In July 2013 the SEC implemented Title II of the JOBS Act of 2012 through Rule 506(c) of Regulation D, which for the first time in over 80 years allowed companies to engage in general solicitation of investors in an unregistered private placement so long as all of the investors were “accredited investors.” The only catch – the issuer must implement reasonable procedures to verify the accredited status of investors. Notably, this allowed companies to expose investment opportunities to a broad audience via the Internet and other public media, democratizing investing in some measure and increasing the ability of companies to raise money.
On the same day that new Rule 506(c) was implemented the SEC issued a related set of proposed rules – yet to be adopted – intended to increase the amount of information which issuers would be required to provide under Regulation D through the electronic filing of Form D on its publicly accessible EDGAR system. One aspect of the proposed rule, however, generated a storm of controversy and public comment – a requirement that the issuer file Form D no later than 15 days before the commencement of an offering in reliance upon Regulation D – coupled with a further requirement which would in effect bar an issuer who failed to comply with any of the Form D filing requirements from using Regulation D for future offerings for a period of at least one year.
This so-called one year bar was intended as an incentive for issuers to file Form D, the SEC noting that a large number of issuers in the past simply failed to file Form D. A principal proponent of this new proposed penalty and pre-offering filing was the North American Securities Administrators Association (NASAA), the principal industry trade group for state regulators. They advocated that a penalty was needed to ensure compliance with the Regulation D filing requirements, and there was a need for a filing requirement which would provide state regulators with at least 15 days advance notice of an offering – before any investor had parted with its money. Driving this pre-filing proposal was the perceived concern by regulators that the use of public solicitation in private placements through the Internet would open up the floodgates of fraud – hence the need for state regulators to have new tools to police Internet offerings – including advanced notice of an offering.
Apart from concerns expressed by NASAA, the SEC, appropriately noting the absence of reliable data resulting from the large number of companies who simply failed to file a Form D, argued that a “penalty” was necessary as a deterrent to the many companies which simply failed to make the filing at all – hence the proposed one year bar.
At the time the proposed rules were issued many, including myself, questioned both the appropriateness of, and need for a pre-offering filing requirement, as well as the need for any penalty on issuers who failed to timely file Form D. As far as a pre-offering filing, many commentators noted the difficulty in determining exactly when an offering begins, especially for startups engaging in such common activities as pitch days or demo days. And a penalty for missing a filing date would undoubtedly fall disproportionately on the smallest of companies, who would be less likely to even have SEC counsel before an offering begins and would be greatly impacted by being shut out of the private placement market for a year or more as a consequence of their non-compliance.
The one year bar generated an overwhelming number of comment letters to the SEC echoing concern over the undue burden this would create on issuers, particularly early stage ventures. I for one commented that a less draconian tool was already available to the SEC to enforce compliance – a letter from the SEC’s Enforcement Division notifying the issuer of the filing deficiency and allowing the issuer an opportunity to cure or face an enforcement proceeding.
The Realities of the Post-JOBS Act Crowdfinance Marketplace
With the benefit of hindsight it has become apparent to most industry observers that rather than general solicitation opening the floodgates of fraud as companies and unscrupulous promoters preyed on unsuspecting investors, those engaged in shady practices tend to stay in the shade, and out of the sunlight of the Internet – which is visible to both the investing public and government regulators. It seems that the often cited maxim of the noted Supreme Court Justice, Felix Frankfurter, that sunlight is the best disinfectant, has held true in the post-JOBS Act world of very public Internet solicitations.
And as to a perceived need to penalize non-filers or late filers with a one year ban from conducting private placements, anecdotal reports are surfacing of the SEC contacting non-compliant issuers and extracting instant compliance of the Form D filing, albeit belatedly. After all, public raises under Rule 506(c) are visible to the SEC and others. So one would expect that this practice alone ought to be sufficient to ensure compliance with the Form D filing requirements.
The Need for Reliable Crowdfinance Market Data Awaits Final SEC Rulemaking
Ironically, however, as the SEC delays the implementation of rules requiring disclosure of Form D information, it is the nascent crowdfinance industry itself that is suffering. You see, one of the most useful features of the proposed Form D rules is a requirement that would require all issuers engaged in a Regulation D offering to report the total amount raised upon completion of the offering. Presently, the only time that a filing is required is within 15 days after the first sale. No further filing is required unless either there is a material change in the terms of the offering, or the offering is still continuing after one year. What this means, as a practical matter, is that most Form D filings will report little or no information as to how much money is ultimately raised, or even when the offering has been completed. Indeed, many issuers simply file the Form D at the commencement of the offering, reflecting only the amount it intends to raise and the type of security offered.
Thus, information regarding how much money is actually raised by issuers in private placements is largely unavailable. Private companies simply have no reporting obligations whatsoever, other than on Form D, and often this information regarding the success of an offering is a closely guarded secret, especially for a failed offering or one where a company fails to raise the maximum targeted amount.
In this emerging crowdfunding marketplace, data as to money raised by these crowdfunding companies would have enormous value to all industry stakeholders, including investors, securities regulators, legislators and other industry participants. But in the absence of SEC rules requiring issuers to report any information on the amount raised upon completion of an offering, what we are seeing instead is the reporting of anecdotal or incomplete information, which often is inherently unreliable and in some instances could actually materially mislead the crowdfinance market place.
We recently witnessed this phenomenon most visibly earlier this month, with the commencement by CNBC of the CNBC Crowdfinance 50 Index, a newly created “index,” which represents the daily average index of the 50 largest “capital commitments raised” by private U.S. companies listed on Crowdnetic’s data platform – which currently aggregates data from 16 crowdfunding platforms. Many in the financial community have applauded this new Index – and for good reason. Why? In one respect it is some confirmation that equity crowdfinance is a true, developing marketplace, worthy of ongoing investor attention on a major business media outlet such as CNBC. And second, it is some indication of the perceived appetite of industry stakeholders for ongoing marketplace information.
But perhaps the greatest significance of the CNBC Crowdfinance 50 Index lies in highlighting the deficit in equity crowdfinance information which is not yet publicly available – the amount of money actually raised by an issuer upon completion of a crowdfinanced offering.
In the World of Public Crowdfinance Raises, There is Often a Slip Between the Cup and the Lip
You see, the CNBC Index simply measures “commitments” received by an issuer during the course of an ongoing offering – not the amount actually raised. And what exactly is an investor “commitment?” Well, that sorta depends on the particular platform and issuer reporting the indexed information. You see, just as many of those Valentine’s Day “commitments” are often short lived one night stands, so too with many investor “commitments.” More often than not, the term “commitment” in the crowdfinance world is essentially the equivalent of a crowdfunding site user clicking a “like” button – a mere non-binding indication of interest. Or in the parlance of the AngelList platform, the Index simply reflects a “reservation” by an investor.
There are those investors who simply wish to reserve a place in line before the offering is “fully committed” – especially in “hot” deals – and then soon lose interest when they focus on the details of the investment opportunity – or simply fail to focus. And many would be investors simply fail to submit to sometimes daunting accredited investor verification procedures – or investors who “commit” simply fail to qualify as accredited investors.
As a result of providing data which only measures “commitments” there is often a wide disparity between investor dollars shown as “committed,” versus dollars which are ultimately invested in a company. This is particularly likely in Rule 506(c) public raises where accreditation procedures are mandatory, versus a traditional “non-public” private placement where an investor can simply “check the box” and self-certify its accredited status. And this disparity between investor commitments and writing a check is often greater in hot public deals, where an investor can simply reserve a place in line, but has no obligation whatsoever to proceed to funding in the fleeting world of the Internet.
Indeed, if one takes the time to read the fine print at the very end of the list of the 50 companies on the CNBC Index, there is a disclosure reflecting the transitory nature of commitments:
“Note: Capital commitments represent the amount of capital that investors have indicated they would like to invest. Subject to the terms of the raise, investors may withdraw their interest before the closing date. In addition, and also subject to the terms of the raise, commitments might not come to fruition if the issuer does not meet its target by the closing date and the raise does not proceed.”
Undoubtedly, many will fail to read this disclaimer. However, for those who click on a listing for a particular company in the Index, the deal information formatting is nothing short of confusing, as it shows the percentage of the raise “Funded”, which appears to represent the dollar amount “Committed” for the particular deal. Of course, the “commitment” of an investor may in some cases never be backed up with actual investor funds. Hence, the CNBC Index data format presents a real potential for investor confusion.
The result: until the SEC issues final rules requiring issuers to report actual sales for a completed offering, there is simply no way to tell when a private issuer has either completed a crowdfinanced raise or how much is actually raised (as in funded) – unless, of course, the issuer voluntarily elects to selectively disclose this information. In the meantime, investors who rush in to invest in a crowdfinanced transaction with the understanding that the transaction is almost fully “committed,” or even “funded,” may ultimately learn that the issuer barely succeeded in raising the minimum targeted offering amount, falling well short of the amount needed to effectively implement its business plan.
The Moral of the Story
In this new world of public crowdfinance, new procedures and new terminology are fast becoming part of the ecosystem. However, these new procedures and new terminology do not necessarily represent “best practices,” even when touted by mainstream financial media outlets such as CNBC.
As always, do your own due diligence – and read the fine print.
Samuel S. Guzik, a Senior Contributor to Crowdfund Insider, is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice. A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium sized business he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. In 2014, some of his speaking engagements have included leading a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy, a panelist at the MIT Sloan School of Business 2014 Crowdfunding Roundtable, and a panelist at a national bar association event which included private practitioners, investor advocates and officials of NASAA. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation. Recently he was cited by SEC Commissioner Daniel M. Gallagher in a public address for his advocacy on SEC regulatory reform for small business. He is admitted to practice before the SEC and in New York and California. Guzik has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. He also frequent blogger on securities and corporate law issues at The Corporate Securities Lawyer Blog.