CROWDFUNDING: LEGAL ASPECTS OF ALTERNATIVE FINANCE

55 Francisco St., Suite 403 San Francisco, CA 94133 Tel: 415.240.9024 net@socialventurelaw.com

Presented by Natalia Thurston, Social Venture Law

Background

Economic Climate Focus on Small Business Growth of Micro-Lending Social Impact Investing Federal Law: JOBS Act SEC Regs (Title II)

Lending Statistics

Source: nbcnews.com

Social Enterprise Sector

Alternative Investment Vehicles

Reward-Based
Entity

offers gifts/rewards in exchange for funding

Indiegogo

Kickstarter,

Peer-to-Peer Lending
Loans

from unrelated individuals to individual borrowers with verifiable credit history

Lending

Club, Prosper

Alternative Investment Vehicles

Direct Public Offerings

Entity raises capital without intermediary offering stock directly to public Requires state-level registration and exemption from SEC regulations; compliance with state Blue Sky laws

Self-Directed IRAs

Individual retirement funds are invested in assets such as real estate, restaurants, promissory notes, tax lien certificates, and private placement securities

LLC Structured IRA IRS regulations govern to prohibit self-dealing

Securities Act of 1933

Section 5 prohibits use of mails or interstate commerce for the direct or indirect sale of securities without SEC registration. Additional provisions in the Securities Act regulate registration process, impose audited financial reporting, public disclosure requirements, and waiting periods on marketing efforts. Section 4(2) exempts from Securities Act requirements transactions by an issuer not involving any public offering. SECs Rule 146 prohibits general solicitation and general advertising; issuers were required to prescreen offerees and evaluate their financial condition and sophistication. (1974)

Securities Act of 1933

Reg D was promulgated in early 1980s to address uncertain patchwork of exemptions Reg D superseded Rule 146 and authorized the SEC to exempt from registration offerings up to $5 million Private placements under Reg D avoid the full burden of the Acts registration, disclosure & reporting requirements General solicitation and general advertising continued to be prohibited without a least an underlying state registration

Regulation D
Rule 504 Eligible Transaction s Eligible Participants
$1 Million maximum offering Not available to reporting (Public) companies or investment companies No limitation on the number of purchasers No accreditation or sophistication requirements

Rule 505
$5 Million maximum offering

Rule 506
No maximum offering size

Limited to 35 purchasers Certain purchasers including accredited investors do not count toward the purchaser limit

Requiremen ts

No affirmative disclosure obligations (state securities offering laws are thought to provide the necessary protections) Resale of securities is

Affirmative disclosure obligations apply when non-accredited investors participate in the transaction Resale of securities is

Limited to 35 purchasers Certain purchasers including accredited investors do not count toward the purchaser limit Non-accredited investors or their representatives must meet sophistication standards Affirmative disclosure obligations apply when non-accredited investors participate in the transaction Resale of securities is

Reg D Limitations

Securities may not be resold except under limited circumstances highlighting lack of liquid secondary market for resale. General Solicitation is not allowed, a preexisting substantive relationship must exist. Generally advisors pre-qualify would be investors before providing information on the securities and frequently use a waiting period before investment.

Reg D Applied

Online investment platform: Mosaic (https://joinmosiac.com) utilizes Reg D exemption to provide loans to solar projects
Investors

must either be residents of California or New York; or they must be accredited investors or in some cases sophisticated non-accredited investors When a projects Note has reached its funding commitment, investors commitment amounts are transferred to the project Investors receive return on their notes from payments made by the projects to Mosaic

Future Legal Landscape

SECs forthcoming regulations

JOBS Act directed SEC to produce regulations allowing crowdfunding up to $1million per year through broker dealer or newly created intermediaries funding portals Reporting/disclosure requirements for crowdfunding rules undetermined JOBS Act instructs SEC to remove ban on general solicitation SECs non-accredited investor solicitation investor rules due Dec 31, 2012; both accredited and nonaccredited rules expected end of 2013

SEC Title II Regulations

SECs adopts new rules lifting ban on general solicitation (July 10, 2013)

New SEC rules address Title II of the JOBS Act, creating a walled garden for accredited investors. New SEC rules address Dodd-Frank Acts investor risk concerns and restricts felons and other bad actors from participating in Reg D offerings Allows equity-based crowdfunding intermediaries to promote investment offerings to accredited investors using the Internet and social media (Ex: CircleUp, Mosaic, Crowdfunder.com) Promotion must lead back to a platform that verifies accredited investors before giving them access to the investment offering Requires additional registrations with SEC New rules regarding Title III unaccredited investors expected by end of 2013

Estimated U.S. market for Title II crowdfunding (accredited investors): $20 Billion (Source: CrowdFundBeat) Estimated U.S. market for Title III crowdfunding (nonaccredited investors): $2 Trillion (Source: CrowdFundBeat)

Fiduciary Duties

Fiduciary duties of broker-dealers vs. investment advisors to investors. Investment advisors (regulated by FINRA) owe a fiduciary obligation to their clients. Broker dealers must recommend suitable investments but are not generally assumed to owe a fiduciary standard.

Distinction between advice/planning and merely facilitating the transaction is lost on many investors. A number of investors in failed Reg D offerings have filed suit against brokerages based on failure to conduct adequate due diligence.

Under the JOBS Act crowdfunding provisions, it is unclear whether a fiduciary duty will be owed by broker-dealers or funding portals to investors. Dodd Frank legislation gives authority to SEC to adopt a uniform fiduciary standard applicable to all giving investment advice. Funding portals may fall under the Uniform Fiduciary Standard along with investment advisors and broker-dealers.

Risks to Investors

Use of Internet and social media to market offerings increases risk to investors of improper offers to sell securities Hack, Pump & Dump Schemes (spreading false information on the Internet to inflate stock price) Risks to investors of fraud will weaken capital markets No current marketplace for secondary exchange of securities Public scrutiny and transparency in reward-based crowdfunding

Public Policy Issues

Regulatory burden too great? Regulations defeat purpose of efficiency? Case Study: Pabst Brewing Company/BuyaBeerCompany.com

Two advertising executives created BuyaBeerCompany.com to raise $300 million to purchase Pabst Brewing Company by collecting pledges through their site, Facebook, and Twitter. Contributors would receive: A crowdsourced certificate of ownership and Beer worth the value of their pledge Collected pledges totaling $14.5 million in the first 3 weeks and more than $200 million in the first four months. SEC took the position that the arrangement constituted an offer to sell securities, triggering Section 5s registration requirement. Ultimately the two agreed to a cease and desist order from the SEC. Pabst was later sold for an undisclosed amount, reportedly about $250 million.

Questions/Discussion
Natalia Thurston Social Venture Law 55 Francisco Street, Suite 403 San Francisco, CA 94133 Tel: (415) 240-9024 Email: net@socialventurelaw.com