NASAA Consults with the SEC on JOBS Act Rulemakings

In a consultation with the SEC under Section 302(c) of the Jumpstart Our Business Startups Act (JOBS Act), the North American Securities Administrators Association (NASAA) has provided specific suggestions regarding the crowdfunding rules that are required under Title III. NASAA's comment letter also offered the views of state securities regulators concerning the rules to be adopted by the SEC under Titles II and IV involving general solicitation in Rule 506 and the new “Regulation A+."

With regard to the new crowdfunding exemption established under Title III, NASAA observed that Section 304 of the JOBS Act requires a funding portal that is not a registered broker or dealer to maintain membership in a national securities association. Given the potential for huge numbers of unsophisticated investors to participate in crowdfunded offerings and the lack of regulatory oversight of these public offerings, NASAA strongly urged the SEC to protect investors by establishing high standards for the funding portal self-regulatory organization (SRO) that are as similar as possible to the SRO for broker-dealers.

To ensure a minimum level of the disclosure of risks and other relevant information by crowdfunding intermediaries, NASAA recommended that the SEC prescribe the use of a specific disclosure form, perhaps one modeled on the SEC Form 1-A or NASAA’s Form U-7 for Small Company Offering Registration. Instead of shortening the form to simplify it, however, NASAA suggested that the SEC allow the use of electronic forms that walk issuers through the disclosure requirements based upon their answers to questions, similar to tax preparation software programs. In this way, disclosure items that are not relevant to a particular issuer would be screened out, but those same items would be completed by issuers for whom they are relevant.

As crowdfunding was advocated as a job-producing innovation, NASAA also suggested that an issuer’s initial disclosure document to investors should disclose, in addition to its financial statements, how many persons the issuer currently employs and how many it intends to employ twelve months after a successful offering. NASAA also believes that the SEC should require an issuer’s actual employment levels to be disclosed to investors annually as part of the issuer’s results of operations. This data can be used to inform subsequent cost-benefit analyses if future changes to the exemption are sought, NASAA wrote.

In addition to information that is specific to the particular issuer and offering, Section 302 of the JOBS Act requires an intermediary to provide investors with disclosures related to the general risks of investing in crowdfunded offerings. Accordingly, NASAA provided the SEC with a sample of the type of language that may be used for this purpose. Section 302 also requires an intermediary to “ensure"  that investors review information, affirm that they understand they may lose their entire investment, and answer various questions demonstrating that they understand certain other risks. In NASAA’s view, the statutory language requires more than self-certification. Accordingly, NASAA believes that intermediaries should be required to design their web portals to require investors to “click through" a page that indicates they have read the investor-education information and to require investors to correctly answer a series of specific questions that are controlled by the SEC.

With regard to the requirements for issuers and intermediaries, NASAA urged the SEC to finalize the disqualification rule for offerings conducted under Rule 506 that was required by the Dodd-Frank Act, and to apply the same standards to the disqualification provisions for issuers who will not be eligible to use the crowdfunding exemption. NASAA also believes that an offering should be subject to disqualification based on the prior bad acts of the funding portal and its management. NASAA recommended that the SEC mandate specific checks that must be done by the intermediary to reduce the risk of fraud, including a background check and a "securities enforcement regulatory history check" of the issuer’s principals. The background check would include a review of credit reports, verification of necessary business or professional licenses, evidence of corporate good standing, UCC checks, and a CRD snapshot report.

As Section 302(b) of the JOBS Act requires an intermediary to ensure that proceeds are not provided to the issuer until the target offering amount is raised, NASAA recommended that the SEC prohibit purchases by an issuer or its officers, directors, control persons, or affiliates from counting toward meeting the target offering amount and breaking escrow. NASAA believes that this will ensure that issuers who have been unable to attract sufficient interest of unaffiliated investors are not permitted to "game the system" to accept investor funds in an offering that would otherwise fail.

Section 201 of the JOBS Act requires the SEC to revise Rule 506 of Regulation D to permit general solicitation or general advertising, provided that all purchasers of the securities are accredited investors. In addition, the legislation creates a new exemption from registration as a broker or dealer for any “platform" that facilitates the sale of such securities under certain conditions. To protect investors, NASAA strongly urged the SEC to adopt meaningful verification requirements and constrain the activities of the new private offering platforms. In addition, because Rule 506 is being expanded to permit general solicitation or advertising, NASAA believes that it is now necessary to strengthen some of the filing requirements for Form D.

NASAA noted that the JOBS Act requires an issuer to take "reasonable steps to verify" the accredited investor status of each purchaser as a condition for the exemption. In NASAA’s view, “verify" implies more than simply accepting an investor’s unsubstantiated representations. Accordingly, in the context of Rule 506, NASAA believes that a verification of status as an accredited investor should require the production of evidence to demonstrate the requisite income level or net worth.

NASAA recommended, however, that the SEC also allow an issuer to obtain the necessary verification through registered broker-dealers, provided that there are independent liability provisions for failure to adequately perform the verification. Additionally, NASAA recommended that the SEC set forth clear, non-exclusive safe harbors to specify the types of actions that will be deemed “reasonable steps to verify." These verification requirements should be tailored to three types of accredited investors: (1) natural persons who purport to satisfy the income test in Rule 501(a)(6); (2) natural persons who purport to satisfy the net worth test in Rule 501(a)(5); and (3) entities who purport to meet one of the other tests set forth in Rule 501(a).

Title II of the JOBS Act authorizes a new type of “platform," presumably internet-based, to facilitate an offer, sale, purchase, or negotiation involving securities. Although prohibiting transaction-based compensation and custody, the JOBS Act allows the platform to conduct “ancillary services, " including due diligence and the provision of standardized offering documents. NASAA expressed concern with the intrusion of these platforms into traditional broker-dealer activities and the potential devolution of those functions, especially since the platforms will not be held to traditional suitability and know-your-customer standards.

To maintain a clear distinction between broker-dealers and platforms, NASAA suggested that the rules adopted by the SEC should articulate the scope of ancillary services that are permissible for unregistered platforms and establish bright lines between compensation “in connection with the purchase or sale " of a security and compensation for ancillary services. In addition, the due diligence that is performed by a platform should be no less rigorous than the reasonable investigation required of registered broker-dealers. If the SEC believes that it lacks the jurisdiction to set rules for the unregistered platforms, NASAA wrote, it should at a minimum provide guidance detailing the type of activities that will subject the platforms to broker-dealer registration requirements.

NASAA believes that the expansion of Rule 506 to allow general solicitation will make it very difficult for SEC and state enforcement personnel to distinguish between legitimate and illegitimate offerings. Accordingly, NASAA believes that an issuer should be required to file a Form D before a public solicitation begins. Moreover, to make the requirement more meaningful, NASAA stated that the failure to file a Form D should also result in the loss of the exemption.

NASAA also believes that it is absolutely imperative that the SEC change the filing deadline at the same time that the Commission changes the rule to facilitate public solicitation. In NASAA’s view, the absence of a strict pre-solicitation filing requirement will allow unscrupulous promoters an easy defense against injunctive actions by state and federal regulators. As regulators will have no way of knowing whether a promoter is legitimately trying to comply with Rule 506, a fraudulent offering will be  allowed to continue until sufficient evidence has been gathered to prove fraud has already occurred. Additionally, NASAA believes that the Form D should be improved to require more fulsome notice to regulators.

To prevent deceptive or misleading advertising in these offerings, NASAA believes that the SEC should require advertising to comply with requirements that are similar to those applicable to registered offerings. Rule 506 offerings should thus be required to include, among other things, a “balanced presentation of risks and rewards, " and adhere to a requirement that statements in advertising are consistent with representations in the offering documents. If the SEC does not adopt any standards, NASAA wrote, unsophisticated or unscrupulous issuers will attempt to take advantage of investors with misleading and deceptive marketing material.