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On CrowdFunding and other Capital Formation Initiatives for Emerging Growth Companies

The following analysis of Crowdfunding legislation is by Bill Kilgallen, Counsel & Frank Marco, Partner at Wiggin & Dana LLP's Emerging Companies Practice Group


Late last year, a number of initiatives were introduced in the Congress that have the potential to stimulate investments in emerging growth companies by both reducing restrictions on the manner in which those companies may seek funding and by easing regulatory burdens imposed on these companies both during and following the fund raising process. Below is a summary of these initiatives, which include:

  1. A major change in the federal securities laws to allow so-called "crowdfunding," thereby facilitating the raising of capital from investors, regardless of whether they are "accredited."

  2. Public advertising of securities offerings, eliminating many of the proscriptions on how securities had to be offered in "private placements" and opening means such as the Internet for offerings.

  3. An increase in the number of stockholders that a company may have before being required to register under federal securities laws.

  4. An increase in the limit for "Regulation A" public offerings.

  5. Creation of a transitional "on-ramp" for emerging growth companies that would simplify many of the requirements to which public companies are subject.

Even if some or all of the pending legislation described below becomes law, the bills will likely be revised before being finalized and, after enactment, the SEC will likely adopt rules that implement and clarify many of the provisions described below.

Crowdfunding The Entrepreneur Access to Capital Act, which passed the House of Representatives by a margin of 413-11, would make a major change by creating a "crowdfunding" private placement exemption. This bill would allow investments by an investor, regardless of whether the investor qualifies as an "accredited investor," in any 12-month period up to the lesser of $10,000 or 10 percent of the investor's annual income. Companies would be permitted to raise up to $1 million per year without registering with the Securities and Exchange Commission or state regulators, or $2 million per year if the company provides potential investors with audited financial statements. The SEC would be required to adjust annually the $1 million and $2 million amounts for inflation. Purchasers of securities being sold in reliance upon this exemption would be prohibited from transferring the securities within one year of purchase unless the securities are sold to the issuer or to an "accredited investor."

Companies making an offering of securities in reliance on this new exemption would be required to satisfy several other requirements, including, among other things, (1) warning investors as to speculative nature of the investment, (2) requiring investors to acknowledge that they understand the risks of the investment, (3) informing investors of the one year transfer restriction described above, (4) outsourcing cash-management functions to a "qualified" third party custodian such as a bank or broker-dealer, (5) notifying investors of the target offering amount and ensuring that the third party custodian withholds invested funds until at least 60 percent of the target offering amount is raised and (6) making available on its website a means by which the company and the investors may communicate with one another.

The bill expressly contemplates that companies may use intermediaries to facilitate an offering in reliance on the new exemption and provides that those intermediaries will not be required to register as a broker solely by reason of participating as an intermediary in the offering. Intermediaries would need to satisfy requirements similar to those listed in the previous paragraph and, in addition, carry out a background check on the principals of the company.

Purchasers of securities sold in reliance upon this exemption would not be counted in determining whether that company has exceeded the number of shareholders of record that would require registration with the SEC.

The SEC would be required to adopt rules that would disqualify companies from making an offering in reliance on this exemption, as well as intermediaries from acting as such, based upon their disciplinary history and the disciplinary history of their officers, directors and other related persons.

Senator Brown (MA) introduced a similar bill in the Senate, The Democratizing Access to Capital Act, that would cap company issuances during any 12-month period at $1 million in all cases, require companies to use an intermediary and limit investments by each investor to $1,000. This bill would require the intermediary to meet the requirements described above as well additional requirements that include, among other things, being open and accessible to the public, prohibiting its employees from having a financial interest in the companies posting offerings through the intermediary and making available a process for making and resolving complaints. This bill would also add an additional preemption on state laws that would prevent states from requiring companies to pay filing fees in connection with sales of securities in reliance on the exemption unless the purchasers of a majority of the securities are resident within that state.

Some, including State securities commissioners and members of the SEC staff, have expressed concern that allowing crowdfunding would facilitate fraud. The investment caps and other requirements described above, and further SEC rules, will aim to mitigate that risk.

Public Advertising The Access to Capital for Job Creators Act passed the House by a margin of 413-11. This bill would allow the use of general advertisements (so-called "general solicitations") to solicit investors for non-publicly traded securities without having to register with the SEC or state regulators as long as all purchasers of the securities are "accredited investors." The bill requires companies to take reasonable steps to ensure that purchasers are accredited investors using methods to be determined by the SEC. By eliminating the requirement that there not be a general solicitation, the Internet and other means for soliciting investors would be opened.

Increase in Shareholder and Asset Size Limits Currently, registration with the SEC is required for companies with assets in excess of $1 million and more than 500 shareholders. This requirement has posed problems for certain widely held emerging growth companies.

Senators Toomey (PA) and Carper (DE) have introduced a bill, The Private Company Flexibility and Growth Act, that would increase the registration triggers described above for all privately held companies. This bill also provides that persons who receive securities pursuant to a company employee compensation plan would not be counted in determining whether that company has exceeded the shareholder trigger. This bill has been introduced in the House by Rep. Schweikert (AZ) with two changes. The first is that this bill would raise the shareholder trigger to 1,000 rather than 2,000. The second is that "accredited investors" would also not be counted in determining whether a company has exceeded the shareholder trigger.

Another bill (H.R. 1965) that would raise the threshold for registration with the SEC for financial institutions passed the House by a vote of 420-2. The bill would raise the $1 million asset trigger to $10 million and the 500 shareholder trigger to 2,000. The bill also would allow financial institutions to deregister with the SEC if they have less than 1,200 shareholders. Currently, deregistration is permitted only if a company has less than 300 shareholders.

Increase in Small Offering Limit The Small Company Capital Formation Act of 2011 passed the House by a margin of 421-1. Section 3(b) of the Securities Act authorizes the SEC to exempt from registration securities offerings that do not exceed $5 million. Pursuant to this authority, the SEC created Regulation A which provides an exemption from registration for public offerings not exceeding $5 million in any 12-month period. This bill would amend Regulation A by increasing the limit of all securities sold within the prior 12-month period in reliance on Regulation A from $5 million to $50 million. Companies that choose to make an offering in reliance on Regulation A must still file an offering statement with the SEC for review. The principal advantages of Regulation A offerings, as opposed to registered offerings, are that required disclosures are simplified and that the completion of an offering under Regulation A does not result in the issuer being required to file periodic reports under the Securities Exchange Act unless it would otherwise be required to file those reports because of the amount of its assets and the number of its shareholders. Also, like securities that are registered, securities issued in a Regulation A offering may be freely traded after being issued. The bill, however, would permit the SEC to require the filing of periodic reports under the Securities Exchange Act if it determines necessary in the public interest. The SEC would also be required to adopt rules that would disqualify companies from making an offering under Regulation A based upon the disciplinary history of the company and its officers, directors and other related persons. Finally, the SEC would be required to review the $50 million cap every two years and increase it as the SEC deems appropriate.

Transitional "On-Ramp" for Emerging Growth Companies The Reopening American Capital Markets to Emerging Growth Companies Act has been introduced in the Senate. This bill creates a new category of company referred to as an "emerging growth company." An emerging growth company is an issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year, has been public for less than five years and does not qualify as a "large accelerated filer," which, generally, is a company that has a public float of $700 million or more. The bill would provide emerging growth companies with the following benefits:

  1. An exemption from the requirement of having its auditors attest to the company's internal control. The chief executive and chief financial officers would still be required to certify that internal controls and procedures are adequate.

  2. An exemption from mandatory audit firm rotation requirements.

  3. Permission to provide only two years of audited financial statements when going public rather than three.

  4. Ability to provide the more streamlined discussion of executive compensation that is currently permitted from companies with a public float of less than $75 million.

  5. An exemption from the "say-on-pay" and "say-on-golden parachute" requirements of the Securities Exchange Act.

  6. An exemption from the requirement to provide disclosure in proxy materials regarding the relationship between executive compensation and the company's financial performance and regarding the ratio of chief executive officer compensation to the compensation of all other employees.

  7. Permission to engage in oral or written communications with potential investors that are "qualified institutional buyers" or institutions that are "accredited investors" to determine whether investors might have an interest in a contemplated securities offering, either prior to or following the date of filing of a registration statement with respect to that offering. A prospectus would still be required to be made available to investors prior to any sale of securities.

  8. Ability, prior to an initial public offering, to confidentially submit to the SEC a draft registration statement for confidential nonpublic review, provided that the initial confidential submission and all amendments thereto are publicly filed with the SEC not later than 21 days before the date on which the company conducts a road show for the public offering.

In addition, the bill would permit the publication by a broker or dealer of research reports about an emerging growth company proposing to make a public offering of its common equity prior to the filing by that company of a registration statement.

The extent to which the above pending legislation will become law is unknown, and amendments made by Congress before enactment and clarification through rule making by the SEC afterward may result in significant changes to the provisions described above. We will continue to monitor the progress of these initiatives. Please do not hesitate to contact us with any questions regarding them.

Bill Kilgallen, Counsel & Frank Marco, Partner at Wiggin & Dana LLP's Emerging Companies Practice Group

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