I receive inquiries at my law practice daily from people seeking to form equity & debt crowdfunding platforms. Since the JOBS Act was signed into law in April 2012, there has been a tremendous amount of excitement with crowdfunding. Interestingly, real estate funding platforms are leading the charge, even more so than platforms focused on technology, medical and other business sectors.
There have been a number of surprises since passage of the JOBS Act. At the Federal level, crowdfunding still remains illegal. As such FINRA, the designated regulator of crowdfunding portals, currently plays virtually no role. What we see instead is the formation of funding platforms, not funding portals (more on this below). But even with no federal crowdfunding, non-accredited will shortly be able to invest by way of Reg A+.
Capital formation for small companies is being, and has already been, altered dramatically. Title II permits general solicitation under Rule 506(c) so long as investors are accredited. Title III Crowdfunding rules for sales to non-accredited investors have never been finalized and are considered by many to be unworkable. Title IV, which becomes effective on June 19, 2015, permits investments by both accredited and non-accredited investors, albeit with some rather expensive strings attached for small businesses.
So, if federal crowdfunding is not yet legal, the thing exciting people is not “crowdfunding” per se (strict regulatory definition), but the use for the first time of funding platforms (websites) with general solicitation and advertising to attract investors under Title II and (as of June 19th) Title IV. It is interesting to note how this has developed, and how companies are raising funds today. And, there is no question that funds are indeed being raise successfully today. Billions of dollar’s worth.
Funding Portals vs. Funding Platforms
The JOBS Act references funding portals at least thirty times. In October 2013, FINRA issued Regulatory Notice 13-34 which set forth the parameters for funding “portals”. Funding portals were to be regulated like miniature broker-dealers. They were to be subject to FINRA membership, supervision, AML, and reporting rules. They were to be subject to FINRA investigations, discipline and sanctions. But without the SEC approving crowdfunding federally, there are no funding portals; they cannot yet legally exist.
Rather, what we are seeing today are funding “platforms”. In contrast to funding “portals” being mentioned over thirty times in the JOB Act, funding “platforms” are mentioned only once. The term funding platform appears just a single time in the Title II exemption from broker-dealer registration. Funding platforms are websites where investments are advertised through general solicitation and where, up to this point at least, sales are made to accredited investors under Rule 506. And while the exemption from federal broker-dealer registration in Title II has been somewhat limited by SEC interpretation, the SEC gave back what it took away by providing no-action relief to FundersClub and AngelList. In short, while the broker-dealer exemption was narrowed, by allowing venture funds to operate funding platforms without registering as broker-dealers the SEC paved the way forward. The message was clear: funding platforms are not required to register as a broker-dealer so long as they do not engage in activities that traditionally require broker-dealer registration. These prohibited acts include: receiving transaction-based compensation (basically commissions, although receiving a carried interest is fine); handling customer funds or securities (use an escrow agent instead); and negotiating or recommending securities transactions (or cold calling). Thus, funding platforms today generally fall into three business models: 1) the broker-dealer model (where commissions are earned and investments are recommended); 2) the investment adviser model (2/20 fees); and 3) the listing service model (where offerings are simply listed for investors, and either no fees are charged such as may be the case with direct issuer offerings, or where the platform charges listing fees or fees for the use tools and services). This is a pretty remarkable change for raising funds for debt or equity offerings. Offerings no longer require broker-dealer syndicates and investments are attracting investors through general solicitation, doing exactly what the JOBS Act was designed to do. The one caveat is that, as the SEC made clear, funding platforms should not act like broker-dealers.
But the market was missing one of the central tenets and purposes of the JOBS Act: investments by non-accredited investors. While non-accredited investors individually may make only small investments, collectively they may create the biggest boost to the capital markets because there are three hundred million of them. As a result, many states have decided not to wait for the Feds, and intrastate crowdfunding for non-accredited investors is already available in 15 states (most recently, in Arizona). This is ideal for intrastate investment, but you cannot go over state lines; though, remarkably, several states are in conversations about creating super-regional crowdfunding and we may see that soon if there is a prolonged course of delay on Title III. Regardless, for true nationally available offerings in which everyone can participate, Reg A+ appears to provide a broad solution, though it is more expensive in terms of both time and money to prepare and file an offering.
Blue Sky Offering Registration vs. the Licensing of Selling Agents
Another hurdle is this: Simply because an offering (the securities themselves) is exempt from state registration does not alleviate the requirement that the seller of securities be registered, or meet an exemption from registration, in each state where the investors reside. The difficulty here is that all state laws are different, and there are even differences in the laws of the states that adopted one of the three versions of the Uniform Securities Act. Getting this all straight when dealing with several states, much less fifty, will cause someone’s head to spin. But a solution is available: hire a broker-dealer to serve as your broker of record to meet those blue sky law requirements.
The Regulatory Risks of Utilizing Funding Platforms to Raise Capital
On the regulatory front we hear a lot from the SEC and FINRA about risk based approaches to regulation, and we understand that participants in the industry need to take steps to mitigate these risks. The regulators and industry have an obligation to educate market participants to do it right and be compliant too. From one securities attorney’s perspective, here are some risk areas that issuers need to concentrate on when using funding platforms to raise funds:
- Don’t forget to register as required in the states where each of your investors reside unless there is an applicable issuer exemption, or hire a broker-dealer that is registered to effect the securities transactions on your behalf there;
- If you are not registered as a broker-dealer, you should not be acting like one. Hire a good securities attorney to guide you to ensure you are not crossing the line;
- Treat non-accredited investors fairly. Treating them unfairly will likely and should result in regulatory action;
- Use an escrow agent. Issuers should not be receiving investment funds directly from investors;
- Disclose all material facts in your offering as required by the Securities Act of 1933. The entire federal securities regulatory structure is predicated on this basic requirement. And don’t think this obligation is limited to the offering documents. You are selling securities, not automobiles. Make sure your marketing materials are fair and balanced, disclosing both the positive and the risks pertaining to any investment. And do not misrepresent or omit any material facts in your marketing or on your website; and
- Stay in compliance with the rules of the securities exemption under which you are conducting your offering.
When these guidelines are followed, the future looks bright for everyone involved in this incredible new FinTech industry.
About Scott Andersen:
Scott is principal at finLawyer.com, General Counsel of FundAmerica and principal at ConsultDA. He was most recently the Deputy Regional Chief Counsel at FINRA, and prior to that was the Enforcement Director at FINRA and the NYSE, Co-Chief of the Securities Prosecutions Unit of the NY Attorney General’s office, and Asst. Attorney General for the State of NY. He concentrates his practice on securities and regulatory law.