Reproduced with permission from Securities Regulation & Law Report, 44 SRLR 1710, 09/17/2012. Copyright �2012 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

C A P I TA L F O R M AT I O N

JOBS Act Crowdfunding Provisions Await Clarification by SEC

BY SARA HANKS

T he Jumpstart Our Business Startups Act (the‘‘JOBS Act’’) was signed by the President on April5, 2012.1 Title III of the JOBS Act creates a new ex-

emption (Section 4(a)(6)) from registration under theSecurities Act of 1933 for the crowdfunding of invest-ment opportunities. In this context, crowdfunding isgenerally defined as the selling of debt and equity secu-rities, in small amounts, to large numbers of peopleover the internet. It is in some ways an extension of the‘‘friends and family’’ financing traditionally relied uponby small businesses before they accessed more formalsources of capital.

Prior to the JOBS Act, unregistered offers to the pub-lic in this manner would have been a violation of Sec-tion 5 of the Securities Act. Indeed, to the frustration ofmany lawyers that have ever prepared a company foran IPO, friends and family financing in the early days ofa company’s existence is frequently made in violation ofSection 5’s registration requirements. Although not all

companies that raise funds through crowdfunding willever progress to an IPO, the existence of a clear exemp-tion for early-stage capital-raising may remove at leastthis source of uncertainty. In fact, even where a smallcompany knows the identity of all the people that it in-tends to offer securities to (and thus does not need tosolicit investment over the internet), Section 4(a)(6)may prove an attractive option, providing that interme-diaries can price their services accordingly.

The JOBS Act was passed over an extremely shortperiod of time and some of its drafting reflects that ur-gency. There are several areas of Title III that appearsomewhat inconsistent on their face, and that will re-quire clarification by the Securities and Exchange Com-mission or the courts. In addition, there are numerousareas where the Commission is directed to adopt rulesto implement Title III. The term most frequently usedwith respect to such rulemaking is ‘‘issue’’ so it is notentirely clear whether the rules are intended to be ad-opted or made effective by the deadline, which is 270days after signature by the President, December 31,2012. At the time of writing, the SEC had not proposedany rules or scheduled any public meetings with respectto rulemaking under Title III.2

A practical discussion of the legal implications ofcrowdfunding prior to the adoption of final rules by theCommission presents some challenges, but there aresome areas that can be identified as presenting issuesthat potential crowdfunders, funding platforms andtheir advisors could start to address prior to any rule-making. The most important among these is the factthat until the SEC has adopted its rules, investmentcrowdfunding is illegal, and no offers and sales of secu-rities may be made in purported reliance upon Section4(a)(6). The broad definition of ‘‘offer’’ under U.S. secu-rities laws is likely to trip up the unwary and inexperi-enced potential issuer, and issuers would be well-

1 Jumpstart Our Business Startups Act, Pub.L. 112-106, 126Stat. 306 (2012).

2 The Commission has solicited comments on rulemakingunder the JOBS Act prior to any proposals: http://www.sec.gov/spotlight/jobsactcomments.shtml. This maystreamline the rulemaking and comment process, and permit ashorter-than-usual comment period.

Sara Hanks is Chief Executive Officer ofCrowdCheck, Inc. and a former partner inClifford Chance.

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Securities Regulation& Law Report™

advised to get advice from experienced securities law-yers prior to saying anything about their futurecrowdfunding plans.

It must also be noted that Title III only changed cer-tain provisions of the Securities Act and the SecuritiesExchange Act of 1934. Some aspects of crowdfundingare affected by provisions in the Investment AdvisersAct of 1940, the Investment Company Act of 1940 andsome provisions of the Exchange Act that have not beenchanged.

New Crowdfunding Exemption 4(a)(6)Title III adds a new exemption from registration un-

der the Securities Act, Section 4(a)(6). Offerings meet-ing the following conditions are not required to be reg-istered with the Commission.

It is possible that the Commission will interpret

‘‘investors’’ as including only non-accredited

investors.

The aggregate amount sold to ‘‘all investors’’, includ-ing any amount sold in reliance on the new exemption,may not exceed $1 million in any 12-month period. Thelanguage of the statute suggests that offerings made un-der other exemptions (Regulation D, for example)might count towards the $1 million limit, but discus-sions with Commission staff suggest that the best viewis currently that the limit applies solely to a crowdfund-ing round, and that amounts sold under other exemp-tions during the 12-month period will not affect thelimit. It is also possible that the Commission will inter-pret ‘‘investors’’ as including only non-accredited inves-tors, in the same way that accredited investors are notincluded in the 35-investor limit in Rule 506 of Regula-tion D. If this turns out to be the case, then a crowd-funding offering could encompass a sizable offeringmade to accredited investors along with $1 million of-fered to non-accredited investors.

An investor is limited in the amount he or she may in-vest in crowdfunding securities in any 12-month period:

s If either the annual income or the net worth of theinvestor is less than $100,000, the investor is limited tothe greater of $2,000 or 5 percent of his or her annualincome or net worth.

s If the annual income or net worth of the investoris $100,000 or more, the investor is limited to 10 percentof his or her annual income or net worth, to a maximumof $100,000.

On the face of the definition a person with $100,000in annual income and no net worth could fall withinboth of these categories, and clarifying rulemaking willbe necessary.

The transaction must be made through a broker, orthrough a ‘‘funding portal,’’ a new designation underthe Exchange Act, which meets the requirements dis-cussed below. This is a significant requirement. It willresult in all the information about an issuer being avail-able in one place, which should help the SEC monitorthe market. It does mean, however, that an issuer is not

able to undertake a crowdfunding offering on its ownwithout an intermediary.

The issuer must comply with the disclosure and otherrequirements set out in more detail below.

The statute does not include a ‘‘substantial compli-ance’’ provision along the lines of Regulation D’s Rule508. The disclosure requirements will be unfamiliar tosmall companies that may be entering the capital mar-kets for the first time and they are likely to make inad-vertent mistakes. Additionally, whereas a failure tomeet all the requirements of Regulation D does not pre-clude reliance on the general provisions of Section4(a)(2), with 4(a)(6) offerings there is no ‘‘fallback’’ ex-emption from registration.3 If the conditions to the ex-emption are not completely met, a Section 5 violationwill result. In light of these facts, if the Commissiondoes not allow for ‘‘substantial compliance,’’ the utilityof Section 4(a)(6) will be significantly constrained.

Requirements for IntermediariesA person acting as an intermediary in a transaction

involving the sales of securities for someone else pursu-ant to Section 4(a)(6) must:

s Register with the Commission as a broker or as afunding portal.

s Register with a self-regulatory organization(SRO). The only SRO that meets the statutory descrip-tion is currently FINRA. FINRA is used to dealing withlarge, sophisticated entities and with larger offeringamounts than will be the norm in crowdfunding, andFINRA faces a challenge in adapting its regulations andregistration process to properly regulate funding por-tals. To the extent that FINRA is not able to formulateits rules by the time the SEC’s rules are in place,broker-dealers may have an advantage over fundingportals.

s Provide Commission-mandated disclosures (in-cluding disclosures relating to risk) and investor educa-tion material.

s Ensure that investors review the education mate-rial, affirm that the investor understands the risk ofloss, and answer questions demonstrating an under-standing of the risks involved in investing in small busi-nesses and the risks of illiquidity and other matters tobe determined by the Commission. It is not clear howthe Commission will monitor whether the platforms aremeeting these requirements, and the extent to which in-vestor education can be supplied and ensured on anindustry-wide basis. It is likely that third-party serviceswill emerge to act as intermediaries between the inves-tors and the funding portals, both checking investors’compliance with the investment limits, and making surethat investors have affirmed their understanding.

s Take measures to reduce the risk of fraud as man-dated by the Commission, including obtaining a back-

3 Section 4(a)(2) of the Securities Act provides an exemp-tion from registration under the Securities Act for ‘‘transac-tions by an issuer not involving any public offering’’. Regula-tion D is a safe harbor under Section 4(a)(2) and thus transac-tions that fail to meet all its requirements might be able to fitwithin the general statutory exemption. As a statutory exemp-tion, 4(a)(6) has no such insurance.

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ground and securities enforcement regulatory historycheck on officers, directors and 20 percent equity hold-ers of the issuer. The Commission may expand this re-quirement significantly and in any case it will need togive guidance as to what is to be done if the backgroundchecks unearth information as to wrongdoing: discloseor disqualify?

s Make the required issuer information (discussedbelow) available to investors and the Commission atleast 21 days before any sales take place.

s Ensure that the issuer gets the offering proceedsonly when it has reached the target offering amount,and let investors cancel their commitment to purchasesecurities in accordance with rules to be set by theCommission.

s Make such efforts as the Commission may deter-mine to ensure that investors do not exceed the limitson investment set out above. In recent proposed rule-making under the JOBS Act, the Commission proposedthat the steps necessary to ‘‘verify’’ an investor’s statusas an accredited investor be left up to the issuer to es-tablish, using a facts-and-circumstances analysis, and itis possible that the Commission could use the same ap-proach in this case, leaving it up to the funding portalsto decide how to verify the investment limits are not ex-ceeded.4

s Protect the privacy of information collected frominvestors.

Funding portals are exempt from having to registerwith the Commission as brokers, but the Commissionwill be adopting rules establishing conditions for thatexemption. The statute imposes significant restrictionson the operations of funding portals, and anecdotal evi-dence suggests that many platforms will choose to reg-ister as (or form a partnership with) a broker dealer inorder to avoid these restrictions and to be able to par-ticipate in offerings under newly proposed Rule 506 (c).

Funding portals may not:

s Pay for finding potential investors. Clarificationwill be needed with respect to this prohibition, but in alllikelihood, the funding portals are likely to be moreconcerned about incentivizing potential issuers to cometo their site than potential investors.

s Give investment advice or recommendations. Thisis likely to be a significant issue in crowdfunding. Nochanges were made in the JOBS Act to the InvestmentAdvisors Act of 1940, and the definition of ‘‘investmentadvice’’ in the Investment Advisers Act is both broadand broadly interpreted by the Commission. Investmentadviser means ‘‘any person who, for compensation, en-gages in the business of advising others . . . as to thevalue of securities or as to the advisability of investingin, purchasing or selling securities or who . . . issues orpromulgates analyses or reports concerning securi-ties.’’5 Any recommendation on the part of a portal,even something as innocuous as alerting investors tothe fact that a particular company is outraising others,may thus amount to investment advice. Portals may sortor ‘‘curate’’ issuers, and may offer their services only tocertain types of issuers, but any selectivity with respect

to issuers may be problematic. Portals will need to beable to reject or remove fraudulent or problematic issu-ers and they will want to be able to select on the basisof their perceived quality or likely success, and the ex-tent to which they will be able to do either is not clear.

s Solicit offers or sales to buy the securities offeredon its portal or compensate anyone for such solicitationor based on the sale of securities on its portal. Thisbroad prohibition will require significant clarification,especially since the posting of a crowdfunding offeringis in itself the solicitation of an offer. Portals will wishto advertise to drive traffic to their sites.

s Hold or manage funds. From a practical point ofview, portals will have to contract for escrow and secu-rities processing services, since the issuer will likely beunable to perform these functions itself.

s Permit their officers, directors or partners fromhaving a financial interest in an issuer using their ser-vices. This may be read as a prohibition in portals’ tak-ing a stake in companies listed on their website, al-though there are several competing interpretations ofthis prohibition, and SEC clarification will be neces-sary.

s Undertake other activities to be specified by theCommission.

The Commission will specify by rule the circum-stances that will disqualify a broker or portal from of-fering securities under Section 4(6).

Requirements for IssuersThe issuer must be incorporated or organized under

the laws of a U.S. state. It may not be an ‘‘investmentcompany’’ under the Investment Company Act of 1940,and cannot be an SEC-reporting company.

The financial statement requirement may be one of

the most burdensome in the statute and will

require SEC rulemaking.

Issuers of crowdfunded securities must provide (thestatute says ‘‘file’’ but as discussed below, liability fol-lows private as opposed to public standards) the Com-mission and investors and the intermediary with the fol-lowing information:

s Name, legal status, web address and physical ad-dress.

s Names of officers, directors and 20% sharehold-ers.

s Description of business and anticipated businessplan.

s Description of financial condition and:— If raising $100,000 or less, tax returns and finan-

cial statements certified by the issuer’s principal execu-tive officer.

— If raising $100-500,000, reviewed financial state-ments.

4 SEC Release No. 33-9354, August 29, 2012.5 Investment Advisers Act of 1940 Section 202(a)(11).

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— If raising $500,000 or more, audited financial state-ments.

s Description of intended use of proceeds of offer-ing.

s Target offering amount, deadline to reach thatamount, and regular updates regarding progress to-ward target.

s Price of securities or method to determine thatprice (with the ability for investor to rescind commit-ment to purchase after the price has been determined).

s Description of ownership and capital structure ofthe issuer, including:

—The terms of securities offered and each other classof securities of the issuer (and the differences betweenthem), including how those terms might be limited, di-luted or qualified by the rights of other classes of secu-rity.

— A description of how exercise of rights of control-ling shareholders could affect the rights of crowdfund-ing shareholders.

— Identification of 20% security holders.— How securities offered are valued and how they

may be valued in the future, including during corporateactions.

— Risks of minority ownership, risks associated withfuture corporate actions, including additional issuancesof shares, sale of issuer’s assets and related party trans-actions.

s Other information prescribed by the Commission.The financial statement requirement may be one of

the most burdensome in the statute. While informal dis-cussions with the SEC Staff have indicated that auditingin compliance with Public Company Accounting Over-sight Board standards will not be required (as would bethe case for public companies), this is still an expensiveproposition, and gives issuers an incentive to tailor thesize and timing of their offerings to avoid a full audit.SEC rulemaking will be required in this area.

Another area of concern is the information requiredabout the terms of the securities and relationships be-tween majority and minority owners, dilution and thelike. Some of these requirements are sophisticated con-cepts and issuers may require assistance in drafting ap-propriate disclosure. Third party drafting services andtemplates will be available, but in general these are notdisclosure requirements that can be met by a series ofdropdown menus.

Issuers will be required to ‘‘file’’ annual reports of re-sults of operations and financial statements in accor-dance with Commission rules to be established with re-spect to content and timing.

Issuers are not permitted to advertise the terms of theoffering, except for notices which direct investors to thebroker or funding portal. The Commission may givesome guidance as to the nature of these notices. Giventhe nature of crowdfunding, issuers are likely to want touse social media extensively. Guidance as to how socialmedia may be used will be very important, and the cir-cumstances under which social media communicationsmight be attributed to the issuer (on a chat board mod-erated by a funding portal, for example) will requireclarification.

Issuers may not compensate anyone for promotingtheir offerings without disclosing that compensation. It

is not clear whether this would include paid advertisingby a funding portal, and this is yet another area whereCommission guidance will be required.

The Commission will specify by rule the circum-stances that will disqualify an issuer from offering secu-rities under Section 4(a)(6), and the statute contem-plates that the Commission will draft additional inves-tor protection requirements.

LiabilityThe liability provisions of the Act present some chal-

lenging issues, which Commission rulemaking may notbe able to help with. The speed with which Title III wasdrafted is evident in some of the language, which mighthave benefitted from some refining.

The Act imposes Section 12(a)(2)-type liability on the‘‘issuer’’ (as defined in the statute). If the issuer makesan untrue statement of a material fact or omits to statea material fact necessary to make its statements, in lightof the circumstances in which they were made, not mis-leading, and cannot sustain the burden of proof that itdid not know, and in the exercise of reasonable care,could not have known, of such untruth or omission, theissuer must reimburse the purchase price of securitiesplus interest.

The first real liability issue presented by the

statute derives from the definition of ‘‘issuer.’’

The extent of liability, and the standard of proof re-quirement, is in reality probably the least problematicaspect of the liability section. In the context of an IPOor follow-on registered offering, for a non-executive di-rector to establish a due diligence defense takes somework and many meetings with people with actualknowledge of the facts stated in a prospectus. In thecontext of a small company seeking crowdfunding, notonly will the ‘‘offering document’’ contain far fewerstatements that must be verified, but also the personneeding to establish the truth of the statements will belikely be the person who made those statements in thefirst place.

The first real issue presented derives from the defini-tion of ‘‘issuer’’, which includes (in addition to the com-pany issuing the securities) any director or partner ofthe issuer, its principal executive officers, and its prin-cipal financial officer, accounting officer and controller.The statute includes the words ‘‘that offers and sells asecurity’’, which could be read to modify either theword ‘‘issuer’’ or the description of the persons subjectto liability. Professor Steven Bradford argues that theformer makes more sense in context, in which case itwould not be necessary for a company officer to be in-volved in the selling process to be subject to liability.6

In light of this interpretation, and also in light of the factthat in a small company all its officers are likely to beinvolved in the crowdfunding effort, it would be foolish

6 The New Federal Crowdfunding Exemption: Promise Un-fulfilled, Forthcoming, Securities Regulation Law Journal, Vol.40, No. 3 (Fall 2012).

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for all the principals of the company not to establishtheir due diligence defense prior to selling securities.

The second issue presented by the definition of ‘‘is-suer’’ is in the inclusion, as a final, standalone clause,of the words ‘‘and any person who offers and sells thesecurities in such offering’’. There are no Title III-specific definitions of these terms, so their normal secu-rities law definitions would presumably apply, includ-ing the Supreme Court analysis of the term ‘‘seller’’ forthe purposes of Section 12 in Pinter v. Dahl.7 Thisanalysis is crucial for the broker-dealers and fundingportals who will act as intermediaries for companiesseeking crowdfunding. In discussing the status as‘‘statutory sellers’’ of persons soliciting the purchase ofsecurities in order to obtain a financial benefit for them-selves (a category that would include brokers and fund-ing portals), the Supreme Court stated that:

The applicability of [Section] 12 liability to brokers and oth-ers who solicit securities purchases has been recognizedfrequently since the passage of the Securities Act. It haslong been ‘‘quite clear,’’ that when a broker acting as agentto one of the principals to the transaction successfully solic-its a purchase, he is a person from whom the buyer pur-chases within the meaning of 12 and is therefore liable as astatutory seller.8

As ‘‘statutory sellers’’, therefore, brokers and fundingportals may be subject to liability for untrue statementsunless they establish their due diligence defense.

The next uncertainty presented by the drafting re-lates to precisely which statements persons other thanthe issuing company are responsible for. The statutereads ‘‘an issuer shall be liable . . . if the issuer . . .[makes an untrue statement of a material fact]’’. If Con-gress had intended that there be no cross-issuer liabil-ity (i.e., making an accounting officer liable for a state-ment attributable to the company itself) then a more ap-propriate wording would have been ‘‘an issuer shall beliable . . . if that issuer . . . .’’

Until the extent of the liability is clarified, brokers

and funding portals should seek to establish

their due diligence defense for statements made

by the issuing company and its affiliates.

On its face, therefore, any of the persons within thedefinition of ‘‘issuer’’ are liable if any of the other per-sons within that definition make an untrue statement ofa material fact. Given the close identity between a smallcompany and its officers and directors (many of whomwill serve in more than one of the roles identified as be-ing ‘‘issuers’’), this is logical in context. What is less in-tuitive, however, is the fact that, as written, the statutewould seem to impose liability on a broker or fundingportal not only for any statements that it makes itselfwith respect to a crowdfunding offering, but also forstatements made by the company or its officers. The Su-preme Court’s interpretation, in Janus Capital Group,

Inc. v. First Derivative Traders9, of what it means to‘‘make’’ a statement, would appear to be of no assis-tance here, given the apparent cross-issuer liability. Un-til the extent of the liability is clarified, brokers andfunding portals should seek to establish their due dili-gence defense for statements made by the issuing com-pany and its affiliates.

Liability under Rule 10b-5 would also apply to thosepersons ‘‘making’’ untrue statements, as limited by theJanus Capital decision. It is easy to imagine the type ofpromotional statements that inexperienced fundingportals might make that would form the basis for a10b-5 suit.

State LawThe Commission will make the issuer information

available to state regulatory authorities. The states arepre-empted from requiring registration of Section4(a)(6) offerings, but there is no restriction of their abil-ity to take enforcement action with respect to fraud ordeceit by issuers, brokers or funding portals. Statesmay impose fees if they are the principal place of busi-ness of the issuer or if more than half the purchasers ofa crowdfunding offering are in that state, so fundingportals will have to establish mechanisms monitoringthe location of investors and assisting issuers to complywith state requirements, which are unlikely to be uni-form. A funding portal’s home state may regulate theportal, but cannot impose rules that are different or ad-ditional to what is required under the JOBS Act.

Resale RestrictionsThe JOBS Act provides that for a year after issuance,

securities sold under Section 4(6) can only be resold:

s Back to the issuer.

s To an ‘‘accredited investor.’’

s In a registered offering of securities (such as aninitial public offering).

s To a family member or on death or divorce.The Commission may adopt other restrictions and

will likely clarify that these are ‘‘restricted’’ securitiesunder the definition of Rule 144(a). Some commentershave requested the ability to create ‘‘liquidity plat-forms’’ for crowdfunded securities, which will not bepossible unless such platforms are registered as stockexchanges or alternative trading systems under the Ex-change Act.

Crowdfunding Securities and RegistrationUnder the Exchange Act

Securities acquired in a Section 4(a)(6) offering arenot included in counting the number of shareholdersthat triggers the need to register a class of securities un-der Section 12(g) of the Exchange Act. Their treatmentunder Section 12(g) after having been transferred, forexample, during the one-year period to an accreditedinvestor, or after that period, in the open markets, is notclear. Presumably the Commission will have to give

7 486 U.S. 622 (1988).8 Id. at 646. 9 564 U.S.__ (2011).

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clear guidance as to what happens if an active second-ary market develops and the original holders of crowd-funded securities all sell their securities, catapulting anissuer into the Exchange Act’s registration require-ments long before it is ready.

ConclusionWhile the Commission is required to ‘‘issue’’ its rules

by Dec. 31, 2012, many such deadlines have beenmissed in recent years, so at the time of writing it is notclear when investment crowdfunding will be legal. TheCommission accepted ‘‘pre-comments’’ on the JOBSAct, and that process may permit a shorter-than-usual

public comment period upon proposal of crowdfundingrules.

In light of Congressional interest in the topic, it islikely that any perceived foot-dragging will be met byrequests for Congressional hearings, and even in theneed for Commission rulewriting being supplanted bylegislation. This already happened in the JOBS Act inthe context of the Section 12(g) triggers, where Con-gress raised the threshold numbers for registration de-spite the fact that Commission staff stated that theywere looking at establishing a new number. It is not im-possible that the drafting pencil could be seized fromthe Commission’s hands again.

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