Help Center

Transmission or maintenance of funds from investors

The rules pertaining to transmission of funds under Regulation CF vary based on the status of the intermediary as a registered broker-dealer or funding portal. Broker-dealers must comply with existing regulations set out in Rule 15c2-4. Under the regulation, funds must be promptly deposited into a separate bank account until the close of the offering when it is promptly transmitted to the issuer. Funding portals, which are prohibited from handling funds or securities, must:

  • Direct funds to a qualified third-party that has agreed to hold the funds in escrow, with qualified third-parties including a registered broker-dealer, bank or credit union; and
  • Direct the qualified third party to transmit funds to the issuer or return funds to the investor depending on the result of the offering under Section 4(a)(6).

Confirmation of transactions

Intermediaries are responsible for sending notice to investors confirming the completion of the transaction. Those notices must disclose pertinent details of the transaction, including:

  • The date of the transaction;
  • The type of security that the investor is purchasing;
  • The identity, price, and number of securities purchased by the investor, as well as the
  • number of securities sold by the issuer in the transaction and the price(s) at which the securities were sold;
  • If a debt security, the interest rate and the yield to maturity calculated from the price paid and date of maturity;
  • If a callable security, the first date that the securities can be called by the issuer; and
  • The source, form and amount of any remuneration received or to be received by the intermediary in connection with the transaction, including any remuneration to be received by the intermediary from persons other than the issuer.

Intermediary responsibility for cancellations and reconfirmations

At various times during an offering, the intermediary may be responsible for reconfirming an investment commitment with investors or cancelling the investment commitment. In the event than an issuer makes a material change to the terms of an offering or to the information provided by the issuer, intermediaries are required to contact investors that have made a commitment and request the investor re-commit to the investment in light of the new information. This confirmation must be received within five days or else the investment commitment must be cancelled by the intermediary. If the intermediary was required to cancel the investment commitment, it must then send a notice of the cancellation to the investor and direct a refuse of the investor’s funds. In the case of a material change occurring within five days of the target end of the offering established by the issuer, the officer must be extended to allow five full business days for the investor to re-commit to the investment. If an issuer does not raise the target funds by the deadline it established, the intermediary has five days to provide investors with notice of the cancellation of the investment commitment, direct the refund of investor funds, and prevent investors from committing any additional funds to the offering.

Protect the privacy of information collected from investors

The statutory language of Section 4A(a)(9) of the Securities Act requires that intermediaries protect the privacy of information collected from investors. Rather than creating new privacy rules, the SEC adopted rules to clarify that broker-dealers and funding portals are required to comply with Regulation S-P, Regulation S-ID, and Regulation S-AM. Taken together, these regulations obligate intermediaries to have policies and procedures in place to protect nonpublic information about investors, prevent identify theft, and limit the information shared with affiliates.

Limitation on payments to finders

An intermediary in an offering under Section 4(a)(6) is prohibited from compensating finders or any person for providing personally identifiable information on any investor or potential investors.

Financial interest in issuers

By statute, the directors, officers, or partners of an intermediary are prohibited from having a financial interest in an issuer using its services. The SEC clarified the way in which this prohibition applies to the intermediary itself. An intermediary may receive a financial interest in the issuer as a form of compensation for the services performed by the intermediary; the financial interest must be of the same class and at the same terms as the securities being sold under Section 4(a)(6).

Special limitations on funding portals

Under the Securities Exchange Act and Regulation CF, funding portals are limited purpose broker dealers that may assist issuers in the offering and sale of securities subject to certain limitations on their activities. The statutory prohibitions on funding portals include:

  • Paying for finding potential investors;
  • Giving investment advice or recommendations;
  • Soliciting offers or sales to buy the securities offered on its portal
  • Compensating anyone for such solicitation or based on the sale of securities on its portal;
  • Holding or managing funds; and
  • Permitting their officers, directors or partners to have a financial interest in an issuer using their services.
  • The SEC provided additional clarification of the statutory limitations by creating a conditional safe harbor for funding portals.

Under the conditional safe harbor, funding portals may:

  • Determine whether and under what terms to allow an issuer to offer securities on the funding portal’s platform;
  • Apply objective criteria to highlight offerings on the platform;
  • Provide search functions for investors to search and sort offerings based on objective criteria;
  • Provide communication channels that allow the issue to communicate with investors and potential investors;
  • Advise issuers on the structure and content of the offering;
  • Compensate third parties for referring persons to the portal and other services, so long as the referral does not include personally identifiably information of any potential investor and the compensation is not transaction based unless the party is a registered broker-dealer;
  • Pay or offer to pay compensation to a registered broker-dealer for services;
  • Receive compensation from a registered broker-dealer;
  • Advertise the existence of the funding portal and identify one or more issuers using objective criteria to determine which issuers to identify;
  • Deny access to the funding portal’s platform if the funding portal has a reasonable basis for believing that the issuer presents the potential for fraud;
  • Direct investors where to transmit funds for the purchase of securities; and
  • Direct third-parties to release funds to issuers or return funds to investors.

Curation of offerings by funding portals

In its proposed rules, the SEC expressly prohibited funding portals from “curating” offerings, as such subjective curation would be investment advice — an activity prohibited to funding portals by statute. In the final rules, the SEC relaxed this requirement by providing funding portals the ability to determine whether and under what terms to allow issuers onto their platforms so long as curation does not result in the provision of investment advice. This requirement relates to the advertising restrictions discussed below. For instance, curation by the funding portal may not support a claim that the issuers on the platform “are safer or better investments”. Instead, the curation should be a back-office type activity that helps portals bring forward the types of issuers they want without that activity becoming a selling point for the platform of the issuers.

Highlighting issuers and offerings

In keeping with the prohibition on providing investment advice, funding portals are only permitted to highlight specific issuers or offerings through the application of objective criteria that is reasonably designed to highlight a broad selection of issuers. The objective criteria must be applied consistently to all issuers and offerings and may not highlight issuers and offerings based on the advisability of investing, whether implicitly or explicitly. Some of the objective criteria noted by the SEC are: the type of securities being offered; the geographic location of the issuer; and the number or amount of investment commitments made. Funding portals may not use the objective criteria in such a way that it highlights or promotes a specific offering, as that would not be designed to highlight a broad selection of issuers. Funding portals are further prohibited from receiving special or additional compensation for identifying or highlighting (or offering to highlight) an issuer or offering on the platform.

Providing search functions

Funding portals may provide search functions that allow investors to sort through offerings based on objective criteria. The search function may allow for the search to be based on multiple criteria that would result in investors only viewing a limited number of offerings. The SEC identifies examples of acceptable search criteria that include the percentage of the target offering amount that has been met, geographic proximity to the investor, and days remaining before the offering deadline. Any criteria chosen by the funding portal must not cross into advisability of investing.

Providing communication channels

In providing communication channels as required by all intermediaries in offerings under Section 4(a)(6), funding portals have limitations on their participation in those communication channels. Funding portals, and their associated persons, may not participate in the communications through the communication channels. They may only establish guidelines about communication through the provided channels and may remove abusive and fraudulent communications. Funding portals are required to make these communication channels open to the public and only allow potential investors with accounts to post on these channels. Funding portals must require any commenter posting in the channels to disclose if he or she is receiving compensation for promoting an issuer. The SEC clarifies that any communication channel can include ratings of the offering by investors and potential investors (e.g., up-votes, down-votes, likes, dislikes). Any rating system used must provide for both positive and negative ratings. If the funding portal only allows for positive ratings, that may be considered investment advice.

Advising Issuers

Funding portals are permitted to advise an issuer about the structure or content of the offering, which includes preparing the offering documentation. The SEC noted that a funding portal could provide pre-drafted templates or forms to the issuers and provide advice on the types of securities the issuer can offer, the terms of those securities and crowdfunding regulations.

Paying for referrals

Funding portals may compensate a third party for referring potential investors to the portal so long as the third party does not provide the funding portal with any personally identifiable information about any of the potential investors. This might include hyperlinks from third parties’ sites. Compensation for such referrals may not be based on the purchase or sale of a security on the portal’s platform unless the third party is a registered broker-dealer.

Compensation arrangements with registered broker-dealers

Funding portals may enter into certain agreements with registered broker-dealers where they can pay each other for services. The proposed rules permit a funding portal to pay or offer to pay a registered broker-dealer for services in connection with an offering made in reliance on Section 4(a)(6). In addition, the SEC allows funding portals to provide services and be paid by a registered broker-dealer in connection with the funding portal’s offer or sale of securities in reliance on Section 4(a)(6). However, the final rules do not allow a funding portal to receive compensation for referrals of investors in offerings made other than in reliance on Section 4(a)(6). This is relevant to the financial considerations for funding portals offering securities of an issuer pursuing concurrent offerings under Section 4(a)(6) and Rule 506(c). The funding portal may not receive commissions for referring accredited investors to a broker-dealer managing the offering under Rule 506(c).

Advertising the funding portal and offerings

Funding portals are subject to limitations on publicity that do not apply to broker-dealers (which have pre-existing and strict rules about advertising and the use of social media). Under the final rules, a funding portal is:

  • Permitted to advertise its own existence;
  • Permitted to identify issuers or offerings in its advertisements based on objective criteria that would identify a large selection of issuers, so long as the criteria used do not implicitly endorse one issuer or offering over others and are consistently applied to all issuers and offerings; and
  • Prohibited from receiving special or additional compensation for identifying or highlighting an issuer or offering in its advertisements.

The rule does not restrict the media formats that funding portals may use to advertise and is solely focused on the content.

Denying potential issuers access to the platform

To stay within the safe harbor established by the SEC, funding portals may engage in the required activity for all intermediaries to deny access to potential issuers where the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud, or otherwise raises concerns about investor protection. To meet this requirement, the funding portal must deny access if it reasonably believes that it is unable to adequately or effectively assess the risk of fraud of the issuer or its potential offering. This obligation also applies to issuers or offerings that have been accepted to the platform and the funding portal later becomes aware of the potential for
fraud. In that case, the funding portal must promptly remove the offering from the platform.

Accepting investor commitment and directing the transmission of funds

While funding portals are explicitly prohibited from handling customer funds and securities by statute, they may accept investment commitments on behalf of issuers and direct those funds to be deposited with a qualified third party. The funding portal is permitted to instruct the qualified third party to deliver funds to the issuer upon completion of the offering or return funds to investors in the event the offering is cancelled. Qualified third parties include registered broker-dealers, and banks or credit unions that have agreed to hold the funds in escrow.

Compliance issues

Funding portals are required to implement written policies and procedures for complying with the various statutory and regulatory requirements for financial intermediaries. In the proposed rules, the SEC noted that funding portals would be required to register as brokers but for the specific exemption from registration that applies to registered funding portals. In the final rules, the SEC determined that funding portals must put in place customer privacy protections of 17 CFR § 248 as they apply to broker-dealers, and the provisions relating to examination and inspection of books and records and facilities by the SEC and FINRA. Of note, the SEC determined that the compliance policies of funding portals do not need to include anti-money laundering provisions. The SEC notes that other parties involved in transactions facilitated by funding portals, such as broker-dealers and banks holding funds, continue to have their own anti-money laundering procedures.

How investors will pay for securities

The statutory authority for crowdfunding and the requirements for intermediaries does not limit or require a payment mechanism by investors. The SEC declined to impose any restrictions on the form of payment that intermediaries may accept. For instance, investors will be able to transmit funds to intermediaries (or their escrow agents) by bank transfer, debit card or PayPal accounts linked to debit cards or funds deposited with PayPal. The SEC leaves intermediaries to use their own discretion in determining whether to accept certain payment methods, like credit cards. In the case of credit cards, there are regulatory issues involved in the purchase of securities using credit (“on margin”) and this is likely to be an area where credit card companies may have to deal with a large number of disputes and potential “charge-backs.” For these reasons, credit card companies may decline to provide their services to this industry altogether, and individual intermediaries may choose not to accept credit cards, for either regulatory or economic reasons.

FINRA requirements

On October 9, 2015 FINRA filed with the SEC for approval its rules for funding portals. Under FINRA’s rules, funding portals would not be subject to some of the more onerous obligations of full broker-dealers, such as capital requirements, and FINRA has not proposed that funding portal personnel be required to pass examinations on securities markets and law, although they will be required to demonstrate that they understand and are capable of compliance with securities regulations. Funding portals will be subject to FINRA’s rules relating to their conduct during offerings taking place under Section 4(a)(6). Specifically, funding portals will be required to adhere to “high standards of commercial honor and just and equitable principles of trade”. Additionally, funding portals may not effect any transactions by their own manipulative or deceptive conduct, or by aiding and abetting such conduct of another person, including any issuer. Further, funding portals will be responsible for the content of any “funding portal communication”, which includes all written or electronic communications distributed by or made available by a funding portal, which may include issuer-created content.

Why intermediaries need to check that the issuer has met the conditions of the exemption

The filing of the information set out above to the SEC is one of the conditions of the exemption from registration for an offering by an issuer. As mentioned above, if an issuer does not comply with all the SEC’s filing requirements, and the omission is not so small that it can fit within the “insignificant deviation” rule, the conditions for the Section 4(a)(6) exemption are not met, and the offer violates the registration requirements of Section 5 of the Securities Act. The remedy for this violation is rescission (i.e., giving the investors their money back; it is like the investors having an ongoing right to “put” the securities back to the issuer). If an intermediary were to host on its platform an offering to which a rescission right applied, and no mention were made of that fact, this would almost certainly be an “omission of a material fact” that the intermediary would be responsible for. Intermediaries should therefore check to make sure the issuers have complied with Regulation CF’s requirements, or have a third party do so.

Simultaneous accredited and crowdfunding offerings

The SEC makes clear its position that that an offering made in reliance on Section 4(a)(6) should not be integrated with another exempt offering. “Integration” means treating two different offerings made at the same time as if they were one offering, subject to all the conditions of both offerings. Because the SEC will not automatically integrate Section 4(a)(6) offerings with other offerings, an issuer may make a Section 4(a)(6) offering that occurs simultaneously with, or is closely preceded or followed by an offering made under Regulation D. While the offers will not be integrated, an issuer must take care that if the Regulation D exemption prohibits general solicitation (e.g. Rule 506(b)), purchasers in that offering may not be solicited by the Section 4(a)(6) offering. Similarly, if the other exemption allows for general solicitation (e.g., Rule 506(c)), then those general solicitations may not include advertisements prohibited under Section 4(a)(6).

It seems likely that “side-by-side” offerings, made to “accredited” investors under Rule 506(b) or 506(c) alongside offerings to unaccredited friends and family in reliance on Section 4(a)(6), will become popular. Rule 506 does not mandate specific disclosure, but the mandatory information requirements would be relatively easy to comply with for most issuers making a Rule 506 offering, and the modest additional costs would be more than offset by the goodwill engendered by including customers and early supporters. The disclosure requirements under Regulation CF are easier to comply with than the requirements that apply if non-accredited investors are included in an offering under Rule 506(b).

Side-by-side offerings of this type may be most easily undertaken by fully registered broker dealers, who would be able to charge commissions for both the accredited and nonaccredited investors. Funding portals may need to act as “bulletin boards” (platforms that do not solicit investors and do not charge commission) or form a relationship with a fully-registered broker with respect to the Rule 506 portion of the offering. This should not be done without the advice of experienced securities law counsel.

The ability to make concurrent offerings means that, when structured properly from a regulatory point of view, a crowdfunding offering can include an accredited investor component increasing the overall size significantly beyond $1 million and not imposing any investment limitations on accredited investors.

Relief for insignificant deviations

The statutory and regulatory requirements for crowdfunding issuers and intermediaries are complex and extensive, and inexperienced issuers may innocently fail to comply with them. The SEC has adopted a three-prong test that would provide issuers a safe harbor for insignificant deviations from a term, condition, or requirement of Regulation CF. To qualify for the safe harbor under proposed Rule 502, the issuer relying on the exemption in Section 4(a)(6) must show:

  • The failure to comply with a term, condition, or requirement was insignificant with respect to the offering as a whole;
  • The issuer made a reasonable and good faith effort to comply with all terms, conditions, and requirements of Regulation CF; and
  • The issuer did not know of the failure to comply, where the failure to comply with a term, condition or requirement was the result of the failure of the intermediary to comply with the requirements of Section 4A(a) and the related rules, or such failure by the intermediary occurred solely in offerings other than the issuer’s offering.

So long as the issuer acted in good faith while attempting to comply with the rule, the issuer should not lose the Section 4(a)(6) exemption just because there was a failure to comply with the rule that was insignificant considering the offering as a whole. The third prong of the safe harbor provision should prevent an issuer from losing the exemption in Section 4(a)(6) because an intermediary violated Section 4A(a). If the issuer knows of the intermediary’s failure to comply with a term, condition, or requirement of Regulation CF, and does nothing to correct it, the issuer will lose the exemption.

Liability

The statutory language expressly set out the liability imposed on issuers for making false or misleading statements and omissions. Section 4A(c) of the Securities Act, added by the JOBS Act, provides that an issuer, including its officers and directors, will be liable to the purchaser of its securities in a transaction under Section 4(a)(6) if the issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary to make the statements, considering the circumstances under which there were made, not misleading. The company and its officers and directors bear the burden of proof with this respect to this liability: they must show that they did not know, and in the exercise of reasonable care, could not have known of the misleading statement or omission. The statutory language applies this liability to “any person who offers or sells the security in such offering.” The SEC (applying interpretation set out in a Supreme Court case) originally noted that based on this definition, intermediaries, including funding portals, would be subject to this liability.

While many commenters objected to this interpretation, the SEC declined to retract the statement or to create an exemption from liability for funding portals (or any intermediaries). The SEC states that the status of an intermediary as “issuer” will depend on a facts and circumstances analysis. The SEC points out that there are appropriate steps that intermediaries might take to rely on the “reasonable care” defense provided by Congress. These steps may include establishing policies and procedures reasonably designed to achieve compliance with Regulation CF, 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. CrowdCheck can help with these processes.

Issuers and intermediaries should be aware that the JOBS Act and Regulation CF do not limit liability associated with other anti-fraud rules and statutes of the securities laws that already exist. For instance, issuers will continue to face liability for manipulative or deceptive practices or misleading statements under Rule 10b-5. Additionally, intermediaries, issuers, and anyone who “willfully participates” in an offering could be liable for false or misleading statements made to induce a securities transaction under Section 9(a)(4) of the Exchange Act.

It is to be hoped that the issue never comes up because no intermediaries find themselves defending allegations of misleading statements, but it is interesting that there has been no discussion of the impact of the Supreme Court 2010 Janus decision on potential intermediary liability. This decision examined what it means to “make” a misleading statement under Rule 10b-5, which has many common elements with Section 4A(c). In addition to SEC liability for securities law violation, FINRA imposes liability on funding portals and broker-dealers that violate the FINRA rules of conduct. Under FINRA Rules 2010, 2020, and funding portal Rule 200, brokers and funding portals are required to observe high standards of commercial honor and not to engage in manipulative, deceptive, or other fraudulent devices. Additionally, funding portal Rule 200 prohibits a funding portal from including on its website information from an issuer that the portal knows or has reason to know contains any untrue or misleading statement.

State law

Under the JOBS Act, the states are pre-empted from requiring registration of Section 4(a)(6) offerings, but there is no restriction of their ability to take enforcement action with respect to fraud or deceit by issuers, brokers or funding portals. States may impose fees if they are the principal place of business of the issuer or if more than half the purchasers of a crowdfunding offering are in that state. A funding portal’s home state may regulate the portal but cannot impose different or additional rules. The SEC declined to mandate that the issuer provide any information directly to state securities regulators on the assumption that state securities regulators would be able to access the issuer’s mandatory disclosures on EDGAR.

Resale restrictions

Securities issued pursuant to Section 4(a)(6) are not freely transferrable by the purchaser for one year after the date of purchase. The statutory text outlines four situations in which a transfer may be made prior to the end of the one-year period; the SEC did not significantly alter these provisions in its Rule 501. Prior to the end of one year, transfers may be made:

  • To the issuer of the securities;
  • To an accredited investor;
  • As part of an offering registered with the SEC; or
  • To a member of the family of the purchaser or the equivalent, to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser, or in connection with the death or divorce of the purchaser.

The SEC clarified that the restrictions on transfer apply to all holders during the one-year period, whether they purchased their securities from the issuer or in a secondary transaction. The SEC did not provide guidance or structure with respect to subsequent trading of crowdfunding securities. However, it should be noted that the JOBS Act pre-emption of state regulation applies only to the initial offer and sale of securities by the issuer. After the end of the statutory restriction on transfer, investors would likely be able to transfer their securities to someone else without registration at the federal level, in reliance on Section 4(a)(1) of the Securities Act. However, subsequent trades must also be made in accordance with state law (which is only preempted when the issuer is a full SEC-reporting company), and the law varies widely from state to state with respect to how securities of non- public companies can be resold. Crowdfunding securities will thus be extremely illiquid. Any entity providing an exchange or market or liquidity facility for the resale of crowdfunding securities would need to be registered with the SEC as a stock exchange or alternative trading system.

Crowdfunding securities and registration under the Exchange Act

The Exchange Act typically requires companies to become reporting companies under the Exchange Act when their shares are held of record by 2,000 persons or 500 persons who are not accredited investors. Recognizing that offers under Section 4(a)(6) are likely to bring in many shareholders, the JOBS Act exempts Section 4(a)(6) securities from the shareholder threshold. The SEC interpreted the statute in Rule 12g-6 to provide that all securities issued pursuant to a Section 4(a)(6) offering would be exempted from the holders-of-record count under the Exchange Act. In other words, the exemption follows the security, not the purchaser. So, if a purchaser resells Section 4(a)(6) securities to another person after one year, there is no change to the number of holders of record. Issuers will have to make sure their securities sold under Section 4(a)(6) bear clear identification as such. In a change from the proposed rules, the exemption from record holder count is conditional upon:

  • The issuer being current in its ongoing reporting obligations;
  • The issuer not having assets more than $25 million; and
  • The issuer engaging a transfer agent registered with the SEC to keep its books.

This conditionality may prove problematic to issuers whose operations (and thus assets) grow rapidly, although the SEC grants them a two-year period in which to transition to full reporting status. Crowdfunding issuers will have to make very sure that they file their annual Form C-ARs on time.

 

<< Continue from Part 1

This post (Regulation Crowdfunding Rules) was written by Peter Thomson on September 21, 2016