Technology has spawned the formation of new internet-based marketplaces for illiquid and restricted securities. In most instances, these markets are operated by entities registered with the U.S. Securities and Exchange Commission (“SEC”) as broker-dealers under the Securities Exchange Act of 1934 (“Exchange Act”). Last year, the JOBS Act1 expanded opportunities for companies to use technology to raise capital more efficiently by, among other things, relaxing the limitations on solicitation of accredited investors in Regulation D under the Securities Act of 1933 (“Securities Act”). The JOBS Act also created a new exception from broker-dealer registration to permit entities to create “funding portals” for the purpose of introducing new investment opportunities to accredited investors. In recent months, the staff of the SEC’s Division of Trading and Markets (“Staff”) has issued FAQs as well as two no-action letters that facilitate the development of these new portals. This OnPoint discusses some of the recent developments in the area.
Section 15(a) of the Exchange Act requires persons who fall within the definition of a broker to become registered with the SEC and also to become members of the Financial Industry Regulatory Authority, Inc. (“FINRA”). The formation and ongoing compliance costs associated with operating as a registered broker-dealer can be significant. The term “broker” is defined in the Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Typical badges of broker activity include “holding oneself out” as being a broker and the receipt of “transaction-based compensation” (which provides the person with a so-called “salesman’s stake” in the success of a transaction).
Section 201 of the JOBS Act
Section 201 of the JOBS Act, enacted by Congress in 2012, seeks to reduce costs and delays that companies may encounter in raising capital. Among other things, section 201 will remove the limitations on general solicitation or advertising that apply to issuers relying on the exemption from securities registration in section 4(2) of the Securities Act and Rule 506 of Regulation D – as long as all purchasers of the securities are accredited investors.2
The JOBS Act also seeks to reduce the costs that intermediaries may incur when providing companies with access to potential investors. Section 201(c) of the JOBS Act adds new paragraph (b) to Section 4 of the Securities Act. This provision states a person who conducts an offering in compliance with Rule 506 of Regulation D will not be required to register with the SEC as a broker-dealer, solely because such person “maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities,” (emphasis supplied) or because that person engages in general solicitations of securities (the “Exemption”).
A person relying on the Exemption may not receive “compensation in connection with the purchase or sale of the security,” have possession of customer funds or securities in connection with the purchase or sale, or be subject to a statutory disqualification as defined in section 3(a)(39) of the Exchange Act. However, the Exemption permits such a person to co-invest in the securities and provide “ancillary services.”
Staff FAQs Regarding the Section 201 Exemption
In February 2013, the Staff issued FAQs addressing multiple issues that have arisen with respect to the Exemption. Among other things, the Staff noted that the Exemption currently is available to persons who wish to rely on it and – unlike other provisions of the JOBS Act – requires no further rulemaking or activity by the SEC.3 Nevertheless, many of the specific terms of the Exemption had not been defined through any formal SEC guidance. In the FAQs, the Staff sought to provide informal guidance that is customarily relied on as though it was issued by the SEC itself.
In the FAQs, the Staff noted:
The Exemption from broker-dealer registration only applies when securities are offered and sold under Rule 506 of Regulation D.
Issuers only will be permitted to rely on the Exemption to conduct internet offerings after the SEC adopts new rules permitting general solicitations under Rule 506.
Internet websites and other social media are specifically covered by the Exemption.
The prohibition against receipt of “compensation in connection with the purchase and sale of a security” includes not only “transaction-based compensation,” but also “any direct or indirect economic benefit to the person or any of its associated persons.” However, because Congress expressly permitted co-investment in the securities being offered, profits associated with these investments would not be impermissible compensation. The Staff suggested that, because of the limits on compensation, the Exemption would primarily be used by venture capital firms.
Salary or other compensation paid to internal marketing staff of an adviser would be considered compensation to such persons in connection with the purchase or sale of securities for purposes of the Exemption.4
Further, the Staff noted that the JOBS Act provides an Exemption from broker-dealer registration only – and that any provisions of the securities laws that otherwise pertain to brokers still may be applicable. The FAQs also offered a reminder that the Exemption applies only to registration with the SEC, and is not an exemption from any state broker-dealer registration requirements.
Recent Investment Portal No-Action Letters
Despite the initial guidance provided by the Staff in the FAQs, numerous practical questions about the operation of the Exemption remained unanswered. In March, however, the Staff issued no-action letters to (i) FundersClub Inc. (“FundersClub”) and FundersClub Management LLC (“FC Management”) and (ii) AngelList LLC (“AngelList”) and AngelList Advisors LLC (“AngelList Advisors”), which may provide some additional guidance.5 The no-action letters indicate the Staff would not recommend enforcement action to the SEC, based on the facts outlined in the letters, if the parties do not register as broker-dealers. Although the no-action letters do not specifically address terms of the Exemption, they may provide guidance as to the types of activities that will be permissible under the Exemption, including procedures for the safekeeping and custody of funds and securities.
Both FundersClub and AngelList argued that no-action relief was consistent with prior SEC no-action letters on broker-dealer registration.6 In particular, the Staff noted that: (1) the firm either was a registered investment adviser under the Investment Advisers Act of 1940 (“Advisers Act”), or a venture capital fund adviser relying on the exemption from investment adviser registration in Advisers Act Rule 203(1)-1; (2) there would be no fees contingent upon the outcome or completion of any securities transaction (compensation would be traditional advisory compensation); (3) the sponsors would not participate in any negotiations between the companies and investors (though they could negotiate with the companies raising funds); (4) the entities would not handle funds or securities involved in completing a transaction; and (5) the entities would not hold themselves out as providing any securities-related service other than a listing or matching service. Set forth below is a general summary of the proposed activities outlined in the no-action requests.
FundersClub and its wholly-owned subsidiary FC Management are advisers to venture capital funds, as defined in Rule 203(1)-1 of the Advisers Act, and therefore exempt from registration as investment advisers. FC Management manages a series of separate investment funds formed for the purpose of investing in one of more start-up companies. As part of this structure, FC Management is permitted to exercise any management rights that it has negotiated with the start-up company, and can sell securities of the start-up company in the secondary market.
FundersClub and FC Management identify and undertake due diligence of the start-up companies, set target amounts of capital, and then post information regarding the start-up companies on the FundersClub website. Subsequently, FundersClub members can submit non-binding indications of interest regarding individual companies that have been posted on the website. Once a fund has reached a target amount of non-binding indications of interest from potential investors, FundersClub negotiates definitive terms of the investment with the start-up company. At that time, FC Management will sign LLC agreements with the investors. Such investors must submit funds to a custody account subject to Rule 206(4)-2 of the Advisers Act, and such funds will then be invested in the start-up company.
FundersClub and FC Management will not receive compensation for selling securities. Instead, they are compensated on the basis of their work in organizing and managing the investment funds. Their compensation is expected to be 20% or less (and is capped at a maximum 30% rate) of the profits of the investment fund. FC Management may also charge an administrative fee that is used to defray actual out-of-pocket costs of the investment fund, including legal fees for fund formation, state filing fees, custody fees and tax reporting fees.
AngelList Advisors is a registered investment adviser that functions as a wholly-owned subsidiary of AngelList. AngelList Advisors identifies and approves portfolio companies, potential “angel investors,” and a “lead angel investor.” Once it has identified and approved a portfolio company and its corresponding lead angel investor, it forms a separate investment vehicle that has the purpose of investing in that portfolio company. AngelList Advisors then makes the investment vehicle available to potential angel investors. If sufficient interest is received, it closes the investment vehicle and collects subscription agreements from the participating investors. After reviewing their subscription agreements, approved investors will be asked to forward capital contributions to a bank or other financial institution.
In its no-action letter request, AngelList described two types of investment models: an Angel Followed Deal and an Angel Advised Deal. In an Angel Followed Deal, the lead angel will not need to take an active role. In an Angel Advised Deal, the lead angel will take an active role in identifying the investment opportunity, leading negotiations, and providing significant managerial assistance and financial guidance.7 AngelList intends to use both models for its investment portal.
AngelList Advisors will provide investment adviser and administrative services to the investment vehicle. These services include determining whether to form the vehicle, seeking investments in the vehicle, determining when and on what terms to dispose of the vehicle’s investments, exercising voting rights, and deciding whether the vehicle should make distributions.
AngelList Advisors will not receive commissions or management fees, but will receive compensation on the basis of carried interest. Accordingly, the compensation would be equal to a portion of the increase in value of the investment. AngelList Advisors will pay for the initial capital requirements to fund organizational costs and expenses.
Common Factors Considered by the SEC Staff
Both of the companies that received no-action letters intend to operate in the venture capital space – though only the FundersClub letter was conditioned on the firm falling within the definition of a venture capital firm in Rule 203(1)-1 of the Advisers Act. While the services of the firms are generally consistent with the terms of the Exemption, as well as the Staff’s FAQs, the no-action letters address several areas that have not been defined. Both letters may shed light on some terms of the Exemption, including whether or not carried interest will be perceived as transaction-based or other compensation, the range of “ancillary services” that might be offered, and the restrictions on handling funds and securities that may apply. The letters also suggest additional terms the Staff may require for similar relief in the future in instances in which the Exemption is not available.8
There is likely to be further activity in this area as entrepreneurs seek to develop new markets and capitalize on opportunities created by the JOBS Act. The FAQs provide some guidance as to the contours of the Exemption. Further, the no-action letters indicate that the SEC Staff might be open to allowing additional types of investment portals. It remains to be seen which of the investment portal models will ultimately predominate. However, restrictions on receipt of compensation and other limitations in the no-action letters and Exemption may encourage more mature entities to register as broker-dealers.