In early November, the U.S. House of Representatives overwhelmingly passed the Entrepreneur Access to Capital Act, a crowdfunding bill which permits startups to offer and sell securities via crowdfunding sites like Kickstarter or social networking sites like Facebook. As I discuss below, this is a game-changer for startups and lifts certain securities law prohibitions that have been on the books since the 1930’s.
The Obama Administration supports the House bill and noted in its Statement of Administrative Policy that: “This bill will make it easier for entrepreneurs to raise capital and create jobs.” Unfortunately, two very different crowdfunding bills have been introduced in the U.S. Senate, and committee hearings have been surprisingly focused on fraud concerns and other potential problems. Indeed, it is unclear whether the Senate will even pass a crowdfunding bill (and, if so, in what form).
As the term suggests, “crowdfunding” is funding from a crowd of people — that is, many people provide small amounts of money to finance something. Crowdfunding has its roots in charitable causes (including the advent of microfinancing to provide financial services to poor people), but has progressed to the online funding of creative and other projects via sites like Kickstarter and RocketHub.
Under current federal and state securities laws, startups are prohibited from selling stock or other securities via crowdfunding sites or social networking sites. Such laws include:
- A prohibition against “general solicitation” – which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor (see “Can I Raise Money For My Startup Via Twitter?”);
- Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering of securities too costly and onerous for a startup (see “Ask the Attorney – Securities Laws”);
- A requirement that any intermediaries (including websites) must be registered with the SEC and applicable state securities commissions as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities (see “Ask the Attorney – Beware of Finders”); and
- A requirement that any company that has 500 or more shareholders and total assets exceeding $10 million must register with the SEC and file periodic reports.
The House Bill
The crowdfunding bill passed by the House lifts all of the foregoing prohibitions and requirements and allows a company to sell securities via crowdfunding sites and/or social networking sites so long as the company (and its intermediary, if applicable) comply with the following key restrictions:
- The company may only raise a maximum of $1 million (or $2 million if the company provides potential investors with audited financial statements);
- Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income; and
- The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.
The First Senate Bill (the “Brown bill”)
- The Brown bill only permits the issuance of securities through a “crowdfunding intermediary”; accordingly, startups would not be permitted to raise funds via social media sites like Facebook, Twitter or LinkedIn (as permitted under the House bill);
- Under the Brown bill, each investor is limited to investing up to $1,000 per company for each 12-month period;
- Similar to the House bill, the Brown bill caps the total amount of capital that may be raised during any twelve-month period at $1 million, but does not raise the cap to $2 million if the issuer provides potential investors with audited financial statements; and
- Finally, the Brown bill permits some form of registration by the State in which the company is organized and/or “any State in which purchasers of 50 percent or greater of the aggregate amount of the issue are…residents.” (The House bill preempts State law and, accordingly, there is no State registration requirement.)
The Brown bill was referred to the Committee on Banking, Housing, and Urban Affairs, and a hearing was held by such Committee on December 1, 2011, with respect to several pieces of capital formation legislation, including crowdfunding. As noted above, the hearing focused on fraud concerns, including testimony from Professor John C. Coffee of Columbia University Law School that:
“[Early stage] issuers are in effect flying on a ‘wing and a prayer,’ selling hope more than substance. Precisely because of this profile, however, such offerings are uniquely subject to fraud, and some issuers will simply be phantom companies without any assets, business model, or real world existence.”
The hearing also included this testimony from Jack Herstein, President of the North American Securities Administrators Association (NASAA):
“Main Street investors should not be treated as the easiest source of funds for the most speculative business ventures. The law should not provide lesser protections to the investors who can least afford to lose their money.”
Indeed, the NASAA, a trade group for state regulators, has been lobbying very hard against the House Bill to prevent the preemption of State law and to reduce the maximum investment amount per investor. As President Herstein wrote in a letter to House members:
“Any effort to remove or weaken the up-front registration and disclosure process should not happen without adequate alternative safeguards….[The House bill] will create an exemption that will expose many more American families to potentially catastrophic financial harm.”
The Second Senate Bill (the “Merkley bill”)
A second crowdfunding bill, called the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (or the “CROWDFUND Act”), was introduced on December 8, 2011, by Senator Merkley. This bill veers even further from the House bill and differs in the following material respects:
- The Merkley bill only permits the issuance of securities through a registered broker-dealer or “funding portal” (which is a new term generally defined as any individual or entity engaged in the business of effecting securities transactions that does not offer advice or recommendations or solicit sales);
- Under the Merkley bill, each investor is limited to investing up to the greater of (i) $500 or (ii) 1% or 2% of his or her annual income (depending upon the amount of such income), per company for each 12-month period;
- The Merkley Bill also creates an aggregate annual cap on the amount of all crowdfunding investments by an investor of (i) $2,000 or (ii) 4% of the investor’s annual income if such income is above $50,000 or (iii) 8% of the investor’s annual income if such income is above $50,000;
- Similar to the House and the Brown bills, the Merkley bill caps the total amount of capital that may be raised during any twelve-month period at $1 million; however, it requires the delivery of audited financial statements to the SEC and investors if the company seeks to raise more than $500,000; and
- Finally, the Merkley bill grants investors a new cause of action against the issuer’s directors or officers personally in the event of fraud.
At a hearing held on December 14, 2011 by the Securities, Insurance, and Investment subcommittee of the Banking Committee, attorney Mark T. Hiraide testified in favor of the Merkley bill and noted that:
“I share Professor Coffee’s concerns that unregistered salespersons may abuse the broker-dealer registration exemption set forth in [the Brown bill].”
The crowdfunding bill that passed in the House by a 407-17 vote (and is enthusiastically supported by the Obama Administration) is stuck in the Senate. Why? Because of effective lobbying by the NASAA and two hearings designed to highlight the potential of fraud. The Senate needs to take a step back and focus on (i) the plight of entrepreneurs and their difficulty in raising capital and (ii) the need for job creation in our country.
“It seems a little crazy to me that you have to be an accredited investor to invest in a company, but you can go to Las Vegas and lose $10,000 at the table in an hour and you don’t have to be an accredited gambler to do that.”
Please write your Senators and beg them to support HR2930, or something close to it. This is indeed CRAZY!!!!