audited financials in offering circular Independent (not PCAOB-registered) auditor

State registration or exemption NOT required State regulators objected to this

Ongoing SEC reporting requirements Information about recently completed offerings Annual and semi-annual reports Current reports for certain events Special financial reports in certain circumstances

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Tier 2 Regulation A Offerings, continued

Individual investor limits (non-accredited investors) 10% of the greater of annual income or net worth

(natural persons)

10% of the greater of annual revenues or net assets at fiscal year-end (entities)

Securities issued exempt from mandatory registration requirements of Section 12(g) Engage registered transfer agent

Remains subject to and current in reporting obligations

Public float of less than $75 million

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Rule 506 vs. Crowdfunding vs. Regulation A

Required disclosure Financial statements

SEC / State review

Cap on amount raised

Types of investors

Investment caps

Methods of solicitation/selling

Resale restrictions

Ongoing SEC reporting

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Remedies for Investors

Crowdfunding Exemption and Regulation A Section 4A(c) of the Securities Act

Section 12 of the Securities Act

Section 10(b) of the Exchange Act

Rule 10b-5

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Crowdfunding - Special Statutory Liability

Section 4A(c) of the Securities Act Private right of action for purchaser against

“issuer” that sells securities in an offering pursuant to Crowdfunding Exemption.

Issuer broadly defined as any person who offers or sells the security, including “issuer’s” directors and principal officers.

Likely includes intermediaries, including funding portals.

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Section 4A(c) of the Securities Act, continued

Investor must show that the “issuer” made: Untrue statement of material fact;

Failed to state a material fact required to be stated; or

Failed to state a material fact necessary in order to make the issuer’s statements, in light of the circumstances under which they were made not misleading.

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Section 4A(c) of the Securities Act, continued

Defenses Reasonable Care

Once material misstatement or omission is shown, burden shifts to defendant to prove that it did not know, and in the exercise of reasonable care could not have known of such untruth of omission.

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Section 4A(c) of the Securities Act, continued

Defenses Loss Causation

Defendant can avoid all or portion of damages by showing that something other than the material misstatement or omission caused the depreciation in value.

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Section 4A(c) of the Securities Act, continued

Remedies - Rescission Primary remedy is rescission, but only an option if

investor still owns the securities.

Investor tenders his or her securities and receives his or her purchase price in return, with interest.

Dividends or interest earned on securities is subtracted from this amount.

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Section 4A(c) of the Securities Act, continued

Remedies – Damages If investor no longer owns the securities, then he

or she may recover damages.

Damages equal the difference between the purchase prices and the disposal price, plus interest, less any income from the security.

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Section 4A(c) of the Securities Act, continued

Statute of Limitations Within one year after investor discovered or with

reasonable diligence should have discovered the material misstatement or omission, and in no event later than three years after untruth or omission.

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Crowdfunding Rules – Safe Harbor

An insignificant deviation from a term, condition, or requirement of the rules will not result in a loss of exemption if issuer can show: Failure was insignificant with respect to offering as a

whole;

Issuer made a good faith attempt to comply; and

In cases in which the issuer’s failure to comply was the result of the intermediary’s failure to comply with its obligations, the issuer did not know of such failure or such failure by the intermediary occurred solely in offerings other than the issuer’s offerings.

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Section 12 of the Securities Act, continued

Section 12(a)(1) Liability for any person who offers or sells a

security in violation of the registration requirement.

Applies if a non-exempt issuer conducts an unregistered offering that fails to comply with an exemption.

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Section 12 of the Securities Act, continued

Section 12(a)(2) – Regulation A Liability for any person who offers or sells a

security on the basis of:

A materially false or misleading prospectus; or

Materially false or misleading oral statements.

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Section 12 of the Securities Act, continued

12(a)(2) – Defenses Same as Section 4A(c) of the Securities Act

Reasonable Care

Loss Causation

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Section 12 of the Securities Act, continued

Remedies: Same as Section 4A(c) of the Securities Act

Rescission

Damages

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Section 12 of the Securities Act, continued

Statute of Limitations 12(a)(1) –

Within one year after date of violation.

12(a)(2) –

Within one year after investor discovered or with reasonable diligence should have discovered the material misstatement or omission, and in no event later than three years after untruth or omission.

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Section 10(b) of the Exchange Act and Rule 10b-5

Applies to issuers and intermediaries. Makes it unlawful to:

Employ any device, scheme or artifice to defraud;

Make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made not misleading; or

Engage in acts, practices, or course of business which operates or would operate as fraud or deceit upon any person

In connection with the purchase or sale of a security.

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Section 10(b) of the Exchange Act and Rule 10b-5

Elements: Misstatement or omission

Materiality

Scienter

Reliance

Proximately Caused Actual Damages (Investor must prove)

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QUESTIONS?

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Contact Information

Penny Somer-Greif 410-347-7341

psomergreif@ober.com

Firm Web site: www.ober.com

Gregory T. Lawrence 410-837-6995

greg@lawcfl.com

Firm Web site: www.lawcfl.com