On October 30th, the Securities and Exchange Commission (the “SEC”) adopted new crowdfunding rules, referred to as Regulation Crowdfunding.  The rules were mandated by the Jumpstart Our Business Startups Act of 2012, with the goal of providing startups and small businesses with the opportunity to raise capital in a more cost-effective manner.  In Part 1 of our three-part series on the crowdfunding rules (available here), we provided an overview of Regulation Crowdfunding.  In Part 2 (available here), we discussed the disclosure requirements applicable to issuers conducting a crowdfunded offering.  In this final part, we summarize the role and obligations of crowdfunding intermediaries.  The Regulation Crowdfunding adopting release is available here. 

Crowdfunding is a method of raising funds on the internet to support various ventures, with the fundraiser typically seeking to raise small amounts from a large number of investors.  To take advantage of Regulation Crowdfunding, the issuer must use a platform operated by an intermediary in connection with its crowdfunded offering.

Who can be an intermediary?

An intermediary is a broker-dealer or funding portal that has registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and is a member of the Financial Industry Regulatory Authority, Inc. (“FINRA”).  Under proposed FINRA Rule 4518, a member would also have to notify FINRA (i) prior to engaging, for the first time, in any offering pursuant to Regulation Crowdfunding or (ii) within 30 days of directly or indirectly controlling, or being controlled by or under common control with, a funding portal.

Prior to the adoption of Regulation Crowdfunding, an intermediary would generally be required to register as a broker-dealer under Section 15(a) of the Exchange Act and comply with applicable U.S. federal and state broker-dealer laws (or seek no-action relief from the SEC), which would likely have been uneconomical for a platform operator catering to startups and small businesses.  Regulation Crowdfunding, however, permits a new category of brokers called “funding portals” to operate crowdfunding platforms and facilitate crowdfunding without registering as broker-dealers.  Instead, funding portals are subject to a new registration regime and are subject to certain limitations on their activities inapplicable to registered broker-dealers.  Funding portals are also subject to the SEC’s examination, enforcement and rulemaking authority.

An intermediary is not permitted to participate in crowdfunding transactions if it or any associated person is subject to statutory disqualification under the “bad actor” provisions, including certain criminal convictions, court injunctions and restraining orders, regulatory agency orders, SEC disciplinary, cease-and-desist and stop orders, suspension or expulsion from membership in self-regulatory organizations and U.S. Postal Service false representation orders.

What is a funding portal and how are its activities limited?

A “funding portal” is a broker-dealer acting as an intermediary in a transaction involving the offer or sale of securities in reliance on Regulation Crowdfunding, so long as it does not:

  • offer investment advice or recommendations;
  • solicit purchases, sales or offers to buy the securities on its platform;
  • compensate employees, agents or other persons for solicitation or based on the sale of securities displayed on its platform; 
  • hold, manage, possess or otherwise handle investor funds or securities; or
  • engage in such other activities as the SEC, by rule, determines appropriate.

Funding portals may, however, engage in back office or other administrative functions other than on the intermediary’s platform.

Given that funding portals cannot offer investment advice or recommendations, they will be unable to physically meet with investors to solicit investments or host launch parties, and their roles with respect to communication channels on their platform will be generally limited to establishing guidelines for communication and removing abusive or potentially fraudulent communications.

In addition, while a registered broker-dealer must comply with the applicable Exchange Act rules with respect to the maintenance and transmission of investor funds, since a funding portal cannot handle investor funds, it must direct investors to transmit their funds directly to a qualified third party, which may be a registered broker-dealer or qualifying bank or credit union.

Each funding portal must register with the SEC by filing a completed Form Funding Portal and must become a member of FINRA.

Can an intermediary own securities of an issuer on its platform?

Yes.  Certain insiders of an intermediary, such as directors and officers, may not have a financial interest in an issuer using the intermediary’s platform.  However, in a significant concession to comments on the proposed rule (and in a change that may align intermediary and investor interests), an intermediary itself may have a financial interest in an issuer (i.e., direct or indirect ownership of, or economic interest in, any class of the issuer’s securities) on its platform so long as:

  • the intermediary receives the financial interest from the issuer as compensation in connection with the crowdfunding transaction; and
  • the financial interest consists of securities of the same class and having the same terms, conditions and rights as those being offered in the crowdfunding transaction.

What are the responsibilities of an intermediary to protect investors from fraud?

Intermediaries must have a reasonable basis for believing that:

  • an issuer complies with Section 4A(b) of the Securities Act of 1933, as amended, including the requirements to file offering statements, annual reports and comply with advertising restrictions (as further discussed in Parts 1 and 2 of this Corporate Update); and 
  • the issuer has established means to keep accurate records of its security holders.  

In satisfying those requirements, the intermediary may rely on representations of the issuer unless the intermediary has reason to question the reliability of those representations.

In addition, an intermediary must deny access to its platform to an issuer if such intermediary has a reasonable basis for believing that (i) the issuer or any other covered persons is subject to any “bad actor” disqualification acts (which investigation must include, at a minimum, a background and securities enforcement regulatory history check with respect to the issuer and its directors, officers and persons who are beneficial owners of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power) or (ii) the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.  In satisfying the latter requirement, an intermediary must deny access to its platform if it reasonably believes that it is unable to adequately or effectively assess the risk of fraud of the issuer or its proposed offering.

Is an intermediary liable to investors for material misstatements and omissions in an issuer’s offering statement or other offering documents?

As discussed in Part 1 of this Corporate Update, the SEC has concluded that an intermediary will be subject to statutory liability to a crowdfunding investor if it or an issuer through offering documents posted on its platform makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, so long as:

  • the purchaser did not know of such untruth or omission; and
  • the intermediary does not sustain the burden of proof that it did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

In its adopting release, the SEC specifically noted the defense available to intermediaries relating to the exercise of reasonable care and suggested that there were “appropriate steps” that intermediaries might take to exercise such reasonable care including “establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents before posting them to the platform to evaluate whether they contain materially false or misleading information.”

What other requirements apply to intermediaries?

The intermediary must also, among other things:

  • provide investors with transaction and educational materials, including disclosures relating to risk and resale restrictions; 
  • disclose on its platform the compensation and promotional activities of any promoter, founder or employee of an issuer;
  • disclose the manner in which the intermediary is compensated for the crowdfunded transaction;
  • make available information required to be provided by the issuer, including an offering statement and progress updates (which must be made available for a minimum of 21 days before any securities are sold in the offering);
  • have a reasonable basis that the investor satisfies the investment limitations under Regulation Crowdfunding (as discussed in Part 1 of this Corporate Update) and obtain certain investor qualification materials and representations from the investor;
  • provide communication channels on its platform so that potential investors can communicate with each other and with representatives of the issuer; and
  • abide by certain rules relating to investment notices, completion of offerings, cancellations and reconfirmations.

When are the new rules effective?

The new rules will be effective 180 days after publication in the Federal Register, but the forms permitting funding portals to register with the SEC will be effective January 29, 2016.

Conclusion

Regulation Crowdfunding has the potential to enhance capital formation among startups and small businesses.  Whether this method of fundraising will become widely adopted depends in part on whether a robust network of funding portals and other crowdfunding intermediaries will develop given the onerous and costly regulatory requirements applicable to intermediaries and their exposure to statutory liability.