SEC ANNOUNCES TEMPORARY RULES TO ENHANCE AVAILABILITY OF REGULATION CROWDFUNDING

  • United States
  • 05/22/2020
  • Morgan Lewis

The US Securities and Exchange Commission (SEC) on May 4 announced temporary relief for companies affected by the coronavirus (COVID-19) pandemic seeking to raise capital in the public market pursuant to Regulation Crowdfunding (Regulation CF). In general, Regulation CF allows an issuer to raise up to $1.07 million in a 12-month period by selling securities to the public through an SEC-registered intermediary, such as an online funding portal.

The temporary rules will apply to Regulation CF offerings initiated between May 4, 2020 and August 31, 2020 by companies (1) otherwise eligible to use Regulation CF; (2) that have been organized and had operations for at least six months; and (3) that have not previously violated the SEC’s crowdfunding rules. The temporary relief is expected to make it easier and quicker for small businesses to complete a Regulation CF offering by relaxing certain timing and financial statement requirements, thereby reducing the costs and delays associated with the original rules.

Relief Relating to Financial Statements

The temporary rules allow an issuer to omit financial information in its initial offering statement on Form C filed with the SEC, and commence its offering before that information is provided to investors. This will allow issuers to gauge the interest of potential investors through the funding portal before committing to the expense and effort of preparing financial statements. However, the omitted financial statements are required to be included in an amendment to Form C, and must be provided to investors before any investment commitments can be accepted.

To take advantage of this relief, the issuer must prominently disclose that (1) the offering is being conducted on an expedited basis due to circumstances relating to COVID-19 and pursuant to the SEC’s temporary regulatory COVID-19 relief; (2) the financial information that has been omitted is not available and will be provided by an amendment to the Form C; (3) investors should review the complete set of offering materials before deciding whether to invest; and (4) no investment commitments will be accepted before the omitted financial information has been provided.

In addition, absent the relief provided by the temporary rules, if the issuer is offering between $107,000 and $535,000 pursuant to Regulation CF over a 12-month period, its financial statements must be reviewed by an independent public accountant, which is often a significant expense for the issuer. The temporary relief eliminates this requirement if the issuer is offering between $107,000 and $250,000 over a 12-month period. Such issuer may provide financial statements and certain information from its tax returns, both certified by the principal executive officer, instead of financial statements reviewed by its auditors. Issuers relying on this relief must also include a prominent legend disclosing that the financial statements were certified by the principal executive officer instead of reviewed by an independent public accountant.

Relief Relating to Timing and Cancellation Requirements
Regulation CF generally requires the Form C to be made publicly available on an intermediary’s platform for a minimum of 21 days before the company can close a sale. The SEC recognized that this 21-day waiting period significantly reduces the utility of Regulation CF for small businesses that are facing urgent needs for capital due to the COVID-19 crisis. Accordingly, the temporary rules suspend the 21-day waiting period and allow the intermediary to accept investment commitments as soon as the Form C is made available, provided that the company has provided the financial statements required under the rules.

Similarly, Regulation CF usually provides investors with an unconditional right to cancel their investment commitments for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. Under the temporary rules, investors may only cancel their investment commitments in the first 48 hours after making the commitments (unless there is a material change to the offering), and eligible issuers can close their offerings 48 hours after they have received investment commitments (that have not been cancelled) for at least their target offering amount.

To take advantage of the expedited closing and altered cancellation rules, (1) the issuer must disclose that the offering is being conducted on an expedited basis due to circumstances relating to COVID-19 and pursuant to the SEC’s temporary regulatory COVID-19 relief; (2) the issuer must prominently disclose the changes to the processes to complete the transaction and cancel investment commitments; (3) the intermediary must provide notice that the target offering amount has been met; and (4) the issuer must continue to meet or exceed the target offering amount at closing.

Practical Considerations

Historically, companies raising money through public crowdsourcing campaigns pursuant to Regulation CF have tended to be startups that were organized fairly recently, have relatively small amounts of assets and revenue, operate out of technological and financial hubs, and have yet to attain profitability or have done so only very recently.

Often these companies are not able to raise sufficient capital through a traditional private placement under Regulation D, either because they are not able to generate enough interest with accredited investors, or because the company does not wish to incur the additional expenses to verify accredited investor status when conducting a general solicitation online pursuant to Rule 506©. Accordingly, Regulation CF represents a comparatively low-cost, albeit somewhat uncertain, method for startups to sell securities broadly to the public, including nonaccredited investors.

Companies seeking to conduct Regulation CF offerings have to engage intermediaries. Intermediaries can be either broker-dealers or funding portals, but both have to register with the Financial Industry Regulatory Authority (FINRA) and the SEC. FINRA maintains a list of registered funding portals and a (much, much longer) list of registered broker-dealers.

A widely voiced criticism of Regulation CF is the small funding threshold (i.e., only up to $1.07 million over a 12-month period), which is often insufficient for many startups to raise enough capital to jumpstart their business plans. In response to this criticism, on March 4, 2020, the SEC announced that it was considering changes to its crowdfunding rules that would raise the maximum amount that can be raised in a crowdfunding round from $1.07 million to $5 million, thereby removing investment limits on accredited investors and making it easier for nonaccredited investors to calculate the limits on their investments. However, it is uncertain when a final rule will be released by the SEC, or whether it will have these proposed provisions.

The SEC has produced a useful chart laying out the temporary rules adopted May 4, as compared to the regular application of Regulation CF.

We anticipate that as a result of these temporary rules, more companies will pursue crowdfunding as a method to raise capital. The relief provided by these temporary rules should allow companies having difficulty arranging for public accountants to review their financial statements due to COVID-19 to move to market sooner, and all companies pursuing crowdfunding to access their crowd-sourced funds much more quickly.