Category Archives: Crowdfunding Laws

Can A Crowdfunding Portal Avoid Broker-Dealer Registration by Registering as an Investment Adviser?

No.

In early 2013 the SEC issued no-action letters concluding that FundersClub and AngelList were not required to register as broker-dealers. Both companies were “venture capital fund advisers,” a special flavor of investment adviser, and some people read into the no-action letters a cause-and-effect, concluding that if a Crowdfunding portal registers as an investment adviser, which is relatively easy, then it doesn’t have to register as a broker-dealer, which is very hard.

When the SEC issues no-action letters, it doesn’t explain its reasoning. It provides the facts and the legal conclusion and leaves it to readers to figure out what was important and wapples and orangeshat wasn’t.

It’s possible that as the SEC weighed the requests by FundersClub and AngelList, a regulator thought “This is a close call, and because they’re already regulated as investment advisers we’ll give them a pass on broker-dealer registration.” But that’s just speculation, not a legal argument. A portal operating exactly in the manner described in the no-action letters might take comfort. Others, including any real estate portal, should not.

Under the securities laws, investment advisers are one thing and broker-dealers are something complete different – different functions, different rules, different risks. If you want to give investment advice, register as an investment adviser. If you’re in the portal business and think you need a broker-dealer, then either register yourself or use a provider like WealthForge or FundAmerica.

Questions? Contact Mark Roderick.

Do the Officers of a Crowdfunding Issuer Have to Register as Broker-Dealers?

thinking woman in jarToday, the most challenging legal question in Title II Crowdfunding is who is required to be a broker-dealer and under what circumstances. The question is most acute for the officers of an issuer, those who direct the issuer’s activities and put the offerings together.

Section 3(a)(4)(A) of the Securities and Exchange Act 1934 generally defines “broker” to mean “any person engaged in the business of effecting transactions in securities for others.” Section 15(a)(1) of the Exchange Act makes it illegal for any “broker. . . .to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless registered with the SEC.

Simply put, anybody in the business of effecting securities transactions for others must be registered. There is a lot of law around what it means to be “engaged in the business of effecting securities transactions for others.” Based on decided cases and SEC announcements, important factors include:

  • The frequency of the transactions.
  • Whether the individual‘s responsibilities include structuring the transaction, identifying and soliciting potential investors, advising investors on the merits of the investment, participating in the order-taking process, and other services critical to the offering.
  • Whether the individual receives commissions or other transaction-based compensation for her efforts.

Perhaps the most important rule is that the issuer itself – the entity that actually issues the stock – does not have to register as a broker-dealer. The logic is that the issuer is effecting the transaction for itself, not for others.

But what about the President of the issuer, and the Vice President, and all the other employees who send the mailings and put the deal on the website and answer questions from prospective investors? Are they required to register as – or, more accurately, become affiliated with – broker-dealers?

The answer is complicated.

SEC Rule 3a4-1, issued under the Exchange Act, provides a “safe harbor” from registration. Under Rule 3a4-1, an employee of an issuer will not have to register if she is not compensated by commissions, and EITHER:

Her duties are limited to:

  • Preparing any written communication or delivering such communication through the mails or other means that does not involve oral solicitation of a potential purchaser, as long as the content of all such communications are approved by a partner, officer or director of the issuer; or
  • Responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser, as long as her response is limited to providing information contained in an offering statement; or
  • Performing ministerial and clerical work.

OR

  • She performs substantial services other than in connection with offerings; and
  • She has not been a broker-dealer within the preceding 12 months; and
  • She does not participate in more than one offering per year, except for offerings where her duties are limited as described above.

Consider the President of the typical Title II portal offering borrower-dependent notes to accredited investors. Her duties are certainly not limited as described above, and she might participate in – actually direct – dozens of offerings per year. Does that mean she has to register as a broker-dealer?

Not necessarily. Rule 3a4-1 is only a safe harbor. If you satisfy the requirements of Rule 3a4-1 then you are automatically okay, i.e., you don’t have to register. But if you don’t satisfy the requirements of Rule 3a4-1, it doesn’t automatically mean you are required to register. Instead, it means your obligation to register will be determined under the large body of law developed by the SEC and courts over the last 80 years.

Courts and the SEC have identified these primary factors among others:

  • The duties of the employee before she became affiliated with the issuer. Was she a broker-dealer?
  • Whether she was hired for the specific purpose of participating in the offerings.
  • Whether she has substantial duties other than participating in the offerings.
  • How she is paid, and in particular whether she receives commission for raising capital.
  • Whether she intends to remain employed by the portal when the offering is finished.

Within the last couple years, a high-ranking lawyer in the SEC spoke publicly but informally about broker-dealer registration in the context of private funds, an area similar to Crowdfunding in some respects. He expressed concern at the way that some funds market interests to investors and suggested that some in-house marketing personnel might be required to register. At the same time, he suggested that an “investor relations” group within a private fund – individuals who spend some of their time soliciting investors – wouldn’t necessarily be required to register if the individuals spend the majority of their time on activities that do not involve solicitation. On one point he was quite clear: the SEC believes that if an individual receives commissions for capital raised, he or she should probably be registered.

Whether an officer or other employee of a Crowdfunding issuer must register as a broker-dealer will be highly sensitive to the facts; change the facts a little and you might get a different answer. With that caveat, I offer these general guidelines:

  • If an employee receives commissions, he has to register no matter what.
  • If an employee performs solely clerical functions, he does not have to register.
  • If an employee participates in only a handful of offerings, he does not have to register.
  • If an employee spends only a small portion of his time soliciting investors, he does not have to register.
  • If an employee advises investors on the merits of an investment, he’s walking close to the line. Describing facts, especially facts that are already available in an offering document or online, in response to an investor inquiry, doesn’t count as advising investors on the merits of an investment.

Here are two corollaries to those guidelines.

  • As long as he’s not paying himself commissions, the Founder and CEO of an issuer that is a bona fide operating company (not merely a shell to raise money) doesn’t have to register.
  • If the CEO hires Janet to solicit investors, and that’s all Janet does, and she speaks regularly with investors over the phone and helps them decide between Project A and Project B, the SEC is probably going to want Janet to be registered.

Of course, the most conservative approach for Crowdfunding issuers to run every transaction through a licensed broker-dealer. However, that adds cost and most issuers are trying to keep costs down.

This area is ripe for guidance from the SEC, and maybe even a new exemption for bona fide employees of small issuers. Stay tuned.

NOTE: I want to give a shout-out to Rich Weintraub, Esq. of Weintraub Law Group in San Diego. He and I had several very stimulating and thought-provoking conversations on this topic. If there are mistakes in the post, they’re all mine.

Questions? Contact Mark Roderick.

Crowdfunding and Fiduciary Obligations

The term “fiduciary obligations” sends a chill down the spine of corporate lawyers – although some may object to using the word “spine” and “corporate lawyer” in the same sentence.

A person with a fiduciary obligation has a special legal duty. A trustee has a fiduciary obligation to the beneficiaries of the trust. The executor of an estate has a fiduciary obligation to the beneficiaries of the estate. The fiduciary obligation is not an obligation to always be successful, or always be right, but rather an obligation to try your best, or something close to that. A trustee who fails to anticipate the stock market crash of 2008 has not breached her fiduciary obligation. A trustee who fails to read published reports of a company’s impending bankruptcy before buying its stock probably has.

A person with a fiduciary obligation is required to be loyal, to look out for the interests of those under her care, to put their interests before her own.

By law and longstanding principle, the directors of a corporation have a fiduciary obligation to the corporation and its shareholders. In the classic case, a director of a corporation in the energy business took for his own benefit the opportunity to develop certain oil wells. Foul! cried the court. He has breached his fiduciary obligation by failing to pass the opportunity along to the corporation, to which he is a fiduciary.

Modern corporate statutes allow the fiduciary obligations of directors to be modified, but not eliminated, even if all the shareholders would sign off. If the corporation is publicly-traded, the exchange likely imposes obligations on the director (and the President, and the CEO, etc.) in addition to the fiduciary obligations imposed by state corporate law.

Which takes us to Crowdfunding. crowd funding word cloud

Most deals in the Crowdfunding space are done in a Delaware limited liability company. The Delaware Limited Liability Company Act allows a manager – the equivalent of a director in a corporation – to eliminate his fiduciary obligation altogether. If I’m representing the sponsor of the deal then of course I want to protect my client as fully as possible. And yet, I’m not sure that’s the best answer for the industry overall.

The U.S. public capital markets thrive mainly because investors trust them, just as the U.S. consumer products industry thrives because people feel safe shopping (that’s why securities laws and consumer-protection laws, as aggravating as they can be, actually help business). My client’s investors may or may not pay attention to the fiduciary duty sections of his LLC Agreement, but I wonder whether the Crowdfunding market as a whole can scale if those running the show regularly operate at a lower level of legal responsibility than the managers of public companies. Will it drive investors away?

Part of my brain says that it will, and yet, over the last 25 years or so, as corporate laws have become more indulgent toward management and executive pay has skyrocketed, lots of people have wondered when investors will say “Enough!” It hasn’t happened so far.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

INTEGRATION OF REGULATION A+ OFFERINGS WITH OTHER OFFERINGS

Yesterday I spoke about Regulation A+ on a panel at the National Press Club in Washington, D.C. One topic was whether offerings under Regulation A+ would be “integrated” with other offerings, including offerings under Title II.

The word “integration” describes a legal concept in U.S. securities laws, where two offerings that the issuer intends to keep separate are treated as one offering instead. For example, I raise $1 million in an offering under Rule 506(b), where I admit 19 non-accredited investors. Needing more money, I start another offering under Rule 506(b) a month later – and for the same project – and admit 23 more non-accredited investors. Wrong! The SEC says those two offerings are “integrated” and now I’ve exceeded the limit of 35 non-accredited investors.growth captial summit

Today, entrepreneurs can raise money under Title II Crowdfunding only from accredited investors. Under Regulation A+ they’ll be able to raise money from non-accredited investors as well, vastly expanding the potential investor base. Unlike a Title II offering, however, where accredited investors can invest an unlimited amount, an investor in a Regulation A+ offering, accredited or non-accredited, will be limited to investing 10% of his or her income or net worth.

The question naturally arises, why not do a Regulation A+ offering for non-accredited investors while at the same time doing a Title II offering for accredited investors, thus maximizing the amount raised from everyone?

The answer, unfortunately, is integration. The two offerings would be treated as one, and they would both fail as a result.

But along with that bad news, the integration rules under the proposed-but-not-adopted Regulation A+ regulations offer good news as well:

  • A Regulation A+ offering will not be integrated with an offering that came first. Thus, I can raise money in a Title II offering, accepting an unlimited amount from accredited investors, and the day after that offering ends conduct a Regulation A+ offering for non-accredited investors.
  • A Regulation A+ offering will not be integrated with an offering to foreign investors under Regulation S. The two can happen simultaneously.
  • A Regulation A+ offering will not be integrated with an offering that begins more than six months after the Regulation A+ offering ends.
  • A Regulation A+ offering will not be integrated with a Title III offering, even if they happen at the same time.

Another takeaway from the conference is that the SEC plans to finalize the proposed regulations under Regulation A+ by the end of the year (this year). Issuers and portals, get ready.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

IMPROVING LEGAL DOCUMENTS IN CROWDFUNDING: TAX ALLOCATIONS

Because I started life as a tax shelter lawyer, I’m especially sensitive to how income and losses are allocated within partnerships and limited liability companies (limited liability companies are taxed as partnerships). Agreements in the Crowdfunding space leave something to be desired.

As we all know, partnerships are not themselves taxable entities. The items of income and loss of the dollar handshakepartnership “flow through” and are reported on the personal tax returns of the owners. Allocating income and losses is simple when you have one class of partnership interest and everything is pro rata, e.g., you get 70% of everything and I get 30%. It becomes a lot more complicated in the real world.

Say, for example:

  • The sponsor of a deal takes a 30% promote in operating cash flow after investors received an 8% annual preferred return.
  • On a sale or refinancing, the sponsor takes a 40% promote after the investors receive a 10% internal rate of return.
  • In the early years of the deal the project generates ordinary losses, then generates cash flow sheltered by depreciation deductions, then generates section 1231 gain.

The allocation of income and loss in a partnership is governed by section 704(b) of the Internal Revenue Code. Long ago, the IRS issued regulations under section 704(b) that use the concept of “capital accounts” to determine whether a given allocation has “substantial economic effect.” Rules within rules, exceptions within exceptions, definitions within definitions, the section 704(b) regulations are a delight for the kind of person (I admit it) who wasn’t necessarily the coolest in high school.

For years afterward, tax shelter lawyers vied with one another to include as many of the rules and definitions of the regulations as possible in their partnership agreements, verbatim. That lasted until we recognized that (1) no matter how hard we tried, it was impossible to be 100% sure that the allocations would come out right; and (2) there was a better way.

The better way is to give management the right to allocate income on a year-to-year basis, with the mandate that the allocation of income should follow the distribution of cash. To wit:

Company shall seek to allocate its income, gains, losses, deductions, and expenses (“Tax Items”) in a manner so that (i) such allocations have “substantial economic effect” as defined in Section 704(b) of the Code and the regulations issued thereunder (the “Regulations”) and otherwise comply with applicable tax laws; (ii) each Member is allocated income equal to the sum of (A) the losses he or it is allocated, and (B) the cash profits he or it receives; and (iii) after taking into account the allocations for each year as well as such factors as the value of the Company’s assets, the allocations likely to be made to each Member in the future, and the distributions each Member is likely to receive, the balance of each Member’s capital account at the time of the liquidation of the Company will be equal to the amount such Member is entitled to receive pursuant to this Agreement. That is, the allocation of the Company’s Tax Items, should, to the extent reasonably possible, following the actual and anticipated distributions of cash, in the discretion of the Manager. In making allocations the Manager shall use reasonable efforts to comply with applicable tax laws, including without limitation through incorporation of a “qualified income offset,” a “gross income allocation,” and a “minimum gain chargeback,” as such terms or concepts are specified in the Regulations. The Manager shall be conclusively deemed to have used reasonable effort if it has sought and obtained advice from counsel.

Even today, I see partnership agreements that devote pages to the allocation of tax items. The approach in the paragraph above is much simpler and, even more important, much more likely to achieve the right result.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

 

SEC SUBCOMMITTEE REPORTS ON ACCREDITED INVESTOR DEFINITION

The Dodd-Frank Act instructs the SEC to evaluate the definition of “accredited investor” and, if it sees fit, to modify the definition “as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.”

As regular readers of this blog know, I’ve been optimistic that the SEC would not take this opportunity to kill Title II Crowdfunding and every other kind of Rule 506(c) private placement (which includes most angel investing as well) by creating an onerous new definition. The report issued recently by a SEC subcommittee, while surprising in some respects, doesn’t dent my optimism.

The subcommittee report makes two important, though obvious, points:

  • The Committee does not believe that the current definition as it pertains to natural persons effectively serves this function in all instances.
  • The current definition’s financial thresholds serve as an imperfect proxy for sophistication, access to information, and ability to withstand losses.

The existing definition is imperfect, yes. The question is, what to do about it?

Although the report does not provide a clear answer to that question, the good news, from my perspective, is that the report does not suggest merely indexing the current thresholds ($200,000 of income, $1 million of net worth) to inflation, which would disqualify most accredited investors and send the private placement market into a tailspin. Instead, the report seeks a standard that will address both financial sophistication and the ability to withstand loss.

The report suggests two specific measures of financial sophistication: the series 7 securities license and the Chartered Financial Analyst designation. Following the lead of the United Kingdom, the report also suggests that those with proven investment experience – for example, a member of an angel investing group – might qualify. Finally, the report suggests, as others have before, that the SEC could develop an examination for the purpose of qualifying investors.

Declining a suggestion from several quarters, the report does not include lawyers or accountants as investors who should be deemed to have financial sophistication.

The reports veers a little off track, in my opinion, when it speculates that, in conjunction with changing the definition of accredited investor, the SEC could limit the amount invested by each investor – following the 10% limit of Regulation A+, for example. That kind of limitation would be new to Rule 506 offerings.

In my Model State Crowdfunding law, I use a definition of accredited investors that includes lawyers, accountants, and anyone with the license from FINRA, as long as the lawyer, accountant, or license-holder has income of at least $75,000. Recognizing the imperfection of any definition, I think that strikes about the right balance. Bolt on an SEC-administered examination option and we’re right there with the subcommittee report.

All in all, it’s good to see the SEC, once again, thinking through the issues carefully. We can see the light at the end of the tunnel.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

SEC ON INTRASTATE CROWDFUNDING: RELAX

I think the SEC has done a terrific job with Crowdfunding, all things considered. In its latest contribution, the SEC just told issuers how to navigate a bumpy stretch of highway in intrastate Crowdfunding.

The bumps start with Federal Rule 147, written long before the Internet was a glimmer in Al Gore’s eye. Among other things, Rule 147 provides that an intrastate offering must be offered only to residents of a single state. That rule makes sense in a paper-only world, but how to comply when an offering is on the Internet, visible to everyone with a browser?

To get past the bumps, the SEC drilled down on the technology and realized that a user’s IP address reveals the state where his or her computer is located. Taking the logical step, the SEC confirms that as long as the offering can be viewed only by users with in-state IP addresses, it satisfies that piece of Rule 147.

I’d like to say the SEC got that idea from my blog, but I’m sure that’s not true.

From the 2013 no-action letters to the flexible regulations under Rule 506(c) to the proposed regulations under Regulation A+, the SEC has shown that it “gets” Crowdfunding. Now, if Congress would just give us a workable Title III. . . .

Questions? Contact Mark Roderick.

A MODEL STATE CROWDFUNDING LAW

Model State CFI was asked recently to draft a Crowdfunding statute for Texas, to augment the proposals made by the Texas State Securities Board. Having done that, I have turned my Texas statute into a model law that could be used by any state, including the handful that have already adopted Crowdfunding in one form or another. The model law is a PDF here.

I drafted the model statute with these goals:

  • To balance the interests of investors, entrepreneurs, and state securities regulators;
  • To reflect the lessons I’ve learned over more than 30 years in the capital formation business;
  • To capture the current best practices of states and the Federal government;
  • To introduce new concepts that will allow Crowdfunding to flourish; and
  • As a Jeffersonian believer in Federalism, to leave space for state-by-state experimentation.

These are some of the key features:

  • The statute relies on portals that will be registered with state securities regulators. The same portal could be registered in more than one state and, indeed, could male offerings at the Federal level as well.
  • The statute imposes disclosure requirements that mirror the disclosures typically made in private placement transactions.
  • The statute expands the concept of “control persons.”
  • The statute requires that state securities regulators have 24/7 real-time access to any material shown to prospective investors.
  • The statute introduces and expands the Federal “bad actor” concept.
  • The statute raises investment limits for truly local projects, to encourage local investing.
  • The statute expands the definition of “accredited investor.”
  • The statute allows issuers to raise up to $2 million per offering.
  • The statute prohibits issuers from seeking to limit their liability for fraud or misrepresentation.
  • The statute gives state regulators broad latitude to modify in accordance with local conditions.

Everything is about balance. Without overwhelming issuers with bureaucracy, the statute protects investors and creates an ecosystem where capitalism can flourish.

I’m going to be reaching out to states with the model law. I would love to hear your input and advice.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

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