The Securities and Exchange Commission (SEC), on October 23, 2013, released its long-awaited proposed rules, Regulation Crowdfunding[i], to implement the crowdfunding provisions of Title III of the Jumpstart our Business Startups Act (JOBS Act)[ii] . “Regulation Crowdfunding” implements the Section 4(a)(6) exemption and Section 4A of the Securities Act of 1933 (Securities Act) and Sections 3(h) and 12(g)(6) of the Securities Exchange Act of 1934 (the “Exchange Act”), and in some cases goes beyond the strict terms of the JOBS Act. The regulations follow the general plans of Title III of the JOBS Act, imposing limits on the amount an issuer can raise, the amount an investor can invest, the disclosure that the issuer will be required to provide, the manner in which the funding portal will be qualified and operate. In Part I of this series, entitled “Issuer, Purchaser and Offering Requirements and Limitations; Issuer Disclosure Obligations; Advertising and Promoting the Offering; Safe Harbor for Insignificant Deviations” which is meant to be read together with this Part II, I discuss the proposed rules relating to the issuer, purchaser and issuance of securities, and in this Part II I will discuss the proposed rules released by the SEC for regulating the Internet crowdfunding intermediary and the additional set of proposed rules released by FINRA (Financial Industry Regulatory Authority).
The Fundamental Nature of the Intermediary – the Role of the Internet
The Commission’s commentary to the proposed rules focused on the concept that a central tenet of crowdfunding is to enable the crowd to share information and evaluate a business idea. The commentary makes it clear that the Commission’s view is that, in order to best accomplish the purposes of the statute, all offers and sales pursuant to the exemption should take place via an Internet platform or similar electronic medium that may develop in the future (such as mobile phone applications), and additionally that an offer should be conducted on only one such platform, even though the JOBS Act does not prescribe either specifically. The Commission’s reasoning is that to fulfill the fundamental characteristic of being widely available to the public, Internet or electronic media are ideal, and that having an offer limited to the use of one platform would concentrate the “collective wisdom of the members of the crowd” in one place, accessible to all.
The Commission has requested public comment on the definition of platform which it proposes to be “an Internet website or other similar electronic medium through which a registered broker dealer or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6).”
Additionally, the commission has asked for public input on whether it should allow intermediaries to restrict who can access their platforms, for example by invitation only or to certain categories of investors.
The proposed rules allow for back office and administrative operations to take place elsewhere other than on their platforms, and describes those activities as including such things as document maintenance, preparation of notices and confirmations, preparing internal policies and procedures, defining information technology security requirements, and preparing information for regulatory filing.
Who can Operate an Internet Intermediary Site
In accordance with Section 4(a)(6) of the JOBS Act, the proposed rules require that crowdfunding offerings under the regulations be conducted through a broker registered with the SEC under Section 15(b) of the Exchange Act, or if not a broker then through an intermediary that is a registered “funding portal” which is also registered with FINRA (or another national securities association registered with the SEC under the Exchange Act, but today FINRA is the only such organization). The Commission noted that funding portals would not be required to register as an exchange under Exchange Act Section 3(a)(1) or as an alternative trading system.
Excluded persons: The crowdfunding intermediary itself, as well as its directors, officers or partners, any person directly or indirectly controlling or controlled by the portal, or any employee (excluding employee who are purely clerical or ministerial) may not have a financial interest – direct or indirect ownership of, or economic interest in , any class of the securities -- in any issuer offering securities on the platform.
Excluded activities: An intermediary that registers as a funding portal, and is not a registered broker, is restricted in the services it can provide. It may not:
Offer investment advice or recommendations;
Solicit purchases, sales or offers to buy the securities displayed on its platform;
Compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its platform; or
Hold, manage, possess, or otherwise handle investor funds or securities. Given that an intermediary that is merely a registered funding portal cannot hold funds, it will either need to be affiliated with a registered broker which is allowed to hold investor funds or contract with a third party to manage funds.
Non-US funding portals. Although only US issuers may offer and sell securities pursuant to Regulation Crowdfunding, the proposed rules would allow nonresident entities to register as funding portals if there is an information sharing arrangement in place between the SEC and the competent regulator where the nonresident portal is organized or has it principal place of business, such arrangement being deemed to provide the Commission and FINRA (or any other registered national securities association) with appropriate tools for supervising such entities. The portal must obtain a written consent of an agent in the US for service of process for a lawsuit, and must obtain an opinion of counsel as to certain matters.
Responsibilities of the Intermediary Funding Portal
Reducing the risk of fraud: The proposed rules set forth a set of affirmative duties of the intermediary that are aimed at reducing the risk of fraud. The Intermediary must have a reasonable basis to believe a crowdfunding issuer is in compliance with crowdfuding regulations, and has set up a means to keep accurate records of the holders of its securities (for example, use of a direct registration system, legends on certificates or use of a registered transfer agent, although none of these are required). However, the intermediary may rely upon representation of the issuer in this regard unless it has reason to question the reliability of such representations.
The intermediary has the duty to minimally conduct a background and securities enforcement regulatory history check on each issuer, officer, director or beneficial owner of 20 percent or more of the issuer’s outstanding voting securities to determine if any such person falls within the “bad actor” disqualification described in Part I of this series. The intermediary must deny access to the platform to an issuer if it has a reasonable basis for believing that the “bad actor” disqualification is triggered or that there otherwise is a potential risk of fraud, or if it is unable to adequately or effectively assess the risk of fraud. Additionally, if any such disqualification triggers come to light after an offering is launched on the platform, the intermediary must remove the offering and return (or in the case of funding portals, which are not allowed to hold investor funds, direct the return of) any funds committed by investors up to that point in time.
Responsibility to deliver educational materials, compensation and other information to investors: An investor must open an account with the intermediary and consent to the electronic delivery of materials before it may be allowed to make an investment commitment. The intermediary is required to provide information about the platform, the intermediary and the offering process to the investor in an electronic message such as an email, or via a link to the information on the intermediary’s website or the issuer’s website. The educational materials must describe in plain language:
The process for the offer, purchase and issuance of securities through the intermediary and the risks of purchasing securities offered and sold via crowdfunding;
The type of security and the risks associated with the security, including potential dilution;
The restrictions on the resale of securities offered and sold;
The limitations on the amounts investors may invest and on the investor’s ability to cancel an investment;
The circumstances in which the issuer may cancel an investment commitment; and
That following the completion of the offering there may or may not be an ongoing relationship between the issuer and the intermediary .
The intermediary is required to keep the most up-to-date version of all educational materials on its platform at all times.
The intermediary must inform investors that all promoters – persons who promote an issuer’s offering for compensation or who is a founder or employee that engages in promotional activities for an issuer on the platform must disclose the compensation it is receiving. The intermediary also must disclose the manner in which it is compensated.
Responsibility to deliver transaction and issuer-related information. The intermediary must make available, for a minimum of 21 days prior to the sale of securities, all the materials discussed in “Issuer Disclosure Requirements” in Part I of this article series, in a manner that may be saved, downloaded or otherwise stored by an investor, and must continue to make the information available including any updates until the offer is completed or cancelled. An investor need not open an account to have access to these materials.
The intermediary must, upon receipt of an investment commitment, send the investor a notification disclosing the dollar amount of the investment, the price of the securities if known, the name of the issuer and the date by which the investor can cancel the investment commitment.
Responsibility to verify investor qualification. The proposed rules require the intermediary to have a reasonable basis for believing that the investor falls within the investment limits prescribed by the rules,[iii] as fully described in Part I of this series. The proposed rules allow the intermediary to rely on an investor’s representation concerning compliance with the investment limitation unless it has reason to question the reliability of the representation. The intermediary must also receive an affirmative representation from each investor that it has reviewed the educational material, understands that its entire investment may be lost and that s/he is able to bear the loss of the investment, as well a completed questionnaire demonstrating that the investor understands that it is restricted in its ability to cancel an investment commitment, and that it is subject to resale restrictions that may make it difficult to sell the investment.
Communication infrastructure. The intermediary must provide a mechanism on its platform to facilitate communication among investors and between investors and the issuer. If the intermediary is merely a registered funding portal and not a registered broker, it must not participate in the communications other than to establish guidelines and remove abusive or potentially fraudulent communications, and it must permit public access to the discussions, but must limit the ability to post comments to persons who have opened an account, the theory being that accountability will reduce the risk of fraudulent or abusive postings. The proposed rules also require any person posting a comment to clearly and prominently disclose with each posting whether s/he if a founder or employee engaged in promotional activities on behalf of the issuer.
Maintenance of investor funds and investor notices. An intermediary that is a registered broker can accept investor funds, and must comply with applicable requirements under the Exchange Act and FINRA.
An intermediary that is a registered funding portal, not a registered broker, must direct investors to transmit money directly to a qualified third-party that has agreed in writing to hold the funds for the benefit of the persons ultimately entitled to receive them. The person entitled to receive the funds will be the issuer if the aggregate commitments equal or exceed the target amount of the offering after the cancellation period has elapsed (which in all cases must be at least 21 days after the first date that the issuer's disclosure information had become publicly available on its platform), or will be the investor when an investment commitment has been canceled either if the investor cancels up to 48 hours of the deadline or the commitment is automatically cancelled for failure to obtain from an investor effective reconfirmation of a commitment upon a material change to the offering or disclosure information, or if the total commitments fall short of the target amount by the deadline.
At or before an offering is completed, an intermediary must send each investor a notification disclosing the date of the transaction, the type of security it is purchasing, identifying information for the security including price, number of securities purchased and the total number of securities sold by the issuer, and the price(s) at which they were sold. If the security is a debt security, the notice must also state the interest rate and the yield to maturity calculated from price paid and maturity date. If callable, the first day that the security can be called by the issuer must be disclosed.
If an offering is not completed for any reason, within five business days after the deadline the intermediary must send a notice of cancellation with the reason, direct the refund of investor funds and prevent any investor from making investment commitments with respect to the cancelled offering.
Compensation Limitations and Disclosure:
Although not prescribed by the JOBS Act, the proposed rules require that the intermediary disclose to an investor opening an account, the source and amount of any remuneration that it will receive from the issuer or persons other than the issuer.
The proposed rules prohibit an intermediary from compensating promoters, finders or lead generators for providing the funding portal with the personal identifying information – information that can be used to distinguish or trace an individual’s identity -- of any potential investor. The Commission sites as examples a person’s name, social security number, date or place of birth, mother’s maiden name, or employment, educational, medical or financial information. The rules permit, however, the compensation of a third party for directing issuers or potential investors to the intermediary’s platform, so long as the third party does not provide personally identifiable information and the compensation is not based on the purchase or sale of a security unless the third party is a registered broker or dealer, as only registered brokers or dealers may receive transaction-based compensation. Thus, flat fees are acceptable.
Limited Discretionary Control Over Issuer’s Access to the Platform, and Presentation of Issuers on the Platform.
In its commentary the Commission noted that it anticipates the desire of funding portals to limit the scope of their businesses by, for example, specializing in offerings by issuers in certain industries or geographic locations. In some circumstances, these limitations could be viewed as providing investment advice. To accommodate reasonable limitations, the proposed safe harbor would permit a funding portal to apply objective criteria to limit the offerings on its platform, without being deemed to be providing investment advice. The criteria would be required to be designed to result in a broad selection of issuers (otherwise the platform could be deemed to be giving an implicit endorsement to the issuers) and be applied consistently to all potential issuers so as not to recommend or implicitly endorse one issuer or offering over others, and the criteria must be clearly displayed on the funding portal’s platform. Some examples of criteria include type of security such as common or preferred stock or debt, geographic location or business or industry segment, but it cannot deny access to the platform based on the advisability of investing in the issuer or the securities.
Additionally, the platform may highlight an offering on the funding’s portal as long as the criteria in this instance is also designed to highlight a broad spectrum of issuers, is applied consistently and is displayed prominently. The criteria may include the same criteria noted above as well as some transaction or security based criteria such as the number or amount of investment commitments, maximum offering amount or minimum investment, progress in meeting the target offering amount, but not on advisability of investing.
The platform may also provide tools for searching, sorting or categorizing offerings.
The registered funding portal may receive compensation from a registered broker or dealer for services provided by the portal, and conversely may compensate a broker or dealer for providing services that it is unable to provide due to its position as not being a registered broker or dealer, in connection with the offer and sale of securities. The parties would need a written agreement and the compensation must otherwise be allowed under the rules and comply with the rules of any registered national securities association of which the portal is required to be a member (i.e. FINRA).
The proposed rules set forth detailed criteria for a funding portal’s record keeping requirements and compliance policies and procedures, and allow the portal to contract with a third party to manage those tasks but the portal nevertheless remains statutorily responsible.
Registering as a Funding Portal
Intermediaries who are not registered brokers may perform the functions of an intermediary if they register as a funding portal. The Commission’s commentary noted that its intention was to establish a streamlined registration process under which a funding portal would register with the Commission by filing a form with information requirements that are consistent with, but less extensive than, the information required for broker-dealers. Under the proposed rules, a funding portal would register by completing a Form Funding Portal, which includes information concerning the funding portal’s principal place of business, its legal organization and its disciplinary history, if any; business activities, including the types of compensation the funding portal would receive; control affiliates of the funding portal and disclosure of their disciplinary history, if any; FINRA membership or membership with any other registered national securities association; and the funding portal’s website address(es) or other means of access.
The funding portal’s registration would become effective the later of: (1) 30 calendar days after the date that the registration is received by the Commission and (2) the date the funding portal is approved for membership in FINRA or any other registered national securities association. This approach is intended to help ensure that a funding portal is subject to regulation by the Commission and FINRA or any other national securities association before it can engage in business with the public. The rules also provide for the mechanism for one portal to succeed to the business of another portal, and to discontinue its operations.
Since a registered funding portal is subject to less regulation and oversight than a registered broker, the proposed rules would require, as a condition of registration, that a funding portal have in place, and thereafter maintain for the duration of such registration, a fidelity bond – a type of insurance that protects its holders against certain types of losses, including those related to malfeasance of its officers and employees and the effect of such malfeasance on the holder’s capital -- that: (1) has a minimum coverage of $100,000; (2) covers any associated person of the funding portal unless otherwise excepted in the rules set forth by FINRA or any other registered national securities association of which it is a member; and (3) meets any other applicable requirements, as set forth by FINRA or any other registered national securities association of which it is a member. The Commission believes a fidelity bond affords a level of protection to investors if a portal violates the prohibition on holding investor funds and then goes out of business, because funding portals will not be required to maintain minimum capital requirements, and because funding portals would not be members of the Securities Investors Protection Corporation (SIPC) which protects investors’ funds up to $500,000. The $100,000 figure is in line with the minimum amount of coverage that brokers are required to have under FINRA rules.
Exemption from registration as a broker under the Exchange Act. The proposed rules clearly state that a registered funding portal will be exempt from registering as a broker under Section 15(a)(1) of the Exchange Act in connection with its activities as a funding portal, but the rules require that the funding portal permit the examination and inspection by representatives of the Commission and national securities association of which it is a member, of all of its business and operations that relate to its activities as a funding portal, including its premises, systems, platforms and records. Funding portals would also be subject to compliance with Chapter X of the Exchange Act including the anti-money laundering provisions.
FINRA proposed rules to govern registered crowdfunding portals[iv] simultaneously with the release of proposed Regulation Crowdfunding. Compared to other broker-dealer members, FINRA has reduced the standards for being approved as a funding portal and has established a quicker turnaround time – 60 days – for approval decisions. FINRA rules also require a fidelity bond. The rules set forth standards of conduct for communications with the public, and exempt the portal from responsibility for communications on its website that are provided by an issuer. The proposed rules also contain compliance procedures, and requirements regarding anti-money laundering efforts and independent testing requirements regarding the Bank Secrecy Act.
The proposed rules set forth the parameters for FINRA investigations and sanctions, circumstances giving rise to disqualification, and the appeals process. FINRA also has the right to make certain information public.
The rules governing the crowdfunding intermediary place substantial responsibilities on the intermediary and require the intermediary to either be, or be affiliated with, a registered broker in order to receive transaction-based compensation, all in the context of offerings by an issuer that are limited to $1 million in a 12-month period – high burden with limited financial upside, particularly when compared with the “accredited investor crowdfunding” market that is active and growing, as described in my article Crowdfunding – Clearing Away the Fog.
[i] The proposed rules can be found at http://www.sec.gov/rules/proposed/2013/33-9470.pdf. .
[ii] Pub. L. No. 112-106, 126 Stat. 306 (2012).
[iii] The proposed rule limits the aggregate amount of securities sold in reliance on the crowdfunding exemption to any individual investor – natural person or entity, regardless of whether such person is an accredited investor or institutional investor – during the 12-month period preceding the current transaction, to the greater of:
$2,000 or 5% of the investor’s annual net worth, whichever is greater, if both the investor’s annual income and net worth are less than $100,000; and
10% of the investor’s annual income or net worth, whichever is greater, with an absolute cap of $100,000, if either annual income or net worth of the investors is $100,000 or more.