Authored by Senator Jeff Merkley (D-OR), Title III of the JOBS Act adds a new crowdfunding exemption from the Securities Act allowing companies to accept and pool donations of up to $1 million over the Internet. Generally, the term crowdfunding describes a new form of raising capital whereby groups of people pool money, typically comprised of small individual contributions, to support an entrepreneurial effort.
Title III imposes disclosure obligations on both crowdfunding intermediaries and crowdfunding issuers. For their part, issuers are required to provide to investors a number of typical offering disclosures including, among others, the business's name and legal status, the names of directors and officers, a description of the business of the issuer, and a report of financial condition. The Ohio Securities Division encourages the Commission to mandate a single-offering-circular standard, incorporating disclosures prepared by both the intermediary and the issuer.
One disclosure document is simpler, reasoned the Division, and may encourage investors to more fully review and consider the document. Moreover, a single offering document would be consistent with other types of offerings where two parties are responsible for preparing disclosure, for example, in an underwritten public offering, underwriters and issuers generally work together to craft a single disclosure document.
Each offering should clearly disclose that the issuer is seeking an exemption from both state and federal securities registration and therefore no regulatory agency has reviewed the offering. The offering should clearly state that an investor must make his or her own investment decision. The offering should also clearly state that regulatory agencies do not recommend or endorse the investment for any offeree and that any representation to the contrary is a violation of state and federal securities laws. This disclosure is similar to that required by Rule 253(d) under the Securities Act.
The Division also asked the SEC to consider restricting if not prohibiting outright, the use of any forecasts or projections of the issuer's future financial performance, whether by the issuer, the intermediary, or any officer, director, employee or agent of either. In the Division's experience, forecasts and projections are often rife with fraud, bear no reasonable basis in reality, and fail to identify the assumptions made and the sources of information relied upon.
The Division explained that it is widely accepted that Title III was intended to be used by very young issuers, and even true start-ups. An issuer with little or no operating history has no historical basis on which to reasonably predict future operating results. The factual or historical basis on which to reasonably predict future financial returns becomes even more tenuous where a business is led by inexperienced management, employs new or unproven processes, offers new or untested products or services, or enters new markets with unknown levels of demand and competition. In the Division’s view, it is difficult to see how any young entity or start-up can, in good faith and with a sound factual or historical basis, predict its future financial performance..
Title III requires that each crowdfunding issuer provide a description of the business of the issuer and the anticipated business plan of the issuer. Traditionally, a business plan was a planning document prepared by management for internal use only, and not intended to be disseminated outside the company. Among start-up companies, however, the word business plan has taken on the meaning of a marketing document used to pitch investors, not to disclose the materials terms and risks of a securities offering. They are neither tailored for prospective investors nor drafted with the securities laws in mind. Thus, the Division said the Commission should clarify the meaning of the term "business plan," as used in Title III so that issuers do not inadvertently provide to investors a document that opens the issuer to potential civil and criminal liability.
Title III conditions the exemption on at least an annual SEC filing of reports of the results of operations and financial statements. In the Division’s view, the most appropriate interpretation of this provision is to require the annual filing of updated financial statements for the fiscal year end in the form as referenced in Section 4A(b)(l) which were provided to investors. Smaller issuers should not be required to obtain an audit. However, the Commission should require audited financial statements for the larger size offerings over $500,000 and for smaller issuers if during the course of their business they obtain an audit for other purposes.
Under Title III, the crowdfunding exemption is only available to offerings transacted through a broker or funding portal. Because crowd funding offerings are exempt from registration and review by the Commission, and preempted from review by state securities regulators, Congress placed upon intermediaries the responsibility of serving as the primary gatekeepers to the crowdfunding marketplace. As such, the intermediaries must play a critical role in ensuring the integrity of the market and maintaining meaningful investor protections. It is crucial that the Commission's rulemaking recognizes the significance of this role, and requires crowdfunding intermediaries to uphold their obligation.
Unlike broker-dealers, the activities of funding portals are significantly restricted under Title III of the JOBS Act. Funding portals may not offer investment advice or make recommendations. The Division hinted that strong guidance from the Commission may be needed to inform this new breed of industry professional about the broad scope of both recommendation and investment advice activities. This guidance may prevent them from creeping into practices prohibited by the statute down the road and would also inform the public of the extent of the lawful capabilities of funding portals.
Crowdfunding intermediaries will have extensive due diligence obligations under existing securities law and under the Title III, noted the Division. As an initial matter, new Section 4A(a)(5) of the Securities Act provides, in part, that crowdfunding intermediaries are to take such measures to reduce the risk of fraud with respect to such transactions, as established by the Commission, by rule. According to the Division, this section establishes a due diligence requirement by noting that the measures to reduce the risk of fraud include conducting a criminal and securities enforcement background check of officers, directors, and 20 percent shareholders of an issuer.
Moreover, given the balance of power in these transactions, the Division believes that crowdfunding intermediaries may be the only securities professionals with the bargaining power necessary to require access to the issuer's information, given that the issuers cannot conduct a crowdfunding offering without the intermediary. Investors will view crowdfunding intermediaries not merely as passive "bulletin boards," noted the Division, but as active gatekeepers that make representations regarding licensing and their affiliation with a self-regulatory agency, and offer various securities with different pricing.