The SEC Streamlines Accredited Investor Verification Under Rule 506(c)

The SEC’s recent final rule release regarding exempt offerings covered various topics, including the subject of my previous post, on the expanded offering limits for Regulation CF crowdfunding and Regulation A offerings. In the release, the SEC also provided some welcome relief in the accredited investor verification process for Rule 506(c) offerings.

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The SEC Broadens the Crowdfunding and Regulation A Exemptions

The SEC issued a 388-page final rule release, entitled Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets. (The clunky wording seems like it was done to accommodate a catchy acronym, but “FCFAEIOBIATCIPM” doesn’t really flow.) The release details rule changes in a variety of areas relating to private offerings, but I will focus for this post on the expansion of the crowdfunding (Regulation CF) and Regulation A offering exemptions, and cover other topics in future posts. Here are the SEC’s press release and fact sheet about all the new rule changes.

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The SEC’s Concept Release on Exempt Offerings and Investment Limits

Share Buybacks as a Political Issue | Andrew Abramowitz, PLLCThe SEC recently issued a long “concept release” on harmonization of securities offering exemptions. Whenever I hear about one of these, my first thought is that it’s somehow like a concept album from a ‘70s prog rock outfit (and therefore to be avoided), but in reality, the point of concept releases is to solicit input from the securities law community on a broad topic without immediately proposing changes. In this case, it’s about the complex web of exempt offering types that have evolved over the years and whether and how to harmonize them.

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The Presumed Sophistication of Accredited Investors

The Presumed Sophistication of Accredited InvestorsA recent Wall Street Journal article highlighted how sketchy brokers have been marketing problematic private placements to accredited investors. While the article focused on the brokers, I was struck by the identity of one of the investor victims noted in the article as having lost a lot of money: George Stephanopoulos, the ABC News anchor and former Clinton Administration official. I don’t mean to cause Mr. Stephanopoulos any further embarrassment by highlighting this here (though I’m guessing that the readership of my blog is far less than that of the Journal), but the fact that he was scammed is a useful illustration of the misguidedness of the accredited investor definition and associated rules.

The current definition of “accredited investor” under SEC rules essentially uses wealth as a proxy for sophistication, as an individual can qualify by either having an annual income of $200,000 or a net worth of $1 million not including the value of one’s primary residence. An offering made to all accredited investors does not have an information requirement, meaning the investors do not need to be provided with a similar level of disclosure that would be associated with a registered public offering.

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Simultaneous Regulation CF and Rule 506(c) Offerings

Simultaneous Regulation CF and Rule 506(c) OfferingsBack when the equity crowdfunding rules were proposed following passage of the JOBS Act, the $1 million offering limit per year for what are now known as Regulation CF offerings was viewed as making this procedure impractical. The amount raised would not be sufficient in light of the legal, accounting and other costs needed to prepare for the offering. However, as crowdfunding is now a reality and companies are giving it a shot, a fix to the dollar limit has evolved: raise funds not just under Regulation CF, but under other exemptions that are not subject to that dollar limit.

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Crowdfunding as a Time-Saver

Equity Crowdfunding | Title III CrowdfundingErnest Holtzheimer blogs with some statistics about how the new JOBS Act-authorized forms of securities offerings are being used following enactment. Both the revamped Regulation A and new Regulation Crowdfunding have seen somewhat underwhelming use to date. The most common objection to Regulation Crowdfunding, the $1 million offering limitation, has led companies to consider using Regulation A, which is more involved compliance-wise. Legislation to increase the offering cap for Regulation Crowdfunding might have a better chance of enactment with the coming all-Republican government, with its anti-regulatory bent. Of course, companies that are willing to limit their investor base to all accredited investors aren’t subject to the offering limit.

Holtzheimer mentions an advantage of crowdfunding that is less remarked-upon than some others: that crowdfunding can help save company founders time, as compared to more traditional forms of investment like angel investment and venture capital. Traditional capital-raising involves spending an enormous amount of time with potential investors, explaining the business, responding to due diligence requests, etc. In addition, when there is an investor syndicate rather than just one investor, the different members of the syndicate may have different requests/concerns, so the process is like herding cats. In contrast, at least in theory, with crowdfunding and Regulation A, once the proper disclosure is prepared and posted for investor review, the investors make their choices, and if there’s enough interest, you just go ahead and close.

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Title III Crowdfunding is Now Live

The effectiveness of Title III crowdfunding got the high-profile Sunday New York Times treatment this past weekend. I think it will take some time for the flow of these deals to come, as portals apply for and receive approval from the SEC and the overall infrastructure develops.

Title III Crowdfunding | JOBS ActThe Times article has a quote from a Mintz Levin securities attorney expressing skepticism and noting that unlike venture capital investing, crowdfunding does not provide institutional validation of a company. I would agree that it doesn’t, but at the same time, it shouldn’t be considered a red flag. Because of the $1 million per year offering limit currently applicable to Title III crowdfunding, this route will only make sense if the business can execute its plans with those kind of funds. Capital-intensive ventures, like those in the life sciences industries, will likely continue to need venture funding. But for those who don’t, even if they don’t get the external validation of an institutional investment, they can get the funds they need to operate relatively easily and without the onerous terms often imposed by venture investors.

The article closes with an interview with a potential crowdfunding investor who said she skimmed the offering circular but says she’s financially sophisticated enough to take the risk. (The offering circular, which is linked to in the article, is actually for a Regulation A+ offering, not Title III crowdfunding.) Much of the commentary about risks for fraud in recent years has focused on Title III crowdfunding, rather than other JOBS Act initiatives, like Regulation A+, but ironically it’s only Title III crowdfunding that has the strict investment limits imposed on investors with low net worth or income, which protect them from being wiped out. The investor profiled in the Times may well lose a lot of money on her Regulation A+ investment (as she could, as well, by investing in a public company), but she’d automatically limit her risk exposure by sticking to Title III crowdfunding offerings only, because of these limits.

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Crowdfunding and the Wisdom of Crowds

Professor Andrew A. Schwartz writes in Harvard’s corporate governance blog about the likelihood of success of soon-to-be implemented Title III crowdfunding. Relative to much commentary on this topic, Professor Schwartz is an optimist about the potential of crowdfunding to overcome some of the risks of investing in entrepreneurial ventures. While I am too for some of the reasons he cites, I’m not sure about one of them: that the “wisdom of the crowd” will lead to better investment decisions than would be made by individuals or small groups, even experts.

Crowdfunding and the Wisdom of Crowds | A. AbramowitzUnder the right conditions, the wisdom of crowds can be quite powerful, as described in New Yorker columnist James Surowiecki’s excellent book called, well, The Wisdom of Crowds. Does the principle apply in the crowdfunding context? Imagine a crowdfunding portal where instead of being able to choose some or none of the available investment opportunities, investors were forced to assess Company A and Company B and pick one of the two to invest in. Under those (unnatural) circumstances, I would expect the crowd to make the right decision, meaning the company that attracts more investors would be the better investment opportunity.

However, that’s not how a crowdfunding portal will work. Instead, an essentially unlimited pool of potential investors will scan the available opportunities and make a yes or no decision about each one. Suppose that a company seeks to raise $500,000 through a crowdfunding portal. 5,000 potential investors review the offering. 4,500 of them decline to participate, and most of them think it’s a terrible, laughable business concept. The remaining 500 like it and each decide to kick in $1,000. So in this scenario, you have a large majority having a bearish view of the company, and yet it successfully raises its full offering. In other words, the immense size of the potential investor pool could lead to bad companies successfully raising capital.

To be sure, there are plenty of bad investments made today, in the pre-crowdfunding world, so crowdfunding will not usher in a new era of good money chasing bad investment ideas. That’s been happening for as long as there’s been investment. I’m just skeptical that we can conclude that a company that completes a crowdfunded offering has been somehow vetted as a result of its approval by the crowd.

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Investment Limits in Title III Crowdfunding

One of the key investor protections built into the SEC’s final rules on Title III crowdfunding is the strict limitation on the amount that investors can invest in these offerings in any 12-month period. The rules as stated by the SEC are somewhat difficult to parse; the following is a brief overview of the calculation to be done for each investor:

  • The limit applies across all offerings by all issuers; i.e., if an investor’s annual limit is $2,000, it can’t invest $2,000 with Issuer A and $2,000 with Issuer B (but it could do $1,000 with each).
  • To calculate the figure, compare the investor’s net worth and annual income, each calculated in accordance with the rules for determining accredited investor status. The lower of those two figures is the one used for the calculation.
  • If that lower figure is under $100,000, then the limit is $2,000 or 5% of the figure, whichever is greater.
  • If that lower figure is equal to or greater than $100,000, then the limit is 10% of that figure, subject to a cap for all investors of $100,000 to be invested in these offerings.

Title III Crowdfunding | JOBS ActI believe that those commentators who have reflexively opposed the whole crowdfunding concept, at least for non-accredited investors, do not fully appreciate the impact of this investment limit. For that significant portion of Americans who fall under the $100,000 threshold for either income or net worth, no more than $2,000 (or a somewhat higher four-figure number) can be invested in all of these offerings per year. While this amount is not insignificant for the non-wealthy, it’s not an amount that will lead to financial ruin. Keep in mind, also, that there are no rules that limit the annual amount that anyone can spend on lottery tickets, gambling or – for an investment example – sketchy public companies. The investment limits contained in the JOBS Act and elaborated on by the SEC, I think, strike the right balance between protecting non-accredited investors while giving them a reasonable opportunity to participate in small business equity markets.

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Legal Disclosure Requirements for Title III Crowdfunding

Before the SEC issued final rules recently relating to Title III crowdfunding – offerings of up to $1 million to accredited or non-accredited investors – there was much skepticism among the investment community whether these offerings could be completed in a cost effective manner, given the combination of a low offering limit and significant compliance requirements. The SEC addressed the concern in part by lifting the requirement that offerings over $500,000 be accompanied by audited financial statements, permitting reviewed statements in an issuer’s first crowdfunded offering. Another significant cost associated with these offerings is also how I make my living: legal disclosure requirements.

Equity Crowdfunding | Title III CrowdfundingFor comparison purposes, I think it would be useful to consider the requirements associated with the most common way to offer securities today in an exempt offering to non-accredited investors: a Rule 506(b) private placement. These offerings require the preparation of a disclosure document, the private placement memorandum (PPM), containing essentially the information required in a prospectus for a public offering. In other words, a lot of information, basically anything that the SEC has ever thought of requiring. Accordingly, a PPM is expensive to prepare.

For Title III crowdfunded offerings, the equivalent of the PPM will be a Form C. Although the form will be required to be filed electronically via EDGAR, which has its own associated costs, the form itself requires somewhat less information than a PPM. To take an example, Form C requires the disclosure of holders of 20% of the issuer’s stock, as opposed to the 5% threshold that would be used in a registered offering document and a PPM. Time will tell what becomes common practice for preparation of the Form C offering document, and they may contain more disclosure than is strictly required, but based on an initial read of the rules, it will be a simpler (and therefore cheaper to produce) document.
However, unlike issuers that rely on Regulation D, issuers who complete a crowdfunded offering will have an ongoing annual disclosure requirement, essentially an annual Form C with all of the same information, except for offering-related disclosure. This requirement, while significant, is far less onerous than the requirements imposed on public companies (quarterly and periodic filings, proxy statements, etc.).

It is difficult to predict whether issuers will find this process to be cost effective, and we will all find out through experience. One factor that may tip the balance in favor of crowdfunding, even with the compliance costs, is that investors will not likely require the onerous terms that sophisticated institutional investors impose on issuers in private offerings – liquidation preferences, anti-dilution provisions, etc.

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