FINRA Proposes Funding Portal Rules under the JOBS Act

November 11, 2013 | Banking & Financial Services


On October 23, 2013, in conjunction with the Securities and Exchange Commission’s (“SEC”) release of proposed Regulation Crowdfunding, the Financial Industry Regulatory Authority (“FINRA”) proposed rules and related forms for funding portals (“Funding Portal Rules”). A funding portal is any person acting as an intermediary in a crowdfunding transaction that does not: (i) offer investment advice or recommendations, (ii) solicit purchases, sales, or offers to buy the securities displayed on its platform or portal, (iii) compensate employees, agents, or other persons for such solicitation or the sale of securities; or (iv) hold, manage, process, or otherwise handle investor funds. Funding portals that engage in crowdfunding on behalf of issuers relying on the JOBS Act’s “crowdfunding exemption” must register with the SEC and become a member of a national securities association. The proposed Funding Portal Rules provide a streamlined membership application process and simplify existing conduct and compliance rules. FINRA is soliciting public comment on the proposed rules through February 3, 2014.

Our analysis of the SEC’s proposal is available here, the full text of FINRA’s proposed rules is available here, and FINRA’s proposed forms are available here.

General Standards

Funding Portal Rule 100 generally provides that all funding portal members and persons associated with funding portal members shall be subject to the FINRA By-Laws and the Funding Portal Rules. Persons associated with a funding portal member include any sole proprietor, partner, officer, director, manager or employee of a funding portal.

Application Process

Proposed Funding Portal Rule 110(a) outlines the membership application process for funding portal applicants (“FP Applicants”). To reflect the limited nature of funding portals’ business, the proposed rule streamlines current NASD Rule 1010 Series membership rules.

Required Forms

FP Applicants will apply for membership by filing new Form FP-NMA with FINRA’s Department of Member Regulation (“Department”). FP Applicants will also need to submit statutory disqualification information using new FP-SD Schedule. The FP applicant must keep this information current and update such information within 10 days following any change in such information. In addition, funding portal members must file new Form FP-CMA upon changes in the funding portal’s ownership or control.1

Membership Interview

FP Applicants must complete a membership interview with the Department within 30 days after filing an application, or within 14 days after filing additional information requested by the Department. The membership interview may be conducted by video conference, or other means that FINRA may specify.

Standards for Granting or Denying Application

The proposed rule lists five standards the Department must consider in granting or denying an FP Applicant’s membership application. The Department must determine whether the FP applicant:

  • Is capable of complying with applicable federal securities laws, rules, and regulations and FINRA’s Funding Portal Rules;
  • Has established all contractual or other arrangements and business relationships with banks, broker-dealers, clearing corporations, or others necessary to initiate the operations described in the FP Applicant’s Form FP-NMA;
  • Has a supervisory system that is reasonably designed to achieve compliance with applicable federal securities laws, rules, and regulations thereunder, and the Funding Portal Rules;
  • Has fully disclosed and established through documentation all direct and indirect sources of funding; and
  • Has a recordkeeping system that enables the FP Applicant to comply with federal, state, and self-regulatory organization recordkeeping requirements.

The Department must serve a written decision within 60 days after the filing of the application. The FP Applicant’s approval for membership is contingent upon the FP Applicant’s filing of an executed written membership agreement.

Appeals Process

In another effort to tailor existing rules to the funding portal context, proposed Funding Portal Rule 110(a) shortens the filing and response time for appeals of the Department’s membership decision from 25 to 14 days and eliminates provisions requiring an appellate hearing. The Proposed Rule retains the right for an FP Applicant to apply for review by the SEC.

Fidelity Bond

Proposed Funding Portal Rule 110(b) streamlines FINRA Rule 4360, but still requires funding portal members to maintain fidelity bond coverage.

Funding Portal Conduct

Funding Portal Rule 200 establishes standards of commercial honor and principles of trade for funding portal members. The Rule also prohibits funding portal members from effecting any transaction in, or inducing the purchase or sale of, any security by means of, or by aiding or abetting, any manipulative, deceptive, or other fraudulent device.

In addition, the proposed Rule sets forth content standards for funding portal communications, which are defined as any electronic or written communication that is distributed or made available by a funding portal member to one or more investors. These content standards do not apply, however, to any communication on the funding portal member’s website that is prepared solely by an issuer, provided the communication does not contain statements that the funding portal member knows or has reason to know are false or misleading.

Funding Portal Compliance

Funding portal members must establish and maintain a supervisory system and anti-money laundering (AML) compliance program under proposed Funding Portal Rule 300. At a minimum, proposed Rule 300(a) requires a funding portal member’s supervisory system to provide for:

  • The establishment and maintenance of written procedures to supervise the activities of the funding portal and its associated persons;
  • The designation of a person with authority to carry out the supervisory responsibilities of the funding portal member; and
  • Reasonable efforts to determine that all supervisory personnel are qualified to carry out their assigned responsibilities.

The Rule is derived from current NASD Rule 3010 and provides more flexibility for funding portal members to tailor their supervisory systems to their own business models.

Proposed Funding Portal Rule 300(b) requires funding portal members to implement a written AML program approved by a member of senior management. The AML program must be reasonably designed to achieve and monitor compliance with the Bank Secrecy Act and the implementing regulations promulgated by the Treasury Department, as well as provide for independent testing for compliance to be conducted every two years.

In addition, funding portal members and associated persons must report any regulatory proceedings, disciplinary action, civil litigation, and other events to FINRA under proposed Rule 300(c).

Investigations and Sanctions

Under proposed Funding Portal Rule 800(a), all funding portal members will be subject to the FINRA Rule 8000 Series, which establishes requirements and procedures for investigations and sanctions by FINRA. Additionally, FINRA must make available to the public information filed by a funding portal member that is currently or was previously registered with FINRA, including any information reported on the funding portal member’s most recently filed Form Funding Portal. The proposed Rule also requires FINRA to disclose to the public whether the funding portal member or any associated person is subject to a statutory disqualification.2 The funding portal member must keep this information current and must update such information within 10 days following any change to the information.

Code of Procedure

Proposed Funding Portal Rule 900(a) subjects all funding portal members to the FINRA Rule 9000 Series, concerning the Code of Procedure for FINRA proceedings. The proposed rule exempts funding portals from FINRA Rule 9000 Series’ eligibility proceedings and instead establishes a more streamlined version under proposed Funding Portal Rule 900(b). Persons who wish to become or remain associated with a funding portal member notwithstanding the existence of a statutory disqualification, and funding portal members or associated persons who wish to obtain relief from the eligibility or qualification requirements of the FINRA By-Laws and Funding Portal Rules, must initiate eligibility proceedings by filing an Application, pursuant to proposed rule 900(b)(4).3 However, if a disqualified funding portal member meets the conditions set forth in proposed Funding Portal Rule 900(b)(7), the disqualified funding portal member need not file an Application, and instead must file a written request for relief.

Arbitration and Mediation

Proposed Funding Portal Rule 1200(a) applies FINRA Rule 12000 Series (Code of Arbitration Procedure for Customer Disputes), FINRA Rule 13000 Series (Code of Arbitration Procedure for Industry Disputes), and FINRA Rule 14000 Series (Code of Mediation Procedure) to all funding portal members, unless context requires otherwise. Furthermore, paragraph (b) of the proposed rule sets forth requirements for funding portals’ use of predispute arbitration agreements for investor accounts and is a streamlined version of current FINRA Rule 2268.

Open Questions

FINRA’s proposed Funding Portal Rules, along with the SEC’s proposed rules under Regulation Crowdfunding, establish many new requirements for funding portals. Although the proposed Rules are quite comprehensive, there nonetheless remain several open questions as to how the Rules will operate in practice. These questions will be important for FINRA and the SEC to address in the final rules:

  • Under Regulation Crowdfunding, the SEC prohibits funding portals from offering investment advice or recommendations. Based on this prohibition, are registered investment advisers barred from operating a funding portal? Even if investment advisers are not precluded from operating a funding portal, how will they comply with the rule?
  • Notwithstanding efforts to reduce them, FINRA’s Proposed Funding Portal Rules impose meaningful costs and regulatory burdens on funding portal members, such as requiring fidelity bond coverage and establishment of a supervisory system and AML compliance program. Will these costs deter interested parties from operating a funding portal, as opposed to existing broker-dealers?
  • Funding Portal Rule 300(a) and (b) set forth minimum requirements for a funding portal’s supervisory system and anti-money laundering compliance program. Although intended to give funding portals flexibility to tailor their systems to their own business models, the requirements do not offer objective criteria or benchmarks for FINRA to evaluate these programs, nor do they offer clear guidance to funding portal members. As a result, it remains unclear what measures funding portals must implement in order to satisfy these requirements.
  • FINRA is requesting public comment on whether licensing requirements should be imposed on associated persons of funding portal members. Consequently, the final rules may include such a requirement.

[1] The filing requirement for Form FP-CMA is triggered upon changes (i) in equity ownership or partnership capital resulting in one person or entity owning or controlling 25% or more of the funding portal’s ownership interest, or (ii) of control persons of the funding portal member, excluding the appointment or election of officers or directors in the normal course of business.

[2] This requirement is similar to FINRA’s BrokerCheck Disclosure.

[3] The term “Application” is defined as FINRA’s Form MC-400 for individuals or Form MC-400A for funding portal members, and must be filed with the Department of Registration and Disclosure.

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. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, and James Harrigan, an O'Melveny associate licensed to practice law in the District of Columbia and Maryland, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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