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Crowdfunding and Securities Laws

34. What is “crowdfunding” and how is it affected by securities registration laws?

The edition of Section 4(a)(6) to the ’33 Act introduced equity crowdfunding as a viable option for seeking investors in a new business. Crowdfunding is a sort of mini-public offering that allows the general public to purchase securities directly from an issuer through authorized, private exchanges. Section 4(a)(6) provides for a Section 5 registration exemption for issuances conducted in accordance with specific crowdfunding methods. To qualify for the exemption under Section 4(a)(6), crowdfunding transactions by an issuer (including all entities controlled by or under common control with the issuer) must meet specified requirements, including the following:

•    the amount raised must not exceed $1 million in a 12-month period (this amount is to be adjusted for inflation at least every five years);

•    individual investments in a 12-month period are limited to:

⁃    the greater of $2,000 or 5 percent of annual income or net worth of an individual, if the annual income or net worth of the investor is less than $100,000;

⁃    10 percent of annual income or net worth (not to exceed an amount sold of  $100,000), if annual income or net worth of the investor is $100,000 or more (these amounts are to be adjusted for inflation at least every five years); and

⁃    transactions must be conducted through an intermediary that either is registered as a broker or is registered as a new type of entity called a “funding portal.”

Many entrepreneurs see the availability of crowdfunding as an important financing option for smaller companies that otherwise lack the resources to seek a public offering or to comply with statutory or rule-based exemptions. Section 4(a)(6) places the burden of compliance on the crowdfunding broker or portal. To become registered as a crowdfunding broker or funding portal, the entity must comply with the following:

•    implement procedures to protect purchasers of securities against fraud;

•    refrain from providing investment advice or soliciting purchasers;

•    provide disclosures substantially similar to those required in a registration or disclosure document;

•    allow for questions and feedback on securities being issued;

•    file an offering statement with the SEC disclosing the terms and details of all issuances (which is also available to investors); and

•    make annual filings with the SEC and make those fillings available to the public on the crowdfunding site or portal.

The qualified broker or portal must also make certain that all investors meet the accreditation standards laid out by Section 4(a)(6). It cannot employ intermediaries to sell securities on behalf of the broker or portal. It must make certain the securities are understood to be restricted and, with limited exception, cannot be sold within a 12-month period of purchase.

•    Discussion: Why do you think Congress decided to provide a statutory method for allowing crowdfunding that is exempt from Section 5 registration requirements? Do you think the limitations on investor and the requirements of brokers or portals are sufficient to protect investors? Why or why not?

•    Practice Question: ABC, LLC is a new company that is growing quickly. It believes that crowdfunding may be the best method for generating much-needed capital. Eric is an investor interested in investing in a startup fund. What are the securities law requirements for ABC to undertake crowdfunding? What are the limitations on Eric as an investor?

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