Crowd Funding: New Tools, New Opportunities

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1 Crowd Funding: New Tools, New Opportunities CAROL BAVOUSETT MATTICK Carol Bavousett Mattick, PLLC 919 Congress Avenue, Ste 919 Austin, TX State Bar of Texas ANNUAL MEETING June 16, 2016 FT WORTH, TX 1

2 CROWD FUNDING: NEW TOOLS, NEW OPPORTUNITIES INTRODUCTION...1 REGULATION CF...1 A. Overall Requirements...2 Which Issuers Cannot Use Regulation CF...2 Primary Requirements...2 Limitations on Investment...3 Any Kind of Security May Be Offered...4 Liability for Persons Offering or Selling a Security...4 B. Requirements for Eligible Issuers...4 The Offering Statement...4 Non-Financial Information...4 Financial Information...6 Duty to Amend and Update...6 Duty to Engage in Annual Reporting and Termination Of Annual Reporting...7 Advertising or Promoting the Offering...8 The Chronology of a Regulation CF Offering From the Issuer s Point of View...8 C. Requirements for All Intermediaries Both Registered Broker Dealers and Funding Portals...9 Disqualification...9 Functional Requirements of the Electronic Platform...10 Policing Compliance of Issuers and Investors...12 D. Additional Requirements for Funding Portals...13 Scope of FP Registration and Allowed Activity...13 Maintenance of Record of the Offering, Communications Among Investors and Other Records...13 Ability to Take Transaction Based Compensation...14 FINRA Regulation...17 E. Other Key Features of Interstate Crowdfunding...19 Pre-Emption of State Substantive Law...19 No Integration: Ability to Do Simultaneous/ Close in Time Offerings Under Other Exemptions...20 Non-Exclusive Method of Compliance...20 F. Practical Questions Raised by Regulation CF...20 Intermediaries Preparing Offering Documentation...20 Interstate and Intrastate Crowdfunding: Parallel Closed Systems...21 Bottleneck: The Importance of Electronic Platforms and Intermediaries...21 FINRA Regulation...21 G. Summary...21 TEXAS INTRASTATE CROWDFUNDING RULES...22 A. Overall Requirements of the Exemption...22 ii

3 A Registered TCP or Texas General Dealer Must Be Involved...22 All Offers and Sales are Made to Texas Residents...22 All Offers and Sales are Made Completely on a Website Operatied by a Registered Intermediary...22 Information Disclosure Required by the Issuer...23 Aggregate Offering Limits Within Twelve (12) Months...23 Limits on the Amount of Investment by Each Investor...23 Escrow of Offering Proceeds...24 B. Requirements for Companies Raising Capital or Issuers of Securities...24 C. Requirements for Texas Crowdfunding Portals...24 D. Comparison Between TCPs and Texas General Dealers...25 E. Compliance with Federal Law The Rule 147 Requirements...25 F. Disqualifications...25 G. Notice of Offering and Resales of Securities...26 H. Summary...26 EXHIBIT A : Disqualifying Events Under Reg CF, Rule iii

4 CROWDFUNDING: NEW TOOLS, NEW OPPORTUNITIES Carol Bavousett Mattick 1 Carol Bavousett Mattick, PLLC Regulation CF ( CF for crowdfunding) was finally adopted by the SEC on October 30, At the same time, the considerable effort expended by states, including Texas, to enact statutes or rules relating to intrastate crowdfunding is still relevant. Intrastate rules offer a parallel alternative in states where there resides enough investment capital to create a market of sorts. At the same time that the SEC adopted Regulation CF, it proposed significant changes to Rule 147, a federal offering exemption that needs to be paired with intrastate crowdfunding offerings. 3 The changes are designed to make intrastate equity crowdfunding easier. Beyond offerings that are crowdfunded, there are Rule 506(c) offerings with general solicitation which can be conducted on websites with no substantive state regulation of the issuers and offerings but substantive state regulation of any intermediaries or platforms involved in the offerings. One of the more interesting applications of interstate equity crowdfunding seems to be simultaneous Reg CF offerings to validate interest in a product while also conducting a Reg D Rule 506 offering to raise growth capital. Anecdotally, large companies like U-Haul are using a version of crowdfunding to get their customers to invest in (and thereby relieve the large company from having to invest in) capital equipment necessary for the business. This article will set out the fundamental requirements involved in interstate and Texas intrastate equity crowdfunding offerings. It will be important to take another look at the intrastate alternative when practitioners and others comment on the proposed changes to SEC Rule and the SEC adopts some version of them. Intrastate crowdfunding offerings must also comply with some federal exemption. A streamlined and modernized version of Rule 147 should be helpful in increasing the use and popularity of intrastate crowdfunding. I. REGULATION CF New Regulation CF is found at 17 CFR Part 227 and follows this general organization: Subpart A General Crowdfunding exemption and requirements Subpart B Requirements for Issuers Disclosure requirements. 1 Carol Mattick has been practicing corporate and securities law as a solo practitioner for over 25 years. Her practice is based in Austin and San Antonio. carol@cbmattick.com; 2 SEC Release , 80 FR 71388, Nov 16, 2015 (the Regulation CF Adoption Release ) 3 SEC Release , 80 FR 69786, Nov 10, 2015 (the Rule 147/504 Proposal Release ) 4 Practitioners and others can comment on the proposed changes to Rule 147 at File No S online at the SEC website, rule-comments@sec.gov. 1

5 Ongoing reporting requirements Filing requirements and form Advertising Promoter compensation. Subpart C Requirements for Intermediaries Intermediaries Measures to reduce risk of fraud Account opening Requirements with respect to transactions Completion of offerings, cancellations and reconfirmations Payments to third parties. Subpart D Funding Portal Regulation Registration of funding portals Exemption Conditional safe harbor Compliance Records to be made and kept by funding portals. Subpart E Miscellaneous Provisions Restrictions on resales Insignificant deviations from a term, condition or requirement of Regulation Crowdfunding Disqualification provisions. One might think that the key provisions of Regulation CF (or Reg CF ) must relate to issuers because this is an offering exemption. However, Regulation CF requires: 1) these offerings be conducted exclusively on an electronic platform that is required to do many things relating to the offering; and 2) that registered intermediaries operate and be responsible for those platforms. The registration and other regulatory requirements on intermediaries as well as the technical requirements for these platforms may well end up being the bottleneck in making this type of capital raising available to issuers. A. Overall Requirements Which Issuers Cannot Use Reg CF Let s start with which issuers cannot use Regulation CF. They include: Non-U.S. Issuers. This means issuers not organized under and subject to, the laws of a State or territory of the United States or the District of Columbia. 5 Theoretically, an issuer could be formed in a U.S. jurisdiction and have its principal place of business elsewhere. 34 Act Reporting Issuers C.F.R (b)(1) 2

6 An issuer can become subject to the requirement to report periodically under the Securities and Exchange Act of 1934 (the 34 Act ) either by: 1) having a sufficient number of holders of a class of securities; 2) having at least $10 million in assets; or 3) conducting an SEC registered offering 6. However, with respect to counting the number of holders, the SEC has exempted holders who received their shares through a Reg CF offering. 7 Investment Companies. This category includes those registered under the Investment Company Act of as well as those exempted from such registration under 3(b) and 3(c) of that Act. Of course, the entities that would have been most likely to seek to use this exemption would have been exempt or private investment companies, including 3(c)(1) and 3(c)(7) funds. An Issuer Disqualified as a Bad Actor (or an issuer who has an affiliated person or entity that is disqualified as a bad actor) under the terms of Regulation CF Rule A Crowdfunding Issuer That Has Not Provided Annual Reports in Previous Two Years. This applies to issuers that have made a Regulation CF offering in the past and are attempting to make another one. and Issuers with No Specific Business Plan or That Intend to Merge With or Acquire an Unidentified Company No blank check, blind pool or shell companies are eligible to make a crowdfunding offering. Also, companies that might qualify to use programs like the Toronto Stock Exchange s Canadian Capital Company program are not eligible. Primary Requirements For an eligible issuer, the primary requirements of a Regulation CF offering are: 6 It is the class of securities that meets the number of holders test that must be registered under the 34 Act. The rules relating to counting of holders were directed to be revised in the Wall Street Reform and Consumer Protection Act of 2010 (commonly known as Dodd-Frank ). Generally, a company can now have as many as 2,000 holders or fewer than 500 holders that are not accredited investors. See 34 Act 12(g) (15 U.S.C. 78l(g)) There are also some tricky provisions relation to what counts as a voting security and held of record. Please review SEC Rule 12g-1 (17 C.F.R g-1, et. seq) and Rule 12h-1 (17 C.F.R h-1, et. seq). 7 SEC Rule 12g-6 (17 C.F.R g-6). The new SEC rule provides that holders that initially received their securities through an offering under Securities Act 4(a)6 (15 U.S.C. 77(d)(a)(6)), the statutory basis for crowdfunding offerings, will be exempted from the record holder count so long as it is current with respect to annual reporting required by Reg CF Rule 202 (17 CFR ); has total assets as of the last fiscal year not exceeding $25 million; and has engaged the services of a transfer agent registered with the SEC. However, as foreshadowed in the new rule, that exemption does not last forever U.S.C. 80a C.F.R See Exhibit A to this paper. 2

7 1) that neither the issuer, its predecessor, nor any person who controls, is controlled by or under common control with the issuer 10 offer an aggregate amount of securities under the statutory crowdfunding exemption of more than $1,000,000 in the twelve months preceding (and including) 11 the offering at hand; 2) that the aggregate amount of securities purchased by any one investor in any crowdfunding offering by any issuer in the preceding twelve months not exceed certain limits described below; 3) that the issuer conduct the offering exclusively on one electronic platform and through one intermediary 12 ; and 4) that both the intermediary operating the electronic platform and the issuer making the offering comply with all of the additional requirements that Regulation CF places on each of them which will be detailed below. Limitations on Investment Regulation CF divides investors into those with lesser means and those with more, but allows both accredited and non-accredited investors to invest without quotas on those two categories of investors. It requires that investors in crowdfunded offerings invest no more than the following amounts in the following circumstances: 1) If an investor s net worth or annual income is less than $100,000, that investor may invest the greater of : a) $2, or b) five percent (5%) of the lesser of the investor s net worth or annual income. 2) If an investor s net worth and annual income is equal to or greater than $100,000, that investor may invest ten percent (10%) of the lesser of the investor s net worth or annual income, not to exceed $100,000. These limitations apply to all of an investor s investments over the preceding twelve (12) months in offerings exempted under 33 Act 4(a)(6), the statutory crowdfunding exemption. The detailed requirements of issuers and intermediaries suggest that both are responsible for ensuring these limits are observed, but put the larger responsibility on the intermediary Regulation CF Rule 100(c), (17 C.F.R (c)). See instruction to paragraph (c), under which control can be direct or indirect and includes the power to direct or cause direction of management and polisies of the entity through ownership of voting securities, by contract or otherwise. 11 If an issuer has raised capital through a crowdfunded offering within the previous 12 months, it must include the target amount for any new offering it contemplates in the $1,000,000 limit. 12 See the Instruction to paragraph (a)(3) to Regulation CF Rule 100(a)(3) (17 C.F.R ) 13 On one hand, issuers are always responsible for making sure that all of the terms of an offering exemption are met. After all, issuers are the ones seeking the exemption. However, Instruction 3 to paragraph (a)(2) under Regulation CF Rule 100 states that an issuer may rely on the efforts of an intermediary that is required by Regulation CF Rule 303(b) to ensure that these limits are met. Where it has actual knowledge that an investor has exceeded the limits applicable to him or her, the issuer will be responsible for speaking up and helping to enforce the limit on investment. 3

8 Any Kind of Security May Be Offered One of the most versatile and flexible features of Regulation CF is present by omission. The regulation does not dictate or limit the type of security that may be offered in a crowdfunded offering. Common equity, debt and all kinds of hybrids should be possible. Liability for Persons Offering or Selling a Security The JOBS Act included a specific type of liability of (and established an explicit private right of action against) issuers and others who offer or sell a security under 33 Act 4(a)(6) exempt offerings. 14 The statute is confusing because it uses the term issuer and then defines that term as any person who offers or sells a security and specifically includes directors, partners, officers, principal financial officers, and controllers of issuers. The statute states that If [the issuer] in the offer or sale of the 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, the [issuer] is liable. There are a couple of caveats: 1) by reference to 34 Act 10(a)(2), the purchaser of the securities must not know of the omission or untruth; and 2) the [issuer] must fail to sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission. The SEC,in the Reg CF Adoption Release, specifically refused to exempt Funding Portals from this liability saying that any intermediary s liability under the provision would turn on the facts and circumstances of the particular matter in question. B. Requirements for Eligible Issuers The Offering Statement The issuer is responsible for compiling information for disclosure to potential investors, filing it with the SEC and delivering it to the intermediary and investors exclusively through the electronic platform. That comes primarily in the form of the issuer s offering statement on Form C. It must include basic information about the issuer, its officers and directors and holders of 20% or more in equity voting power, including whether the issuer has previously failed to comply with Regulation CF s ongoing reporting requirements. Basic information about the intermediary, its interest in the transaction and whether it holds any equity stake in the issuer must also be disclosed. Non-Financial Information The bulk of substantive disclosure in the offering statement comes in form and breadth similar to that required in a Form 1-A, the offering statement required in Regulation A and A+ offerings. Briefly, the subject matter includes: The purpose and intended use of proceeds, in reasonable detail U.S.C. 4A(c) 15 See Instruction to paragraph (i), Regulation CF Rule 201(i) (17 C.F.R (i)) If there are different options for use of the proceeds, issuers should discuss factors that will impact how the issuer chooses to spend the monies raised. 4

9 Information about the offering including a target offering amount 16, the offering price, and procedures for making a subscription to the offering and having it returned Description of the business of the issuer, the industry in which it fits and the issuer s anticipated business plan The number of employees, information on directors and officers, including their experience and what they have been doing for the past three years in particular and a list of those who hold at least 20% of the equity of the issuer prior to the offering, as measured by voting power. Description of the ownership and capital structure, the terms of the securities offered, the rights and preferences of other issued securities, the effect of exercise of rights by existing holders, and related issues A reasonably detailed description of the issuer s indebtedness A reasonably detailed description of all exempt offerings done by the issuer within the last three years Information about transactions between the issuer on one hand and directors, officers, 20% holders, and other parties related to it and them on the other hand, but only to the extent that the dollar value involved in the transaction exceeds five percent (5%) of the total amount raised (or seeking to be raised in the current offering) by the issuer in crowdfunding offerings over the preceding twelve (12) months. Material factors that make an investment in the issuer risky or speculative Restrictions on transfer of the securities by an investor, including and beyond the one year restriction imposed by Regulation CF 17 Discussion and analysis by the issuer s management about the issuer s financial condition, liquidity, capital resources and historical results of operations (an MD&A section) The target offering amount needs to be carefully thought out. Financial statement and other requirements depend on the target amount sought. Unlike traditional private placements with a minimum amount and maximum amount to be raised, the target offering amount acts as both minimum and maximum. If it decides to accept more than the target amount, an issuer is required to update investors about that fact and its repercussions. If a target amount is not met within the time period set by the issuer, all funds committed must be returned to the potential investors. It is unclear whether an issuer can do a continuous offering without a deadline but only a target offering amount. 17 Regulation CF Rule 501(a) (17 C.F.R (a)) in which investors may not transfer the equity shares purchased in a Reg CF offering to another purchaser within one year unless that purchaser is an accredited investor, a member of the investors family or the sale is part of a secondary public offering. 18 See Instruction 2 to paragraph s, Regulation CF Rule 201(s), (17 C.F.R (s)) which requires issuers with little or no operational history to focus this disclosure on financial milestones as well as operational and liquidity challenges. 5

10 Financial Information The type of financial information that issuers must provide to potential investors depends on the target offering amount that the issuer sets: If the target offering amount is set at less than or equal to $100,000, the issuer must provide potential investors with the amount of total income received, taxable income and total tax incurred by the issuer and financial statements. Such information must be certified by a principal executive officer to accurately reflect filed tax returns and certified to be true and correct. If the target offering amount is set at greater than $100,000 but less than or equal to $500,000, the issuer must provide potential investors with a complete set of financial statements that have been reviewed by an independent certified public accountant. If the target offering amount is set at greater than $500,000 but no more than $1,000,000 and the issuer has not offered securities under 33 Act 4(a)(6) previously, the issuer must provide potential investors with a complete set of financial statements that have been reviewed by an independent certified public accountant. If the target offering amount is set at greater than $500,000 but no more than $1,000,000 and the issuer does not fall in the previous category, the issuer must provide potential investors with a complete set of audited financial statements audited by an independent certified public accountant. 19 Duty to Amend and Update During the offering process, the issuer has the opportunity to amend the information previously provided and must amend it if there have been material changes in that information. The issuer provides the new information on Form C/A, filed with the SEC and provided on the electronic platform of the intermediary. If it is material, the issuer must alert investors that the change is material and seek a recommitment from any investor who has already committed to invest in the offering. 20 During the course of the offering, an issuer must update investors about the progress of the offering by filing a Form C-U with the SEC and on the electronic platform of the intermediary. 19 This provision contained in Regulation CF Rule 201(t) (17 C.F.R (t)) states that audited financial statements are the default choice unless the issuer has not previously done a crowdfunded offering. It appears the SEC is trying to lessen the burden on smaller issuers and assumes that smaller issuers would start with a crowdfunded offering. However, the formulation of this requirement suggests that issuers that have done other kinds of exempt offerings but not a 4(a)(6) offering would be allowed to provide reviewed rather than audited financials. There are a total of 10 Instructions to paragraph (t) under Reg CF Rule 201 which give significant specificity about how to interpret this requirement. For instance, the requirement is for two years of financial statements and if more rigorous financial information is available on an issuer at any target offering level, that information must be provided to potential investors. 20 The Form C/A, which can be found at 17 C.F.R , has a check box indicating whether the amendment is material. Reg CF Rule 203(a)(2) provides that an investor must affirmatively re-commit to invest in the offering within five days of the filing of Form C/A with material amendments or his/her/its investment will be automatically cancelled and his/her/its monies will be returned. 6

11 If the intermediary is updating the progress of the offering on a regular basis on its own, that activity relieves the issuer s responsibility to provide updates to the intermediary and potential investors but does not excuse a failure to file with the SEC. 21 An issuer has an obligation to update within five days of the occurrence of the following: Fifty percent (50%) of the commitments required to reach the target offering amount have been received One hundred percent (100%) of the commitments required to reach the target offering amount have been received The offering deadline, if the issuer decides to accept more than the targeted offering amount The offering deadline, if the issuer decides to close the offering Duty to Engage in Annual Reporting and Termination of Annual Reporting One of the features of Regulation CF that mimics or is similar to the features of the new Regulation A and A+ is the requirement of Reg CF issuers to annually file with the SEC and post on the issuer s website a report that contains: 1) most of the substantive information that the issuer provided in its original offering statement 22 ; 2) its financial statements, certified by a principal executive officer of the issuer; and 3) a discussion of the issuer s financial condition similar to that required in the original offering statement by Reg CF Rule 201(s). 23 The annual report must be filed and posted within 120 days of the end of the fiscal year which is the subject of the report. These annual reports must continue to be filed until the occurrence of one of the following events: The issuer becomes subject to the requirement to file periodic reports under the 34 Act; After the issuer s most recent offering under 33 Act 4(a)(6), the issuer has filed at least one annual report and also has fewer than 300 holders of record; After the issuer s most recent offering under 33 Act 4(a)(6), the issuer has filed at least three annual reports and also has less than $10 million in total assets; 21 Reg CF Rule 203(a)(3)(iii), (17 C.F.R (a)(3)(iii)). Form C-U is found at 17 C.F.R Per Rule 202(a), it must include the information required by Rule 201 (a), (b), (c), (d), (e), (f), (m), (p), (q), (r), and (x). The provisions missing are those relating directly to the offering 23 Regulation CF Rule 202(a) 7

12 or The issuer repurchases or another party purchases all of the securities issued [by that issuer] pursuant to 33 Act 4(a)(6), including repayment of debt securities and redemption of redeemable securities 24 The issuer liquidates its assets or dissolves its business under state law. Within five days of becoming eligible to terminate annual reporting, an issuer must file a notice of termination with the SEC on Form C-TR. 25 That information will be available electronically on the SEC website to inform investors of the termination of reporting. Advertising or Promoting the Offering A central tenant of Regulation CF offerings is that most of the communication about the offering occurs on the electronic platform between issuer and potential investor and among potential investors. Outside of official issuer communications, founders and employees of issuers must disclose their affiliation with the issuer when they communicate on the electronic platform with potential investors. An issuer can compensate other persons to promote the offering but only: 1) if the promotion occurs on the electronic platform/website; and 2) the issuer takes reasonable steps to ensure that the promoter discloses the fact that he/she/it is being paid by the issuer to promote the offering. Those reasonable steps can be accomplished through obtaining representations from promoters that they are in fact disclosing the compensation every time they communicate with a potential investor and monitoring the activity of promoters on the site. Communication about the offering outside the electronic platform is limited. An issuer is allowed to advertise or provide information about the offering so long as it is limited to the basic facts of the offering, much like the communication of a tombstone ad relating to a public offering. The Chronology of a Regulation CF Offering From the Issuer s Point of View Like the requirement to report electronically on Form D for Reg D offerings, Regulation CF issuers will have to apply for credentials to the Edgar system and submit Forms C, C/A, C-U and C-TR electronically. The issuer must file Form C and the intermediary must make the issuer s offering statement available to the SEC at least 21 days prior to any sale of the securities. The SEC has directed issuers to provide specific information to investors in the offering statement regarding the chronology of the offering and offering mechanics: The issuer must set a target offering amount and a deadline by which the target must be raised and state those in the offering statement This appears to require repurchase of all of the crowdfunded securities issued by this issuer but not any of the other securities offered under other exemptions that might have been issued by the issuer. 24 Regulation CF Rule 202(b)(3), (17 C.F.R (b)(3)) 26 Regulation CF Rule 201(g), (17 C.F.R (g)) 8

13 The issuer must tell investors that: o They are able to cancel any investment to which they commit at any time prior to forty eight (48) hours before the offering deadline 27 o If the target offering amount is met early, the issuer must provide investors five (5) days notice 28 o If the target offering amount is not met by the deadline, all funds will be returned to investors and o If the issuer files an amendment to the offering statement that contains a material change, the investor s investment commitment will be cancelled and his/her/its funds will be returned unless he/she/it affirmatively re-commits to invest. As it is living by the foregoing requirements, the issuer must make any amendments and report any updates electronically within the five (5) day timeframes given in the Rules. The issuer must also monitor promoters and its business communications outside of the electronic platform to comply with the limitations on communications about the offering. The requirements of a Regulation CF offering on both the issuer and the intermediary lend themselves to a structure where investors make commitments and the issuer calls for funding at a specific time such as the deadline date of the offering. While a Funding Portal as defined under the 34 Act 29 cannot hold investor funds or securities, Reg CF Rule 303(e) 30 requires a Funding Portal to direct investors to transmit their monies for investment commitments to a qualified third party. That includes: 1) a registered broker dealer with the ability to hold custody of client funds (a clearing broker ); or 2) a bank or credit union acting as an escrow agent. Since intermediaries participating in Regulation CF offerings must be either registered broker dealers or Funding Portals and since those intermediaries must either comply with 34 Act Rule 15c2-4 regarding clearing or Reg CF Rule 303(e), issuers effectively cannot hold the commitments of potential investors themselves in a Regulation CF offering. C. Requirements for All Intermediaries Both Registered BDs and Funding Portals Disqualification Any intermediary, whether registered broker or Funding Portal, may not act as an intermediary in a transaction under 33 Act 4(a)(6) if it is subject to a statutory disqualification under 34 Act 3(a)(39). 31 Regulation CF places a large amount of responsibility on intermediaries for the conduct of offerings under 33 Act 4(a)(6) and the implementing regulation. Intermediaries are required 27 Regulation CF Rule 201(j)(1) and (4), (17 C.F.R (j)(1), (4) 28 Regulation CF Rule 201(j)(3), (17 C.F.R (j)(3)) Act 3(a)(80), (15 U.S.C. 78c(a)(80)) C.F.R (e) 31 Regulation CF, Rule 503(d) (17 C.F.R (d)) 9

14 by Regulation CF Rule 302(a)(2) to provide all information required under the Regulation CF Rules through electronic means. Functional Requirements of the Electronic Platform These integrated electronic platforms must orchestrate a series of gateways in issuer dealings with potential investors and provide the following functionality in doing so: It must make available to the SEC and investors any information the issuer is required to provide the SEC and investors under Reg CF Rule 201 and and any additional information provided by the issuer o in a downloadable and savable form o for a period of at least 21 days prior to the sale of any securities on the platform by the issuer and until the sale of securities is completed or cancelled. 33 But, it may not display the information unless and until it has a reasonable belief that the information does meet the requirements for the issuer under Rules 201 and 202 and the issuer and its related parties are not disqualified and pass a background check conducted or provided for by the intermediary. It must provide a mechanism for potential investors to be able to communicate with the issuer and other potential investors through the electronic platform 34 and by a link to the platform in any number of electronic means of communication including and various types of social media. It cannot require a potential investor to open an account in order to see the information provided by it and the issuer 35 But, it must require potential investors to open an account prior to being able to engage in that communication or make a commitment to invest 36 and must obtain consent for electronic delivery. 37 It must provide a mechanism to require promoters and those affiliated with the issuer (but not official spokespeople for the issuer) and who open accounts to communicate with potential investors to disclose their status as promoters or affiliates and whether they are being compensated to promote the offering every time they post a comment in the communication channels This includes any amendments, updates, annual reports and notice of termination of annual reporting. 33 Regulation CF Rule 303(a)(1)-(3), (17 C.F.R (a)(1)-(3)) 34 Regulation CF Rule 303(c), (17 C.F.R (c )) While a registered BD can engage in that conversation, a registered Funding Portal may not except to police the communications between issuer and investors for inappropriate comments (Rule 303(c)(1)) 35 Regulation CF Rule 303(a)(4), (17 C.F.R (a)(4)); Rule 303(c)(2), (17 C.F.R (c)(2)) 36 Regulation CF Rule 303(c)(3), (17 C.F.R (c)(3)); As a practical matter, both potential investors and others will open accounts. 37 Regulation CF Rule 302(a)(1), (17 C.F.R (a)(1) Under Rule 302(a)(2), the intermediary must update those disclosures if they change and re-deliver them prior to obtaining a commitment to invest from a potential investor 38 Regulation CF Rule 303(c )(4), (17 C.F.R (c)(4)) 10

15 It must provide certain information in conjunction with opening an account, including: o Educational materials that disclose in plain English, clearly and effectively, nine different enumerated risks or warnings about investments in crowdfunding issuers. 39 o The disclosure of promoter or issuer affiliate status mentioned above. o The manner and amount of compensation that the intermediary will receive in connection with 33 Act 4(a)(6) offerings. Before it accepts a commitment to invest in an offering, the intermediary must receive certain representations from a potential investor that he/she/it has reviewed the educational materials and understands the risk of loss and further has completed a questionnaire that demonstrates that the potential investor understands the restrictions on his/her/its ability to cancel the investment or resell it after the offering. 42 The intermediary must create a mechanism in the platform to accomplish this requirement. It must provide an electronic notice of commitment to the investor which includes the dollar amount invested; the price of the security bought, if known; the name of the issuer; and the date and time at which the investor will be free from any restrictions on the resale of the investment. It must provide a mechanism for the investor to re-commit after the posting of a material amendment to the information provided by the issuer. And It must provide a relationship with a qualified third party ( QTF ) and mechanism by which an investor can transmit monies to the QTF and/or receive a refund from the QTF in the event of the investor s failure to re-commit or the failure of the issuer to raise the target offering amount by the deadline. 39 Regulation CF Rule 302(b)(1), (17 C.F.R (b)(1)) 40 Regulation CF Rule 302(d), (17 C.F.R (d)). This is the only place in Regulation CF that the intermediary s compensation is mentioned other than limitations on financial interests in the issuer as compensation. No one affiliated with the intermediary may take a financial interest in the issuer as compensation and the intermediary itself may only take a financial interest as compensation for services in connection with the offering and only if the financial interest is of (or related to) the same type of security offered to investors in the offering. Regulation CF Rule 300(b), (17 C.F.R (b)) 41 Language in the JOBS Act led commentators to speculate whether the SEC was going to allow Funding Portals to take transaction based compensation in relation to the offerings listed on their electronic platforms. However, despite the indirect mention of compensation in the final regulation, SEC Staff have been quoted as saying that the SEC intended that Funding Portals could receive transaction based compensation. 42 Regulation CF Rule 303 (b)(2)(a)-(c), (17 C.F.R. _ (b)(2)) 11

16 Policing Compliance of Issuers and Investors In addition to meeting the functional requirements of the electronic platform, the intermediary is called on by Regulation CF to police the compliance of issuer and investor with their own responsibilities under the Regulation: An intermediary must have a reasonable belief that any issuer promoting an offering on its site is in compliance with the issuer s own requirements under the Regulation. Absent other knowledge it may have, the intermediary may rely on representations of the issuer by its principal officers. 43 An intermediary must have a reasonable belief that an issuer has the means to keep an accurate record of its security holders. If an issuer engages a registered transfer agent, the intermediary is allowed to presume the issuer can do so. 44 An intermediary must have a reasonable belief that neither an issuer nor any of its related or affiliated parties, its directors, officers, 20% equity holders or promoters have a criminal or securities regulatory record which would disqualify the issuer from being able to claim exemption from securities offering registration under Regulation CF. An intermediary must conduct a criminal and securities regulatory background check on each relevant party to support that reasonable belief. If it cannot maintain that reasonable belief, the intermediary must deny access on the platform to the issuer and its offering. 45 An intermediary must deny access on the platform to any issuer that the intermediary reasonably believes presents the potential for fraud, including when it believes it is unable to effectively assess the issuer s risk for fraud. 46 An intermediary must have a reasonable belief, both at the time of original investment and at any follow-on investment, that each investor in each issuer s offering is in compliance with Regulation CF s limitations on the amount any one investor can invest in any 33Act 4(a)(6) offering within the twelve months preceding the inquiry and including the investment to be made in the offering at hand. An intermediary may rely on representations by the investor to support that reasonable belief, absent other information it possesses to the contrary Regulation CF Rule 301(a), (17 C.F.R (a)) 44 Regulation CF Rule 301(b), (17 C.F.R (b)) 45 Regulation CF Rule 301(c)(1), (17 C.F.R (c)(1)); Rule 503, (17 C.F.R ) 46 Regulation CF, Rule 301(c)(2), (17 C.F.R (c)(2)) 47 Regulation CF, Rule 303(b)(1), (17 C.F.R (b)(1)). Although the Rule states that an intermediary can rely on investor representations, absent other knowledge, it is unclear how an intermediary would be able to verify the investor s investments in 4(a)(6) offerings if they were made across a number of intermediaries platforms. 12

17 D. Additional Requirements for Funding Portals Any funding portal must be registered as such with the SEC and also become a member of FINRA in order to be considered a Funding Portal which can host Regulation CF offerings. 48 The SEC has created a parallel but more lightly regulated category of broker dealers. Scope of Registration and Allowed Activity of Funding Portals The quid pro quo for the lighter regulation is the circumscribed ability of Funding Portals to act as a broker dealer. Registered Funding Portals may not : 1) offer investment advice; 2) solicit purchases, offers or sales of securities; or 3) compensate its employees, independent contractors, third party solicitors or others based on the sale of securities on its platform. 49 In contrast, a registered broker dealer acting as a crowdfunding intermediary can do all of those activities as well as negotiate the terms of an investment on behalf of the issuer or investor, be involved in valuation of an issuer and other activities that might be required. Candidates must register on a pared down registration form called Form Funding Portal on the online CRD system operated by FINRA. The information in Form Funding Portal will be publicly available online. The registration is effective within thirty (30) days after the later of the date of submission of the form or the date approved as a FINRA member. Any inaccuracy must be the subject of an amendment within thirty (30) days of discovery of the inaccuracy. 50 Once the registration is effective, Funding Portals must provide the integrated electronic platform, meet the obligations to police requirements on issuers and investors and maintain books and records as outlined before. In addition, they are able to advise issuers about structuring their offerings and prepare offering documentation for them. 51 Maintenance of Records of the Offering, the Communication Among Investors and Other Records While registered broker dealers have their own books and records requirements, Regulation CF, Rules 403 and 404 provide the requirements for Funding Portals. Records of the following information and relating to a period of the previous five (5) years must be retained: 48 The provisions of the JOBS Act that created and defined Funding Portals contemplated that they would also be FINRA members but required FINRA to promulgate administrative rules designed specifically for crowdfunding issuers. Those FINRA regulations have not been yet been promulgated. 49 If, as we presume, Funding Portals can take transaction based compensation for the services they render in effecting crowdfunding offerings, it is unclear why they cannot compensate at least their employees (if not third parties) based on the sale of securities on their platforms. I am assuming that last phrase means transaction based compensation, but that is also not absolutely clear. 50 Regulation CF, Rule 400(b) (17 C.F.R (b)) 51 FINRA, in particular, has taken the lead in requiring intermediaries to take on securities law responsibilities traditionally thought of as the responsibility of issuers and their counsel. Beginning with making it a broker responsibility to file information about OTC issuers whose securities the broker wants to quote under Rule 15c2-11 and Form 211 through the newer FINRA Rule 5123 which places more responsibility on brokers to vet issuers and recent FINRA enforcement action against brokers engaging in exempt offerings, both the SEC and FINRA have made brokers more responsible for the offerings which issuers make. 13

18 All records relating to potential and actual investors; All records relating issuers and their control persons All communications on or through the platform All records relating to persons promoting the issuers securities All records required to demonstate compliance by the Funding Portal All notices provided to issuers and investors All written agreements relating to the Funding Portal s business All daily, monthly and quarterly summaries of transactions effected through the platform Logs reflecting issuer progress toward their target offering amounts and Organizational documents, including certificate of formation, governing agreements and records of equity holder meetings or consents 52 In addition, Funding Portals must have, comply with or allow: A set of written policies and procedures designed to achieve compliance with the federal securities laws relating to its business as a Funding Portal This puts in place a requirement similar to that to which registered investment advisers are subject. Examination of the Funding Portal s business operations such as its premises, systems, platforms and records by the SEC and FINRA The requirements of 17 C.F.R. 248 relating to private information, including: o Regulation S-P relating to safeguarding and privacy of consumer financial information, presumably that of potential and actual investors; o Regulation S-AM, relating to usage of financial eligibility information obtained from a Funding Portal s affiliate to make a solicitation to that consumer; and o Regulation S-ID, relating to protection, detection and mitigation of identity theft, presumably of potential and actual investors. 53 Ability to Take Transaction Based Compensation It is difficult to believe, but it is not entirely clear from the statutes and the SEC releases proposing and then adopting Regulation CF whether Funding Portals can take transaction-based compensation for their services provided in connection with offerings on their electronic platforms. The beginning of the inquiry is to look at the definition of Funding Portal in 34 Act 3(a)(80) which was added as a part of the JOBS Act. The term funding portal means: any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 52 Regulation CF, Rule 404(a)-(b), (17 C.F.R (a)-(b)) 53 Regulation CF, Rule 403 (a)-(c), (17 C.F.R (a)-(c)) 14

19 1933 (15 U.S.C. 77d(6)), that does not: (A) (B) (C) (D) (E) offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal; compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; hold, manage, possess, or otherwise handle investor funds or securities; or engage in such other activities as the Commission, by rule, determines appropriate.. The statutory provision is restated verbatim in Regulation CF, Rule 300(c) and both are problematic for the ability to take transaction-based compensation. Funding Portals cannot engage in the primary activity for which brokers typically earn transaction-based compensation: soliciting purchases, sales or offers. The definition also prohibits compensating employees of intermediaries and others based on the sale of securities.referenced on the.portal. However, the definition: 1) doesn t prohibit the Funding Portal itself from receiving compensation based on the sale of securities; and 2) it is not entirely clear that receiving compensation based on the sale of securities is the same as taking transaction-based compensation. On the other hand, there are a number of provisions in Regulation CF relating to requirements of intermediaries which presume transaction-based compensation is being taken: Reg CR, Rule 300(b)(1) makes clear that persons related to the intermediary such as officers, directors or partners cannot hold a financial interest in an issuer but that intermediaries themselves can hold such an interest so long as it is received as compensation for services provided to the issuer in connection with the sale of securities through the intermediary s platform Reg CF, Rule 302(d) provides the intermediary must clearly disclose the manner in which it is compensated in connection with 33 Act 4(a)(6) offering Reg CF, Rule 303(f)(1)(vi) provides that the intermediary must send a confirmation of the transaction, at or before completion, that discloses the source, form and amount of any remuneration received by the intermediary. The 300 series of Rules under Reg CF sets forth the requirements for all intermediaries, including registered broker dealers and Funding Portals. Brokers registered under 34 Act 15(a)(1) could, of course, take transaction based compensation. The no-action letters 54 and FAQ 55 issued by the SEC relating to the JOBS Act and dealing with electronic platforms have so far focused on Section 201 of the JOBS Act which deals with 54 See FundersClub Inc. and FundersClub Management LLC, SEC No-Action Letter (Mar. 26, 2013); AngelList LLC, SEC No-Action Letter (Mar. 28, 2013). 55 See Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act, available at 15

20 general solicitation in Rule 506 offerings. The resulting Securities Act of (b)(2) states the conditions under which a website or platform not exclusively operated by an issuer but involved in the Rule 506 offering may operate without having to register as a broker dealer under 34 Act 15(a)(1) and specifically states that such a website or platform must receive no compensation in connection with the purchase or sale of such security. Reg CF, Rule 401 exempts Funding Portals from the same broker registration requirements under 34 Act 15(a)(1). However, 33 Act 4(b)(2) deals specifically and only with Rule 506 offerings. The 400 series of Rules under Regulation CF sets forth the specific additional requirements of Funding Portals. Reg CF, Rule 402(b)(7) allows Funding Portals to pay referral fees (whether for referring issuers or investors) to other persons. 56 Regulation CF Rule 402(b)(6) also explicitly states that Funding Portals may enter into agreements with registered broker dealers and share fees. This would facilitate the escrow of offering proceeds before the target offering amount is reached as well as other business arrangements. But, it would also be consistent with Funding Portals being able to take transaction-based compensation. Perhaps the most confusing guidance is the fact that the Regulation CF Proposal Release contained a Rule 305(b) which stated that an intermediary: may compensate a person for directing issuers to the intermediary s platform, provided that, unless the compensation is made to a registered broker or dealer, the compensation is not based, directly or indirectly, on the purchase or sale of a security offered in reliance on Section 4(a)(6) of the Securities Act on or through the intermediary s platform. That would suggest that the SEC s position is definitely that Funding Portals cannot take transaction based compensation. Footnote 907 in the Reg CF Adoption Release supports that view, stating: We note that the receipt of direct or indirect transaction-based compensation would strongly indicate that the recipient is acting as a broker. As such, the party receiving the compensation in the scenario described needs to consider whether it would be required to register as a broker. However, the Reg CF Adoption Release removed the proposed Rule 305(b), saying that the SEC felt it would be duplicative of the adopted Rule 402(b)(6), mentioned above. In the text adopting Reg CF, Rule 402, the SEC acknowledges that commenters are asking questions about the scope of permissible activities of Funding Portals, given the language of the statutory 56 Regulation CF Rule 402(b)(7), (17 C.F.R (b)(7)) It is unclear whether the SEC expects that these other persons will be registered as intermediary representatives or whether they can be unregistered persons. This overlaps with the long running discussion about allowing finders or intermediaries in nonpublic company transactions to operate under an exemption from federal broker dealer registration. In January 2014, the SEC issued a no-action letter, M&A Brokers (publicly avail. 1/31/2014), determining that where such intermediaries were involved in selling a majority interest in non-public companies, they were exempt from federal requirements to register as broker dealers. However, the SEC has not provided that interpretation for intermediaries who are placing investments in non-public companies rather than selling control of the businesses. Presumably, while the SEC may allow referral fees to unregistered referral sources for crowdfunding intermediaries, it would not allow those fees to be transaction based compensation nor would it allow such persons to be involved in negotiations, valuation or advising a party about sale or purchase of the issuer s security all indicia of acting as a broker dealer. 16