Category Archives: Investment Advisers Act of 1940 (IAA)

You Can Use Subsidiaries Without Violating the 100 Investor Rule

crowdfunding_investorEveryone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.

The basics of the 100 investor rule:

  • A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
  • A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
  • There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.

Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.

In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?

Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?

Fortunately, the answer is No.

For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.

That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.

Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.

Questions? Let me know.

 

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.

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