SEC’s Proposed Crowdfunding Regulations: Six Deadly Sins

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Crowdfund Insider | | January 9, 2014

Doug Ellenoff and Kim WalesHOW 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!

Where is the Crowd?

At last check, there were less than 100 comment letters submitted to the SEC regarding the proposed crowdfunding regulations – not very impressive by Kickstarter’s benchmarks 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).

View:  Canadian Resources for Proposed U.S. Crowdfunding Rules

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 on Crowdfund 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 – without the 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.

State of the Union Congress and SenateThe 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 prohibit intermediaries 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.

View:  Saskatchewan Approves Equity Crowdfunding Exemption (Dec 6, 2013)

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.

Wall Street Charging Bull (Wikipedia)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

JOBS Act 2012 TextSection 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.

View:  Canadian Crowdfunding Directory

The Problem 

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.

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