Working the Crowd: A Primer for Funding Portals
February 10, 2016
One of the key investor protections of Regulation Crowdfunding under JOBS Act Title III is the requirement that offerings must be conducted exclusively through a single platform operated by a registered broker-dealer or a new type of SEC registrant, a funding portal. Although SEC registration for funding portals began January 29, 2016, intermediaries (funding portals and broker-dealers) may not engage in crowdfunding activities until May 16, 2016, the date that Regulation Crowdfunding goes live. It remains to be seen how popular Title III crowdfunding will prove to be given its burdensome rules relative to other available exemptions, but the potential is enormous both for issuers and for the brand new type of financial intermediary it created, the funding portal.
The SEC spent three years trying to reconcile the enormous capital markets potential of the “crowd” with the investor protection concerns voiced by equity crowdfunding’s critics. The SEC believes that requiring an issuer to use only one intermediary to conduct an offering helps foster the creation of a crowd, by facilitating information sharing and avoiding dilution or dispersement of the crowd, and helps minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one intermediary would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit. But to mitigate fraud risk concerns, the SEC has also imposed a heavy gatekeeping burden on intermediaries, particularly funding portals.
This blog post will focus on the rules governing funding portals, and will summarize the permitted “safe harbor” activities and compliance rules unique to funding portals, as well as certain requirements common to both types of Regulation Crowdfunding intermediaries (broker-dealers and funding portals).
Unique Funding Portal Requirements
Registration. Funding portals are required to register with the SEC on Form Funding Portal, a stripped-down version of Form BD, the registration form for broker-dealers. For example, unlike broker-dealer registration, funding portals will not be required to post a fidelity bond to register as a funding portal. As required under the JOBS Act, SEC registered funding portals are exempt from broker-dealer registration. The text of the Form currently appears only in the final rules release on pages 623-664 (inclusive of Schedules A-D and general instructions).[i]
All registered funding portals are also required to become members of the Financial Industry Regulatory Authority, or FINRA. FINRA funding portal registration information can be found here.
A funding portal’s SEC registration becomes effective on the later of: (1) 30 calendar days after the date that the registration is filed with the SEC; or (2) the date the funding portal is approved for FINRA membership.
Form Funding Portal must be filed electronically on EDGAR, although as of this writing the Form has not been assigned a submission type or even been listed on the EDGAR forms index. To gain access to EDGAR for the electronic filing of Form Funding Portal, a funding portal will first need to obtain an EDGAR access code and a central index key, or CIK, by submitting a Form ID with the SEC. When a funding portal’s registration becomes effective, the information on Form Funding Portal becomes publicly available except for certain personally identifiable information. As of this writing, there are no Form Funding Portals shown to have been filed on EDGAR, although at least one portal, StartEngine Capital LLC, put out a press release that it did so on January 29.
Permitted Activities – Safe Harbor. Unlike registered broker-dealers, funding portals are prohibited from giving investment advice, soliciting offers, paying success fees to persons for solicitations or handling investor funds or securities. To help funding portals navigate these prohibitions while trying to function as effective intermediaries, the rules provide a safe harbor for the following activities:
- Curating Offerings. A funding portal may use broad discretion to determine whether and under what circumstances to allow an issuer to offer and sell securities through its platform, subject to the prohibition on providing investment advice or recommendations and provided it complies with all other provisions of Regulation Crowdfunding. The SEC believes this kind of discretion is important for the protection of investors, as well as to the viability of the funding portal industry and the crowdfunding market.
- Highlighting Issuers and Offerings. A funding portal is permitted to highlight particular issuers or offerings on its platform based on objective criteria where the criteria are reasonably designed to highlight a broad selection of issuers offering securities through the platform, are applied consistently to all issuers and offerings and are clearly displayed on the platform. The permissible criteria include type of securities offered (e.g., common stock, preferred stock or debt securities), geographic location of the issuer, industry or business segment of the issuer, number or amount of investment commitments made, progress in meeting the target offering amount and minimum or maximum investment amount.
- Providing Search Functions. A funding portal may provide search functions on its platform that investors could use to search, sort or categorize available offerings according to objective criteria, and that would allow investors to sort through offerings based on a combination of different criteria, such as by the percentage of the target offering amount that has been met, geographic proximity to the investor and number of days remaining before the closing date of an offering. However, search criteria may not include the advisability of investing in the issuer or its offering, or an assessment of any characteristic of the issuer, its business plan, its management or risks associated with an investment.
- Providing Communication Channels. A funding portal may provide communication channels by which investors can communicate with one another and with representatives of the issuer through the funding portal’s platform about offerings conducted through the platform, but neither the funding portal nor its associated persons or employees may participate in these communications, other than to establish guidelines about communications and to remove abusive or potentially fraudulent communications. The communication channels must be made available to the general public and must restrict the posting of comments to those who have accounts on the funding portal’s platform. The funding portal must require each person posting comments to disclose clearly with each posting whether he is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or will receive any compensation for promoting an issuer.
- Advising Issuers. A funding portal may advise an issuer about the structure or content of the issuer’s offering, including preparing offering documentation. For example, a funding portal may provide pre-drafted templates or forms for an issuer to use in its offering, and advice about the types of securities the issuer can offer, the terms of those securities and the procedures and regulations associated with crowdfunding. Without these services, the SEC believes that crowdfunding as a method to raise capital might not be viable.
- Paying for Referrals. A funding portal may compensate a third party for referring a person to the funding portal if the third party does not provide the funding portal with personally identifiable information about any investor, and the compensation, other than that paid to a registered broker-dealer, is not a transaction based success fee. The SEC believes the prohibition on success fees will help to minimize the incentive for high-pressure sales tactics and other abusive practices in this area.
- Compensation Arrangements with Registered Broker-Dealers. A funding portal may pay compensation to a registered broker-dealer for services, including for referring a person to the funding portal, in connection with the offer or sale of securities, provided that the services are provided pursuant to a written agreement between the funding portal and the registered broker-dealer, the compensation is permitted under Regulation Crowdfunding and the compensation complies with FINRA rules.
- Advertising. A funding portal may advertise its existence and identify one or more issuers or offerings available on its portal on the basis of objective criteria, so long as the criteria are reasonably designed to identify a broad selection of issuers offering securities through the platform and are applied consistently to all potential issuers and offerings, and the funding portal does not receive special or additional compensation for identifying the issuer or offering in this manner. However, a funding portal may not base its decision as to which issuers to include in its advertisements on whether it has a financial interest in the issuer, and any advertising may not directly or indirectly favor issuers in which the funding portal has invested or will invest.
- Denying Access to Platform. A funding portal may deny access to its platform to an issuer if the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.
- Accepting Investor Commitments. A funding portal may, on behalf of an issuer, accept investment commitments from investors but may not actually handle the funds.
- Directing Transmission of Funds. A funding portal may direct investors where to transmit funds and may direct a qualified third party to release proceeds of an offering to the issuer upon completion of the offering or to return investor proceeds when an investment commitment or offering is cancelled. Interestingly, the SEC chose not to impose requirements that would prohibit variations of a contingency offering, such as minimum-maximum offerings, that would establish a fixed deadline for transmission of funds as compared to the proposed requirement to transmit funds “promptly” or that would require funding portals to maintain a certain amount of net capital.
Compliance. A funding portal must have written policies and procedures reasonably designed to achieve compliance with the federal securities laws and regulations relating to its business as a funding portal. In addition, funding portals must follow the same privacy rules as those applicable to brokers. Finally, funding portals are required to preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years.
Rules Governing Crowdfunding Intermediaries Generally
The following rules apply to all Regulation Crowdfunding intermediaries, i.e., funding portals and broker-dealers:
- Receiving Financial Interests in Issuers. The intermediary entity (but not its directors, officers or partners) is permitted to receive a financial interest in an issuer using its services, provided that the financial interest is compensation for the services provided to the issuer in connection with the offering and the financial interest consists of the same security as being offered to investors in the offering. This was as an accommodation in the final rules that will better enable issuers to pay intermediary upfront fees (through stock) and also have the added benefit of aligning the interests of issuer, intermediary and investors.
- Measures to Reduce Risk of Fraud. There are several measures that intermediaries are required to take that are designed to reduce the risk of fraud in crowdfunding transactions. An intermediary is required to have a reasonable basis for believing that the issuers on its platform comply with Regulation Crowdfunding and have established means to keep accurate records of the holders of the securities, and may reasonably rely on representations of the issuer unless the intermediary has reason to question the reliability of those representations. An intermediary must deny access if it has a reasonable basis for believing that an issuer, or any of its officers, directors or any 20% owner is subject to a disqualification under Regulation Crowdfunding.
- Accounts and Electronic Delivery. Intermediaries may not accept an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained from the investor consent to electronic delivery of materials.
- Educational Materials. Intermediaries must deliver certain educational materials to investors, including information on process for purchase of securities, types of securities that may be offered on the intermediary’s platform, risks associated with each type of security, restrictions on resale, types of information that an issuer is required to provide in annual reports, frequency of the delivery of that information, limits on amounts investors may invest and limitations on an investor’s right to cancel an investment commitment.
- Promoters. Intermediaries must inform investors, at the time of account opening, that promoters must clearly disclose in all communications on the platform the receipt of promotion compensation and the fact that he is engaging in promotional activities on behalf of the issuer.
- Compensation Disclosure. At the time of opening an account, intermediaries must clearly disclose the manner in which they will be compensated in connection with Regulation Crowdfunding offerings.
- Issuer Information. Intermediaries must make available to the SEC and investors, not later than 21 days prior to the first day on which securities are sold to any investor, any information provided by the issuer pursuant to Regulation Crowdfunding, and that such information be publicly available on the platform for a minimum of 21 days before any securities are sold in the offering, during which time the intermediary may accept investment commitments, and remain publicly available on the platform until the offering is completed or cancelled.
- Investor Qualification. Before accepting an investment commitment, an intermediary must have a reasonable basis for believing that the investor satisfies the investment limits under Regulation Crowdfunding. An intermediary may rely on an investor’s representations concerning annual income, net worth and the amount of the investor’s other investments in Regulation Crowdfunding offerings through other intermediaries unless the intermediary has a reasonable basis to question the reliability of the representation. Intermediaries must also confirm that an investor has reviewed the intermediary’s educational materials, understands that the entire amount of his investment may be lost and is in a financial condition to bear the loss of the investment and has completed a questionnaire demonstrating an understanding of the risks of any potential investment.
- Communication Channels. Intermediaries must provide on their platforms channels through which investors can communicate with one another and with representatives of the issuer about offerings, to make the channels publicly available, permit only those persons who have opened accounts to post comments and require any person posting a comment in the channels to disclose whether he is a founder or employee of an issuer engaging in promotional activities on behalf of the issuer or otherwise compensated to promote the issuer’s offering. Funding portals are prohibited from participating in communications in these channels.
- Transaction Confirmations. At or before the completion of a transaction, an intermediary must send to each investor a notification disclosing date of transaction, type of security, identity, price and number of securities purchased by the investor, certain specified terms of the security and source, form and amount of any remuneration to be received by the intermediary in connection with the transaction.
- Completion of Offerings, Cancellations and Reconfirmations. Intermediaries must give investors the right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. If an issuer reaches the target prior to deadline, it could close the offering provided the offering has been open for a minimum of 21 days, the intermediary provided notice about the new offering deadline at least five business days prior to the new offering deadline and investors are given the opportunity to reconsider and cancel their investment commitment until 48 hours prior to the new offering deadline. Finally, if there was a material change to the offering terms or to the information provided by the issuer, the intermediary would be required to give or send to any investors who have made investment commitments notice of the material change, stating that the investor’s investment commitment will be cancelled unless the investor reconfirms his or her commitment within five business days of receipt of the notice.
[i] Although funding portal registration went live on January 29, 2016, Form Funding Portal does not yet appear on the SEC’s website and a Google search came up empty.