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January 14, 2013

Ohio Securities Division Offers SEC Detailed Comments on Implementing Crowdfunding Regulations

By Jim Hamilton, J.D., LL.M

In a detailed comment letter to the SEC, the Ohio Securities Division (OSD) set forth a number of recommendations for the SEC to consider as it drafts regulations implementing the crowdfunding provisions (Title III) of the Jumpstart Our Business Startups (JOBS) Act. Broadly, the OSD urged the Commission not to rely on the "wisdom of the crowd" theory because it is effective at exposing only the simplest form of fraud and not those forms that pose the greatest risk to investors. Claiming that the crowd is immune from fraud because of its internet research savvy takes a far too simplistic view of the manners by which fraudulent and abusive practices occur in the securities context, said the OSD in a letter signed by Ohio Securities Commissioner Andrea Seidt.

Authored by Sen. Jeff Merkley (D-OR), Title III of the JOBS Act adds a new crowdfunding exemption from the Securities Act, allowing companies to accept and pool donations of up to $1 million over the Internet. Generally, the term "crowdfunding" describes a new form of raising capital whereby groups of people pool money, typically small individual contributions, to support an entrepreneurial effort.

Title III imposes disclosure obligations on both crowdfunding intermediaries and crowdfunding issuers. For their part, issuers are required to provide to investors a number of typical offering disclosures including, among others, the business's name and legal status, the names of directors and officers, a description of the business of the issuer, and a report of financial condition. The OSD encouraged the Commission to mandate a single-offering-circular standard, incorporating disclosures prepared by both the intermediary and the issuer.

One disclosure document is simpler, the OSD reasoned, and may encourage investors to more fully review and consider the document. Moreover, a single offering document would be consistent with other types of offerings where two parties are responsible for preparing disclosure; for example, in an underwritten public offering, underwriters and issuers generally work together to craft a single disclosure document.

Each offering should clearly disclose that the issuer is seeking an exemption from both state and federal securities registration and, therefore, that no regulatory agency has reviewed the offering. The offering should clearly state that an investor must make his or her own investment decision. The offering should also clearly state that regulatory agencies do not recommend or endorse the investment for any offeree and that any representation to the contrary is a violation of state and federal securities laws. This disclosure is similar to that required by Rule 253(d) under the Securities Act.

The OSD also asked the SEC to consider restricting, if not prohibiting, the use of any forecasts or projections of the issuer's future financial performance, whether by the issuer or the intermediary, or any officer, director, employee or agent of either. In the OSD's experience, forecasts and projections are often rife with fraud, bear no reasonable basis in reality, and fail to identify the assumptions made and the sources of information relied upon.

The OSD explained that it is widely accepted that Title III was intended to be used by very young issuers and true start-ups. An issuer with little or no operating history has no historical basis on which to reasonably predict future operating results. The factual or historical basis on which to reasonably predict future financial returns becomes even more tenuous where a business is led by inexperienced management, employs new or unproven processes, offers new or untested products or services, or enters new markets with unknown levels of demand and competition. In the OSD's view, it is difficult to see how any young entity or start-up can, in good faith and with a sound factual or historical basis, predict its future financial performance.

Title III requires that each crowdfunding issuer provide a description of the business of the issuer and the anticipated business plan of the issuer. Traditionally, a business plan was a planning document prepared by management for internal use only and not intended for dissemination outside the company. Among start-up companies, however, the phrase "business plan" has taken on the meaning of a marketing document used to pitch to investors, not to disclose the materials terms and risks of a securities offering. These are neither tailored for prospective investors nor drafted with the securities laws in mind. Thus, the OSD said, the Commission should clarify the meaning of the term "business plan," as used in Title III so that issuers do not inadvertently provide to investors a document that opens the issuer to potential civil and criminal liability.

Title III conditions the exemption on at-least annual filings with the SEC of reports regarding the results of operations and financial statements. In the OSD's view, the most appropriate interpretation of this provision is to require the annual filing of updated financial statements for the fiscal year end in the form as referenced in Securities Act Section 4A(b)(l) that were provided to investors. Smaller issuers should not be required to obtain an audit, according to the OSD, but the SEC should require audited financial statements for larger offerings over $500,000 and for smaller issuers, if they obtain an audit for other purposes during the course of their business.

Under Title III, the crowdfunding exemption is only available for offerings transacted through a broker or funding portal. Because crowdfunding offerings are exempt from registration with and review by the Commission, as well as preempted from review by state securities regulators, Congress placed upon intermediaries the responsibility of serving as the primary gatekeepers to the crowdfunding marketplace. As such, the intermediaries must play a critical role in ensuring the integrity of the market and maintaining meaningful investor protections. It is crucial that the SEC's rulemaking recognizes the significance of this role and requires crowdfunding intermediaries to uphold their obligation, the OSD stated.

Unlike broker-dealers, the activities of funding portals are significantly restricted under Title III of the JOBS Act. Funding portals may not offer investment advice or make recommendations. The OSD noted that strong guidance from the Commission may be necessary to inform this new breed of industry professional about the broad scope of these activities. Such guidance may prevent them from creeping into practices prohibited by the statute down the road and would also inform the public of the extent of the lawful capabilities of funding portal, according to the OSD.

The OSD noted that crowdfunding intermediaries will have extensive due diligence obligations. As an initial matter, new Section 4A(a)(5) of the Securities Act provides, in part, that crowdfunding intermediaries are to take such measures to reduce the risk of fraud with respect to such transactions as established by the Commission. According to the OSD, this section establishes a due diligence requirement by noting that the measures to reduce the risk of fraud include conducting a criminal and securities enforcement background check of officers, directors, and 20-percent shareholders of an issuer.

Moreover, given the balance of power in these transactions, the OSD explained, crowdfunding intermediaries may be the only securities professionals with the bargaining power necessary to require access to the issuer's information, given that the issuers cannot conduct a crowdfunding offering without the intermediary. Investors will view crowdfunding intermediaries not merely as passive "bulletin boards," noted the OSD, but as active gatekeepers that make representations regarding licensing and their affiliation with a self­regulatory agency and that offer various securities with different pricing.

TopStory: JOBSAct

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