FINRA: Funding Portals, Start Your Engines!

by Pepper Hamilton LLP
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The regulatory framework for the crowdfunding exemption created under the Jumpstart Our Business Startups Act of 2012, or JOBS Act, is beginning to take shape. On the same day the Securities and Exchange Commission (SEC) published crowdfunding rules for comment (See Pepper’s October 23, 2013 Client Alert, “SEC Proposes Crowdfunding Rules”), the Financial Industry Regulatory Authority (FINRA) issued rules governing funding portals.

If you’ve never heard of a funding portal, don’t fret – it is a new type of financial intermediary that was created by Congress under the JOBS Act to facilitate equity crowdfunding to the general public. Under the JOBS Act, issuers using the crowdfunding exemption to offer securities to the public (as opposed to accredited investors) must offer and sell their securities through SEC-registered broker-dealers or funding portals that have registered as crowdfunding intermediaries. The act further requires funding portals to gain membership in a national securities association – spoiler alert: FINRA is the only national securities association. The full text of FINRA’s proposed rules, forms, and the accompanying regulatory notice may be read at: http://www.finra.org/Industry/Regulation/Notices/2013/P370744.

The newly proposed funding portal application rules and forms provide for a “slimmed down” application of current FINRA broker-dealer rules on funding portals. Sort of an all-star team of your old favorites, but now in a convenient funding portal size.

Applying to be a funding portal and maintaining compliance with the “new” rules is not an undertaking to be taken lightly or for the faint of heart. Below is an outline of the new FINRA rules and their relationship to current FINRA broker-dealer rules:

Proposed Funding Portal Rules

Summary of Rule

Rule 100 – General Standards

  • Provides that FINRA by-laws apply to funding portals and associated persons.

Rule 110 – Establishes membership application process for funding portals

  • Provides for approval decisions within 60 days after an application is filed, as opposed to 180 days for broker-dealer applications.
  • Consolidates the 14 application standards under FINRA’s Form NMA and CMA Series for broker-dealers into five standards:
    1. ability to comply with federal securities laws and FINRA rules
    2. business relationships and contractual arrangements that demonstrate ability to initiate business operations
    3. supervisory system
    4. direct and indirect funding sources, and
    5. recordkeeping systems.
  • Requires funding portal members to maintain fidelity bond coverage.

Rule 200 – Establishes professional conduct standards for funding portals

  • Generally based on the FINRA Rule 2010 Standards of Commercial Honor and Principles of Trade.

Rule 300 – Establishes supervisory structure for funding portals

  • (a) Requires funding portals to supervise the activities of associated persons.
  • (b) Requires a written anti-money laundering compliance program, but allows independent testing for compliance every two years.
  • (c) Requires reporting of regulatory proceedings and disciplinary activities.

Rule 800 – Investigations and Sanctions

  • Generally subjects funding portals to FINRA investigations and sanctions (FINRA Rule 8000 Series).

Rule 900 – Code of Procedure

  • Generally applies the FINRA Code of Procedures (FINRA Rule 9000 Series) to funding portals.

Rule 1200 – Arbitration and Mediation

  • Generally applies FINRA arbitration and mediation procedures (FINRA Rule 12000 Series, 13000 Series, and 14000 Series) to funding portals.

As a reminder, under the JOBS Act and the SEC’s proposed rules, funding portals are very limited in their role facilitating public equity crowdfunding, yet are still bestowed with great responsibility. Specifically, funding portals are prohibited from:

  • offering investment advice or recommendations
  • soliciting purchases, sales or offers to buy the securities
  • compensating employees based on sales, and
  • holding, managing or possessing investor funds or securities.

On the other hand, funding portals must do all of the following:

  • provide disclosures related to risks and other investor education materials as the SEC shall require
    • ensure that each investor reviews investor education materials
    • obtain investor representation that he or she understands:
      • that entire investment is at risk
      • that investing in start-ups and emerging companies is risky, and
      • that crowdfunding investments are illiquid
  • obtain background check on officers, directors and 20 percent or greater shareholders
  • file with SEC and distribute disclosure materials at least 21 days prior to first sale date
  • ensure offering proceeds are only provided to the issuer when the raise has met its target; if the target is not met, it must allow investors to cancel orders
  • make efforts to ensure no investor exceeds the individual crowdfunding investment cap across all transactions
  • protect investor privacy
  • not work with issuers where a portal officer, director or partner has a financial interest.

FINRA has requested comments on all aspects of the proposed funding portal rules, and has made specific requests for comments on the following issues:

  • adequacy of investor protections
  • non-imposition of licensing requirements on associated persons of funding portal members
  • cost of fidelity bond coverage for funding portals
  • cost of implementing and maintaining supervisory systems
  • propriety of regulatory burden placed on funding portals
  • accommodating the scope of the funding portal business.

The comment period will expire on February 3, 2014.

Pepper Points

  • FINRA has done a commendable job streamlining a highly complex broker-dealer registration and compliance regimen to tailor it for funding portals.
  • FINRA has not proposed that funding portal representatives be licensed (e.g., by maintaining a Series 7, 24 or 63 exam).
  • Many of these rules appear to be “check the box” standards, but FINRA will have broad examination and disciplinary authority over funding portals.
  • Time will tell if enough entrepreneurs are interested in starting funding portals given the still high-touch regulations and the overall viability of public equity crowdfunding.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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