SEC PROPOSES MAJOR UPGRADES TO CROWDFUNDING RULES

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.

Married Couples As Accredited Investors

When a married couple invests in an offering under Rule 506(b), Rule 506(c), or Tier 2 of Regulation A, we have to decide whether the couple is “accredited” within the meaning of 17 CFR §501(a). How can we conclude that a married couple is accredited?

A human being can be an accredited investor in only four ways:

iStock-1125972221.jpg

  • Method #1: If her net worth exceeds $1,000,000 (without taking into account her principal residence); or
  • Method #2: If her net worth with her spouse exceeds $1,000,000 (without taking into account their principal residence); or
  • Method #3: Her income exceeded $200,000 in each of the two most recent years and she has a reasonable expectation that her income will exceed $200,000 in the current year;
  • Method #4: Her joint income with her spouse exceeded $300,000 in each of the two most recent years and she has a reasonable expectation that their joint income will exceed $300,000 in the current year.

A few examples:

EXAMPLE 1: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $50,000 (credit cards!). Their joint annual income is $150,000. Husband is accredited under Method #1 or Method #2. Wife is accredited under Method #2.

EXAMPLE 2: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $500,000 (student loans!). Their joint annual income is $150,000. Husband is accredited under Method #1. Wife is not accredited.

EXAMPLE 3: Husband’s net worth is $850,000 and his income is $25,000. Wife’s has a negative net worth of $500,000 and income of $250,000. Husband is not accredited. Wife is accredited under Method #3.

Now, suppose Husband and Wife want to invest jointly in an offering under Rule 506(c), where all investors must be accredited.

They are allowed to invest jointly in Example 1, because both Husband and Wife are accredited. They are not allowed to invest jointly in Example 2 because Wife is not accredited, and they are not allowed to invest jointly in Example 3 because Husband is not accredited.

The point is that Husband and Wife may invest jointly only where both Husband and Wife are accredited individually. At the beginning, I asked “How can we conclude that a married couple is accredited?” The answer: There is no such thing as a married couple being accredited. Only individuals are accredited.

CAUTION: Suppose you are an issuer conducting a Rule 506(c) offering, relying on verification letters from accountants or other third parties. If a married couple wants to invest jointly, you should not rely on a letter saying the couple is accredited. Instead, the letter should say that Husband and Wife are both accredited individually.

Questions? Let me know.

Simple Wholesaling Podcast: Raising Money Online for Your Deals & More

CLICK HERE TO LISTEN

Mark Roderick appeared on the Simple Wholesaling Podcast to talk about crowdfunding and the laws and logistics of raising money online.

In this episode, Mark discusses:

  • Mark’s story
  • Raising capital online
  • Businesses that have been very successful
  • How entrepreneurs and the consumers are protected online
  • Portals he recommends
  • Where people should start if they’re interested to try crowdfunding
  • The “don’ts” when trying to raise money on the Internet
  • What accredited investor means
  • The types of returns entrepreneurs pay out to their crowd investors
  • The effects on the stock market when we have many options to invest in different things

Trusts as Accredited Investors in Crowdfunding and Token Sales

Trusts as Accredited Investors in Crowdfunding and Token Sales Example NewCo, LLC is conducting an offering under Rule 506(c) and receives a subscription from the Smith Family Trust. The Trust could be an accredited investor under any of four rules.

Rules for All Trusts

Rule #1: The Trust is an accredited investor if the trustee or co-trustee is a bank, insurance company, registered investment company, business development company, or small business investment company.

Rule #2: Alternatively, the Trust is an accredited investor if:

  • It has more than $5,000,000 in assets;
  • It was not formed for the purpose of investing in NewCo; and
  • Its trustee has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of a prospective investment.

Rule for Revocable Trusts

Rule #3: If the Trust is a revocable trust, it is an accredited investor if:

  • Mary Smith, the grantor, is herself an accredited investor;
  • The Trust may be amended or revoked at any time by Ms. Smith; and
  • The tax benefits of investments made by the trust pass through to Ms. Smith.

Rule for Irrevocable Trusts

Rule #4: If the Trust is an irrevocable trust, it is an accredited investor if:

  • Mary Smith, the grantor, is herself an accredited investor;
  • The trust is a grantor trust for Federal income tax purposes and Ms. Smith is the sole funding source;
  • Ms. Smith would be taxed on all income of the trust and would be taxed on the sale of trust assets;
  • Ms. Smith is the trustee with sole investment discretion;
  • The entire amount of Ms. Smith’s contribution plus a rate of return would be paid to the grantor prior to any other payments;
  • The Trust was established by Ms. Smith for estate planning purposes; and
  • Creditors of Ms. Smith would be able to reach her interest in the Trust.

Simple, right?

Questions? Let me know.

 

SEC SUBCOMMITTEE REPORTS ON ACCREDITED INVESTOR DEFINITION

The Dodd-Frank Act instructs the SEC to evaluate the definition of “accredited investor” and, if it sees fit, to modify the definition “as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.”

As regular readers of this blog know, I’ve been optimistic that the SEC would not take this opportunity to kill Title II Crowdfunding and every other kind of Rule 506(c) private placement (which includes most angel investing as well) by creating an onerous new definition. The report issued recently by a SEC subcommittee, while surprising in some respects, doesn’t dent my optimism.

The subcommittee report makes two important, though obvious, points:

  • The Committee does not believe that the current definition as it pertains to natural persons effectively serves this function in all instances.
  • The current definition’s financial thresholds serve as an imperfect proxy for sophistication, access to information, and ability to withstand losses.

The existing definition is imperfect, yes. The question is, what to do about it?

Although the report does not provide a clear answer to that question, the good news, from my perspective, is that the report does not suggest merely indexing the current thresholds ($200,000 of income, $1 million of net worth) to inflation, which would disqualify most accredited investors and send the private placement market into a tailspin. Instead, the report seeks a standard that will address both financial sophistication and the ability to withstand loss.

The report suggests two specific measures of financial sophistication: the series 7 securities license and the Chartered Financial Analyst designation. Following the lead of the United Kingdom, the report also suggests that those with proven investment experience – for example, a member of an angel investing group – might qualify. Finally, the report suggests, as others have before, that the SEC could develop an examination for the purpose of qualifying investors.

Declining a suggestion from several quarters, the report does not include lawyers or accountants as investors who should be deemed to have financial sophistication.

The reports veers a little off track, in my opinion, when it speculates that, in conjunction with changing the definition of accredited investor, the SEC could limit the amount invested by each investor – following the 10% limit of Regulation A+, for example. That kind of limitation would be new to Rule 506 offerings.

In my Model State Crowdfunding law, I use a definition of accredited investors that includes lawyers, accountants, and anyone with the license from FINRA, as long as the lawyer, accountant, or license-holder has income of at least $75,000. Recognizing the imperfection of any definition, I think that strikes about the right balance. Bolt on an SEC-administered examination option and we’re right there with the subcommittee report.

All in all, it’s good to see the SEC, once again, thinking through the issues carefully. We can see the light at the end of the tunnel.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

UPDATE ON ACCREDITED INVESTOR DEFINITION

I wrote to my close friend Mary Jo White, the Chair of the SEC, urging that the SEC expand, rather than restrict, the definition of accredited investor. My letter is here.

SEC letter_Roderick

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

 

 

 

 

A CONSTRUCTIVE APPROACH TO ACCREDITED INVESTOR DEFINITION

crowdfunding_investorSection 413(b) of Title IV of the Dodd-Frank Act allows the SEC to evaluate the current definition of “accredited investor,” which has been in place since 1982, and to revisit the issue at four year intervals. As the SEC deliberates, alarm bells are sounding in the industry, warning that a new definition could destroy not only the nascent Crowdfunding industry but the entire ecosystem around private capital formation.

Though well-intended, these warnings are misguided, in my opinion.

If the SEC indexed the existing definition to the CPI over the last 32 years, leading to an income threshold of about $500,000 and a net worth threshold of about $2.5 million, the effect would indeed be devastating, with only star athletes and Google employees allowed to invest. However, I see no reason to believe the SEC has anything like that in mind, for several reasons:

  • The SEC could have changed the definition on its own initiative at any time over the last 32 years but hasn’t.
  • Not only has the SEC not changed the definition, it has never expressed any particular concern with Rule 506, where most private placements take place.
  • Most important, the Dodd-Frank Act instructs the SEC to modify the definition “as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.” In my own extensive but necessarily anecdotal experience, I have seen no evidence that the current income or net worth requirements fail to protect investors or, for that matter, that they are particularly relevant to protecting invesors. In the absence of widespread problems, there is simply no reason to make the definition more stringent than it is today and, given the Congressional mandate to keep one eye on the economy – that is, on the economic benefits of making capital available – there are probably stronger reasons to relax the current definition.

According to the Chairman of the SEC, Mary Jo White, the SEC is considering a more nuanced definition of accredited investor, one that takes into account not just income and net worth but also financial sophistication. That sounds right to me.

For now, the best way to help the SEC adopt a sensible definition of accredited investor is to provide real data. If you have reliable information about the incidence of fraud in private placements, for example, or about the correlation (or lack thereof) between financial sophistication and annual income, the SEC would love to see it. Feel free to send it to me and I will forward it.

In the meantime, don’t worry. . . .too much.

Questions? Contact Mark Roderick