Category Archives: FundersClub

Are Crowdfunding Portals Investment Advisers?

Looking for the solution of the mazeInvestment advisers are regulated by the Investment Advisers Act of 1940 – another of those old laws that govern today’s securities markets – and by also by the states. Do these laws apply to Crowdfunding portals?

It depends.

The IAA generally applies to anyone who:

  • “[E]ngage[s] in the business of advising others. . . .as to the value of securities or as to the advisability of investing in securities. . . .” or
  • “[I]ssues or promulgates analyses or reports concerning securities.”

On the other hand, the IAA generally does not apply to “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation,” a term broad enough to include websites.

Not surprisingly, neither the SEC nor any court has yet applied those definitions to a Crowdfunding portal. The best sources of information are no-action letters issued by the SEC to electronic “matching” services and a handful of court decisions. Under these authorities:

  • A portal that merely posts investment opportunities using information provided by the issuer is probably not an investment adviser.
  • A portal that explains why every investor should have a portion of her portfolio in real estate, or in startups, is moving toward investment adviser territory.
  • A portal that advertises its industry experience and its expertise in “vetting” deals is moving toward investment adviser territory.
  • A portal that assigns ratings to investment opportunities or otherwise provides investors with the tools to select one opportunity over another is very close to the line.
  • A portal that seeks to match an investor’s personal investment preferences to opportunities on the site is an investment adviser.
  • A portal that collects money from investors and uses its own discretion in selecting investment opportunities is an investment advisor.

A portal that doesn’t want to register as an investment adviser faces a dilemma: no matter how many disclaimers the portal posts on its site, users might view the portal as an investment adviser anyway. For example, a user might decide to invest $5,000 in every deal listed by Fundrise and Patch of Land, believing she’s creating her own Fundrise and Patch of Land “mutual funds” and leaving it to her “advisers” at the portals to select individual securities. On one hand, you spend every hour of every day developing a brand that’s based on finding great deals for your registered users. On the other hand, the more successful your brand the more you look like an investment adviser.

Why not just bite the bullet and register as an investment adviser? Three primary reasons:

  • Paperwork and Cost. Unsurprisingly, investment advisers are subject to lots of regulation and oversight. It’s nothing like registering as a broker-dealer, but it’s plenty cumbersome.
  • Additional Liability. An investment adviser owes statutory and fiduciary duties to its clients.
  • Disruption of Business Model. A Crowdfunding portal that is also an investment adviser might not be able to operate the way it wants to operate. For example, an investment adviser registered with the SEC generally may not receive compensation in the form of a carried interest. 

I believe the future of Crowdfunding involves pools of assets rather than individual assets. Many portals have already moved in that direction. On FundersClub, for example, investors can choose to invest in funds that select individual securities after the fact, agnostic as to industry, i.e., a Crowdfunded venture capital fund.

Once a portal takes that step – accepting investor dollars and deciding how to invest them – the portal has stepped decisively across the line into investment adviser territory. Ideally you take that step rationally, having decided that the benefits, meaning primarily the ability to attract additional capital, outweigh the costs.

Questions? Contact Mark Roderick.

WHAT CAN I SHOW ON MY SITE, TO WHOM, AND WHEN?

The SEC no-action letters issued to FundersClub and AngelList early in 2013 created some confusion around the deal-specific information that can be shown to prospective investors. Let’s try to clear that up.

Rule 506(b) Deals

You cannot show your Rule 506(b) deals to just anyone browsing the Internet, because that would be “general solicitation and advertising,” which is permitted under Rule 506(c) but still prohibited under Rule 506(b). If you’re a real estate portal, you can say “We have great real estate deals on our site,” but you can’t say “Look at this multi-family rental project in Austin.”

Both FundersClub and AngelList hid their deals behind a firewall. A user couldn’t see the deals until he registered at the site and promised he was accredited. In the 2013 no-action letters the SEC approved this arrangement, sort of.

I say “sort of” for three reasons:

  • The two no-action letters weren’t actually about registering users. They were about whether FundersClub and AngelList had to register as broker-dealers. Nowhere do the no-action letters say “We agree that, because you hide your deals behind firewalls, you’re not engaged in prohibited general solicitation and advertising.”
  • The no-action letters were issued by the Division of Trading and Markets within the SEC, not the Division of Corporation Finance. Typically, the Division of Corporation Finance would deal with so-called “exempt offerings” (offerings that are exempt from the general registration requirements of the Securities Act of 1933), of which general solicitation is a part.
  • Most intriguingly, the no-action letters aren’t exactly consistent with prior SEC rulings dealing with the online solicitation of customers, specifically the IPONET rulings in 2000. Those rulings assumed that the person doing the online solicitation was a registered broker-dealer; by definition, FundersClub and AngelList were not broker-dealers.

As a result, we can’t be 100% certain that the SEC, if asked point blank, would approve those arrangements from the perspective of general solicitation and advertising.

Nevertheless, the no-action letters were issued and the Crowdfunding industry has adopted the FundersClub and AngelList model: if you’re doing Rule 506(b) deals, you put the actual deals behind a registration firewall.

Once an investor registers at your site he can see the deals, but he can’t invest in them. In a series of no-action letters issued long before the JOBS Act, the SEC established that once an investor has become a customer, he has to wait before investing – the so-called “cooling off period.”

Some sites today are using a 21 day cooling off period, presumably because Title III incorporates a 21 day cooling off period. But the Title III rule is irrelevant to Rule 506(b). Thirty days is probably better, although, again, the notion of a cooling off period comes from SEC rulings, not a statute.

One more twist: at the end of the cooling off period, your investor can invest only in new deals, not deals that were on the site when he registered.

Rule 506(c) Deals

Rule 506(c) is far simpler. If you are doing only Rule 506(c) deals, you can show anything to anyone anytime.

Using Rule 506(c), you can show every detail of every deal to every casual viewer, even before the viewer has registered at your site. If you think that’s a bad idea from a marketing perspective or because you’re trying to protect confidential information, no problem. You don’t have to show all the details on your home page, but you can.

You can also make users register before they can see deals, just like Rule 506(b). If you take that route, you can ask users whether they’re accredited when they register, as you would under Rule 506(b), but you don’t have to ask. You can let everyone see the deals, accredited and non-accredited alike.

If you ask whether users are accredited – because you think it’s a good idea from a marketing perspective – that doesn’t mean you have to stop non-accredited investors at the door. Non-accredited investors can see the deals, too. Maybe they’ll tell their accredited friends.

Suppose a user tells you she’s accredited when she registers. Can you take her word for it? At that point in the process, absolutely! We don’t want to spend money or time on verification yet, and we don’t want to create transactional friction where we don’t have to.

With Rule 506(c), there is only one critical moment: when your investor is ready to write a check. At that point you must verify that she’s accredited, not merely by asking her but by looking at her tax returns, or getting a letter from her lawyer, or, most likely, having her verified by a third party service like VerifyInvestors or Crowdentials.

There’s no cooling off period with Rule 506(c), either. Your investors can see all the deals and invest right away.

Have I mentioned before that Rule 506(c) is better for Crowdfunding?

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

Will The SEC’s 15 Day Notification Rule End Angel Fairs?

No, it won’t.

On July 10, 2013 the SEC proposed rules that would, among other things, require a company to notify the SEC at least 15 days before using any “general solicitation” to raise money under the newly-adopted Rule 506(c) of Regulation D, also known as Title II Crowdfunding.

This proposal triggered more anxiety in the investment community than any other. Angel groups in particular were concerned about the possible effect on “angel fairs” and similar networking events, where companies look for investors and publicity by making presentations and handing out literature. If these activities constituted general solicitation, so the thinking went, and a company had not notified the SEC at least 15 days in advance, the company would be violating the law with potentially serious consequences.

Should companies stop presenting at angel fairs? Should attendance at angel fairs be limited? Would the SEC rule bring a wrenching halt to the way startups have raised money for 30 years?

There are two reasons why the concerns in the investment community are probably overblown.

First, “general solicitation” is not a new concept. Regulation D has always prohibited general solicitation. Rule 506 of Regulation D is itself a regulatory implementation of section 4(a)(2) of the Securities Act of 1933, which provides simply that the registration requirements do not apply to “transactions by an issuer not involving any public offering.” It has always been the position of the SEC, reflected in Rule 502(c), that using general solicitation to attract investors crossed the indistinct line from “private offering” to “public offering.”

Thus, every angel fair that has ever been held for the last several decades has been subject to the SEC prohibition on general solicitation. Yet given all that time and all those opportunities, the SEC has never taken the position that what happens at angel fairs constitutes prohibited general solicitation.

Having stood aside and permitted angel fairs for three decades, it seems unlikely that the SEC would take the opposite position today, after Congress announces its support for Crowdfunding by enacting the JOBS Act!

So far, it is safe to say that the SEC has taken the opposite approach, i.e., by making Crowdfunding easier, not more difficult. Consider, for example, the two no-action letters issued by the SEC on March 26, 2013 to FundersClub and AngelList. It seems very possible, even likely, that these letters would not have been issued before enactment of the JOBS Act. The SEC seems to have taken the wishes of Congress to heart and there is no reason to believe it intended to do otherwise with the 15 day proposal.

The other reason the concerns are overblown is that the rule in question is not yet in effect. The public comment period ended on September 23, 2013 and the SEC is considering the many comments made by the investment community. The chances are very high that when the SEC issues the final rule, these comments will be taken into account.

Maybe I’ll be proven wrong. Maybe the SEC will suddenly reverse course after 30 years and issue final rules that blow angel fairs out of the water, throw up unnecessary impediments to Crowdfunding despite the JOBS Act, and make everyone angry. Don’t bet on it.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

SEC Finalizes “General Solicitation” Regulations: Full Steam Ahead

Since President Obama signed the JOBS Act into law on April 5, 2012, we have been waiting for the SEC to finalize the rules on Crowdfunding.

At long last the SEC has done just that, at least with respect to one of the two components of Crowdfunding. Sometime in mid-September, company will be allowed to use “general solicitation” in certain “Rule 506 offerings.” The rules governing the other component of Crowdfunding, where small issuers will be allowed to raise money through Internet portals from small, unsophisticated investors, will have to wait for later in the year.

Even so, these new regulations mark the largest change to the securities laws in almost 80 years. Companies will now be allowed to raise money from accredited investors (in the case of individuals, those with over $1 million of net worth or incomes over $200,000 per year) through social media, print materials, email, and other means. Not only will companies have greater access to the capital they need, but the new rules are likely to significantly disrupt the money-raising industry, displacing brokers, lawyers, and other middlemen just as the Internet has displaced so many middlemen before them.

Now the technical rules.

The rules allow general solicitation and general advertising where:

  • All purchasers are accredited investors; and
  • The company takes reasonable steps to verify that the purchasers are accredited investors; and
  • All of the requirements in Rule 501, Rule 502(a), and 502(d) are satisfied.

Whether the company has taken “reasonable steps” will be determined on a case-by-case basis. Among the relevant factors:

  • The type of accredited investor that the purchaser claims to be (e.g., the CEO of a Fortune 100 company or a store clerk).
  • The amount and type of information that the issuer has about the purchaser.
  • The nature of the offering, including the manner of the solicitation.

When the regulations were proposed last August, many people complained about the absence of hard-and-fast rules and the resulting ambiguity. The final rules take a large step in the direction of certainty by providing that a company will be considered to have taken reasonable steps to verify that a natural person is an accredited investor if it does any of the following:

  • If basing the decision on the purchaser’s net income:
    • Reviews W-2s, 1099s, or other IRS documents that report the person’s income for the past two years; and
    • Obtains a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
    • If basing the decision on the purchaser’s net worth:
      • Reviews one or more types of documents dated within the past three months, including bank statements, brokerage statements, tax assessments, and a report from one of the national consumer reporting agencies concerning liabilities; and obtains a written representation that the person has disclosed all liabilities necessary to make a net worth determination; or
      • Obtains a written representation from certain third parties, including registered broker-dealers or investment advisors, that they have taken reasonable steps to verify the person’s accredited investor status within the past three months and have determined that the person is an accredited investor; or
      • Permits existing security-holders who had acquired issuer securities in a previous Rule 506 offering and had qualified as accredited investors at that time to certify his or her accredited investor status at the time of the sale.

These steps are neither exclusive nor mandatory. The final rules also discuss other factors and procedures.

In addition to taking reasonable steps to verify that purchasers are accredited, the company must also have a reasonable belief that they are accredited. This has always been part of Rule 506 and was not changed by the JOBS Act.

NOTE:  These new rules offer enormous opportunities for entrepreneurs seeking to raise money for their existing businesses or start new businesses. Please contact us if you would like to discuss your idea.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

SEC: FundersClub, AngelList Not Required To Register As Broker-Dealers

Through “no-action letters” dated March 26, 2013, the Securities and Exchange Commission has just ruled neither FundersClub nor AngelList, both nationally-recognized equity-based Crowdfunding portals, is required to register as a broker dealer under Federal securities law.

But portals are structured as investment advisory services and are registered as investment advisors. When a company is funded by investors, the portals do not receive cash compensation, as a broker would typically receive, but instead receive compensation more customary for a fund advisor: an interest in the future profits of the company – a “carried interest.” The form of the compensation seemed to be the principal factor that convinced the SEC to rule favorably.

Other equity-based portals might register as broker-dealers to avoid the issue altogether. Because both of these coordinated decisions could have gone the other way, however, the larger lesson may be that the SEC is taking a relatively hands-off approach to the rapidly-evolving Crowdfunding industry. If you are a portal or company waiting anxiously for the SEC regulations later this year, that is good news.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

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