November 4, 2011
Houses Passes a Crowdfunding Bill
Yesterday, the House of Representatives voted to approve H.R. 2930, the Entrepreneur Access to Capital Act. The bill, introduced by Congressman Patrick McHenry, would establish a federal securities law exemption for crowdfunding. The 407-17 bipartisan vote came shortly after the Obama administration released a statement suporting the bill.
The basic structure of the bill passed yesterday is similar to what Representative McHenry originally proposed. The offering amount is limited to $1 million, or $2 million if the issuer provides investors with audited financial statements. (The limit in the original bill was $5 million, with no special rule for issuers providing financials.) And each investor may invest annually up to the lesser of $10,000 or 10% of the investor’s annual income, with issuers allowed to rely on investors’ self-certifications of their income. As a result of a couple of floor amendments yesterday, all of those dollar amounts are subject to adjustment for inflation.
However, the final bill adds a lot of detail that didn’t appear in the original bill. Many of those changes track recommendations I have made in my article on crowdfunding. (Full disclosure: One of Representative McHenry’s legislative assistants contacted me shortly after the original bill was introduced asking for suggestions regarding possible changes. However, I was not involved in drafting the revised bill.)
Here are the additional requirements. If the securities are sold through an intermediary, such as a crowdfunding site, the intermediary is responsible for fulfilling these requirements. If the securities are sold directly by the issuer, the issuer is responsible, and the issuer must also disclose its interest in the offering.
- Disclosure and Testing Requirements. The bill requires warnings to investors about the speculative nature and risk of small business offerings. Before investing, investors must answer questions demonstrating an understanding of (1) the risk of investing in startups, (2) the risk of illiquidity, and (3) such other matters as the SEC deems appropriate.
- Funding Goals and Closing Offerings. The issuer must state a funding target and a deadline for reaching that target. No funds may be drawn by the issuer until it reaches at least 60% of the target amount.
- Information Requirements. Both the SEC and investors must be provided with information about the issuer, including its address and the names of its principals. Information about the target amount of the offering, the deadline for reaching that target, the offering’s purpose, and the intended use of the proceeds must also be provided. When the offering is completed, the SEC must be provided with a notice that indicates the aggregate offering amount and the number of purchasers.
- State Access to Information. The SEC must make the information it receives under the exemption available to the states.
- SEC Access. The SEC must be given investor-level access to the crowdfunding web site.
- Background Check. The intermediary, if one is used, must do a background check on the issuer’s principals.
- Disqualifications. The SEC is required to enact rules to disqualify certain issuers and intermediaries, similar to the rules section 926 of the Dodd-Frank Act requires the SEC to add to Rule 506 of Regulation D.
- Communications Channel. The issuer, or the intermediary if one is used, must establish a means for communication between the issuer and investors.
- Cash Management. Cash management functions must be outsourced to a broker or depositary institution.
- Books and Records. Both the issuer and the intermediary are required to maintain such books and records as the SEC deems appropriate.
- Fraud Protection.The issuer, or the intermediary if one is used, must take “reasonable measures to reduce the risk of fraud.”
- No Investment Advice. The issuer, or the intermediary if one is used, may not offer investment advice.
- Resales. Resales are prohibited for one year, except for sales to accredited investors or back to the issuer.
- Protection from Treatment as Brokers. The bill protects intermediaries operating crowdfunding sites from being treated as brokers under federal law. As a result of a couple of floor amendments, the bill probably would not protect crowdfunding sites from being treated as brokers under state law.
- Exchange Act Reporting Threshold. Crowdfunding investors will not count against the 500-shareholder floor that triggers Exchange Act reporting.
- Integration Protection. The bill provides that nothing in the exemption “shall be construed as preventing an issuer from raising capital through methods not described” in the exemption. This language is a little ambiguous, but I believe it is designed to preclude crowdfunding offerings from being exempted with offerings pursuant to other exemptions.
Many of these changes make sense, but I find a few of bill’s provisions troublesome.
- Fraud-Reduction Measures. What exactly are “reasonable measures to reduce the risk of fraud?” The answer is important because the exemption is conditioned on such steps being taken. A purchaser or the SEC might be able to argue after the fact that the sales violated the Securities Act because insufficient steps were taken to reduce the risk of fraud.Also, if a crowdfunding website doesn't take such steps, could it be liable for any fraud?
- The Consequences of Non-Compliance. This raises a more general problem with the bill as written. It says the exemption is available “provided that” all of the requirements are met. Any violation, no matter how minor and no matter how many purchasers it affects, could cause an issuer to lose the exemption. If, for example, something on an intermediary’s web site could be construed as investment advice, that could destroy the exemption for all the issuers who used that site. This kind of problem caused the SEC to add “reasonable basis” and “insignificant deviation” provisions to Regulation D. Similar protection is needed here.
- Other Cost-Increasing Measures. The key to a successful exemption for the very small offerings to which crowdfunding appeals is keeping the cost low. A number of the new requirements—background checks, recordkeeping requirements, disclosure and information requirements—are going to add to the cost of using the exemption. I think that some of those requirements aren’t worth their cost.
- Resales. Finally, I am worried about the prohibition on resales. As I argue in my article, this is a trap for the unsophisticated purchasers crowdfunding is likely to attract. It’s especially troublesome if resales are deemed to destroy the issuer’s exemption.
Nevertheless, the bill is a huge step in the right direction, and Representative McHenry and his staff should be congratulated for moving the debate along. I’m especially happy to see that the Congressman held the line on state preemption (except for the broker issue mentioned above), which I feel is key to a useful crowdfunding exemption. I think the states have a vital role to play in antifraud enforcement, but complying with state registration requirements would be too costly for these small offerings.
It will be interesting to see what happens in the Senate. If Obama continues to support the bill, we may soon have a crowdfunding exemption.