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Crowdfunding Vehicles and Avoiding the Registration Requirement

The CfPA supports the following changes.

i. The rules governing crowdfunding vehicles (“CV”) are challenging to apply in practice – the concept of a “one-to-one relationship” is not easily interpreted in many contexts. There is a need for greater clarity and examples of how the CV should be structured when the securities being offered are SAFEs, convertible notes, etc. (as opposed to shares or LLC equity interests).

ii. The use of a crowdfunding vehicle can add a great deal of expense and complexity to an offering because the crowdfunding vehicle itself is subject to all of the same compliance requirements as the underlying issuer. To reduce the need to use crowdfunding vehicles, we support removing the $25 million asset cap for companies wishing to avoid registration under Section 12(g).

iii.There is a lack of consistency regarding the use of Series LLCs as crowdfunding vehicles – while one portal uses a Series LLC, other portals have been told by FINRA that Series LLCs may not be used. FINRA or the SEC should provide unequivocal guidance on this issue.

iv. We also request clarification regarding what it means to be “current in ongoing annual reports” with respect to the requirements for avoiding registration under Section 12(g). We request confirmation that as long as the issuer has filed all required reports, it will be considered “current in ongoing annual reports.”

Background

Most companies utilizing Regulation Crowdfunding are not, and never intend to become, part of broader public markets and do not intend to become subject to the extensive current, quarterly, and annual reporting requirements imposed on publicly traded companies or those subject to reporting obligations under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). 

Companies utilizing Regulation Crowdfunding do so to enable a large number of investors (who typically are not accredited) to be able to invest and support their growth. This can present potential problems for companies that experience significant growth (from an asset perspective) if they have too many record holders to escape the reporting obligations under Section 12(g) of the Securities and Exchange Act.  

We believe it is crucial for companies utilizing Regulation Crowdfunding to have a clear understanding of how to structure Regulation Crowdfunding offerings and what compliance steps are required to avoid the registration requirements imposed under Section 12(g) of the Exchange Act. Our policy recommendations are designed to address areas where there is uncertainty and need for clarification or consistent treatment from the SEC and other regulators.  

Summary of Law

We first provide a brief overview of pertinent statutes, rules, and regulations that come into play:

Section 12(g) of the Exchange Act requires companies to become registered with the SEC (and thus become subject to reporting requirements under the Exchange Act) when they meet certain asset tests ($10M) and investor “record holder thresholds” (having a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited investors). Assuming that the asset test is or may be met in the future, under current law, Regulation Crowdfunding issuers can utilize two strategies to try to avoid triggering these Exchange Act registration requirements:

First, Rule 12g-6 provides a conditional exemption from the registration requirements under Section 12(g). Rule 12g-6 states that securities issued in a Regulation Crowdfunding offering will not be counted towards Section 12(g)’s record holder threshold if: (1) the issuer is current in its ongoing annual reports; (2) has gross assets of $25 million or less as of the end of the most recently completed fiscal year; and (3) has engaged a transfer agent to serve as the transfer agent for the securities in question. Rule 12g-6 also provides a two-year transition period for issuers that exceed the asset test, provided that the issuer remains current in its ongoing annual reports. If registration is otherwise required and an issuer violates the conditional exemption by not being current in periodic reporting requirements then the transition period terminates immediately, requiring registration with the SEC within 120 days after the fiscal year in which registration is triggered.

Second, issuers may utilize a “crowdfunding vehicle” meeting the requirements of Rule 3a-9 of the Exchange Act to reduce the number of record holders counted for purposes of Section 12(g). Rule 12g5-1(a)(9) permits an issuer (as well as the crowdfunding vehicle itself) to exclude from its record holders securities issued in the offering to natural persons (but not to investors that are not natural persons).

Serving merely as a “conduit” for investors to invest in the crowdfunding issuer, the crowdfunding vehicle is a co-issuer in the offering, files a joint Form C with the crowdfunding issuer and is required to provide all of the required Form C disclosure with respect to the offer and sale of its securities to investors. Rule 3a-9 sets forth a number or conditions that must be satisfied. For example, the crowdfunding vehicle:

• Can have no purpose other than owning securities of the issuer;

• Must have the same fiscal year end as the issuer;

• May not borrow money;

• Must be reimbursed for all its expenses only by the issuer; and

• Must “maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”

Greater clarity and examples of a “one-to-one relationship

Crowdfunding vehicles are typically structured as limited liability companies, which issue a number of “interests” or “units”. The translation of a number of “units” of the crowdfunding vehicle to the same number of equity interests (usually “shares” of a corporation or “interests” or “units” of a limited liability company) on a one-to-one basis is relatively straightforward. However, implementation of the requirement that the crowdfunding vehicle must “maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding” presents several challenges, some of which we identify below, along with our recommended solutions.

Issue:  How does a crowdfunding issuer implement the one-to-one relationship for non-equity securities that are denominated in dollar amounts (such as SAFEs, convertible debt, revenue share debt).  

Suggested Solution: The rules should clarify that the offering can utilize a dollar-to-unit conversion, i.e., every unit of the crowdfunding vehicle equals $1 of the SAFE/loan.

Issue:  How does a crowdfunding issuer implement these requirements without issuing new or different units to investors if a security converts into another class or type of “underlying security” at a ratio that is not one-to-one or in a manner that provides different rights associated with the underlying security?  

Suggested Solution: The SEC can provide guidance that (1) as long at the initial issuance of the securities was on a one-to-one basis, the original unit of the crowdfunding vehicle can convert into a different ratio of the underlying security if that is caused by conversion or exchange rights of the issuer’s securities and (2) the new rights of the underlying security may be automatically transitioned to those existing units (without the need to issue new or different securities by the crowdfunding vehicle) through contractual provisions.

Issue:  How do the co-issuers reconcile the differences in laws among types of entities (LLCs vs. corporations) and states with the requirement to make the rights associated with owning an issuer’s security to be identical to the rights associated with owning a crowdfunding vehicle’s security?  

Suggested Solution: The SEC can provide guidance that the rights arising solely from state laws governing corporations, limited liability companies, limited partnership, and other legal entities will not be taken into account for these purposes.

Request

We request that the Staff provide guidance (either in the form of FAQs similar to those issued in May 2021 or expansion to its C&DIs on Regulation Crowdfunding, last updated in April 2017) to address these matters.  

Removal of the $25 million asset cap to avoid the 12(g) registration requirement

Since the passage of the JOBS Act in 2012, we have seen increases in thresholds of amounts that may be raised under Regulation Crowdfunding (for inflation as well as when the SEC increased the maximum threshold from $1.07M to $5M in 2021).  

Increasing or eliminating the asset test in Rule 3a-9 would be consistent with the steps the SEC has taken historically.  

The expense of registering as a public company and complying with the ongoing reporting requirements are extremely high. A company that has a large number of investors whose assets have increased over time should not be required to undertake this burden. Equal Exchange, a fair trade worker cooperative based in Massachusetts, is an example of a company that has grown quite large and has raised funds from thousands of investors. Requiring a company like that to register would likely drive it into bankruptcy.

Request

We request that the $25 million threshold be removed or increased to at least $50 million.

Consistent treatment of series LLC as crowdfunding vehicles

Series LLCs are unique limited liability companies, permitted to be formed under some state statutes, where a “parent” or “umbrella” LLC is created with one or more sub-LLCs or “series” that branch off from it. Practitioners generally agree that a Series LLC cannot be used as a crowdfunding vehicle, because it does not satisfy the requirements imposed by Rule 3a-9. However, at least one prominent crowdfunding portal has been using the Series LLC for years and continues to do so, despite these risks. If, as many practitioners believe, the use of a Series LLC as a crowdfunding vehicle does not satisfy the law, then any offering that uses this structure will violate the law.  

Request

Consistent regulatory compliance is necessary to ensure the viability of the industry. As stated above, FINRA or the SEC should clearly articulate whether the Series LLC structure is permissible for use as a crowdfunding vehicle and apply that position consistently when regulating all funding portals or registered intermediaries.  

Clarification regarding what it means to be “current in ongoing annual reports” 

We seek confirmation from the SEC staff that terminating a crowdfunding issuers’ annual reporting obligations (which is permitted under Rule 202(b) of Regulation Crowdfunding) will not eliminate such issuers’ ability to rely on the conditional exemption from Section 12(g) reporting provided by Rule 12g-6.  

In order for a crowdfunding issuer to take advantage of the conditional exemption from Section 12(g) reporting requirements, that issuer must (among other things) be “current in its ongoing annual reports”. This is the same threshold requirement that entitles issuers to use the two-year transition period under Rule 12g-6. We request that the SEC clarify what this means in light of the ability for crowdfunding issuers to terminate their annual reporting obligations pursuant to Rule 202(b) of Regulation Crowdfunding.  

Rule 202(b) stipulates that annual reports must continue to be filed and made available to investors until one of five different scenarios have been met (including once an issuer has filed annual reports for the three most recent fiscal years and has total assets that do not exceed $10M). Many crowdfunding issuers take advantage of the opportunity to terminate their annual reporting obligations, and we believe, as long as they satisfy the requirements imposed by Rule 202(b) when doing so, no further reporting obligation would be triggered. Thus, such issuers would be deemed to be “current” in their annual reporting obligations. 

Request

We request that the SEC provide guidance (either in the form of FAQs similar to those issued in May 2021 or expansion to its C&DIs on Regulation Crowdfunding, last updated in April 2017) to clarify what it means to be “current” in annual reporting requirements, so that issuers, intermediaries, and their advisors can know for certain how doing so might impact an issuer’s ability to rely on the conditional exemption provided under Rule 12g-6. And, further, if the SEC takes the view that terminating annual reports would eliminate an issuer’s ability to rely on the conditional exemption, we request that the Staff provide clarity on how a crowdfunding issuer should correct this – we suggest that this may be done by filing annual reports for the most recent three fiscal years, and thus becoming “current”.

Statutory Authority

Removal of the $25 million asset cap to avoid the 12(g) registration requirement requires SEC rulemaking. The SEC staff has the authority to provide the requested guidance on the other issues described above without formal rulemaking.