The SEC and crypto: the answer is Rule 261
A few years ago, we spent a lot of time with the Staff of the Division of Corporation Finance discussing
November 11, 2024
An IPO occurs when shares of a company are sold to the general public on a securities exchange (typically NYSE or NASDAQ) for the first time. The company needs to file a registration statement with the SEC, which includes detailed and complex disclosure, high costs with hiring lawyers, accountants, investment bankers, etc. In addition, the company has to provide ongoing annual and quarterly reporting, and any material, corporate events and changes in shareholdings of insiders. The company can be sued for any "material misstatements or omissions" in its filings.
Under the Crowdfund Act, a company is limited to raising $1 million through issuing crowdfunding securities in any 12-month period. The amount the company raised through any securities crowdfunding offering in the preceding 12-month period counts towards the $1 million cap.. While initially set at $1 million per year, through SEC rulemaking, the amount is currently set at $5 million.
Under the Crowdfund Act, an investor is limited in the amount that may be invested in crowdfunding securities in any 12-month period. If the annual income or net worth of the investor is $100,000 or more, the investor is limited to 10% of their annual income or net worth, to a maximum of $100,000, in any 12-month period.
Under the Crowdfund Act, an investor is limited in the amount they may invest in crowdfunding securities in any 12-month period. If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to investing the greater of $2,000 or 5% of their annual income or net worth.
Under the Crowdfund Act, an investor is limited in the amount that may be invested in crowdfunding securities in any 12-month period based upon their annual income or net worth. Through SEC rulemaking, the current caps are set out below:
● If either the investors’ annual income or net worth are less than $124,000, the investor can invest the greater of $2,500 or up to 5% of annual income or net worth, whichever is greater.
● If both the investors’ annual income or net worth is greater than $124,000, the investor can invest up to 10% of the greater of annual income or net worth, not to exceed $124,000.
● However, if an investor qualifies as an accredited investor, as defined by the SEC, there is no annual limit for crowdfunding investments for that investor.
Any public statement made by a company during the time it is offering securities to potential investors may be treated as offering materials that the company is responsible for. The offering materials may be presented as a formal memorandum or public offering prospectus. Other communications that may be treated as offering materials are company responses to questions from potential investors, marketing materials, slide shows, or videos.
A formalized, legal document filed with the Securities and Exchange Commission that contains information required under the Securities Act. The issuer provides the prospectus to potential investors during a registered offering. The prospectus contains details about the company and the securities offering for sale to the public.
This information is what a company needs to file with the SEC in order to be able to sell securities in a registered offering. The registration statement is available to the public on the SEC's website shortly after the company files it with the SEC. Crowdfunding securities are subject to an exemption from registration, as the requirements of registration are frequently too burdensome for a company in its infancy. Crowdfunding investments are subject to their own, more limited, disclosure requirements. If a company registers with the SEC, the registration form should include the essential facts to present an accurate picture of the company and its securities. This includes a description of the company's business, description of the security to be offered for sale (e.g. stock, bond, terms, etc.), details of the management of the company, financial statements certified by independent accountants, and ongoing disclosure. The SEC reviews the disclosure for compliance with the requirement of accuracy and truthfulness but does not evaluate whether the investment is good or not.
A PPM is a formal disclosure document delivered to potential investors during a securities offering exempted from registration. The PPM contains the objectives, risks, and terms of the investment offer. A PPM is not always required. For example, where only accredited investors are offered securities, a PPM is optional and the issuer and intermediaries can decide for themselves what information to disclose, and how to disclose it.
The general term for the process of evaluating a person, organization, system, process, company, project, or product is an audit.
A systematic review of intellectual property assets owned, used, or acquired by a company used to examine use of intellectual property and indentify risks in the company's intellectual property portfolio.
The effort a reasonable person (the legal term is a “prudent man”) in the management of his or her own money would take to investigate a company before making an investment in securities.
An audit is an examination and evaluation of the financial statements of an organization. An audit is required for offers of more than $618,000 under the Crowdfund Act. An auditor will ascertain the validity and reliability of information contained in the financial statements. An auditor typically issues an opinion as to whether the financial statements are presented fairly in all material respects. An audit is not a total guarantee of accuracy as it seeks to provide only reasonable assurance that the financial statements are free from error.
A properly run business has a number of obligations under state laws to protect officers, directors, and shareholders from being the subjects of a legal claim. The corporate formalities necessary to satisfy these obligations include, but are not limited to: holding shareholder meetings, board of director meetings, and maintaining records of finances and important decisions.
During a financial statement review, an accountant will review the financial statements prepared by a company to establish whether there are material modifications necessary to bring the statements into conformity with an applicable financial reporting framework. This process is less intensive than an audit and is required for offerings between $124,000 and $618,000 under the Crowdfund Act.
Title III of the JOBS Act is the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012, or the Crowdfund Act. It was signed into law by President Obama on April 5, 2012. crowdfunding will be legal once the SEC adopts crowdfunding rules (within 270 days of when the Crowdfund Act was signed into law), and registers funding portals.
The Jumpstart Our Business Startups Act, or JOBS Act, was passed with bipartisan support and signed into law by President Obama on April 5, 2012. It was intended to encourage funding of small businesses in the US by easing various securities regulations. The JOBS Act includes the Crowdfund Act, which enables crowdfunding.
The Securities Act of 1933, also known as the "truth in securities" law, was enacted to protect investors following the stock market crash of 1929 and the Great Depression that ensued. Its main objectives were to ensure that investors received complete and accurate information regarding the securities they were planning to purchase, and to prohibit fraud in the sale of securities. The Securities Act follows a disclosure philosophy; i.e. it is not illegal to sell a poor investment if it is accurately disclosed as such. It is only illegal to make false statements or present a misleading view of the investment. Companies are required to disclose important financial and other information by filing a registration statement with the SEC.
All income received by a company minus all operating costs, including costs of goods and services, overhead expenses, and depreciation. Some people may think of this as a company’s profits.
A report summarizing the financial conditions of a company over a specified period of time. Financial statements generally include the balance sheet and income statement of a company, and often a statement of cash flows.
All income received by a company without deducting costs.
A cash flow statement report a company's inflows and outflows of cash. Unlike the balance sheet, a cash flow statement shows changes over time rather than provided a snapshot of the company's activities at a fixed point in time.
The profit earned from a company's normal business operations. Operating profit does not include profits earned from a company's investments and does not take into account interests and taxes. Operating profit may also be represented as earnings before interest and tax (EBIT).
The money spent directly on producing products. COGS includes direct costs such as raw materials and labor expenses for the people who make the product or provide the service. COGS does not include office overhead, just the direct costs of making the goods or providing the service.
An income statement may also be referred to as a "profit and loss statement". The income statement provides information on how much revenue a company earned over a specific time period. The statement also shows the costs and other operating expenses the company encountered. The bottom line of the income statement shows the company's net earnings or losses.
The amount of money is the company is spending in the pre-revenue or start-up phase. It is called the burn rate because the company is using up its current cash without bringing in revenue to offset expenses. Investors can use the burn rate to work out how much longer the company can keep going before it has to raise more money.
All income received by a company minus all operating costs, including costs of goods and services, overhead expenses, and depreciation. Some people may think of this as a company’s profits.
An accounting principle that matches revenues to expenses at the time in which the transaction occurs rather than when payments are made or received. This principle allows a company to combine current cash inflows and outflows with future expected inflows and outflows to give an accurate picture of the company's current financial condition.
The balance sheet shows what a company owns and what is owes at a particular point in time. It provides details about a company's assets, liability, and shareholder equity. The balance sheet is based on the accounting equation that shareholder equity is equal to a company's assets minus its liabilities. Investors should bear in mind that because a balance sheet is a “snapshot” of the company’s finances on a given day, events that happen immediately before or after that date might not be reflected.
Financial statements prepared on the basis of some assumed events and transactions that have not yet occurred are referred to as “pro forma” financial statements. These statements have not been audited and are not prepared in accordance with generally accepted accounting principles. It is important that the investor understand the assumptions underpinning a pro forma financial statement and question the basis for those assumptions. Investors should ask whether any third party has investigated those assumptions, and whether any accountant has “checked the math” (CPAs can’t confirm whether pro forma financials are accurate, but they can check whether they are properly presented and add up.)
An occurrence, event, or information that a reasonable person would find important when making a decision.
A wrong or false statement.
Failure to state information.
A set of rules adopted by the company for the governance of its officers, directors, and shareholders.
The basic organizational document filed with a state to legally operate as a company. It may also be called the Articles of Incorporation.
Property that results from original creative thought. Intellectual property protected under U.S. law include patents, trademarks, and copyrighted material.
Individuals elected to represent shareholders of a company. Directors establish corporate management related policies and make decisions on major company issues such as the hiring and firing or officers, and dividend payments to shareholders. Directors owe the company the fiduciary duties of care and loyalty. This means that directors must act in the best interests of the company, refrain from self-dealing, and make decisions on an informed basis.
Executives of the company who develop and implement high-level strategy and manage the day-to-day affairs of the company. Officers are appointed by the directors. Common officer roles include Chief Executive Officer, Chief Financial Officer, and Chief Operating Officer.
The ultimate owners of a company. Any person, company, or other institution that owns a least one share in a company is a shareholder. The term is often used interchangeably with stockholder.
Startup and early stage companies frequently change their product, selling strategy, or business plan to adapt, when their prior actions are not leading to profits or a scalable business. These "pivots" may revamp the company into something very different than what was originally presented to investors. Investors must bear in mind that these changes happen, but consider whether the entrepreneur gave sufficient warning about the possibility of a change in plans.
An early-stage, high-potential, high risk, growth company. Many of the companies seeking crowdfunding are startups. They typically consist of a founder and an idea, and are usually associated with new technology. They can become incredibly successful, like Google, Apple or Facebook, or go bust, like many companies in the dot com era. A company grows from being a startup as it passes certain milestones, such as becoming profitable, being purchased through a merger or acquisition, or becoming publicly traded in an IPO.
Dilution describes a reduction in control, earnings or value of the shares due to the company issuing additional shares. If the company decides to issue more shares, an investor can experience value dilution, with each share worth less than previously, and control dilution, with the total percentage an investor owns being less than before. There may also be earnings dilution, with a reduction in the amount earned per share. However, this typically occurs if the company offers dividends, and most companies seeking crowdfunding are unlikely to offer dividends.
Valuation is an estimate of what the company is worth. This would help the investor determine whether the price paid per share is a fair price, a good investment, or a poor investment. To value a company, an investor should consider the assets and liabilities of the company. A startup typically has few tangible assets (such as property), it typically has more intangible assets such as patents, copyrights, software, trade secrets, customer relationships and other items of growth potential. A startup typically has liabilities such as loans outstanding.
An investor holding crowdfunding securities has limited exit options. These include selling the securities back to the company, selling to an accredited investor, selling in a registered offering of securities (e.g. an IPO), selling to a family member on death or divorce, and other restrictions imposed by the SEC.
All offers and sales of securities must be registered under Section 5 of the Securities Act of 1933, or covered by an available Exemption. The SEC takes a broad view as to what is an "offer," so any kind of "market conditioning," i.e., something that makes you want to make an investment, is considered an "offer" of securities. Companies need to file a registration statement with the SEC before selling shares to the general public, i.e. an Initial Public Offering. There are exemptions available, typically for accredited investors or qualified institutional buyers, and the new crowdfunding exemption as provided under the Crowdfund Act.
An exit for investors is an event that allows the investors to get their money (or some of their money) back. For example, when a company makes an IPO, the existing investors may be able to sell all their shares in the same public marketplace. However, if the stock is not publicly traded, the investor will need an event such as a private sale of the investment in order to recover the investment. In general, an investor cannot exit an investment and recoup his gains (or losses) unless there is a marketplace where such investments can legally be offered and sold (and these are rare for small holdings of securities) or another investor (such as a VC group) offers to buy the securities.
A rule promulgated by the Securities and Exchange Commission that makes it unlawful for any person to (a) employ any device, scheme, or artifice to defraud; (b) make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person. What this means in lay terms is that no-one can sell a security by making an untrue statement about something important.
Statutory provision that imposes liability on any person who offers or sells a security for any untrue statement of material fact or omission of a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading. This section is like Rule 10b-5 in that it prohibits people from making untrue statements in order to sell securities, but it is stricter because the person making the untrue statement has to prove he or she didn’t know it was false.
FINRA is a self-regulatory organization for all securities firms doing business in the United States. FINRA sets its own rules and regulations in consultation with the Securities and Exchange Commission.
The Securities and Exchange Commission was created under the Securities Exchange Act of 1934. This law, together with the Securities Act of 1933, aimed to restore investor confidence in the capital markets following the Great Depression. The role of the SEC is to protect investors and promote stability in the markets. The SEC has the authority to establish regulations and enforce securities laws covering the offer, sale, and exchange of securities, as well as participants in the securities marketplace.
State regulations that cover the offering and sale of securities within state boundaries. The term comes from a 1917 Supreme Court decision in which Justice Joseph McKenna wrote that he wished to protect investors from securities with "no more basis than so many feet of blue sky."
A term defined by the Securities and Exchange Commission to refer to investors who are financially sophisticated and have a reduced need for the protection provided by mandated disclosures that are produced when a securities offering is registered with the SEC. Accredited investors typically have individual income of more than $200,000 per year ($300,000 with their spouse), or have a net worth of over $1 million excluding home value. Accredited investors also include the general partners, officers, and directors of the company offering securities.
Anyone who invests his or her own money in a startup at the very early stage of a company’s life. That means if you invest in a startup, you are acting as an “angel” by providing financial backing to the entrepreneurial venture. Angels do not have to be millionaires, but they do need to be financially sound enough to withstand losing their investment.
QIBs are allowed to buy private placements under SEC Rule 144A. These offerings are generally not registered with the SEC and so are only available to those whom the courts have found able to "fend for themselves." These include institutions that manage at least $100 million of securities not affiliated with itself, or a registered broker-dealer investing at least $10 million in non-affiliate securities.
Financial capital provided to startup companies. The typical venture capital investment occurs after the initial seed funding, angel investment or crowdfunding round, when the company has demonstrated that the idea is feasible (sometimes called a "proof of concept"). Venture capitalists usually get a large portion of the company's ownership and significant control over company decisions.
The process of filing a registration statement with the SEC, in order to disclose important information about the company so an investor can make an informed decision about whether or not to purchase securities. All securities offered in the U.S. must either be registered with the SEC or must qualify for an exemption from registration requirements.
Rule 506(c) exempts an issuer of securities from registration under the Securities Act for offerings of an unlimited size. Like Rule 506(b), the securities may only be sold to accredited investors. Rule 506(c) differs from Rule 506(b) in that qualified issuers may utilize general solicitation to advertise the existence of the offer. Additionally, the issuer must take reasonable steps to verify that purchasers of securities are, in fact, accredited investors.
The sale of securities to the public after registering with the Securities and Exchange Commission. The Crowdfund Act makes an exception to the registration requirements for a public offering. crowdfunding offerings to the public under the Crowdfund Act do not need to be registered with the SEC but must follow specific rules.
Rule 505 exempts an issuer of securities from registration under the Securities Act for offerings of up to $10 million. The exemption only applies if the securities are sold to accredited investors and up to 35 unaccredited investors. Investors are not allowed to sell their securities freely for at least one year.
Rule 504 exempts an issuer of securities from registration under the Securities Act for offerings of up to $10 million. The offer and sale must that take place exclusively in one or more states, and the offering is done in accordance with the securities laws of those states.
The exemption that is available for crowdfunding is Section 4(a)(6) of the Securities Act. It is available for offers and sales made through a registered portal. Other exemptions from registration include private placements under Section 4(a)(2) of the Securities Act, Rule 144A, which is restricted to qualified institutional buyers, specific securities under Section 3 of the Securities Act, transactional exemptions under Section 4, international offerings under regulation S, Private Investment in Public Entities (PIPEs), etc.
Rule 506(b) exempts an issuer of securities from registration under the Securities Act for offerings of an unlimited size. To qualify for the exemption, the securities may only be offered and sold to accredited investors and up to 35 non-accredited investors who meet certain sophistication requirements (such as being officers or directors of the company selling securities). Under Rule 506(b), the issuer may not engage in general solicitation of the offer and must have a reasonable belief that the purchasers are accredited investors or sophisticated, non-accredited investors.
The sale of newly issued debt or equity securities to a single buyer or limited number of buyers without a public offering.
Investors who buy bonds lend money to the company for a specified period of time (e.g. 3 or 5 years) and the company promises to repay the loan at a specified time with a fixed interest rate. If you buy a bond, you are in effect lending money to the company and taking a chance that it will be able to pay you back when the time comes. If the company goes bankrupt before the bond matures (i.e. when the company promised to pay you back), you will have lost all your money. If the company is very successful and goes public, you will not be able to benefit as much as if you had bought shares since you are not an owner in the company, you are a lender or bondholder.
If you own equity in a company, you become a shareholder of the company and own a small part of the business. Whether or not you have a vote in the direction of the company depends on what sort of shares the company is offering. crowdfunding investors, unlike venture capitalists or angel investors who make large investments, are unlikely to have any say in the company's direction. Until the company "goes public" and does an IPO, the only way to get any of your money back is through the private markets, e.g. by finding an accredited investor to buy your shares, selling the shares back to the company (if the company wants to buy them), or selling the shares to an Angel Investor or venture capitalist who is interested in the company. It is not as easy as selling shares on the public markets. Equity can also be subject to dilution.
A type of partnership used to raise funding for a company. In exchange for an investment, the limited partner receives a share of the profits of the company and is shielding from the potential liabilities of the company. A limited partnership must have a general partner or partners who receive a greater share of the profits, but may be personally liable for the liabilities of the company.
Preferred stock combines elements of equity and debt securities. The holder of preferred shares may receive a set dividend from the company according to the terms of the preferred shares. If the company fails, preferred shareholders receive a portion of the liquidation after debt holders are made whole. Preferred shareholders typically do not have voting power in shareholder elections.
A limited liability company is a legal entity that combines the characteristics of a corporation and a partnership. The owners of an LLC are called members and act in a capacity similar to shareholders of a corporation.
Stock in a company that entitled the holder to a share in the company's profits and a share of the voting power in shareholder elections.
an amount of money borrowed by the Company from an investor (e.g. a bond), or a bank (a loan).
A debt instrument that can be converted into other securities, such a preferred stock, under certain conditions.
A few years ago, we spent a lot of time with the Staff of the Division of Corporation Finance discussing
This is mostly a classic run-away-with-the-money case, combined with a bunch of misleading statements and omissions. But there are a
I was thinking of calling this series “Fraud of the Month” but didn’t want to go that far. You may