Crowdfunding is a method of raising capital through small individual contributions from a broad group of people via the Internet. To date, crowdfunding has been used primarily to generate financial support for artistic endeavors like films and musical recordings, but it generally has not been used to offer and sell securities because of the risk of triggering the onerous requirements of securities laws. Now, to facilitate capital formation by startup companies, the SEC has proposed rules mandated by the JOBS Act that would permit companies to offer and sell securities to the public through crowdfunding.
Transaction Requirements for Crowdfunding
Under the SEC's proposals, crowdfunding would be permitted without registering the securities with the SEC subject to various conditions, including the following:
- the issuer is limited to raising a maximum of US$1 million in any 12-month period;
- the maximum amount an investor could invest in any 12-month period would be:
- US$2,000 or 5% of the investor's annual income or net worth, whichever is greater, if the investor's annual income and net worth are less than US$100,000; or
- 10% of the investor's annual income or net worth, whichever is greater, up to a limit of US$100,000, if the investor's annual income or net worth is greater than US$100,000;
- transactions would have to be conducted online through a platform operated by an SEC-registered intermediary (either a broker-dealer or a funding portal);
- the issuer must prepare an offering document disclosing information to investors about:
- the issuer's business plan, the risks of the offering and the planned use of proceeds;
- the issuer's directors, officers, major shareholders and related party transactions;
- the price and valuation of the offered securities, the target offering amount and the deadline to reach the target; and
- the issuer's financial condition, including financial statements that in some cases would have to be reviewed or audited.
The issuer would also have to file an annual report with the SEC and make the report available on the issuer's website. Subject to very limited exceptions, securities purchased in crowdfunding transactions could not be resold for one year.
Responsibilities of Intermediaries
The proposed rules would impose various responsibilities on crowdfunding intermediaries to facilitate investor education and reduce the risk of fraud. Among other things, intermediaries would be required to make an issuer's disclosure document available for 21 days before securities are sold and provide communication channels to permit discussions about offerings on the platform. Intermediaries would be prohibited from offering investment advice or soliciting purchases or sales.
Certain issuers would not be eligible for crowdfunding, including SEC-reporting issuers, non-U.S. issuers, investment companies and most hedge funds and other private funds. The proposal would also disqualify any issuer without a specific business plan or whose business plan is to engage in an M&A transaction with an unidentified company.
The Ontario Securities Commission is also considering crowdfunding, although specific rules have not yet been proposed. We expect any rules to be consistent with the SEC’s proposals to permit crowdfunding for only relatively small transactions and require the use of an authorized funding portal. In considering whether to follow the SEC's approach in respect of the responsibilities of funding portals and the disclosure required of issuers, the OSC’s challenge will be to keep the regulatory burdens and associated compliance costs manageable for Canada’s smallest issuers, yet robust enough to prevent abuse and maintain the integrity of the crowdfunding market.
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