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Stalled SEC regulations inhibit crowdfunding

posted Oct 14, 2014, 1:01 AM by J Shaw   [ updated Oct 14, 2014, 1:02 AM ]
In Albuquerque private and public-sector programs are underway to assist entrepreneurs to start new ventures. These “accelerator” programs will succeed only if the new businesses get capital. With equity small-investor crowdfunding stalled in the Securities Exchange Commission’s rule-making process and having significant limitations, the New Mexico startups will probably have to raise capital by private offerings exempt from SEC registration.

The startups will be able to raise capital without dollar limit under the most common existing private offering exemption, SEC Rule 506(b), and a new private offering method adopted by the SEC in 2013 as Rule 506(c).

Before 2013, federal law required that all private offerings be free of public or media solicitation. Under Rule 506(b), the issuer or finder company acting for the issuer had to contact potential purchasers without general solicitation. Rule 506(b) remains unchanged. In essence it permits the issuer to make a private offering to 35 sophisticated investors and an unlimited number of accredited investors.

Accredited investors are officers of the issuer, substantial businesses or trusts and individuals with net worth of over $1 million – not including the principal residence – or joint income of over $300,000 for two years.

Usually, issuers use an offering memorandum that contains typical SEC “worst case” disclosures. Resales of the securities are restricted for a year under most situations.

In September 2013, the SEC added Rule 506(c) that permits general solicitation for exempt securities. Sales can only be to accredited investors. General solicitation means virtually any public communication. The JOBS Act authorized the change.

The new rule requires that the issuer take reasonable steps to verify that purchasers are accredited investors. This rule requirement has been the most burdensome legal requirement of the new rule. The verification requires legal costs. It has also started a cottage industry on the Internet. Accredited investor “clubs” are advertised on the Internet that claim they have accredited investors waiting to invest in Rule 506(c) offerings.

On the other side, accredited investor crowdfunding portal sites are offering matchmaking of entrepreneurs and accredited investors. It is worth noting that although the 506(c) offering is exempt from state securities registration, the offers are still subject to state anti-fraud laws and minimal form filings. Resales are subject to restrictions.

The Dodd-Frank Act requires that all Rule 506 offerings be subject to a new “bad actor” rule. Bad actors are those persons closely connected to the issuer who have been convicted of certain crimes or subject to certain government agency discipline.

A New Mexico startup may be tempted to seek funding through one of the many accredited investor crowdfund portal sites on the Internet. Or wait on one of the SEC-delayed, small-investor crowdfund sites and go for $1 million maximum. At least some of these crowdfund portals will win prizes for website design.

The startup may be better advised to let the crowdfund sites shake out, investigate thoroughly and see what works. The New Mexico Securities Division has reported that even before Rule 506(c) was adopted, Rule 506 resulted in $172 billion in capital raised by issuers in 2012 and 99 percent of the capital raised.

In short, for the time being, Rule 506(b) may be more productive than either Rule 506(c) or the small-investor crowdfund rules currently under review by the SEC. Rule 506(b) also does not require the burdensome accredited investor verification.

We shall watch the Albuquerque accelerator experiment with interest – and hope.

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