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The Top 10 Crowdfunding LegalDevelopments of 2015

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January 11, 2016 @ 6:00 am By Kiran Lingam

 

2015 could go down as the most active year for regulatory reform in the private securities marketsince 1940.   After a long delay since passage of the JOBS Act in 2012, we saw an unprecedentedflurry of regulatory activity in 2015.

Without further ado, here are the top 10 crowdfunding and private securities legal developments of2015:

#10 – RAISE Act and Private Secondary Markets(December 2015).

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Snuck into a transportation bill, the Reforming

Access for Investments in Startup Enterprises (“RAISE”) Act formalizes a securities exemption forshareholders to sell their shares on a secondary market.  In short, employees and earlyshareholders can now rely on a statute to sell their shares in private companies to accreditedinvestors so long as they meet certain conditions.   Prior to the RAISE Act, most sellers relied on aninformal exemption developed under case law, referred to as the 4(a)1/2 exemption and which hasnow been codified into 4(a)(7).  The typical case here is the startup employee who desires to sellhis shares before the company is sold or goes public.   These type of secondary sales have beenpopularized by companies like SecondMarket and EquityZen.

Upshot:  This is a step in the right direction for facilitating secondary markets and liquidity forprivate securities.

#9 – Accredited Investor Definition – SEC StaffRecommendations (December 2015).This may have the most dramatic impact across the securities markets.  Regulation D offerings toaccredited investors account for nearly all current fundraising for private companies and privatefunds.   Some have proposed changes to the accredited investor definition that could seriouslyhamper startup and small business fundraising by reducing the number of accredited investors inthe country by over 50%.

In response to this possibility, there was an avalanche of feedback delivered to the SEC,advocating to; (1) leave the financial thresholds alone (if it ain’t broke…) and, (2) potentially expandthe definition to include certain sophisticated persons.

In December of this year, the SEC staff released its recommendations, which effectively created 3“tiers” of Accredited Investors:

*All numbers would be indexed to inflation going forward.

Upshot:  Disaster seems to be averted and there may even be a new class of sophisticatedmillennial/young professional accredited investors.  On the downside, transactions would havemoderately more friction and legal expense.  There is still some work to be done here, in particularon clarifying the proposed sophistication standards under Tier 2, but all-in-all a positive result forfundraising.  These recommendations are out for comment are not final.

#8 – CitizenVC No Action Letter (August 2015).In this letter, the Securities and Exchange Commission confirmed that an online investmentplatform can operate under Rule 506(b) of Regulation D without being deemed to have engaged inGeneral Solicitation so long as proper procedures are followed.  While the letter did not containany surprises, it dispelled many incorrect interpretations of the law prevailing in the market andalso provided more certainty to those seeking to operate under Rule 506(b).  In pertinent part, theletter dismissed the idea that a 30 day cooling off period is mandatory for platforms operating

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under Rule 506(b).

Upshot:  Many investment platforms are now pulling back to conducting “private” Rule 506(b)offerings rather than “public” Rule 506(c) offerings.

#7 – Regulation A+ Implemented (June 2015).On June 19, 2015, Title IV of the JOBS Act went into effect allowing companies to raise up to$50M in a “mini-IPO” style offering.  On the first day, several offerings launched into “testing thewaters” and received a strong response.   Subsequently, the Elio Motors offering was qualified bythe SEC on November 20, 2015, and the fundraising is currently underway.

Upshot:  The verdict is still out on the effectiveness of straight Regulation A+ offerings.  If costsare contained and these companies are successful in raising significant amounts of money, then anew alternative to venture capital and private equity capital could emerge for mid-sizedbusinesses.

#6 – SEC Action against Ascenergy Oil & GasCrowdfunding Scheme (October 2015).

The SEC has been active on the enforcement

front.  In this case, Ascenergy raised $5M from over 90 investors including via listings on severalfunding platforms for oil & gas projects.   The SEC found that most of the proceeds were actuallybeing used for other purposes including payments to the principals and not oil and gasdevelopment.  Notably, Ascenergy did not appear on any platform operated by a broker-dealer,but rather listed on the more “open” non-broker dealer platforms.

Upshot:  In the wake of sweeping regulatory change, regulators are on high alert for fraud and badactors and are willing to take action.

#5 – PATH Act Permanently Extends QSBS TaxExclusion (December 2015).

In a big win for angel investors, the PATH Act

makes permanent a 100% capital gains tax exclusion for “qualified small business stock.”   Inshort, if an individual purchases shares in a qualified small business (i.e. a startup) and holds it for5 years, they will not be required to pay taxes on the gain on those shares, subject to severalconditions.  Historically, the Angel Capital Association and others have been fighting for annualextensions for this exclusion, which is now permanent.

Upshot: Qualified small businesses that are raising capital should make sure their investors areaware of this potentially large tax benefit.

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#4 – Intrastate Crowdfunding – Modernization of Rule147 and Rule 504 (October 2015).During the wait for the Title III Equity Crowdfunding rules, over 30 states took matters into theirown hands and implemented intrastate crowdfunding rules.  Usage of these laws has been lowand many view the uncertainty created by the interaction with federal law as the primary culprit.  Now the SEC has proposed to fix the federal rules to pave the way for intrastate crowdfunding by,among other things (i) allowing internet advertising, (ii) allowing companies incorporated in otherstates (i.e. Delaware) to participate, and (iii) providing more flexibility on how to qualify as doingbusiness in a particular state (i.e. if a majority of your employees are in the state, then the companycan qualify as doing business in that state).

Upshot:  State crowdfunding laws, which are generally much less stringent than nationalcrowdfunding under Title III of the JOBS Act, could provide a useful path for local crowdfunding.

#3- Overstock Gets SEC Approval to Issue SharesUsing Blockchain (Dec 2015).

In the latest proposal to use blockchain technology to disrupt

existing industries, Overstock is seeking to create a new, digital, securities market where we are nolonger reliant on broker-dealers and other intermediaries.  In theory, such a system could replaceexisting trading markets (i.e. the NYSE, NASDAQ and OTC) and eliminate bid/ask spreads.

Upshot:  This is likely the first of many concepts where the blockchain is applied to the securitiesmarkets.

#2 – SEC qualifies Fundrise Reg A+ “eREIT”(November 2015).

Unlike Regulation Crowdfunding, the Regulation

A+ rules are not specifically restricted to operating companies, opening the door for certain typesof investment vehicles (so long as they also comply with other applicable regulation).   Ultimately,this could be the most powerful use case for Regulation A+.  The eREIT allows Fundrise to acceptinvestments from unaccredited investors and deploy them across a variety of real estateinvestment asset classes.

Upshot:  This is a huge development in the real estate crowdfunding market as well as for themassive traditional REIT market.  We expect to see many more Reg A+ REIT filings from platformsand traditional REIT managers in 2016.

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#1 – Title III Equity Crowdfunding Final Rules (October2015).

The wait is finally coming to an end and we will

have legal, national, securities crowdfunding rules effective on May 16, 2016.  These rules providea framework for raising capital up to $1M from both unaccredited and accredited investors subjectto a plethora of requirements, restrictions, regulations, and limitations.   While many have writtenTitle III crowdfunding off as too complicated, burdensome, expensive or regulated, many platformsare eagerly pressing forward with plans to launch equity crowdfunding offerings this summer.

Upshot:  As many of the established players are shying away from Title III crowdfunding, thoseplatforms that are able to figure out how to navigate and automate the regulatory requirements andtransaction processes in a cost effective manner could be well positioned to dominate this marketfor many years to come.

2016 – The Year of Opportunity

Bonus – Reg A+ Shelf Registration.  In Q1 2016,

we could see the first approved Regulation A+ shelf registration, which would allow deal-by-dealaccess to unaccredited investors through a borrower payment dependent note structure.  Thiswould be similar to how Lending Club and Prosper reach unaccredited investors, but with thelower costs and compliance obligations of a Regulation A+ offering (as compared to a full-fledgedIPO).  For debt offerings, this could prove to be more effective than Title III crowdfunding.

While 2015 brought us sweeping regulatory changes, 2016 may be the year where we see rapidinnovation as industry leaders identify new market opportunities created by these developments.

 

 

Kiran Lingam is a Partner in FinTech at Nelson Mullins Riley and

Scarborough and Managing Director of LendTech Angels.  He has written several of the

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seminal articles on new securities laws under the JOBS Act, including on Accredited InvestorCrowdfunding (Title II), Retail Crowdfunding (Title III) and Regulation A (Title IV).   Prior toNelson Mullins, Kiran was General Counsel at equity crowdfunding platform SeedInvest.  He isa Charter Member and Board member of TiE (The Indus Entrepreneurs) and TiE Angels.   Kiranreceived a B.A. in Economics from Cornell University and a J.D., with honors, from theUniversity of Georgia.

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