What is Crowdfunding?
Crowdfunding is a marketing tool that businesses use to obtain capital from a large number of individuals, typically over the Internet.
Are There Different Kinds of Crowdfunding?
There are two basic kinds of crowdfunding campaigns.
- "Traditional" crowdfunding (i.e., Kickstarter, Indiegogo, GoFundMe, individual company sponsored campaigns, etc.) involves a business or person seeking donations from the "crowd" or trying to pre-sell a product or service to the crowd. Use of the Internet to obtain money from the crowd through traditional crowdfunding gained significant traction in the in the 1990s and early 2000's.
- "Equity" or "investment" crowdfunding is the newer type of crowdfunding that involves a business accepting money in exchange for an ownership interest in the business (i.e., equity) or the promise of a financial return (through a loan or other investment vehicle).
How is Crowdfunding Regulated?
Traditional crowdfunding involves little regulation and oversight, but is subject to consumer protections and consumer fraud prevention. It can also give rise to unique tax issues, depending on the circumstances surrounding the campaign.
Investment crowdfunding, on the other hand, is HIGHLY regulated because it involves the offer and sale of "securities."
What Is a "Security"?
Section 2(a)(1) of the federal Securities Act of 1933, as amended, and applicable state "blue sky" laws (such as Section 78A-2(11) of the North Carolina Securities Act), each provide a detailed list of items that are considered to be "securities." These lists include things easily recognized as "securities" like stock, shares, debt, etc. But these statutory definitions have also been expanded upon by the courts (through landmark cases such as SEC v. W. J. Howey Co. et al., 328 U.S. 293 (1946) and Reves v. Ernst & Young, 110 S. Ct. 945 (1990)) in such a way that it becomes less about what the item being sold to the public is called and more about what that instrument does or promises to do.
So, irrespective of how you label it, if a campaign promises a financial return without the investor playing an active role in the management and daily operations of the underlying business enterprise (i.e., the investor is "passive"), then it's pretty likely that your crowdfunding campaign involves a securities offering and will be regulated accordingly.
What Securities Laws Apply?
Broadly speaking, an offering of securities will be regulated by the jurisdiction where the offering has originated as well as where it is being directed. So, offerings being conducted from the United States by United States businesses will typically be regulated by the federal government (usually the Securities Exchange Commission ("SEC") and/or the Financial Industry Regulatory Authority ("FINRA")), primarily through the Securities Act of 1933, as amended, and the federal Securities Exchange Act of 1934, as amended, as well as any state that has jurisdiction over the offering.
Thus, offerings can be regulated not only by federal law, but also by the "blue sky" laws and securities administrators in the states where the business is located and in each state where prospective investors are located. So, a business located in Charlotte, North Carolina that makes offers to investors who reside only in South Carolina would likely need to comply with federal law and with both the blue sky laws of North Carolina (because the business is located there) and South Carolina (because the offer is directed to residents of that state).
Businesses conducting crowdfunding offerings through the Internet need to take particular care to comply with the laws of each jurisdiction where an offer is made or directed (this could even include foreign jurisdictions, depending on the way the offer is structured).
What Has Changed to Allow Investment Crowdfunding Campaigns?
Historically, federal securities laws prohibited the use of general advertising in the offer and sale of unregistered securities. The design of these laws also favored participation in unregistered offerings by only wealthy, sophisticated "accredited investors." The term "accredited investor" is defined in Rule 501 of Regulation D, promulgated by the SEC under the Securities Act of 1933, as amended. Generally speaking, accredited investors include entities with a significant amount of assets and individuals with historically high salaries or high net-worth.
These restrictions began to shift with the enactment of the federal JOBS Act of 2012, which created a variety of exemptions permitting companies to raise capital through the use of general advertisement and public solicitation, in each case subject to a number of rules and regulations that impact (among other things):
- The amount of money that can be raised through an offering;
- The nature of investor that can participate and the amount of money an investor can invest in the offering;
- The types of disclosures that must be provided to investors;
- The manner by which the offering must be conducted;
- The extent of on-going reporting requirements imposed on businesses using the exemption; and,
- The manner by which a business can advertise and solicit investors.
What Could Happen if You Fail to Comply With Applicable Securities Laws?
The typical remedy for conducting an unregistered securities offering or engaging the services of an unregistered broker-dealer is "rescission" of the transaction. Rescission gives investors the right to undo their purchase (i.e., get their money back, plus interest). If the offending business cannot re-pay investors the money they invested, plus interest, the officers, directors, and controlling shareholders of the business, and other people related to the business or the transaction, may have personal liability to investors.
Failure to comply with securities laws can also result in criminal charges, regulatory enforcement actions, and fines. In addition, it can result in the business and its insiders being characterized as "bad actors" and thus prohibited from utilizing certain exemptions or engaging in the offer and sale of securities for several years to come.
Are There any Big Picture Guidelines to Remember?
Although the regulations vary by jurisdiction, generally, you should keep in mind the following guidelines for investment crowdfunding campaigns conducted in the United States:
- Register the securities you are offering or find an exemption from registration requirements. There are several common exemptions that typically apply to investment crowdfunding campaigns (discussed below).
- Understand the scope of anti-fraud liability. Businesses selling securities (whether under an exemption or through a registered offering) may be held liable for "misleading statements" and "omissions" made in connection with the offer and sale of a security. Businesses (and their sponsors and owners) can be held responsible for such activities, irrespective of whether they involve deliberate or unintentional misrepresentation or omission.
- Do not engage unregistered broker-dealers to sell securities. Absent an exemption, persons who are engaged in the business of effecting transactions in securities for the account of others must register with the SEC and FINRA and are subject to strict regulatory requirements. Businesses that engage unregistered broker-dealers face liability for such activities. Certain exemptions require the use of specific types of intermediaries to conduct crowdfunding campaigns.
- Seek the advice of a qualified securities attorney before commencing any activities involving the offer and sale of securities (or anything that could be deemed as such). The rules are different depending on what exemption you elect to follow. It's important to plan in advance to ensure that you can comply with the exemption that best suits your goals.
What Are the Exemptions You Can Use to Conduct an Investment Crowdfunding Campaign?
The most common exemptions used by businesses to raise capital from the crowd are as follows:
- Accredited Investor Crowdfunding (aka "Rule 506(c)" Offerings). This is the most flexible (i.e. the least regulated) and most common form of investment crowdfunding. There is no limit on the amount of money a business can raise, nor are there any caps imposed on the amount each person can invest. However, the business may only sell securities to verified "accredited investors."
- Regulation A (aka "Regulation A+" or the "Mini-IPO"). This exemption is similar to a registered public offering because businesses must file and pre-clear certain disclosures (called an "offering statement") with the SEC and (for Tier 1 offerings) state regulators. Businesses pursing an offering under Tier 1 of Regulation A can only raise up to $20 million in any rolling 12 month period. This limit increases to $50 million under Tier 2 of Regulation A.
Anyone can invest in offerings conducted under Regulation A, however, caps are imposed on non-accredited investors participating in Tier 2 offerings. Issuers often engage a registered broker-dealer (or an investment bank) to assist in sales efforts and may elect to list the securities issued in the offering for trading on one or more secondary markets.
- Regulation Crowdfunding (aka Title III of the JOBS Act, Reg CF or Section 4(a)(6) Offerings). This is the exemption that is most commonly referred to as "crowdfunding." A business can raise up to $1.07 million in any rolling 12 month period.
Anyone can invest, however all investors (including accredited investors) are subject to investment caps—ranging from just over $2,000 to just over $100,000.
Businesses MUST conduct these offerings through a single on-line platform that is operated by either a registered funding portal or a registered broker-dealer. There are strict limitations placed on the manner by which the offering may be advertised.
- Intrastate Crowdfunding (Varies by Jurisdiction). Many states (including North Carolina) have adopted statutes or rules creating exemptions for "intrastate" crowdfunding offerings. In many cases, these exemptions closely mirror those of Regulation Crowdfunding, with the exception that the exemptions are only available to those businesses doing business in the state offering securities that are only sold to investors who are residents of that same state.
© 2017 Ward and Smith, P.A. For further information regarding the issues described above, please contact Benji Taylor Jones.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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