HOW TO MAKE THE SEC REPENT BEFORE IT IS TOO LATE.
In a previous article in Crowdfund Insider on November 4, 2013, I identified a number of serious problems with the SEC’s proposed crowdfunding regulations. I also promised readers to share my opinions on what can and should be done by crowdfunding supporters to fix the problems – and how to do it. As I said then: “It will take a large and vocal crowd – and the wisdom and political will of the SEC to implement it.” With the February 3 SEC comment deadline fast approaching – there is no time like the present!
At last check, there were less than 100 comment letters submitted to the SECregarding the proposed crowdfunding regulations – not very impressive by Kickstarter’sbenchmarks for successful crowdsourced projects. Though there is likely to be a flurry of new comment letters as the February 3 deadline approaches, I remain concerned about the relative lack of comments, more than two months after the proposed regulations were made available to the public.
The time is at hand to crowdsource comments for the SEC!
It’s not a lot of fun to go through 585 pages of proposed regulations (my sympathies are with the SEC staff who wrote them). Some of the provisions which may seem innocuous at first read, upon further scrutiny have the potential to be “industry killers”. As I took my second deep dive into the proposed regulations, in preparation for two upcoming speaking engagements, I noticed a couple of these “industry killers.” Even more disconcerting, some of these “industry killers” have not been noted in the published articles or comments I have read to date.
On a more optimistic note, I have also concluded that some of the more major failings of the proposed rules do not eminate from the JOBS Act itself – which for now is written in stone. Rather, these failings are a product of the SEC’s collective wisdom. What this means is that there is an opportunity for the public to present concerns to the SEC, with a reasonable expectation that the SEC will listen – and hopefully fix the defects when it enacts final rules.
With that in mind, here is my short list of issues embedded in the proposed regulations (not the JOBS Act) that have the potential to snuff out the investment crowdfunding market – not necessarily in order of importance (they are all important).
The Six Deadly Sins of the SEC’s Proposed Regulations
Sin No. 1 – Audited Financial Statements
This is an issue which, fortunately, has not gone unnoticed by the public. Kudos to Kim Wales, a co-founder of CfIRA, who recently wrote a comprehensive article on this issue onCrowdfund Insider. Others have joined in her concerns.
The issue is this: The proposed rules require a company which seeks to crowdfund more than $500,000 (including prior crowdfunded offerings in the prior 12 months), to provide two years of audited financial statements when it files its initial offering materials with the portal and the SEC. This requirement is problematic for a number of reasons.
First, crowdfunded companies will generally be small companies, many of whom have no revenues. So it is not clear what the requirement of audited financials will provide – as opposed to independently “reviewed” financials – other than more upfront costs which a potential crowdfunder will need to incur simply to get in the game.
Second, it simply is not fair for the SEC to require audited financials for any company crowdfunding up to $1 million in a 12 month period. For more than 20 years, the SEC has allowed companies to raise up to $5 million, in a mini-registered offering called SEC Regulation A – withoutthe requirement of audited financials. All that is required under Regulation A are “reviewed” financials.
And to add insult to injury, this Regulation A requirement does not appear to be an oversight on the part of the SEC. On December 18 the SEC issued proposed rules addressing Regulation A and the new Regulation A+ – the latter courtesy of Title IV of the JOBS Act, which directed the SEC to raise the Regulation A limits from $5 million to $50 million. Though the Regulation A+ release proposed some changes to the existing Regulation A, it left companies the ability to use reviewed financial statements for offerings up to $5 million.
In the crowdfunding release the SEC advises that it received preliminary comments asking it to limit or eliminate the requirement for audited financial statements. The SEC ignored these comments when it issued the proposed rules – without providing any cogent reasons for doing so. Essentially, the SEC simply said that it preferred to take a wait and see approach. Given the tremendous burden this requirement places on small business, it seems to me that “wait and see” is not an option – especially when it has given much better treatment to companies seeking to raise up to $5 million.
So what can the SEC do about this? Plenty.
The JOBS Act does require that crowdfunded companies seeking to raise over $500,000 provide audited financial statements. However, what has gone unnoticed in the press and comment letters on the proposed rules is that in the very same sentence in Title III of the JOBS Act that Congress required audited financial statements – it also gave the SEC the express discretion to change the $500,000 threshold. “Wait and see” simply doesn’t cut it.
It is time for those who wish to see investment crowdfunding as a viable market to submit their comments to the SEC on this issue.
Sin No. 2 – Restrictions on Compensation Paid to Crowdfunding Platforms
This is another potential “industry killer” – not required by the JOBS Act. The JOBS Act prohibits officers and directors of the intermediary (platform) from having any economic interest in the crowdfunded company. In the proposed rules the SEC expanded this requirement to prohibitintermediaries from having any economic interest, in addition to officers and directors. The principal reason given by the SEC for this expansion of the statutory requirement – it seemed like a logical extension of the Congressional mandate.
I and many of my brethren have made highly “logical” arguments to a judge in the past – which have been (properly) rejected because they make no sense when viewed as part of a bigger picture. So too is the case with the SEC’s logic.
OK. Why should I care about the ability of a platform to have an economic interest in a crowdfunding company? Let me count the ways.
Economic interests, such as warrants or “carried interests” in future profits, are commonplace on Wall Street, especially with high risk transactions. It is a way to increase the potential financial reward – but without cash flow drain to the company it is funding. So too, with crowdfunding and portals. If intermediaries are limited to cash compensation, that will translate into higher up front and backend costs to crowdfunded companies. This will come initially out of the pocket of the crowdfunder, and if the offering is successful, will indirectly come out of the pocket of investors – leaving less money available for working capital.
By all accounts crowdfunding is a high risk proposition – indeed one of the riskiest possible investments. And the dollars involved are small, by financing standards – a maximum of $1 million over 12 months. If the potential reward is out of line with the risks to an intermediary and other costs of doing business – one of two things will happen. First, many intermediaries will not enter this arena at all, and those that do may ultimately fold their tents if business is not profitable. Second, It also ensures that a licensed broker-dealer, who is free to engage in any type of financing transaction (not so with a non-broker dealer “funding portal”), will eschew the crowdfunding route for an otherwise fundable company – and instead will go another route such as Regulation D private placement – which carries no SEC restrictions on equity compensation.
In sum, this logical extension of a JOBS Act requirement will ensure that most broker-dealers will ignore the investment crowdfunding route – and it will increase costs to companies in need of funding. And for non-broker-dealer portals, this is an unnecessary variable in their cost-benefit analysis – particularly problematic for them (versus broker-dealers) as their only revenue will be derived from crowdfunded offerings – and not from other avenues such as private placements.
An extension of the law – yes. Logical? No!
Sin No. 3 – Unnecessary Liability for Funding Portals – Based Upon a Tenuous Read of the JOBS Act
Section 4A(c)(1)(A) and (B) of the JOBS Act impose liability for misstatements or omissions as to an “issuer described in paragraph (2)” of such section. Subsection 4A(c)(3) defines “issuer” as “any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security [in a Title III transaction] and any person who offers or sells the security in such offering.” [Emphasis added]
The statute imposes liability on an issuer and the specified officers and directors any other person who offers or sells the security. Thus, there is no statutory liability for any intermediary unless the intermediary (or its agents) is engaged in the offer or sale of the Title III security.
The problem for intermediaries who are not broker-dealers is created not necessarily by any proposed rule, but in dicta which the SEC gratuitously (and wrongly, in my opinion) included in the proposing release – at page 280. Section 4A of the JOBS Act provides that an “issuer” is liable for the refund of the purchase price of the security to the purchaser if in connection with the offer and sale of a crowdfunded security it makes a material misstatement or a material omission, and is unable to sustain the burden of showing that it could not have known of such untruth or omission even if it had exercised reasonable care.
In Section II.A.5 of the Release, entitled “Scope of Statutory Liability” the Commission states:
Section 4A(c)(3) defines, for purposes of the liability provisions of Section 4A, an issuer as including “any person who offers or sells the security in such offering.” On the basis of this definition, it appears likely that intermediaries, including funding portals, would be considered issuers for purposes of this liability provision. We believe that steps intermediaries could take in exercising reasonable care in light of this liability provision would include establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and that include the intermediary conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information. [Emphasis added]
By the SEC making this statement, in effect saying that all intermediaries are “likely” engaged in the offer or sale of Title III securities within the meaning of statutory liability provisions, it has opened the door wide open to an investor bringing an action against an intermediary as a an “offeror” or “seller.”And to prevail the intermediary must meet the statutory burden of proof of a “due diligence” defense. This position by the SEC is problematic on a number of levels, the biggest impact falling on intermediaries who are not broker-dealers.
What the SEC has done, in my opinion, based upon a faulty reading of the JOBS Act, is to take a position which would impose statutory seller liability on a funding portal where there is no basis to impose such liability on a funding portal – as (in my opinion) it is not correct to state that a funding portal will be engaging in activities arising to the level of offering or selling securities, as intended by Congress – they are simply a conduit with limited duties under the JOBS Act.
According to the SEC’s release regarding the proposed rules, what follows from this perceived statutory liability on funding platforms is further dictum suggesting that funding portals must affirmatively conduct due diligence on an issuer’s offering materials. This appears to be contrary to the express obligations which Congress imposed on intermediaries in Section 4A(a).
The net result of the SEC’s position is that in order for a funding portal to avoid liability to a purchaser on the basis of an issuer’s false or misleading offering materials, the funding portal would be well advised to conduct due diligence on the issuer’s offering materials. This seems at odds with the passive role to which a funding portal is limited.
A broker-dealer who operates as an intermediary, on the other hand, should (and would) face liability if it were actively engaged in the offer and sale of the security, which is normally the case. Accordingly, FINRA rules affirmatively require a broker-dealer (in any private placement) to conduct due diligence on an issuer and the offering materials, and to have proper procedures and controls in place in regard to due diligence. FINRA imposes similar duties on the broker-dealer to evaluate suitability of the investment for the specific investor.
Thus, if the SEC’s expansive dictum is not qualified (better yet, a safe harbor provided for a funding portal not acting as a broker-dealer), not only will newly established funding portals have the burden and expense of creating internal due diligence procedures, but will be required to perform additional due diligence for each and every issuer to effectively establish a “due diligence” defense.
These initial and transaction specific costs in and of themselves are burdensome, and may serve as an unnecessary barrier by non-broker-dealer intermediaries (i.e. funding portals) to enter this industry. Also, consider that to the extent imposing unnecessary liability may not deter funding portals from entering the business, the heightened risk and additional due diligence costs will of necessity require a funding portal to charge higher fees than would otherwise be necessary.
Bear in mind that a broker-dealer will already have these procedures in place under FINRA rules, as they offer and sell securities in the ordinary course of their business – so they will not have this initial cost of doing business. Nor will funding portals have businesses other than Title III crowdfunding to spread these internal control costs – as would a broker-dealer. Moreover, a broker-dealer would, in theory, have an opportunity to engage in other business transactions with a Title III issuer outside the Title III offering, including future private placements and market-making activity. These opportunities would not be available to a funding portal, as they are not a fully licensed broker-dealer. So as to the opportunity of a funding portal to earn fees in a Title III transaction, it would not be on a level playing field with licensed broker-dealers.
This issue is a potential “industry killer”, with small business being the victim – especially if broker-dealers shun the Title III market as too small relative to the risks and rewards.
Note the SEC’s request for comment, Paragraph 120, appearing at page 131 of the release:
120. No intermediary can engage in crowdfunding activities without being registered with the Commission and becoming a member of FINRA or another registered national securities association. We recognize that while there is an established framework for brokers to register with the Commission and become members of FINRA, no such framework is yet in place for funding portals. We do not intend to create a regulatory imbalance that would unduly favor either brokers or funding portals. Are there steps we should take to ensure that we do not create a regulatory imbalance?337 Please explain. [Emphasis added]
In this regard:
- There is a “regulatory imbalance” as between funding portals and broker-dealers, as noted above.
- The SEC, in footnote 336 to Paragraph 120 (see below), even acknowledges this regulatory imbalance.
- The SEC highlights in footnote 336 that a broker-dealer, but not a funding portal, may “engage in solicitations” in a crowdfunded offering – the precise activity that should trigger liability as an “offeror” or “seller under the 1933 Act and Title III liability provisions for persons who “offer” or “sell”.
Here is Footnote 336, in all of its glory:
336/ We note, however, that a registered broker could nonetheless have a competitive advantage to the extent it would be able to provide a wider range of services than a registered funding portal could provide in connection with crowdfunding transactions made in reliance on Section 4(a)(6). Unlike a funding portal, a registered broker-dealer could make recommendations, engage in solicitations and handle investor funds and securities. In addition, a registered broker-dealer, but not a funding portal, could potentially facilitate a secondary market for securities sold pursuant to Section 4(a)(6). See Exchange Act Section 3(a)(80) [15 U.S.C. 78c(a)(80)] (providing that a funding portal may act as an intermediary solely in securities transactions effected pursuant to Securities Act Section 4(a)(6), which are offerings by issuers and not resales). [Emphasis added]
I note for the sake of completeness that funding portals are allowed (but not required) to assist an issuer in preparing offering materials. However, this activity ought not arise to the level of a solicitation – it is analogous to the services an issuer’s securities counsel might perform – an activity which clearly would not trigger statutory liability as an offeror or seller.
This potential, unnecessary liability to a funding portal, is further complicated in view of two other factors discussed in this article. First, as discussed above, under the SEC’s proposed rules all intermediaries are prohibiting from mitigating this financial risk by taking an equity stake in the issuer. And second, as discussed below, according to the SEC in the proposed rules, an intermediary which is not a broker-dealer is prohibited from excluding companies from its platform based upon subjective factors, such as quality of management, valuation of the company, market size, need for additional capital, pending litigation, or other subjective factors which increase the risk to an investor. Not so for a licensed broker-dealer.
As I stated in my November 4 article on Crowdfund Insider: The Commission, in effect, has created a schizophrenic business paradigm for funding platforms – a business model which imposes the risks/liability attendant to being a broker-dealer – but without the ability to use the broker-dealer compensation model – or even to create value for a different compensation model by being able to screen issuers.
In my opinion, what the SEC needs to do, going forward, given that it has not only put its foot in its mouth, but hung every funding portal out to dry by (in my opinion), erroneous dictum, is to create a safe harbor rule for funding portals that do no more than conduct their business in the ordinary course, and do not otherwise engage in activities that could be deemed solicitations. If not, this gratuitous imposition of guarantor liability on a funding portal may very well kill Title III crowdfunding before it can get off the ground – or force funding portals to impose needlessly high fees.
Sin No. 4 – The Prohibition Against Curation by Non-Broker Dealer Intermediaries
Congress dictated that funding portals (i.e. non broker-dealers) could not offer investment advice or recommendations – unlike licensed broker-dealers, who may offer investment advice and recommend securities. The SEC has taken this one step further in the Release, by prohibiting funding portals from excluding companies on the basis of subjective or qualitative factors, Under the proposed rules an intermediary which is not a broker-dealer is prohibited from excluding companies from its platform based upon qualitative factors, such as quality of management, valuation of the company, market size, need for additional capital, pending litigation, or other qualitative factors which increase the risk to an investor. As I noted in my November 4 article on Crowdfund Insider, why would someone bother going to a portal that reads more like an unfiltered Craig’s List bulletin board, as opposed to a menu of carefully curated investment opportunities. This gives broker-dealers a major competitive advantage over funding portals, both from the company (issuer) perspective and the investor perspective. Though, in my opinion, Title III of the JOBS Act does not preclude funding portals from presenting a list of carefully curated investments (so long as there is a disclaimer by the funding portal that they are not recommending any security, and a statement that all of the listed investments carry significant risks), the SEC in in the proposing Release has clearly precluded funding portals from doing so – even if they have on their staff a licensed broker-dealer, certified public accountant, or Certified Financial Planner.
And given the position of the SEC in the proposed release that an intermediary has an affirmative obligation to review offering materials, and likely will face statutory liability as a seller of the security, the inability of a funding portal to screen issuers based upon qualitative factors becomes a significant deterrent to conducting business – even with higher fees.
Sin No. 5 – Complex Non-Financial Disclosure
As I discussed in my November 4 article, the disclosure regime proposed by the SEC is overly complex – especially considering the dollar size of the transactions. The 10 pages of disclosure regulations will unnerve the average entrepreneur, no matter how seasoned –discouraging crowdfunders from even going down this road – especially those considering a raise on the lower end of the financial spectrum.
Though the SEC in recent statements has discussed, as a general matter, the need to tailor disclosure to the size of the company – in order to avoid unnecessary costs and expenses to a company – it clearly is not ready to apply this broad policy objective to crowdfunding companies. And the concept of scaled disclosure is not something new, either to the SEC or under state securities laws.
Today, many companies seeking to raise up to $1 million may take advantage of what is known as a “SCOR” offering – an offering up to $1 million which is exempt from federal registration, but typically requires a “blue sky” review at the state level. To facilitate disclosure for these smaller offerings, in the late 1990’s the North American Securities Administrators Association (NASAA) in conjunction with the American Bar Association, came up with a simple, plain English disclosure format that has been adopted in over 30 states. This was done by NASAA in order to alleviate some of the burden and expense associated with preparing a comprehensive investor disclosure document.
The SCOR disclosure model remains in use today at the state level, and ought to serve as a useful starting point for the SEC to craft a more user friendly disclosure regime for crowdfunding companies – lest they not travel down this road at all.
Sin No. 6 – Ongoing Annual Disclosure Following a Successful Crowdfunded Offering
One of the most burdensome requirements in the SEC’s proposed rule is the requirement that every year after a company successfully concludes a crowdfunded offering it must file detailed disclosure reports, including financial statements, essentially long as the crowdfunded securities are outstanding.
Under Title III of the JOBS Act, Congress required the SEC to promulgate rules requiring annual “reports of the results of operations and financial statements, as the Commission shall, by rule, determine appropriate, subject to such exceptions or termination dates as the Commission shall establish by rule.”
The proposed rules, as promulgated, when far beyond anything that it was required to do under the JOBS Act – essentially requiring the same detailed disclosures, year after year, that are provided to investors when the offering is conducted.
And not only was the extensive (as in expensive) SEC-proposed ongoing disclosure not mandated by Congress, it directly conflicts with requirements of the SEC in other types of offerings to unsophisticated investors allowing raises up to $5 million. Specifically, under Regulation A, discussed above, after an offering is completed (Regulation A is essentially a mini-public offering)there is absolutely no ongoing disclosure whatsoever.
Is the SEC trying to kill the crowd before it can even form?
What to Do Next
What I have attempted to do is to identify what I consider to be the most serious issues embedded in the proposed regulations – it is not intended to be an exhaustive list. There may be other points which need to be addressed. And perhaps some will not agree with my conclusions or analyses.
However, for all of those people who have an interest in making investment crowdfunding not only work, but work well, and not be hampered by unnecessary, burdensome regulations, I urge you to put your comments in writing and submit them to the SEC no later than February 3, 2014. And feel free to quote from my articles if you find this helpful or convenient. Otherwise, there may not be a second chance – either to comment – or for the investment crowdfunding market itself.
There is no time like the present!
Samuel S. Guzik writes a regular column, The Crowdfunding Counselor, for Crowdfund Insider. He is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience. He is admitted to practice before the SEC and in New York and California. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. He also frequent blogger on securities and corporate law issues at The Corporate Securities Lawyer Blog.