Crowdfunding Disclosure and Other Compliance Challenges


The capital-raising world has been buzzing about the new choices the JOBS Act’s1 exemptions from registration have given a wide range of businesses (including start-ups, small businesses, and real estate developers) about how to communicate with and sell securities directly to the public using any media or technology that becomes available:

  • SEC Rule 506(c)2 authorized by Title II of the JOBS Act, allows issuers to raise unlimited amounts of capital using advertising and general solicitations with very flexible disclosure rules, if you sell only to verified accredited investors. See Chapter 11.
  • Regulation Crowdfunding3 authorized by Title III of the JOBS Act creates a highly regulated environment for Section 4(a)(6)4 offerings of $1 million or less within any 12-month period to both accredited and unaccredited investors. See Chapter 13.
  • Regulation A5 authorized by Title IV of the JOBS Act allows you to do a general solicitation and advertise and to sell to both accredited and non-accredited investors, if you comply with specified disclosure rules and have offering documents reviewed by the SEC. See Chapter 12.
  • Some offerings that use SEC Rule 506(b)6 are conducted on the same technology platforms that also facilitate Rule 506(c) offerings. If a broker-dealer who operates the platform has “pre-qualified” the accredited investors (who have password access to the part of the platform that facilitates the Rule 506(b) offering), a Rule 506(b) offering technically is not a general solicitation.7 But to casual observers, it may look like the Rule 506(c) offerings that may be conducted on the same platform. See Chapter 10
  • Two types of state Crowdfunding laws that exempt offerings from state securities registration laws allow general solicitations and sales to both accredited and non-accredited investors, if you also comply with an SEC rule that exempts a general solicitation and sales to non-accredited investors. Depending on the state, Crowdfunding laws can be used with the federal exemption for intrastate offerings (using SEC Rule 147)8 or with the less restrictive SEC Rule 504.9 On October 30, 2015, the SEC proposed amending both Rule 147 and Rule 504 to facilitate their use by issuers that conduct state Crowdfunding offerings.10 The proposed amendment to Rule 147 includes easing restrictions on advertising and the number of connections the issuer must have to the state where the offering occurs. The proposed amendment to SEC Rule 504 increases the maximum amount that can be raised during any 12-month period to $5 million and adds Bad Actor restrictions. See Chapters 15 and 16.

Because the Internet is fast and cheap, most Crowdfunding offerings are using technology platforms that advertise to attract investors. Other offerings utilize the issuer's own Web site and Social Media campaigns like those that businesses have been using to sell products and services for the past two decades.

With all the excitement about the new found freedom these exemptions provide, we should remind ourselves that finding an exemption from registration is only the first part of complying with securities laws. The other big requirement of securities laws is that when issuers communicate with investors they must also:

  • Not make any misstatements of material facts.
  • Not omit any material facts that are necessary to avoid misleading investors about material facts the issuer has disclosed to investors.

Much less has been written about how to comply with disclosure rules in Crowdfunding offerings than about the new exemptions from registration, but Crowdfunding offerings will present many disclosure challenges because many new issuers will be conducing offerings.

Some basic disclosures questions we will explore in this Part III include:

QUESTIONS

ANSWERS

Have the new securities laws changed disclosure requirements?

No. Except for a few mandatory disclosure requirements (including those related to the types of financial statements issuers must provide to investors) the new exemptions have made no changes to disclosure requirements.

Will all the new businesses that will be making offerings understand how to comply with traditional disclosure rules?

Often not. The new exemptions are designed to make it possible for issuers that have never sold securities before to raise capital.

Will all the new businesses that will be making offerings be able to afford competent lawyers and accountants to help them comply with traditional disclosure rules?

Often not. The Internet and Social Media have greatly reduced the cost of communicating and have allowed virtually anyone to tell their story to the world. But the fees of competent legal and accounting advisers are likely to be unaffordable for many new issuers.

Is the issuer's risk of liability for failing to comply with disclosure rules the same in all the types of new exemptions from registration?

No. Different exemptions from registration carry with them different standards for determining liability, different issuer defenses and different burdens of proof.

Do different media for conducting offerings present the same disclosure challenges?

No. Some types of Social Media strictly limit how much you can say. To be effective, most Social Media communications have to be much less formal than traditional securities disclosures. In theory, you could try to sell an offering by posting a traditional Private Placement Memorandum on a Web site, but that would probably not be the most effective way to use the Internet and Social Media to sell securities.

How can you get the most disclosure bang for the amount of money in your budget?

Look before you speak is the best budget advice. Except in limited circumstances, what is material to investors depends on the story you decide to tell about your business. Generally, the more claims you make about your business the greater your disclosure burden becomes. Try to think like an investor about your business. You can effectively sell your offering if you concentrate on the things investors are most likely to find attractive about your business while also lowering investor expectations about other attributes of your business.

 

Before we jump into dealing with each of these questions in greater detail, let's establish a matrix that conceptualizes the liability risk exposure businesses are facing:

HIGHEST

RISK

MEDIUM

RISK

LOWER

RISK

LOWEST

RISK

  • First time issuer
  • Complex business
  • Use state or Federal Crowdfunding exemption
  • Selling to unsophisticated investors
  • Conduct a Social Media campaign
  • Very low budget for professional advice
  • Experienced issuer
  • Simple business
  • Use state or Federal Crowdfunding exemption
  • Selling to unsophisticated investors
  • Rely solely on an established platforms that conduct due diligence
  • Reasonable budget for professional advice
  • Experienced issuer
  • Complex business
  • Rule 506(c) offerring
  • Selling to institutional or highly sophisticated investors
  • Conduct a Social Media campaign
  • Reasonable budget for professional advice
  • Experienced issuer
  • Simple business
  • Rule 506(c) offerring
  • Selling to institutional or highly sophisticated investors
  • Rely solely on an established platforms that conduct due diligence
  • Reasonable budget for professional advice

 

As we move through our analysis, we will explain the reasons why each of these factors increases or lowers liability risk. The table above describes a continuum of risk. One might be tempted to settle for something in the middle. Maybe getting 85% right answers on a test gets you a B grade in a college course, but securities disclosure laws strive for perfection.

One single misstatement of material fact or misleading omission of a material fact is sufficient to create liability, unless you have a defense. Disclosing 99 other material facts does not get you off the liability hook if you make a mistake.

Defenses then become important. What defenses your exemption from registration allows may be critical to determining liability.

In this Part III, we will deal with basic blocking and tackling issues. How do you conduct offerings without violating the new rules or the old rules that remain in place? Because the rules changes are designed to permit large numbers of small and midsize businesses to use digital tools to raise capital, our compliance discussion will focus in particular on the challenges faced by small and midsize issuers that have modest budgets for offering transaction expenses.

Cost-effective disclosure will become increasingly important as technology tools enable very small businesses to communicate with millions of potential investors.

We will focus on the substance of securities law changes and strategies for complying with the new rules. Nothing in the new rules change the disclosure standards issuers must meet when they sell securities, but when people use new technology communications tools, complying with the same disclosure standards will pose new challenges.

Dealing with these challenges, we will discuss:

  • How to use cost-effective Social Media in your offering sales efforts.
  • The different liability standards that apply to different types of offerings.
  • General principles of materiality and specific issues related to avoiding fraud when using Social Media.
  • The challenges financial statements and financial projections issues pose for small and midsize businesses.
  • Different liability standards for different types of public offerings and private offerings.
  • Due diligence issues.
  • How FINRA Rules impact offerings conducted by registered broker-dealers, including platforms operated by registered broker-dealers.
  • Accredited investor verification issues in Rule 506(c) offerings both within Rule 506(c)'s safe harbor and using the principals-based approach to taking reasonable steps to verify accredited investor status outside the safe harbor. We will discuss specific verification issues that relate to angel groups and small investment funds and when you can rely on third party vendors to verify accredited investor status.
  • Technical issues related to Form D, legends and other matters.
  • Bad Actor restrictions.

 

Crowdfunding: A Legal Guide to Investment & Platform Regulation, 2016 ed.

By Jim Verdonik. Jim Verdonik began practicing securities law with a large New York City law firm where he primarily represented investment bankers and venture capital funds in transactions with technology and science based businesses. Since relocating to Research Triangle, NC, he has counseled both companies and investors about securities, business and technology commercialization issues. Excerpted from Crowdfunding: A Legal Guide to Investment & Platform Regulation, 2016 ed., available for purchase on ThomsonReuters.com. This practical guide offers readers comprehensive and straightforward information so that they can make strategic decisions with regard to raising capital. The guide answers questions on a wide range of current and future crowdfunding issues.

 

1. H. R. 3606 (April 5, 2012).

2. 230 C.F.R. § 506(c).

3. 227 C.F.R. §§ 100 et seq.

4. 5 U.S.C.A. § 77d(a)(6).

5. 230 C.F.R. §§ 251 et seq.

6. 230 C.F.R. § 506(b).

7. Lamp Technology (1997) and Citizen VC, Inc. (2015) no-action letters permit sales in Rule 506(b) offerings on platforms that can be accessed only by accredited investors who have specified types of relationships with the platform operator or the issuer.

8. 230 C.F.R. § 147.

9. 230 C.F.R. § 504.

10. Proposed Rule Amendments to Facilitate Intrastate and Regional Securities Offerings SEC Release No 33-9973 (October 30, 2015) (80 Fed. Reg. 69,785).