Tag Archives: FinTech industr

Can A Crowdfunding Issuer Sell Its Own Securities?

Securities Cash  Register

Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?

For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.

For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.

Section 18(a)(1) of Securities Act

Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:

Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.

Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?

Here’s the statute again, with extra words removed:

No law requiring registration or qualification of securities transactions shall apply to a covered security.

A sale of a security is definitely a “securities transaction.” So here’s the question:  does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.

But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.

For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.

What’s At Stake

If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.

The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.

I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.

And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.

What To Do

The simplest solution is to sell through a clearing broker licensed in every state.

Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).

If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.

Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.

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My thanks to Jillian Sidoti, Esq. and Anthony Zeoli, Esq., who provided valuable insight.

Questions? Let me know.

Diagram For Borrower-Dependent Notes

Borrower-dependent notes secured by real estate are the backbone of today’s Crowdfunding industry. Here’s a diagram showing one possible structure. There are others, but I like this best in most situations.

Caveat #1:  A diagram can’t address these critical issues:

  • Broker-dealer registration
  • The terms of the Notes and the Indenture
  • The terms of the Trust
  • The assignment of collateral
  • State lending laws

Caveat #2:  This structure doesn’t work for Title III or Title IV. More on that later.

Questions? Let me know.

Using Blockchain Technology in Crowdfunding

Guest Co-Author: Benjamin L. Roderick

What Is Blockchain?

Blockchain is the term given to a highly sophisticated database tool that allows “distributed verification.” Most of us heard about blockchain because it is the technological backbone of Bitcoin, the alternative currency, but the possible applications go far beyond that.

To understand what “distributed verification” means, let’s look at a typical Bitcoin transaction, where Franchesca uses her Bitcoin currency to buy a TV from Herb.

On the surface, the transaction is simple: Herb gives Franchesca his TV and Franchesca gives Herb some Bitcoin. But how does Herb know that Franchesca actually owns Bitcoin? And how does he get it from her?  The answer is the blockchain. Distributed all over the world, the blockchain verifies that Franchesca owns Bitcoin, and then records the transfer from Franchesca to Herb, so Herb can use the Bitcoin to buy groceries from Janet.

Benefits of Blockchain

The primary benefits of the blockchain are:

  • It’s secure
  • It provides universal authentication
  • It provides trust for trust-less networks
  • It’s automated
  • It’s almost friction-free, drastically lowering transaction costs
  • It’s easy to audit
  • It’s decentralized
  • It can be (but doesn’t have to be) anonymous.

Here’s a table illustrating where and how blockchain technology can add value:

Ben Roderick Guest Blog Post image

Blockchain technology isn’t perfect yet; some might say it’s not even ready for prime time. Today, the primary drawback is how long it takes to authenticate transactions. A transaction today in Bitcoin takes about 10 minutes to clear, and Bitcoin is a microscopic market compared to, say, credit card transactions. Indeed, the Bitcoin community is engaged in a civil war as to how, or even whether, to change the technology to speed up transactions.

Application of Blockchain Technology

But you can understand why blockchain technology is attracting so much interest from government and private industry. For example, the music industry is plagued by uncertainty over ownership of rights. The title industry exists because of uncertainty as to the ownership of real estate. Credit card issuers spend tens (hundreds?) of millions of dollars processing and authenticating transactions. Airlines have yet to find a way to ensure that every plane is late.

Everyone wants a secure, decentralized, efficient network that can authenticate transactions or information, as long as the FBI gets a back door (no joke).

Here are some possible applications in the Crowdfunding industry:

  • In Title III, we need a centralized system that knows how much an investor has invested in Title III deals.
  • In Title III and Title IV, we need a way to verify the income and net worth of investors.
  • In Title II and Title IV, we could certainly use a way to verify that investors are accredited in some centralized way.
  • A blockchain: the ultimate aggregator and verifier of Crowdfunding deals.

Crowdfunding and blockchain are both pieces of the FinTech industry. We’re going to see blockchain startups raising money using Crowdfunding, and we’re going to see Crowdfunding companies using blockchain technology. A blockchain startup using a Crowdfunding company that uses blockchain technology – that’s not far down the road.

Ben Roderick is currently working on blockchain applications for his MBA Capstone project at Carnegie Mellon University, graduating in May 2016. His email address:  Broderic@tepper.cmu.edu.

Questions? Let me know.

 

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