CHAPTER 13
The JOBS Act and Regulation Crowdfunding Rules
On April 5, 2012, President Barack Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act, for short, which gives you an idea of what the government seeks to achieve with this statute).*
The act, described by one early commentator as a “dog’s breakfast,” is an eclectic combination of law changes designed to make it easier for emerging growth companies to raise capital without having to deal with the sometimes onerous requirements of federal and state securities laws.
The JOBS Act is divided into six sections, or titles, each of which addresses a specific area of securities law compliance for different types of companies. Some of these titles do not refer directly to crowdfunded offerings of securities, the primary topic of this book, but are discussed briefly in order to give a reader a better understanding of the JOBS Act’s scope and impact on the marketplace for private offerings of securities.
Title I: The IPO On-Ramp
Title I of the JOBS Act established a new process and disclosure regime for IPOs of securities. The statute creates a new class of companies called emerging growth companies (EGCs); an emerging growth company is defined as an issuer with total annual gross revenues of less than $1 billion (subject to inflationary adjustment by the SEC every five years) during its most recently completed fiscal year.
For those companies that qualify as EGCs, Title I creates a simplified IPO process, or IPO on-ramp. Instead of preparing and filing a formal IPO registration statement and prospectus, EGCs can obtain confidential SEC staff review of draft IPO registration statements, scaled disclosure requirements, no restrictions on “test the waters” communications with qualified institutional buyers and institutional accredited investors before and after filing a registration statement, and fewer restrictions on research (including research by participating underwriters) around the time of an offering.
Title I does not relate directly to crowdfunding and is not discussed elsewhere in this book. Interested readers should review the frequently asked questions about Title I posted by the SEC staff at www.sec.gov/divisions/corpfin/guidance/cfjjobsactfaq-title-i-general.htm.
Title II: Private Placements and New Rule 506(c)
Title II of the JOBS Act directs the SEC to eliminate the ban on general solicitation and general advertising for certain offerings under Rule 506 of Regulation D, provided that the securities are sold only to accredited investors.
Rule 506 of Regulation D, discussed in Chapter 12, has traditionally been the most popular means for conducting a private offering because it permitted issuers to raise an unlimited amount of money and preempts state securities laws, as long as all purchasers in the offering were accredited investors (very wealthy and/or sophisticated people) and up to thirty-five nonaccredited investors (everyone else). No general solicitation or general advertising was allowed in a traditional Rule 506 offering.
Title II directs the SEC to revise Rule 506 to provide that the prohibition against general solicitation or general advertising in Rule 502(c) shall not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors or the issuer “reasonably believes” them to be accredited investors. Title II further requires that issuers using general solicitation or general advertising in connection with Rule 506 offerings take reasonable steps to verify that purchasers of securities are accredited investors, using methods to be determined by the SEC. If an issuer is not comfortable making this effort, it can still use a traditional Rule 506 offering (no general solicitation or advertising, purchasers limited to accredited investors, and up to thirty-five other investors).
On July 10, 2013, the SEC approved final rules under Title II that eliminate the prohibition against general solicitation and general advertising in certain offerings of securities pursuant to Rule 506 of Regulation D. The rules create a new form of offering under Rule 506(c) that permits issuers to use general solicitation in connection with the sale of securities in private placements if the purchasers of all securities are accredited investors, and the issuer takes reasonable steps to verify that the purchasers are accredited investors.
The new rules leave intact Section 4(a)(2) of the Securities Act, which exempts from registration transactions by an issuer “not involving any public offering,” and existing Rule 506(b), which provides a safe harbor under Section 4(a)(2) for offerings conducted without general solicitation.
Under Rule 506(c), issuers will be permitted to approach prospective investors even without a preexisting relationship. Advertisements, articles, notices, or other public communications will be permitted, as will public seminars and meetings to promote the offering. The bad news here is that there will be a greater risk of running afoul of federal and state antifraud rules while engaging in general solicitation activities under Rule 506(c), such as live speaking engagements and webinars where it may be difficult if not impossible for company founders and promoters to hold their tongues when necessary.
Rule 506(c) requires issuers to take “reasonable steps” to verify accredited investor status. Unlike Rule 506 offerings, where general solicitation is not used, an investor will not be able to self-certify his status by filling out an accredited-investor questionnaire such as that included as Appendix 10. While such questionnaires will no doubt continue to be used, an issuer under Rule 506(c) will have to perform some due diligence on each of her investors, such as reviewing federal income tax returns, personal financial statements, bank and brokerage statements, credit reports, and other financial information, and/or requesting certification letters from the investor’s brokers, lawyers, and accountants confirming the information in the questionnaire.
An issuer relying on Rule 506(c) will have to fill out and File SEC Form D (a sales report) no later than fifteen calendar days before commencing general solicitation and general advertising, and include specific disclosures in its general solicitation and advertising materials. In a traditional Rule 506 offering involving no general solicitation, Form D is not due until fifteen calendar days after the first sale of securities in the offering. On Form D, an issuer must state whether it is relying on Rule 506(c) or a traditional private placement under Rule 506 (one without general solicitation) and will not be able to change it later if it makes a mistake.
Because of its anticipated impact on angel investor offerings, the text of new Rule 506(c) deserves to be quoted in full:
(c) Conditions to be met in offerings not subject to limitation on manner of offering—(1) General conditions. To qualify for exemption under this section, sales must satisfy all the terms and conditions of §§230.501 and 230.502(a) and (d).
(2) Specific conditions—(i) Nature of purchasers. All purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors.
(ii) Verification of accredited investor status. The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors. The issuer shall be deemed to take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and non-mandatory methods of verifying that a natural person who purchases securities in such offering is an accredited investor; provided, however, that the issuer does not have knowledge that such person is not an accredited investor:
(A) In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
(B) In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
(1) With respect to assets: Bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
(2) With respect to liabilities: A consumer report from at least one of the nationwide consumer reporting agencies; or
(C) Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
(1) A registered broker-dealer;
(2) An investment adviser registered with the Securities and Exchange Commission;
(3) A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
(4) A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
(D) In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to September 23, 2013 and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
The SEC also created new Rules 506(d) and (e), providing that companies that have run afoul of the securities laws in the past (by committing one or more of the “bad acts” that disqualify issuers from offering securities under Regulation A) could not avail themselves of the new unlimited “accredited investor only” offerings. Basically, a company cannot take advantage of a Rule 506(c) offering if it, or any of its directors, officers, or principals:
Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors, and affiliated issuers) of any felony or misdemeanor in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities
Is subject to any order, judgment, or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities
Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that at the time of such sale (i) bars the person from association with an entity regulated by such commission, authority, agency, or officer; engaging in the business of securities, insurance, or banking; or engaging in savings association or credit union activities, or (ii) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale
Is subject to an SEC order that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer, or investment adviser; places limitations on the activities, functions, or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock
Is subject to any order of the commission entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of Section 5 of the Securities Act or the antifraud provisions of any federal securities law
Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade
Has filed (as a registrant or issuer), or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or
Is subject to a U.S. Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations
Under new SEC Rule 506(e), the issuer is required to furnish to each purchaser, during a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification under Rule 506(d) but occurred before September 23, 2013. The failure to furnish such information in a timely fashion will not prevent an issuer from relying on Rule 506(c) if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter or matters.
As I will state in this book’s Afterword, I believe it is Title II of the JOBS Act—as opposed to the crowdfunding provisions in Title III—that will actually facilitate crowdfunding, at least by the more seasoned early-stage private companies that tend to attract accredited investors.
That said, there are a few “gotchas” in Title II.
First, Title II leaves intact the general solicitation and general advertising prohibition for offerings that include any “non-accredited” investors, such as employees, product developers, and other people contributing sweat equity for their shares. These people would have to be brought on board as founders (and their number would be strictly limited as under previous law) well before a company offers securities under Title II.
Second, an issuer who plans to rely on Rule 506(c) but fails to comply to the letter with the rule’s requirements may not be able to rely on the residual exemption under Section 4(a)(2) of the Securities Act, as issuers who rely on the traditional Rule 506 offering have always been able to do, because of that section’s express prohibition on general solicitation and general advertising.
Third, while the JOBS Act expressly preempted state securities laws that might otherwise prevent or restrict an offering under the Title III crowdfunding provisions of the JOBS Act, the same blanket preemption does not apply to offerings under new Rule 506(c). While the National Securities Markets and Improvements Act of 1996, discussed in the previous chapter, generally preempts state securities laws requiring registration at the state level of Rule 506 offerings (including offerings under Rule 506(c)), offerings under Rule 506(c) may still be subject to notice filing requirements (and possibly fees) in some states. Determining whether a Rule 506(c) offering triggers notice-filing requirements and payment of fees will likely involve additional diligence for issuers currently relying on blue-sky exemptions conditioned on the prohibition of general solicitation, with attention to the specific rules of each state.
Finally, while the JOBS Act preempts any state blue-sky laws requiring registration of securities at the state level, the states are still allowed to enforce their antifraud rules to target Rule 506(c) private placements, as well as crowdfunded offerings, for fraud. Crowdfunded offerings will often involve a high degree of risk. Start-ups have a high rate of failure, and—let’s face it—some offerings will likely involve fraud, or at least sloppiness in complying with the securities laws. Given the $1 million limit on the size of the offering, the SEC will not be likely to engage in significant enforcement activities. So the burden of enforcing the crowdfunding marketplace for securities may well fall to the states, and there may be fifty different sets of rules and fifty different regulators.
Given that the states have also been given responsibility for overseeing funding portals, as discussed in Chapter 11, the message Titles II and III send to issuers may well be, “You register with the feds, but you answer to your state regulator(s) if anything goes wrong.”
Title III: Crowdfunded Offerings of Securities
Title III is the heart of the JOBS Act, containing the provisions that will allow crowdfunded offerings of securities on the Internet. On October 23, 2013, the SEC issued a proposed Regulation Crowdfunding containing rules and regulations implementing Title III. After a period of public comment, the final version of Regulation Crowdfunding was approved by the SEC on October 30, 2015, with an effective date of May 16, 2016.
Title III added a new Section 4(a)(6) to the Securities Act to permit companies to engage in crowdfunded offerings of securities without having to go through the public offering registration process. The exemption is subject to the following conditions:
The aggregate amount an issuer may sell to all investors in reliance on the new exemption may not exceed $1 million in any twelve-month period (offerings made under other exemptions such as Regulation A do not count toward the $1 million limit).
An investor is limited in the amount he or she may invest in crowdfunding securities in any twelve-month period.
• If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to the greater of $2,000 or 5 percent of his or her annual income or net worth.
• If the annual income or net worth of the investor is $100,000 or more, the investor is limited to 10 percent of the lesser of his or her annual income or net worth, to a maximum of $100,000 (the SEC justified this approach by expressing concern about the number of U.S. households—approximately 20 percent—where there is a sizable gap between net worth and annual income, and the ability of these households to withstand the risk of loss).
• Regulation Crowdfunding treats investors who fall within both of these definitions as being able to take advantage of the higher investment limit.
The transaction must be made through a broker-dealer registered with the SEC or through a funding portal (a new designation under the Securities and Exchange Act of 1934) that meets the requirements described in detail in Chapter 11.
The issuer must comply with numerous disclosure and other requirements, described in detail elsewhere in this book.
Title III of the JOBS Act also added new Section 4A to the Securities Act of 1933, containing numerous hoops that issuers, funding portals, and investors will need to jump through to launch a successful crowdfunded offering. Regulation Crowdfunding, which implemented these requirements, contains nearly seven hundred pages of new regulations.
The author has spread discussion of Regulation Crowdfunding over several chapters. See the last section of Chapter 2 for the location of the discussions of the Regulation Crowdfunding provisions that apply at each stage of the crowdfunded offering process.
The bottom line on Title III of the JOBS Act and Regulation Crowdfunding is that companies desiring to use the crowdfunding option will have to go through much of the paperwork involved in an IPO or an offering of securities under the “simplified public offering” rules in the SEC’s Regulation A, although on a streamlined scale. Once a successful Title III crowdfunded offering is completed, the issuing company will have to file annual reports with the SEC and deal with dozens, or perhaps hundreds, of investors whose level of sophistication and maturity will be all over the map, just like public companies do.
Title IV: Expanded Availability of Regulation A
Title IV of the JOBS Act created a new Section 3(b)(2) of the Securities Act to allow companies to issue up to $50 million in securities under Regulation A (up from $5 million). Although the details of certain provisions of the new exemption must be decided by future SEC rule making, Title IV of the JOBS Act does specify several important requirements of the new exemption:
Offering Limitation. The new exemption will allow companies to issue up to $50 million in securities under Regulation A (up from the $5 million currently available) within the prior twelve-month period. Unlike the $5 million limitation under Regulation A, which has remained in place since 1992, the SEC is required every two years to consider raising the $50 million limitation.
Unrestricted Resales. Similar to offerings under Regulation A, securities sold under the new exemption will be freely tradable upon issuance to investors in the offering.
Testing the Waters. Similar to offerings under Regulation A, issuers that rely on the new exemption may confidentially solicit investor interest prior to filing offering statements with the SEC. However, the SEC must conduct further rule making to determine the terms and conditions placed on such solicitation.
Audited Financial Statements. Unlike issuers who conduct offerings under Regulation A, issuers relying on the new exemption must file audited financial statements with the SEC on an annual basis upon completion of the offering. The SEC must conduct further rule making to determine whether audited financial statements should also be required as part of the offering statement.
Liability. The civil liability provisions of Section 12(a)(2) of the Securities Act apply to people offering or selling such securities pursuant to the new exemption.
Offering Statement. Companies relying on the new exemption may need to file an offering statement with the SEC. However, the SEC must conduct further rule making to determine the requirements of any such offering statement.
Periodic SEC Reporting. Unlike Regulation A, companies relying on the new exemption may be subject to periodic SEC reporting upon completion of the offering. However, the SEC must conduct further rule making to determine specific filing requirements, if any. Specifically, the SEC must consider requiring periodic disclosure about a company’s business operations, financial condition, corporate governance principles, and use of investor funds.
The SEC approved regulations under Title IV of the JOBS Act in SEC Release No. 33-9741, effective March 25, 2015 (www.sec.gov/rules/final/2015/33-9741.pdf).
Title V: Changes to Definition of “Public Company” in the Securities and Exchange Act of 1934
Title V of the JOBS Act amends Section 12(g) of the 1934 Securities and Exchange Act, which governs the annual reports and other documents required to be filed with the SEC by publicly traded companies. The amendments raise the threshold number of shareholders required to trigger securities registration requirements with the SEC.
Registration under the 1934 act has significant consequences. Registered companies must file periodic reports, adhere to the proxy rules, prohibit short-swing profits, and comply with other requirements of the federal securities laws. These provisions protect investors but also add significant cost to a company’s operations.
Title V changed the requirements for registration in a complicated fashion. The amendment increased the threshold for registration from five hundred holders of record to two thousand. But it provided that companies with five hundred nonaccredited investors must register. The JOBS Act also excluded from the total those employees who acquired shares through certain compensation plans.
Title V of the JOBS Act increased the threshold for registration in Section 12(g) to two thousand people of record or five hundred people “who are not accredited investors.” In addition, the provision excluded from the definition of “holder of record” those people who received securities through employee compensation plans. The legislation instructed the SEC to adopt a safe harbor implementing the provision and to examine whether it needed additional enforcement authority to prevent evasion of the requirement.
Title VI: Special Provisions for Banks and Bank Holding Companies
Title VI of the JOBS Act raises the threshold for banks and bank holding companies for mandatory 1934 act registration from five hundred shareholders of record to two thousand (and unlike Title V, there is no limitation to the number of nonaccredited investors). Since passage of the JOBS Act, a bank or a bank holding company is required to register its securities when its total assets exceed $10 million and any class of its equity securities is held of record by two thousand or more people. As with other types of issuers, this number does not include employees who acquired their securities through an exempt employee compensation plan or holders who acquired their securities through crowdfunding offerings.
Title VI also amended Section 12(g)(4) of the 1934 act, which provides a mechanism for deregistration. Issuers may terminate the registration of certain securities by filing a certification with the SEC that the number of holders of record of the class of securities in question has fallen to fewer than three hundred people. Title VI sets the threshold at one thousand two hundred for banks and bank holding companies. (It remains three hundred for other types of issuers.)
* Pub.L. 112-206, 126 Stat. 306, codified at 15 U.S.C. § 78a (at www.gpo.gov/fdsys/pkg/PLAW-112publ106/pdf/PLAW-112publ106.pdf).