pdf

Crowdfunding Portal Registration with the SEC Becomes Effective

January 29, 2016

 

Beginning on January 29, 2016, “funding portals,” a new type of entity to facilitate crowdfunding transactions, can register with the U.S. Securities and Exchange Commission (“SEC”) under newly effective SEC registration forms. Registration is the first step in implementing Regulation Crowdfunding, a set of new rules adopted by the SEC on October 30, 2015 to finally implement the Section 4(a)(6) exemption from registration under the Securities Act for the offer or sale of securities in crowdfunding transactions. The Section 4(a)(6) “crowdfunding” exemption was introduced by the Jumpstart Our Business Startups (“JOBS”) Act enacted in 2012, but will not become effective until Regulation Crowdfunding is fully implemented.

Regulation Crowdfunding broadens the ability of unaccredited investors to invest in private companies by permitting private companies to raise up to $1 million dollars from investors over a 12 month period without SEC registration if certain conditions are met, including that the transaction be made through an intermediary that is either a registered broker-dealer or a funding portal. A large number of crowdfunding portals limited to accredited investors have already emerged, but Regulation Crowdfunding for the first time allows almost all investors to invest in crowdfunding transactions. Based on their more limited scope of activities, funding portals are exempt from the registration requirements and other restrictions that govern broker-dealers (including state registration or other requirements), but are subject to certain requirements tailored to the new funding portals. Funding portals are also required to become members of the Financial Industry Regulatory Authority, Inc. (“FINRA”), and became subject to FINRA rules for funding portals that were approved by the SEC on January 22, 2016.

Both registered broker-dealers and funding portals, planning to take advantage of the new exemption, will want to evaluate the new rules, which are summarized in more detail below, to consider how best to structure their businesses to address regulatory requirements and mitigate potential liabilities.

Funding Portals

A funding portal is defined under Section 3(a)(80) of the Securities Exchange Act of 1934, amended (“Exchange Act”), as any person acting as an intermediary in a crowdfunding transaction who does not undertake certain prohibited activities.

The below chart summarizes the prohibited activities as well as expressly permitted activities of funding portals:

 

Prohibited Funding Portal Activities

Permitted Funding Portal Activities

Advice & Recommendations

  • offer investment advice or recommendations (even if incidental to execution of a transaction)
  • advise issuers on the structure or content of offerings

  • determine whether and under what terms to allow an issuer to offer and sell securities through its platform and deny access to certain issuers based on potential fraud or investor protection concerns

Solicitations, Advertisements & Communications

  • solicit purchases, sales or offers to buy the securities displayed on its platform or portal
  • advertise the funding portal’s existence

  • provide search functions on its platform and apply objective criteria to highlight offerings on its platform

  • provide communication channels for potential investors and issuers

Compensations & Payments

  • compensate employees, agents or other persons for solicitation or the sale of securities
  • compensate others for referring persons to the funding portal and for other services

  • pay a registered broker or dealer for services provided by the funding portal in connection with the offer or sale of securities by the registered broker or dealer to the funding portal

  • receive compensation from a registered broker‑dealer for corresponding services provided by the funding portal to the broker dealer


Investor Funds & Proceeds

  • hold, manage, process or otherwise handle funds
  • accept investment commitments and direct the transmission of funds

  • direct a qualified third party to release proceeds to an issuer upon completion of a crowdfunding offering or to return proceeds to investors in the event of cancellation

Obligations of Intermediaries in Crowdfunding Offerings

Regulation Crowdfunding also imposes requirements on all intermediaries (both funding portals and broker-dealers) relating to issuer screening and diligence, investor screening and qualification, required disclosures and payments and procedural requirements, as discussed further below:

 

Issuer Screening and Diligence

  • must have a “reasonable basis” for believing that the issuer is in compliance with the securities laws (for this purpose, an intermediary has a responsibility to assess whether it may reasonably rely on an issuer’s representation of compliance through the course of its interactions with potential issuers) and have established a means to keep accurate records of holders of the securities it offers (for this purpose, an intermediary may rely on issuer representations, absent reason to believe to the contrary)

  • must deny access to the online platform if, at any time, the intermediary has a reasonable basis to believe that an issuer is subject to a disqualification or presents the potential for fraud or otherwise raises concerns about investor protection

  • required to conduct background and securities enforcement checks on the issuer, and the issuers officers, directors, and 20% or more shareholders

  • prohibition on the intermediary’s directors, officers, and partners from having any financial interest in an issuer that is using the intermediary, (unless received as compensation for the services provided in the offer and sale of the issuer’s securities in reliance on the exemption)

Investor Screening and Qualification

  • must require each investor to answer questions demonstrating the investors understanding that there are restrictions on the ability to cancel an investment commitment, and that it may be difficult for an investor to resell the securities

  • may not accept an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained the investors consent to electronic delivery of materials

  • must have a reasonable basis to believe that investors satisfy the investment limitations of the crowdfunding regulations (intermediaries may rely on an investors representations, absent reason to believe to the contrary)

Disclosure Obligations

  • obligated to provide investors, at the time the investor opens an account, certain plain language educational materials, including about the investment process, the securities offered, information a company must provide to investors, resale restrictions and investment limits, and updating these materials as necessary

  • must make certain information provided by the issuer publicly available on the platform for a minimum of 21 days before any securities are sold and throughout the offering period

Payments and Procedural Requirements

  • must direct investors to transmit money directly to a qualified third party to hold the funds for the benefit of the investors and promptly direct the third party to transmit the investor funds to the issuer when the offering is completed (funding portals cannot receive any funds)

  • required to send investors notice of the material change stating that the investment commitment will be canceled unless the investor reconfirms the commitment within five business days of receipt of the notice. 

  • if the investor does not reconfirm the commitment within the five business days, the intermediary must (i) send the investor notice that the commitment was canceled, stating the reason for the cancellation and the refund that the investor should expect to receive, and (ii) direct the refund of investor funds

  • may only transmit offering proceeds to an issuer if the target offering amount is met or exceeded 

  • within five business days of an uncompleted offering, must (i) send notice to each investor disclosing the cancellation of the offering, the reason for the cancellation, and the refund amount that the investor should expect to receive; (ii) direct the refund of investor funds; and (iii) prevent investors from making investment commitments with respect to that offering on its platform

Additional Requirements for Funding Portals

  • required to implement policies and procedures that are reasonably designed to achieve compliance with the federal securities laws

  • must create and maintain certain records for a minimum of five years, including records of (i) investors and notices or confirmations provided to investors; (ii) information about issuers using the platform; (iii) all communications occurring on or through the platform; (iv) compliance with the requirements of the crowdfunding rules; (v) all written agreements entered into by the funding portal; (vi) monthly and quarterly summaries of transactions effected through the portal; (vii) each securities offering; (viii) organizational documents; and (ix) those records required to be kept pursuant to the Bank Secrecy Act (should a funding portal become subject to the requirements of the Bank Secrecy Act); and

  • need to comply with Regulation S-P (Privacy of Consumer Financial Information and Safeguarding Personal Information), Regulation S-AM (Limitations of Affiliate Marketing), and Regulation S‑ID (Identity Theft Red Flags).

Registering as a Funding Portal

Funding portals register with the SEC by filing Form Funding Portal, which requires information about the funding portal’s place of business, its legal organization, business activities, control affiliates, and the portal’s website or means of access, among other things. The form must be amended within 30 days of becoming inaccurate for any reason, and funding portals must file a withdrawal of registration upon ceasing to operate as a funding portal. Similar to Form BD, most of the information provided to the SEC on Form Funding Portal will be publicly available.

Statutory Liability and “Due Diligence Defense” for Intermediaries

Section 4A(c) of the Securities Act provides that an issuer who conducts a crowdfunding offering will be liable to a purchaser of its securities if, in the offer or sale of the securities, such issuer (i) makes an untrue statement of a material fact or (ii) 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; provided, however, that the purchaser does not know of the untruth or omission, and the issuer is unable to prove that it did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

As Section 4A(c)(3) defines an issuer to include “any person who offers or sells the security in such offering,” such liability provisions likely apply to intermediaries, including funding portals. However, the SEC stated that it believes that intermediaries may take certain steps in exercising reasonable care, such as establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, or 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.

FINRA Funding Portal Rules

In addition to Regulation Crowdfunding, a set of new FINRA rules specifically for funding portals, among other things:

  • addresses membership application process for funding portals and for approval of change of control of funding portals;

  • mandates conduct requirements, including antifraud prohibitions on the use of false and misleading statements in public communications (specifically prohibiting (i) false, exaggerated or misleading statements or claims, (ii) predicting or projecting performance or implying that past performance may recur, or (iii) making any exaggerated or unwarranted claim, opinion or forecast), subject to certain exceptions for communications prepared solely by an issuer;

  • requires reporting of annual revenues on a U.S. GAAP basis (FINRA will generally make all information filed by a funding portal member public);

  • requires establishment and maintenance of a system to supervise activities of associated persons reasonably designed to achieve compliance with applicable rules, including (i) written procedures, (ii) designation of a person with supervisory authority, and (iii) reasonable efforts to determine that supervisory personnel have sufficient training and experience;

  • subjects funding portals to examination and inspection and FINRA rules governing investigations and sanctions;

  • imposes reporting requirements for involvement by the funding portal or associated persons for certain events, including regulatory proceeding and written fraud claims; and

  • provides that persons “associated with” a funding portal (including for example, directors, officers, certain employees and control persons) have the same duties and obligations as a funding portal member.

The full text of the adopting release is available here, Title III and other provisions of the JOBS Act are explained more fully in our JOBS Act client alert, available here, and a more general overview of Regulation Crowdfunding is discussed in our client alert on the new crowdfunding rules, available here.

Please contact the attorneys listed below or your contacts with O’Melveny if you have any questions regarding this release.


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Robert Plesnarski, an O'Melveny partner licensed to practice in the District of Columbia and Pennsylvania, Eric Sibbitt, an O'Melveny partner licensed to practice law in California and New York, James Harrigan, an O'Melveny associate licensed to practice law in the District of Columbia and Maryland, and Zhao Liu, an O'Melveny associate licensed to practice law in District of Columbia and California, contributed to the content of this alert. The views expressed in this newsletter are the views of the authors except as otherwise noted.

Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York's Rules of Professional Conduct to O'Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, Phone:+1-212-326-2000. © 2016 O'Melveny & Myers LLP. All Rights Reserved.