On April 5th, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law, which included the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (the Crowdfund Act or the Act) (http://www.govtrack.us/congress/bills/112/hr3606). The Crowdfund Act will ease the restrictions that had limited the ability of entrepreneurs, including artists, to finance their projects by raising small amounts of money from everyday investors online. Although securities cannot be offered for sale under the exemption from registration created by the Act (the crowdfunding exemption) until the SEC completes its rulemaking, the Act will soon impact many entertainment entrepreneurs seeking funds to finance films and other artistic endeavors, as well as their legal advisors.
Crowdfunding can be defined as a collective effort to pool money, popular today through the Internet, to support a project, cause or organization. It has become an increasingly common and effective way for entrepreneurs and artists to finance business and creative endeavors, making it easy to solicit financing from anyone with internet access and available capital.
Compliance with U.S. securities laws prior to the Crowdfund Act, however, required that crowdfunding be restricted to rewards, pre-payment, donation, and interest-free loan-based models, limiting the full possibilities of crowdfunding to stimulate entrepreneurship. A security is an investment of money in a common enterprise with an expectation of profits arising from the efforts of others. When a security is offered to the public over the Internet or through other means, the offering party is required to meet registration and ongoing disclosure requirements with the SEC. While this serves the public interest in helping guard against potential fraud, the time and expense involved in meeting these requirements make public offerings impractical for almost all start-ups and small businesses, and especially for artists. There are several exemptions to the public registration requirement, but prior to the Crowdfund Act, none would apply to a crowdfunding equity model where a financial stake in a business or project could be promoted online to the general investing public.
The challenge with equity crowdfunding is to create a regulatory framework that unlocks its full small business-stimulus possibility while mitigating the serious risk of fraud that comes with easing restrictions on the public solicitation of investment opportunities online. The SEC is charged with adopting and enforcing rules required to implement the Act that are due within 270 days of its signing into law (i.e., before January 1, 2013), but the Act itself provides baseline rules that include a combination of funding caps, rules governing websites that offer securities under the crowdfunding exemption and targeted disclosure and reporting obligations.
• It sets a $1 million cap on the amount that can be raised over a 12 month period by an issuer offering unregistered securities under the crowdfunding exemption. Any securities sold by the issuer, whether under the crowdfunding exemption or not, count toward this $1 million limit.
• It sets a cap on the amount each investor can invest in a single offering made under the exemption, with different limits based on investors' annual income or net worth.
• It requires that transactions entered into under the crowdfunding exemption be conducted through an intermediary that meets requirements set out in the Act. Such intermediaries must register with the SEC as a "funding portal", conduct background checks on the officers, directors and significant (20% or more) stockholders of the issuer, announce a minimum financing target pursuant to which funds will only be disbursed to the issuer once reached and screen investors with questions designed to demonstrate sufficient financial acumen to appreciate the unique risks of an investment in securities under the crowdfunding exemption.
• It requires that the issuer file certain basic information about itself with the SEC and make a variety of other disclosures available to its intermediaries and investors, including its intended use of the proceeds and certain financial information (the extent of which depends on the overall amount of financing the issuer has sought under the crowdfunding exemption over the past 12 months).
Each of these requirements and others will be further elaborated on in the forthcoming SEC rules, which will determine the complexity of the funding portal registration process and in effect, when securities can start being offered under the crowdfunding exemption.
Other key features of the Act limit the resale of securities purchased under the exemption, prohibit issuers from advertising the terms of an offering and provide a remedy for investors harmed by an issuer or intermediary's material misstatements or omissions. One challenge the SEC must consider is its fraud prosecution strategy where, with potential damages that may often be very small, victims may not have the financial incentive to incur the expense of seeking legal redress. States, however, will also be able to take action against issuers and intermediaries for fraud, despite the Act's preemption of state blue sky laws.
Besides fraud, there are other issues that may be difficult for the SEC to address. In a typical seed investment, lawyers, financial advisors and other representatives of the investor negotiate tagalong rights and other preferences to make sure that early-stage investors' interests are protected. Otherwise, early investors could become completely diluted as the company moves on to later-stage capital raises. The Act anticipates this concern, requiring that the issuer provides a description of its capital structure and the terms of the offering, including how crowdfunding investors "may be materially limited, diluted, or qualified by the rights of any other class of security of the issuer." Nonetheless, it will be a major challenge for disparate small investors to replicate the leverage and sophistication that enables an angel investor to receive offering terms that merits its capital risk.
While small business hiring and commercial innovation are the most common themes used to tout the Crowdfund Act, the Act is also likely to impact the arts. Crowdfunding already has a special role in the creative community for a variety of reasons. Audience taste is extremely difficult to predict, and crowdfunded creative projects benefit from public feedback before production begins. They go forward when enough potential consumers (who are also likely to promote it to others) use their money to express interest and belief in a project, in contrast to hierarchical decision-making. Independent contributors are also free from public relations and corporate conflict concerns that can otherwise hinder financial support for unorthodox works.
First-time filmmakers and other less-established artists have historically had even fewer legal financing options than other entrepreneurs. Angel investors or banks will rarely finance a creative project helmed by a novice. Before websites like Kickstarter and Indiegogo came along, friends, family, personal savings and credit cards were often the only way to fund such an independent endeavor.
These platforms are still likely to thrive once the crowdfunding exemption takes effect. While much less onerous than the requirements for a public offering, complying with the Crowdfund Act and forthcoming SEC rules will still require significant care and expense. Retaining full control over a project successfully funded by a Kickstarter or similar campaign will also appeal to many artists over the challenges of dealing with stockholders from an issuance under the crowdfunding exemption. Additionally, individuals that currently contribute to the arts are unlikely to begin supporting only those projects that have the possibility of profit, particularly when being presented with information on how risky are such investments.
In many cases, however, issuing securities under the crowdfunding exemption will be the preferred method of financing a film or other creative project. It will be of particular interest to those filmmakers and other artists with projects that are more commercially-oriented and have substantial budgetary requirements. As David Marlett, Executive Director of the National Crowdfunding Association, has pointed out, filmmakers could raise more than $1 million for a single film by having multiple offerings under the crowdfunding exemption spaced at least 12 months apart.
In comments to the SEC (http://www.sec.gov/comments/jobs-title-iii/jobstitleiii-22.htm), prominent entertainment attorney and author Mark Litwak made the case that the forthcoming rules should consider certain differences between films and other creative endeavors relative to "traditional businesses". Litwak's suggestions for regulating film financing under the crowdfunding exemption include:
• requiring filmmakers to rigorously document and report expenditures, including a limit that only 10% of the funds raised are used for cash payments (with all other expenses to be paid by check or credit card so that there is a record);
• requiring that a script or synopsis, line item budget and deadline for completion be provided to potential investors; and
• requiring a final cost report be issued to investors on completion and that updates to investors are provided every 90 days until the film is released.
Such distinctions could help facilitate the use of the crowdfunding exemption for films and other creative works by further protecting investors from fraud.
Anyone considering offering stock under the new exemption will need to carefully review the Act, the forthcoming SEC rules and other guidance, consider the costs against other funding alternatives and consult an attorney. Despite the expenses and challenges, the crowdfunding exemption could have broad implications on the arts and development of artists.
Ronald L. Barabas is a Corporate and Entertainment Attorney at Di Santo Bowles Bruno & Lutzer LLP. He can be contacted at firstname.lastname@example.org.