On October 23, 2013, the SEC proposed rules governing the offer and sale of securities through "crowdfunding." If adopted, these rules would permit companies to raise capital by selling small amounts of equity to large groups of investors via regulated, online crowdfunding platforms.
Crowdfunding platforms are necessary because companies looking to undertake a crowdfunding offering can only do so through an intermediary that has registered with the Financial Industry Regulatory Authority, or FINRA, the organization that currently oversees, among other things, securities brokers.
Throughout this client update, we will use the term "issuer" to refer to any company looking to sell its securities through crowdfunding; "platform" to refer to the online portal connecting issuers and investors; and "intermediary" to refer to an entity operating a crowdfunding platform.
This is the second of a two-part client update series discussing the proposed crowdfunding rules. The first update addressed the proposed rules governing issuers seeking to raise capital through crowdfunding, and is available here.
Who Can Be an Intermediary?
Register with FINRA and the SEC as either a funding portal or a broker-dealer
Two types of entities can be crowdfunding intermediaries and operate crowdfunding platforms. There are advantages and disadvantages associated with each.
1. Funding Portal. There will be a new entity designation, "funding portal," that will permit a person to register as a funding portal and then connect investors with issuers through crowdfunding. The application process will be less involved than what is required to register as a broker-dealer. Funding portals and their partners, managers, directors, control persons, and most employees, will be limited in their activities, however:
- Funding portals may not offer investment advice or recommendations, including about any of the issuers listed on the platform. Funding portals will be prohibited from disclosing that listed issuers are pre-screened, indicating in any way that the issuers listed on the platform are somehow vetted or are otherwise good investment opportunities, or promoting certain issuers listed on the platform over others.
- Funding portals will be limited in their ability to advertise and may not solicit purchases, sales, or offers to buy securities on the platform. Funding portals can advertise their existence, but they may not advertise certain listed issuers over others due to the restriction on recommendations.
- Funding portals may not compensate employees, agents, or others for successful solicitations, or based on the amount of securities sold.
- Although they will be required to post a fidelity bond, funding portals may not hold, manage, or handle investor funds or investor securities.
2. Registered Broker-Dealers. Registered broker-dealers may also operate crowdfunding platforms, and are far less restricted in their activities. They may engage in most of the activities prohibited to funding portals but are, of course, otherwise subject to regulation.
Complying with the Proposed Rules
The proposed rules spell out the steps necessary for an intermediary to operate a crowdfunding platform. Below are some of the more important requirements that will affect intermediaries on an ongoing basis.
Take steps to reduce the risk of fraud and non-compliance with the proposed rules
- Reasonable Basis: An intermediary must have a "reasonable basis" for believing that an issuer has complied with all relevant crowdfunding regulations, and will be able to keep accurate records of the people who hold its securities. Intermediaries can reasonably rely on an issuer's representations that it is in compliance and keeps accurate records.
- Bad Actor Disqualification: Intermediaries must conduct certain background and regulatory checks on issuers and related parties to ensure that there are no "bad actors" involved in the offering. For a discussion of "bad actor" rules as they relate to Rule 506 private placements — which are substantially similar to the proposed crowdfunding "bad actor" rules — click here.
- Suspicion of Fraud: An intermediary must deny an issuer access to its crowdfunding platform if it believes that the issuer or the offering may be fraudulent. Note that an intermediary does not need to have a reasonable basis for believing that an issuer may commit fraud.
- Investor Verification: Because the amount that any investor can contribute to a crowdfunding raise is limited by that investor's income and net worth, intermediaries will need to confirm that the investor knows about these limits, and will not exceed them by participating in the offering. Intermediaries can accomplish this by requiring investors to represent that they are complying with applicable restrictions on their investment amounts.
- Cancelled Commitments: Investors need to be able to cancel their commitments up to 48 hours before the deadline an issuer has set for completion of the raise. Intermediaries will have strict obligations to inform investors of this right, and to make it possible for them to cancel.
- Privacy and Identity Theft Protection: Because investors will transfer sensitive information to intermediaries, the SEC has subjected funding portals to the same privacy rules applicable to brokers. These rules require, among other things, funding portals to have privacy policies in place; send out annual privacy notices; and have procedures in place to detect and prevent identity theft. This could be a substantial administrative burden, and the penalties for failure to comply may be significant.
Provide educational materials
As proposed, intermediaries will be required to provide investors with educational materials regarding the nature of investing in early-stage companies. Intermediaries will need to provide, in "plain language," information on a long list of items related to investing and associated risks; applicable limitations on investment, cancellation and resale; and some information about the issuer. Because anyone who wants to invest through a platform must open an account with that intermediary and consent to electronic delivery of documents, intermediaries will be able to send necessary information to the e-mail address on file for each investor.
Facilitate investor communications
The SEC has proposed a requirement that intermediaries provide, through crowdfunding platforms, ways for investors to communicate with each other and with representatives of listed issuers. Intermediaries would be obligated to make these communication channels available to the public, not just investors. In this way, outsiders such as journalists, investors, lawyers, or others could review communications about an issuer, although only those registered with the intermediary would be allowed to post comments. The SEC hopes that information from the crowd will help reduce the risk of fraud.
No financial interests in listed issuers
The directors, officers, and partners of an intermediary, as well as the intermediary itself, will not be able to have a financial interest in any issuer listed on the platform. This prohibition extends to receiving compensation in the form of an issuer's securities, which is a common practice in other types of offerings. This rule is designed to prevent conflicts of interest, but may remove an important incentive for many seeking to operate a crowdfunding platform. In addition, it removes the alignment of the interests of investors and intermediaries.
Making Money as an Intermediary — Is it Possible?
The brief — and unsatisfying — answer is that it will depend. There are a number of factors that will affect the revenues that an intermediary can derive from operating a platform, as well as the potential liability of intermediaries.
Because intermediaries will not be able to share in the upside of their listed companies due to the prohibition on investing in issuers, there is no potential for contingent future payouts. Intermediaries that are broker-dealers will have much more flexibility than intermediaries that are only registered as funding portals because they will be able to make recommendations and receive transaction-based compensation. Funding portals will be able to charge a listing fee, or any other fee that is not contingent on the success of the capital raise. Because the amount of work on required of the intermediary will be roughly the same for a small raise as a large one, these fees may be a significant portion of a smaller raise. Individual company capital raises are in any event limited to a maximum of $1,000,000 in any 12-month period under the crowdfunding rules.
Potential securities law liability
In its proposed rules, the SEC makes it clear that intermediaries will be liable for an issuer's material misstatements and omissions, as well as being subject to general anti-fraud liability. The only defense will be if the intermediary did not know, and in the exercise of reasonable care could not have known, about the fraud. "Reasonable care" means that the intermediary conducted appropriately robust due diligence on an issuer, including evaluating any materials an issuer wants to post on the platform, and has policies and procedures in place that would help it comply with all applicable procedural requirements.
Implications and Interpretations
- We anticipate that the crowdfunding websites offered by brokers and funding portals will be very different. Brokers, because they can make investment recommendations, will be able to curate funding portals that offer pre-screened companies. Funding portals, under the proposed rules, will not have this ability. However, funding portals can differentiate their platforms in other ways, such as by listing companies exclusively from one geographic area to facilitate local business development, or by only listing companies that operate in a certain industry.
- Because funding portals are limited in the ways in which they can be compensated, non-profits, incubators, quasi-governmental entities, or others motivated by non-financial factors may constitute many of the entities choosing to become funding portals.
- It is unclear whether companies will prefer to list on crowdfunding platforms operated by broker-dealers or by funding portals. While broker-dealers may be able to exercise more discretion in choosing the companies on their platforms, they might also charge more than funding portals. However, a broker-dealer's willingness to accept a success-based fee might be more attractive to companies looking for lower listing or other initial fees. Companies will need to shop around for the option that best suits their needs.
- Complying with the "bad actor" rules will likely present intermediaries with an ongoing administrative burden, and failing to comply with the rules could result in substantial liability. Anyone considering becoming an intermediary should be prepared to conduct bad actor inquiries both internally and on an ongoing basis for every issuer listed.
- The extension of fraud liability to intermediaries significantly increases the risk of operating a funding platform. Often, if an issuer commits fraud or simply goes out of business, the only deep pocket remaining will be that of the intermediary operating a crowdfunding platform. This potential liability should be of particular concern to non-profit entities that may seek to become intermediaries.
The full text of the SEC release proposing the new crowdfunding rules is available here. We expect that the SEC will receive many comments on the proposed rules. Comments are due on or before February 3, 2014, and can be submitted to the SEC here.
This Client Update is intended to provide general information to our clients and should not be construed as legal advice. If you have questions regarding this client update, please contact your principal attorney at Tonkon Torp LLP, or Tom Palmer (503.802.2018; firstname.lastname@example.org), Drea Schmidt (503.802.5703; email@example.com) or Claire Brown (503.802.5731; firstname.lastname@example.org) of our Corporate Finance Practice Group.