Is the Game Worth the Candle? The Burdens of the Proposed Crowdfunding Exemption

In April 2012, Congress passed the Jumpstart Our Business Startups Act (the “JOBS Act”) with the intent (as the Act’s name suggests) to provide small businesses with increased access to sources of capital and bolster job and overall economic growth. Of the Act’s several provisions, Section 201(a) of the JOBS Act directed the Securities and Exchange Commission (the “SEC”) to lift the long-standing ban on general solicitation and advertising in offerings conducted pursuant to Rule 506 of Regulation D. In accordance with the foregoing mandate, earlier this year the SEC adopted new Rule 506(c) allowing companies to raise capital from accredited investors through general solicitation. Companies have already begun to utilize the new rule, which went into effect on September 23, 2013, to raise capital. For a more detailed analysis of new Rule 506(c) and related amendments, please see our legal insight dated July 12, 2013.

With somewhat less fanfare, Congress, pursuant to Section 301 of the JOBS Act, added new Section 4(a)(6) to the Securities Act of 1933, as amended (the “Securities Act”), which provides a registration exemption for small companies and “startups” seeking to offer and sale securities through the Internet via “crowdfunding.” This article explores crowdfunding and the SEC’s proposed rules, and provides comparisons of the crowdfunding exemption with other registration exemptions available to companies seeking to raise capital through the sale of their securities. In its proposing release, the SEC noted that the crowdfunding rules were “designed to help provide startups and small businesses with capital by making relatively low offerings of securities less costly.” As will be discussed and analyzed in this article, however, the crowdfunding exemption, as proposed and statutorily mandated, poses various obstacles and regulatory hurdles that may undermine the relative utility of the exemption, especially when compared to other exemptions available to small companies.

Crowdfunding

“Crowdfunding” refers to a method of raising money, via the Internet, by seeking small contributions from large numbers of people. The broad expansion of access to the Internet has allowed for the fluid and fast exchange of information and ideas. Companies and individuals have sought to utilize this electronic medium to broadly disseminate their plans and projects with the goal of attracting a broad range of people who share similar interests but may not otherwise have been aware of the company or initiative and may not be wealthy and sophisticated investors that are typically targeted in private securities offerings.

Crowdfunding, however, does not necessarily entail the offer and sale of securities. For instance, non-equity crowdfunding has arisen as a popular way to fund various forms of artistic projects, including films, computer games and music. Internet-based platforms, such as Kickstarter, provide information regarding various projects seeking donations and contributions and provide an opportunity for individuals to donate or contribute money to projects of their choice. In exchange, the contributors do not receive any ownership interest in the project; instead, they may receive rewards or gifts, such as a free copy of the finished work or tickets to view the film.

Until recently, restrictions on general solicitation and investor sophistication requirements had made private placement exemptions generally unavailable for securities-based crowdfunding transactions, and registration is too costly in light of the size and funding goals of companies seeking to utilize crowdfunding. In this gap, supporters lobbied for a registration exemption and the implementation of a regulatory regime that would provide certainty for companies (and the related Internet-based platforms) seeking to engage in securities-based crowdfunding while providing such companies with greater sources of capital at marginal cost. Yet, investor advocates voiced legitimate concerns regarding the potential for fraud and the lack of transparency and accountability, and called for the imposition of various mechanisms to protect investors. As will be discussed further below, the crowdfunding exemption enacted by Congress, and as proposed by the SEC, offers small companies certain benefits, but with the intent to protect investors, imposes disclosure requirements that companies may discover are too costly and burdensome.

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