House Bill 2015-1246, the Colorado Crowdfunding Act (“CF Act”), became effective August 5, 2015. The CF Act added C.R.S. § 11-51-308.5 to the Colorado Securities Act (§§ 11-51-101 et seq.) to establish an exemption from registration under the Colorado Securities Act for capital formation for small businesses seeking up to $1 million ($2 million if audited financial statements are available) from a crowd of prospective investors in what looks much like a public offering of securities. The primary sponsors were Representatives Pete Lee and Dan Pabon and Senators Mark Scheffel and Owen Hill, and it passed through the 2015 Colorado General Assembly almost unanimously. According to the legislative declaration:
Start-up companies play a critical role in expanding economic opportunities, creating new jobs, and generating revenues; and
Lack of access to capital is an obstacle to starting and expanding small business, inhibits job growth, and has negatively affected the state’s economy.
The General Assembly also determined that, in its judgment, costs and complexities of compliance with the existing registration or exemption requirements of the federal and state securities laws “can outweigh the benefits to Colorado businesses seeking to raise capital by small securities offerings” and that “crowdfunding…raising money on-line through small contributions from a large number of investors…will enable Colorado businesses to obtain capital, democratize venture capital formation, and facilitate investment by Colorado residents in Colorado start-ups, thereby promoting the formation and growth of local companies and the accompanying job creation.” Will the CF Act meet these goals?
The Colorado Crowdfunding Act
The CF Act requires that the issuer and the offering be exempt from the registration requirements of federal law pursuant to the intrastate exemption set forth in § 3(a)(11) of the Securities Act of 1933 and Rule 147 adopted by the Securities and Exchange Commission (the “SEC”). The CF Act was discussed in detail in the April 2015 Business Law Section Newsletter, but the CF Act was not self-implementing. Although effective August 5, 2015, the CF Act required rulemaking from the Colorado Division of Securities (the “Division”) to be implemented.
In order to be adopted before the effective date of the CF Act, on July 29, 2015, the Division acted on an emergency basis to adopt Rules 3.20 through 3.30 after publishing draft rules and receiving public input. (The rules are found in the Code of Colorado Regulations available through the Secretary of State’s website at 3 CCR 704-1:51-3.20 et seq.) Formal decision making under the Colorado Administrative Procedure Act (C.R.S. § 24-4-101 et seq.) will occur this fall. C.R.S. § 24-4-103(6)(a) provides that emergency rules are effective for no more than 120 days after adoption. The final rules will be considered at a hearing to be held on August 31, 2015, at 1:30 pm.
It is important to note that no issuer may use the CF Act “in conjunction with any other exemption pursuant to section 11-51-307, 11-51-308, or 11-51-309 during the immediately preceding twelve-month period” (C.R.S. § 11-51-308.5(3)(a)(XI)). The precise meaning of this statutory language is not clear. Does it mean that an issuer that has issued securities pursuant to one of those Colorado exemptions in the prior twelve months is unable to raise funds under the CF Act? Or does it mean that the prior offering and the crowdfunding offering somehow have to be related, part of a “single plan of financing”?
The rules, as adopted, are intended to implement the legislative intent as expressed in the statute and to make crowdfunding a feasible alternative to the normal methods of capital formation by small businesses in Colorado—a “friends and family” private placement or intrastate offering, venture capital financing, or a state- or federally-registered public offering. Because the CF Act is based on the federal intrastate exemption, it can only be used by Colorado businesses soliciting funds from Colorado residents, primarily for use in Colorado. The securities offered and sold pursuant to the CF Act must “come to rest” in Colorado—meaning that there have to be transfer restrictions imposed under Rule 147 to ensure that, for at least twelve months, they are not transferred to persons who are not Colorado residents.
The Issuer and Disclosure. The CF Act contemplates, and the rules provide for, the issuer giving a broad public notice to persons who may be interested in the offering. The notice may be in print format or in electronic format (through email, social media, or otherwise), but must be limited to Colorado residents. Following the guidance of SEC Compliance and Disclosure Interpretation 141.04, Colorado Rule 3.24.I provides that where an electronic-based notice “sent by or on behalf of the issuer” has appropriate legends and warnings, the public notification is permitted, even where it may be accessible to non-Colorado residents.
The CF Act and the rules (especially Rule 3.22.B) impose the obligation for full and fair disclosure on the issuer seeking to raise funds from the crowd. The rules include Form CF-2 which forms the basis for disclosure, although it is expected that many issuers will also use a memorandum format or a business plan for disclosure which they will incorporate by reference into the Form CF-2. It is likely that prospective investors will want to perform further due diligence and make inquiries of the issuer. Where the discussions with prospective investors lead the issuer to disclose material information not already contained in the Form CF-2 disclosure, the issuer must amend the Form CF-2 disclosure within five business days (Rule 3.22.D). Where material events have occurred after the filing of the initial Form CF-2 (or after the filing of any amendment), the issuer must appropriately amend the disclosure within five days.
The Investors. The investors must be Colorado residents. In fact, using language similar to SEC Rule 506(c), the CF Act requires that before making any sales, “the issuer shall obtain documentary evidence from each prospective purchaser that provides the seller with a reasonable basis to believe that the purchaser meets the [Colorado residency] requirements.” (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)) This arguably requires more than a simple investor affirmation as to residency since it requires “documentary evidence.” This language suggests that the issuer must review and maintain copies of the investor’s driver’s license, state voting registration, utility bills, or other documentary evidence to establish residency in addition to the investor’s affirmation.
No person may invest more than $5,000 in a crowdfunding offering unless that person is an “accredited investor” as that term is defined by the SEC. If a person is an accredited investor, there is no statutory limitation on the investment amount (subject to the maximum limits of the crowdfunding offering). In determining whether a person is an accredited investor, Rule 3.24.A.1 requires the issuer to have a “reasonable basis” for establishing the accredited investor status. This is language that is similar to Rule 506(c)(2)(ii) (which requires that the issuer “take reasonable steps to verify that purchasers” are accredited investors). It is not likely that an investor self-certification will be sufficient if challenged.
In any crowdfunding offering in Colorado, the prudent issuer will require the purchaser to sign (electronically or on paper) a subscription agreement or investment letter warranting residency and acknowledging the restrictions on ownership and further transferability of the security. The subscription agreement or investment letter will also likely follow the normal form for such documents and include warranties by the purchaser that:
he/she has been fully informed about the transaction, the risks, and the issuer;
the purchaser is acquiring the securities for investment purposes only and without a view toward further distribution;
the purchaser is aware of the transferability restrictions to which the crowdfunding securities are subject; and
the purchaser has consulted with legal counsel and other advisors as the purchaser has determined to be necessary or appropriate in the circumstances.
These investor representations and supporting documentation are information that the issuer and the on-line intermediary must maintain for at least five years. (Rules 3.23 and 3.25)
The On-Line Intermediaries. The CF Act contemplates, and the rules provide for, the crowdfunding offerings being accomplished through broker-dealers, sales representatives, or on-line intermediaries. Where broker-dealers or sales representatives are involved, the CF Act and the rules defer to FINRA which regulates broker-dealers and sales representatives. The Colorado Securities Act was amended to define “on-line intermediary” (C.R.S. § 11-51-201(11.5)) and to describe certain prohibited activities (C.R.S. § 11-51-308.5(3)(c)(III)). As set forth in the statute and the rules (and especially Rule 3.29.A):
On-line intermediaries cannot handle or possess funds or securities in the offering process.
On-line intermediaries cannot own a financial interest in any crowdfunding participant or receive compensation that is based on the amount raised.
On-line intermediaries cannot be affiliated with or under common control with an issuer conducting a crowdfunding offering through that intermediary.
On-line intermediaries cannot offer investment advice or recommendations or solicit purchases or sales of securities displayed on its website (but is merely a repository for the information displayed).
On-line intermediaries must post the disclosure documents, and likely will have extensive terms and conditions, risk warnings, and investor acknowledgements that must be accepted as a condition precedent to the investor continuing to the funding site.
On-line intermediaries have specific record-keeping obligations, and must take steps to ascertain that the persons viewing crowdfunding offerings through their website are in fact Colorado residents.
On-line intermediaries may generally advertise their website but may not “identify, promote, or otherwise refer to a security offered by it.’ (C.R.S. § 11-51-308.5(3)(c)(V)).
The CF Act amended the Colorado Securities Act to exempt on-line intermediaries acting within the limitations of the CF Act from the registration requirements for broker-dealers and sales representatives. (C.R.S. § 11-51-402(1)(c)) Where an on-line intermediary reaches beyond the narrow scope of permissible actions described in the statute and the rules, the on-line intermediary may venture into broker-dealer territory. For example, an on-line intermediary who sends out an issuer-specific notification to its email list may be considered to be “engaged in a solicitation”; on the other hand, an affiliate of the on-line intermediary that is not an alter ego of the on-line intermediary may be able to provide these and other services in the nature of “marketing” or “crowd formation” to the issuer. Transaction-based compensation and direct solicitation and marketing is likely to result in broker-dealer classification, however. In this consideration, it is important to note that a number of on-line intermediaries doing business in other states are in fact licensed broker-dealers.
Subject to the requirements of Rules 3.27 and 3.28.C (discussed below), the role of an on-line intermediary may be passive—a bulletin-board like posting service. In some cases, the on-line intermediary may have a more active role. The rules contemplate that an issuer may contract with an on-line intermediary to collect residency information and preserve records for the benefit of the issuer, but this remains the issuer’s responsibility. (Rule 3.23.B) To help on-line intermediaries identify the boundaries of its role as compared to that of a broker-dealer, the rules also provide that an on-line intermediary that “does nothing more than collect information regarding the purchase of securities” and “provides a link to transmit funds to the escrow agent” is not conducting a prohibited act. (Rule 3.29.B)
Rules 3.27 and 3.28.C impose certain obligations on on-line intermediaries which require the on-line intermediary to be more involved than the typical bulletin-board posting.
Rule 3.27 requires on-line intermediaries to establish “written supervisory procedures and a system for applying such procedures that is reasonably expected to prevent and detect violations of the Colorado Securities Act, given the limited role of the on-line intermediary under the CF Act.”
More significantly, Rule 3.28.C requires that the on-line intermediary affirmatively “deny access” to an issuer where the on-line intermediary has a “reasonable basis for believing”:
that the issuer is not in compliance with § 11-51-308.5;
has not established a means to keep accurate records; or
that the issuer or offering presents the potential for fraud or otherwise raises concerns regarding investor protection.
The use of the phrase “reasonable basis” in the context of Rule 3.28.C does not necessarily impose a due diligence obligation on the on-line intermediary; it does not permit the on-line intermediary to ignore facts that would come to its attention that might suggest the negatives set forth in the Rule. The wording of this rule creates an affirmative obligation to “deny access” only when the intermediary reasonably believes wrongdoing is occurring. This prohibits “willful blindness” on the part of the on-line intermediary; however, it does not require the same level of due diligence as (for example) the rule requiring the issuer to reasonably believe that the investor is a Colorado resident (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)), which requires documentary confirmation, or Rule 3.24.A.1, which requires an affirmative “reasonable basis” for determining that a purchaser is an “accredited investor” to take advantage of that provision.
With experience, the on-line intermediary may become the driving force behind crowdfunding in Colorado. Where the on-line intermediary has established a successful track record of relationships with escrow agents and investors, they may attract issuers. Where the on-line intermediary has offered record retention services and other permitted services at a reasonable cost, the on-line intermediaries will be instrumental in the success of the offering and compliance with the CF Act. Because an investor may use an on-line intermediary for more than one crowdfunding investment, the on-line intermediaries will likely look at the investors as their clients—not the issuers. Hopefully this will assist in the goal of investor protection which is the focus of the Colorado Securities Act.
All Crowdfunding Offerings Must Be Through Escrow. Importantly, the CF Act requires that all crowdfunding offerings be funded through an escrow at a depository institution, such as a bank or savings and loan (C.R.S. §§ 11-51-308.5(3)(a)(IV)(D); 11-51-308.5(3)(a)(IV)(F); and 11-51-308.5(3)(a)(IX)). The maximum amount of the offering to be raised can be no more than twice the minimum amount of the offering, and funds cannot be released from escrow until at least the minimum offering is raised.
The CF Act provides that the escrow agent must be “a bank, regulated trust company or corporate fiduciary, savings bank, savings and loan association, or credit union authorized to do business in Colorado” (C.R.S. §§ 11-51-308.5(3)(a)(IV)(D)). This is somewhat different than the definition of “depository institution” found in C.R.S. 11-51-201(5), but hopefully will be interpreted similarly.
When the issuer has raised at least the minimum offering in the escrow and desires the release of the offering proceeds (whether or not the issuer wishes to continue the offering), the issuer must file a Form ES-CF with the Securities Commissioner and wait seven days before having the funds released from escrow. As a condition to the release from escrow, the issuer must also provide for the delivery of the securities and certain notices to the persons participating in the crowdfunding offering as defined in the rules. It is likely that many of the crowdfunded securities will be uncertificated.
Corporate stock may be certificated or uncertificated. If uncertificated, C.R.S. § 7-106-207 sets forth the information that must be included in a written statement that (according to the CF Act and the rules) must be sent to the purchaser at or before the release of the escrow funds. C.R.S. § 7-106-206 sets forth the information that must be included on certificates for corporate stock.
Neither the Colorado LLC Act nor the partnership acts contemplate certificates representing ownership interests. Even an issuer-made certificate would not constitute a “certificate” in the corporate sense unless the election contemplated under § 4-8-202 is made in the operating agreement or partnership agreement.
Where the securities consist of a debt instrument (such as a promissory note), the debt instrument should be in writing and delivered at or before the release of the escrow funds.
In any case, it is important that the issuer maintain records accurately reflecting the ownership of the securities issued in the crowdfunding offering and any other outstanding securities of the issuer. The issuer may choose to do this directly or by retaining a transfer agent to do so.
While the issuer may continue the crowdfunding offering after obtaining the release of funds from escrow, all funds must still go through the escrow account and releases from the escrow must be accomplished in accordance with the rules. Furthermore, any release of funds from the escrow is likely a material event for which the issuer would be obligated to update its disclosure; the expenditure of those funds after release from escrow may also be a material event requiring updated disclosure.
Data Collection, Record-Keeping, and Reporting. The on-line intermediary may provide a method of collecting data from investors who deposit funds into escrow, and may provide a portal to the escrow agent for the transfer of funds by ACH. These are among the records that the issuer must obtain and retain, although the rules provide that the issuer may contract with the on-line portal to maintain the records retention on the issuer’s behalf.
During and following the offering, the issuer has certain reporting obligations to all of its owners, including the new investors. These reports are defined in the CF Act and the rules, and the obligation continues indefinitely. Wise issuers will report more frequently to their owners and investors than the quarterly report required by the CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) and the rules (Rule 3.24.D, Notice of Completion of the Transaction and Rule 3.24.H, Quarterly Report Timing). The CF Act does set forth the minimum requirements for these reports, however, including an obligation to report the compensation being paid to the directors and executive officers and to provide a management analysis of the issuer’s business operations and financial condition.
Bad Actors Are Prohibited. Certain persons are prohibited from using the exemption from registration provided by the CF Act. These are referred to as “bad actors” and the definition is similar to the similar definition found in SEC Rule 506(d). The CF Act has provisions that the “bad actor” prohibition to both issuers (C.R.S. § 11-51-3-8.5(3)(a)(XIII)) and on-line intermediaries (§ 11-51-308.5(3)(c)(VII)), but Rule 3.30 expands the disqualification for issuers well beyond the SEC Rule 506(d) definition of “bad actors.”
The rules provide that where an issuer is subject to a bad actor disqualification, the Securities Commissioner can waive certain of the bases for disqualification. The Securities Commissioner will not waive a disqualification based on certain felony convictions and certain final orders issued by the SEC or state securities administrators. Before issuing a waiver, the Commissioner must make the following finding:
In balancing all relevant factors, granting the waiver is consistent with the objective of the Colorado Securities Act to protect investors and maintain public confidence in securities markets while avoiding unreasonable burdens on participants in capital markets.
Liability Risk From Crowdfunding
Unlike the rewards-based crowdfunding models of Kickstarter, Indiegogo, and other similar sites, crowdfunding under the CF Act involves the offer and sale of securities which is subject to regulation under and compliance with federal law (the Securities Act of 1933 and the Securities Exchange Act of 1934) and, in Colorado, the Colorado Securities Act. Strict compliance with the CF Act and the rules does not exempt the issuer or the other participants in the offering from potential liability; a failure to comply strictly with the CF Act and the rules may lead to potential administrative civil, or even criminal, liability.
Federal Compliance. The first issue under the CF Act, as under the crowdfunding legislation adopted in more than 20 other states, is compliance with SEC Rule 147 which provides an exemption from the registration requirements of § 5 of the 1933 Act. A failure to comply with Rule 147 leads to a violation of the registration requirements of the 1933 Act and the risk of issuer liability for rescission (§ 12(a)(1) of the 1933 Act) and the liability of the persons controlling the issuer (§ 15 of the 1933 Act).
Even strict compliance with the requirements of Rule 147 does not preclude the risk of future liability. Like all exemptions from registration, Rule 147 merely exempts the offering from the registration requirements of the 1933 Act; it does not provide an exemption from the disclosure and anti-fraud requirements.
Where the disclosure in the Colorado Form CF-2 is inadequate, incomplete, or inaccurate in any material respect, the issuer (under 1933 Act § 12(a)(2) and 1934 Act Rule 10b-5) and persons controlling the issuer are potentially liable, as are (potentially) other participants in the offering.
Where the issuer or its controlling persons take actions (such as spending the proceeds raised) contrary to the disclosure, they have significant risk of liability.
When broker-dealers or sales representatives are involved in the offering, they have the risk of liability under both federal law and the rules of their governing organization, the Financial Industry Regulatory Authority (“FINRA”). When an on-line intermediary is involved, the liability of the on-line intermediary is lesser as long as the on-line intermediary does not participate in the offering beyond merely posting the disclosure documents and perhaps gathering information and maintaining certain limited records.
Of course, where the on-line intermediary (or any other participant in the offering) knows, or reasonably should know, that the disclosure is inadequate, incomplete, or inaccurate in any material respect, such persons have significantly increased their risk of liability in an administrative, civil, or even criminal forum.
Colorado Compliance. Strict compliance with the CF Act and the rules also creates an exemption from the registration requirements found in § 11-51-301 of the Colorado Securities Act. Disclosure in the Form CF-2 that is accurate and complete in all material respects also limits the risk of liability for securities fraud. Where there is a failure to comply with the exemption or the disclosure requirements in any material respect, issuers and persons controlling the issuer are potentially liable in a state administrative, civil, or even criminal forum.
In Colorado, § 11-51-501 makes it unlawful for any person (issuer, broker-dealer, sales representative, or investment advisor) or controlling person (§ 11-51-604(5)) to “employ any device, scheme, or artifice to defraud” an investor, to “make any untrue statement of a 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 are made, not misleading,” or to “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Where the Securities Commissioner suspects a violation of the registration requirements, the broker-dealer licensing requirements, or the disclosure requirements, he may initiate an investigation (§ 11-51-601) or seek enforcement by an administrative cease-and-desist proceeding (§ 11-51-606(1.5)), injunction (§ 11-51-602), civil action (§ 11-51-604), or through a criminal proceeding (§ 11-51-603). Under § 11-51-604, investors may also seek civil damages against the issuer and controlling persons for violations of the anti-fraud rules.
Colorado Crowdfunding Act. The CF Act provides certain exemptions from liability which are applicable to the Colorado Securities Act but which would not be applicable under a federal complaint.
There is no provision exempting issuers or the issuer’s controlling persons from liability for disclosure that is inadequate, incomplete, or inaccurate in any material respect, or for post-offering actions that are inconsistent with the disclosure made.
Escrow agents are the key to the success (and even the ability to conduct) an offering under the CF Act. The Act (in § 11-51-308.5(3)(a)(IV)(D)) provides that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.” Most escrow agreements will provide contractual exoneration of the escrow agent except in the case of bad faith or willful misconduct by the escrow agent.
Broker-dealers and sales representatives participating in any offering under the CF Act remain subject to their regulatory obligations, including due diligence and “know your customer.” Because of these continuing requirements, broker-dealers and sales representatives will want to complete due diligence investigations and hire legal counsel—all of which will make a crowdfunding offering much more expensive to the issuer.
On-line intermediaries (defined in § 11-51-201(11.5)) are more likely participants in crowdfunding offerings in Colorado than are broker-dealers and sales representatives. On-line intermediaries are specifically exempted from the definition of “broker-dealer” under § 11-51-402(1)(c) provided the on-line intermediary limits its activities as contemplated in the CF Act and the rules. Even though originally contemplated to be passive bulletin boards who may provide some services, the rules impose certain additional obligations not specifically contemplated in the CF Act, including the obligations described in Rule 3.28.C to deny access to the on-line intermediary where the on-line intermediary has a “reasonable basis” for believing that the issuer is not acting in compliance with the CF Act, that the issuer does not have adequate record-keeping capabilities, or that the issuer raises investor protection concerns.
The Risk of Fraud. Fraud is one of the principal risks of a crowdfunding offering as it is with any capital raising transaction involving the offer and sale of securities. It is likely that offerings under the CF Act will follow the national trend—where purchasers invest from $100 to $300 in equity or debt securities. In most cases, this will be “pocket change” or “slot machine money.” Where the purchaser loses her investment either through a bad business decision or even fraud, it likely will not be worth the purchaser’s time and expenditure to take legal action. Perhaps the purchaser will file a complaint with the Colorado Division of Securities, but it is unlikely that the purchaser will take any more extensive action to recover her investment.
Thus, purchasers of crowdfund securities seeking to protect themselves should follow the typical mantra of investor advocates—know and trust your management. This again leads to the most-likely-to-be-successful crowdfunding offering—those within affinity groups where the investors know management or have other bases to trust management.
Is There a Role for Attorneys?
Although crowdfunding is intended to be a simple concept for small businesses and startups in Colorado to raise capital (as described by Representative Lee in his press release issued August 5, 2015), and even though the rules and the forms are written in a step-by-step nature, anticipating that most issuers will proceed without sophisticated legal counsel, there remain sophisticated legal issues that each issuer will have to address. Crowdfunding issuers proceeding without legal counsel will be well-advised to understand the rules and the statute. On-line intermediaries and other advisors need to consider issues surrounding the unauthorized practice of law before assisting prospective issuers in their efforts to comply with the CF Act.
Among the legal questions that issuers and on-line intermediaries will need to address in each crowdfunding offering will be:
What is a “single plan of financing” under Rule 147 and how is that interpreted with the limitations of C.R.S. § 11-51-308.5(3)(a)(XI)? Does any prior securities offering by the issuer restrict the issuer’s ability to conduct a crowdfunding offering?
Where do the actions of the on-line intermediary become the actions of an unlicensed broker-dealer? Where does the advice provided to the issuer by the on-line intermediary become the unauthorized practice of law?
Who drafts the escrow agreement and the agreement with the on-line intermediary, and interprets it for the issuer? This is unlikely to be an off-the-shelf form and will have to be tailored to each issuer, on-line intermediary, and offering.
What is “adequate disclosure” for the purposes of Form CF-2?
What level of due diligence and documentation will be sufficient to meet the issuer’s and on-line intermediary’s obligations when determining residency of investors and whether they are accredited?
How does the issuer manage the future transferability of the securities issued under the CF Act, and what in fact are the limitations?
Does the “reasonable basis” requirement for on-line intermediaries under Rule 3.28.C require that the on-line intermediary take affirmative steps, or does it merely prohibit willful blindness?
Does the issuer’s notice to the crowd meet the requirements of being “within Colorado” as defined in Rule 3.24.I?
These legal questions have to be considered based on a specific set of facts—facts that likely change from issuer to issuer, on-line intermediary to on-line intermediary, and offering to offering. Those issuers and on-line intermediaries who proceed without competent legal assistance will be taking risks. Unfortunately, lawyers usually want to be paid whether or not the offering is successful, or even commenced. This may be a significant investment for the prospective crowdfunding issuer.
Another consideration for prospective crowdfunding issuers is how to deal with the resulting investors. Assuming that the crowdfunding offering is successful, the issuer may have several hundred to perhaps several thousand new security holders. The CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) requires quarterly reporting to these owners. The larger the number of owners, the more difficult reporting will be. Furthermore, experience in the public company world indicates that these owners will be seeking information from the issuer on a regular basis, lodging complaints where performance is not as expected, and trying to develop a trading market. Each security holder is likely to have a different, personalized agenda that may result in significant management time and expense to resolve.
Thoughts on Crowdfunding in Colorado
If the risks can be managed to the satisfaction of the participants, the CF Act may become an extremely useful tool in capital formation for small businesses. It is new, the rules and the Act itself are untested, and there will undoubtedly be many issues that develop. One of the biggest may be whether any depository institution (defined in C.R.S. § 11-51-101) will be willing to act as an escrow agent in a crowdfunding offering at a reasonable cost, recognizing that many investments are likely to be small—$100 or so per person. In brief discussions with certain local banks, they have expressed reluctance to participate in these untested offerings, even though the CF Act specifically provides (in § 11-51-308.5(3)(a)(IV)(D)) that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.”
It is likely that crowdfunding offerings will be targeted to affinity groups by the issuers—perhaps a broader version of a “family and friends” private placement. Karl Dakin has written a number of blogs that relate to crowdfunding including one entitled “Characteristics of a Crowd” (May 11, 2015). As Professor Dakin indicates, “any message within a crowdfunding campaign must address the perspective of the investor.” Included in the perspective of the investor is whether the investor is considering investing “pocket change” or an investment that could be characterized as “a major life decision.” As Professor Dakin advises with respect to the issuer’s disclosure and other communications with prospective investors:
Too often, entrepreneurs fail to address the perspectives of the investors. They either assume that all investors are alike or that their deal is so good that all investors will invest. This is not true for classical investments based upon seeking a return on investment. And, it will represent a greater error in thinking with regard to crowdfunding.
As a result, Professor Dakin notes that too many issuers are “looking for money in all the wrong places,” “pitching to the wrong people,” “pitching too early” before the issuer is ready, “not knowing the investor,” and considering “investors as ATMs.”
In his paper Teenage Crowdfunding, Professor Andrew A. Schwartz of the University of Colorado Law School predicts that younger entrepreneurs will take advantage of crowdfunding because of their social media and networking skills. Chris Tyrell of Crowdfund Insider suggests that “Crowdfunding is Changing the Female Entrepreneurial Landscape.” Crowdfunding may in fact become the capital formation tool that the Colorado legislature and the U.S. Congress envisioned, but expectations have to be moderated to fit within reality.
Because of the lesser formality of the crowdfunding process, abuse and fraud are possible. Because of the smaller amounts raised, it is hoped that such abuse will be nominal. Nevertheless, prospective investors and attorneys who advise them must be alert for warning signs. Knowing your principals is your best protection, which is why affinity crowdfunding offerings are more likely to succeed than blind offerings to unknown investors. On the other hand, there has been plenty of affinity fraud in the annals of the Securities and Exchange Commission. (See “Affinity Fraud: How To Avoid Investment Scams That Target Groups” (last visited July 15, 2015)).
Properly used and constructed, however, crowdfunding in Colorado may be a very successful tool for smaller businesses seeking to raise capital within their sphere of influence—customers, clients, vendors, friends, family, and others. Although contemplated in the CF Act, it is unlikely that broker-dealers or sales representatives will be involved in the offerings because of their due diligence obligations under their regulatory rules (and the related cost which would be passed on to the crowdfunding issuer). It is also unlikely that issuers will use sophisticated legal guidance, again because of the cost which can quickly make a smaller offering unaffordable.
The best advice for an issuer looking for a crowdfunding offering is to be familiar with the statute and the rules, and to seek an on-line intermediary that will be competent and provide assistance, not only posting the disclosure, but also ensuring the residency of the investors, the required record keeping, arrangements with an affordable escrow agent, and perhaps providing other help in exchange for the non-percentage based fee. On-line intermediaries that are not broker-dealers are operating in other states that have already authorized crowdfunding; as the CF market develops, on-line intermediaries can be expected to appear in Colorado. This may be sooner; this may be later, and it will depend on the market. There will likely be competent on-line intermediaries, and unfortunately there will likely be incompetent on-line intermediaries; issuers should make all relevant inquiries to be comfortable that they are dealing with the correct on-line intermediary.
Let the offerings roll!