Wednesday, January 16, 2013

Ohio Securities Division Offers SEC Detailed Comments on Regulations Implementing the Crowdfunding Provisions of the JOBS Act

In a detailed and substantive comment letter to the SEC, the Ohio Securities Division set forth a number of recommendations for the Commission to consider at it drafts regulations implementing the crowdfunding provisions (Title III) of the Jumpstart Out Business Startups (JOBS) Act. Broadly, the Division urged the Commission not to rely on the "wisdom of the crowd" theory because it is effective at exposing only the simplest form of fraud, and not those forms of fraud that pose the greatest risk to investors. Claiming that  the  crowd  is  immune from  fraud  because  of its internet  research  savvy  takes  a  far  too  simplistic  view  of the  ways  fraudulent  and  abusive practices occur in the securities context, said the Division in a letter signed by Ohio Securities Commissioner Andrea Seidt.

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.

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