Crowdfunding for the masses: the birth of crowdfunding portals
March 2014 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
While both startups seeking capital and investors on the prowl for the next big thing have been quick to endorse equity crowdfunding, there’s a third group that sees exciting opportunities in this new capital fundraising scheme: prospective funding portals. This year, we’ll witness the creation of entirely new regulated entities that will facilitate the sale of crowdfunded securities to both accredited and non-accredited investors. Although funding portals are required to register with both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), they are not subject to the extensive regulatory framework governing broker-dealers.
Considering launching a website to offer crowdfunded securities? Based on proposed Regulation Crowdfunding, the rules prescribed by the SEC to implement the requirements of Title III of the JOBS Act, here are some things to keep in mind before you rush out to register.
Issuers, investors, intermediaries
The proposed rules limit both the amount of crowdfunded securities that an issuer may offer in a 12-month period, and the amount that a prospective investor may purchase. These limits will have a substantial effect on who uses funding portals to raise funds. Regulation Crowdfunding prescribes rules governing the offer and sale of securities under a new Section 4(a)(6) of the Securities Act of 1933 (the ‘Securities Act’). US issuers may utilise this new exemption from registration provided that the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided under Section 4(a)(6) during the 12-month period preceding the date of such transaction, is not more than $1m.
Investors are limited as to how much they can invest in crowdfunded offerings in a 12-month period – from the greater of $2000 or 5 percent of the investor’s annual income or net worth (if either annual income or net worth is less than $100,000) up to $100,000 (if either annual income or net worth is greater than $100,000). The value of an individual’s primary residence is excluded from the net worth calculation.
In addition, a transaction in reliance on Section 4(a)(6) must be conducted through an intermediary, which may either be a registered broker-dealer or a funding portal, and must take place exclusively online through a platform operated by the intermediary. In contrast to intermediaries who are registered broker-dealers, funding portals have extremely limited functions. Their sole purpose is to act as intermediaries in transactions involving the offer or sale of crowdfunded securities. Without registering as a broker-dealer or an investment adviser, a funding portal cannot offer investment advice or recommendations. For example, a funding portal is not permitted to highlight ‘recommended’ offerings, describe interesting or novel offerings, or even decide which companies can make offerings on its website based on other than objective criteria, such as offerings in a particular industry. Also, unlike a broker-dealer, a funding portal does not play the role of a securities salesperson; a portal is not permitted to solicit purchases, sales or offers to buy the securities offered or displayed on its website.
Funding portal compensation
Funding portals may earn commissions based on the amount of money that is raised for issuers, but beyond that, their options for making money on crowdfunded offerings are limited. Neither a funding portal (nor its directors, officers and partners) may take an equity stake in the issuer as compensation for the services the portal is providing in connection with the offer and sale of securities. Moreover, the funding portal and its directors, officers and partners are prohibited from having any financial interest in an issuer using its services. This proposed rule, which would prohibit the director of a portal from investing in the companies on the portal, is intended to eliminate cherry-picking by advancing one issuer’s fundraising efforts over those of another issuer. Furthermore, funding portal employees cannot be compensated based on sales of crowdfunded securities or for soliciting purchases of crowdfunded securities.
Funding portals are required to conduct certain diligence on prospective issuers seeking to list their offerings on the portal’s website. The funding portal must have a reasonable basis for believing that an issuer seeking to offer and sell securities through the portal complies with certain requirements, and has established means to keep accurate records of its security holders. The portal may reasonably rely on the issuer’s representations as to its compliance, unless the portal knows or has reason to know that the representations are false.
Portals play a gatekeeper role. If the portal believes that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection, the portal must deny access to its platform. The portal must conduct a background and securities enforcement regulatory history check on each issuer as well as each of its officers, directors or 20 percent beneficial owners, but beyond this requirement, the proposed rules do not specify actions that a portal must take to reduce the risk of fraud. If the portal is unable to assess the risk of fraud – for example, if it cannot obtain background check information on certain officers of an issuer – the portal is required to deny access. Similarly, if the portal has a reasonable basis for believing that an issuer (or any of its officers, directors or 20 percent beneficial owners) is subject to a disqualification under the proposed rules, the portal must deny access to its platform. If the portal learns of the potential for fraud after the offering is already posted to the website, the portal must promptly remove the offering from the site, cancel the offering and return to investors any funds they may have committed.
Investor education requirements
The proposed rules require the portal to provide educational materials about crowdfunding to every potential investor opening an account with the portal.
Among other things, the materials must contain basic terms about crowdfunding transactions, including limitations on investment amounts, the circumstances under which an investor can cancel an investment commitment and obtain a refund, and the restrictions on the resale of crowdfunded securities. The materials must also contain information about the crowdfunding process, the risks associated with purchasing crowdfunded securities, the types of securities that may be offered by the portal, and the risks associated with each type of security. These materials must also be posted on the portal’s website. Before an investor makes an investment commitment, the portal is required to provide updated materials to ensure that each investor has information about key aspects of investing through the portal that may have changed.
Communications on the portal
The portal is like a big chat room for potential investors and issuers. The proposed rules require the portal to provide channels through which investors can communicate with one another and with representatives of the issuer about offerings made available on the portal’s platform. These communications, in which the ‘wisdom of the crowd’ is presumably revealed, are intended to help potential investors assess the issuer and the investment opportunity. To promote transparency and accountability, all communications between investors and the issuer about the terms of the offering are required to flow through the portal. Portals themselves can’t join in the discussions – apart from establishing guidelines for communication and removing abusive or potentially fraudulent communications. To keep the discussion honest, any commenter who is a founder, officer, director or employee of the issuer or is being compensated (directly or indirectly) to promote the issuer’s offering is required to identify himself/herself as such and disclose the receipt of compensation each time the commentator makes a promotional communication. Portals are well placed to ensure that promoters are clearly identified in postings.
Funding portal potential liability
An issuer will be liable to a purchaser of crowdfunded securities if the issuer, in the offer or sale of securities, 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 – unless the purchaser knew of the untruth or omission or the issuer did not know, and in the exercise of reasonable care could not have known, about the untruth or omission. The SEC has stated that it appears likely that funding portals would be considered issuers for purposes of this liability provision. In order to address this potential liability, funding portals will need to establish due diligence policies and procedures and consider reviewing the issuer’s offering documents to evaluate whether they contain materially false or misleading information.
Investor’s right to cancel
Investors have an unconditional right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. This flexibility is intended to allow investors to have the full benefit of the views of other potential investors regarding a crowdfunded offering, even after the investor has made a commitment. If an issuer fails to complete an offering because the target is not reached or the issuer decides to terminate the offering, the portal must, within five business days, give each investor who had made an investment commitment a notification disclosing the cancellation of the offering, the reason and the refund amount that the investor should expect to receive; direct the refund; and prevent investors from making investment commitments with respect to that offering on its platform.
Registration and ongoing requirements
While the proposed SEC rules and proposed FINRA rules governing the registration and compliance obligations of funding portals are certainly less extensive than the rules pertaining to broker-dealers, these new entities are still heavily regulated. The proposed SEC rules require a prospective funding portal to file a ‘Form Funding Portal’ with the SEC. The information sought is consistent with, but less extensive than, the information required for broker-dealers on Form BD. For example, Form Funding Portal would require information regarding the portal’s ownership and management, including disciplinary history. The portal would also need to register with FINRA, pursuant to the FINRA proposed rules, and would be subject to FINRA conduct requirements for funding portals.
Do the benefits of acting as a funding portal outweigh the compliance costs and the risk of potential liability? Even though funding portals may earn transaction-based compensation, the proposed limit of $1m on the amount that an issuer may raise in a 12-month period by issuing crowdfunded securities will require a successful funding portal to feature a large number of offerings. As a consequence, the funding portals that make a strong impression with issuers and investors in the early days of crowdfunding – and that have the sophistication to avoid regulatory pitfalls – will have a significant advantage in the race to become the portal of choice.
Michael Burwick and Eliza Sporn Fromberg are counsel at Day Pitney LLP. Mr Burwick can be contacted on +1 (617) 345 4637 or by email: firstname.lastname@example.org. Ms Fromberg can be contacted on +1 (212) 297 5847 or by email: email@example.com.
© Financier Worldwide
Michael Burwick and Eliza Sporn Fromberg
Day Pitney LLP