Part 2 of a 5 Part Series
Addressing the Issues and the SEC’s Solution
As the paraphrased saying goes, with great fundraising power comes great legal complexity. In our last blogpost, we discussed the historical and contextual backdrop of Rule 3a-9 of the Investment Company Act of 1940, as amended (the “ICA”) and briefly touched on how it operates within the investment crowdfunding ecosystem to provide a solution to the administrative and compliance obstacles imposed by Section 4A(f)(3) of the Securities Act of 1933, as amended (the “Securities Act”). In this second installment in our blogpost series, we explain how Rule 3a-9 was designed to address the challenges posed by Section 4A(f)(3) of the Securities Act and how it operates to untangle the web of regulatory constraints.
Crowdfunding SPV Investment Company Treatment and Section 12(g) Risks under the Original Regulation Crowdfunding Rules
Section 4A(f)(3) of the Securities Act explicitly prohibited investment companies from relying on the Regulation Crowdfunding (“Reg CF”) exemption from the registration requirements of the Securities Act. An SPV in the Reg CF context would sell its own securities to the crowd in a Reg CF campaign, and then would use that capital to buy securities of the company seeking to raise capital. This type of SPV would fall under the prohibition in Section 4A(f)(3) of the Securities Act because it would be considered an “investment company,” i.e., a company “engaged primarily… in the business of investing, reinvesting, or trading in securities.” This meant that SPVs could not be utilized for Reg CF campaigns without running afoul of Section 4A(f)(3) of the Securities Act, not to mention the investment company registration requirements of the ICA.
Further, and as discussed in our previous blogpost, companies also risked being required to register their securities with the Securities and Exchange Commission (the “SEC”) under Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As a reminder, Section 12(g) of the Securities Act sets a threshold for (i) the total value of an issuer’s assets, and (ii) the number of investors in a single class of securities of the issuer, before it must register its securities with the SEC. While Reg CF issuers are afforded a conditional exemption to Section 12(g) under SEC Rule 12(g)-6, which will be discussed in greater detail in a later blogpost in this series, Reg. CF issuers who did not meet the criteria for that exemption found themselves beholden to the asset and investor restrictions of Section 12(g) in their fundraising efforts. Without the ability to pool Reg CF investors into one entity (or one line item on the capitalization table), crowdfunded companies had to be careful with the value of their assets, and if applicable, how many investors they took investments from.
Potential Solutions
One possible solution to these problems would have been to remove the prohibition of Section 4A(f)(3) all together. This would have been contrary to the SEC’s intent, however, to preserve the crowdfunding space for its intended beneficiaries, i.e. startups and small businesses, and to protect unsophisticated retail investors from the risks of investing in the complex investment vehicles that comprise the majority of investment companies registered under the ICA. With this in mind, the SEC needed a more precise solution that would allow the use of Reg CF SPVs while still excluding investment companies from the crowdfunding space.
Rule 3a-9 of the Investment Company Act of 1940 and Its Accomplishments
Enter Rule 3a-9 of the ICA. Rule 3a-9, as adopted, is a carveout exemption from the definition of an “investment company” under the ICA specifically for Reg CF SPVs. Rule 3a-9(a) begins with “a crowdfunding vehicle will be deemed not to be an investment company if the vehicle…” Rule 3a-9 then proceeds to list nine conditions that must be met for the rule to apply.
While the requirements of Rule 3a-9 will be discussed at length in our next blogpost, it is easy to recognize what this new exemption accomplished. On the one hand, Section 4A(f)(3) was left untouched so that investment companies are still prohibited from utilizing Reg CF to raise capital, thus protecting the investment crowdfunding space from dilution by more advanced invaders (i.e., investment companies) and protecting the general investing public from investments the SEC indirectly deemed too complex for comfort (i.e., investments in investment companies). Simultaneously, Rule 3a-9 allows companies seeking to raise capital pursuant to Reg CF to ease the administrative and financial burdens of having a capitalization table of hundreds or thousands of investors. Rule 3a-9 accomplishes this easing of burdens by permitting an SPV formed for the specific purpose (i.e., with no other business purpose) of taking in investments from crowdfunding investors and then using that cash to invest in the company seeking to raise capital under Reg CF. The result is one clean investor (i.e., the SPV), in which all crowdfunding investors are owners, on the company’s capitalization table.
And in addition to easing the administrative and financial burdens of managing an unwieldly capitalization table, having only one investor on a company’s capitalization table greatly reduces the risk of triggering the registration requirements under Section 12(g) of the Securities Act. It is important to note, however, that the treatment of a crowdfunding SPV as a “single investor” is subject to possible look-through conditions, codified in Rule 12g5-1(a)(9)(ii) of the Securities Act, which will be discussed in a future blogpost.
Ancillary Benefits
As an added bonus, moreover, the SPV structure not only ensures that investors in the SPV receive the same exposure as if they had invested directly in the company seeking to raise capital in the Reg CF campaign, but it may even encourage companies to offer voting rights and other terms to investors that might not have been included in the terms of the securities offered had the investors been directly on the company’s capitalization table.
In sum, Rule 3a-9 emerged as a catalyst to the ever-improving investment crowdfunding landscape by allowing issuers to utilize SPVs to aggregate crowdfunding investments into a single entity. The result has been that crowdfunded companies are released from their substantial capitalization table management burdens and investor threshold risks, while Rule 3a-9 itself maintains consistency with the intent of Reg CF, preserves the rights and economic exposure of investors, and ensures the investment crowdfunding space is reserved for startups and small businesses.
By: Jason Siev, Ryan Blum, and Robin Sosnow