The SEC recently granted two accredited crowdfunding sites exemptions from the broker-dealer rules because the type of carried interest (or close equivalent) used to compensate the site is not transaction based compensation. But some of the accredited crowdfunding sites broadly attract potential investors to their sites by what could constitute advertising on the face of the site or elsewhere. The concern is whether that sort of advertising constitutes a general solicitation and whether the procedures are adequate to determine investors are in fact accredited to qualify for the Regulation D exemption.
Sure, before gaining entrance you have to fill out a questionnaire and certify that you are accredited. But we all think we know how this works. You answer a few canned questions about your income and net worth, and perhaps whether you have invested in start-ups before or something like that. We then suspect a computer instantaneously determines whether or not you are accredited.
But does this combination of advertising and perfunctory qualification work? We believe the SEC has not passed directly on that question. But as Travis Crabtree of Looper Reed points out, in one of the no-action letters the company tips its hat, saying they are relying on a no-action letter issued to Lamp Technologies Inc. We decided to peel back the onion and take a closer look, and for the time being ignoring the fact that only the person to whom the no-action letter is issued can rely on it.
Lamp Technologies offers powerful analogies that the accredited crowdfunding sites are not engaged in general solicitation. Lamp Technologies is really two no-action letters, which you can read here and here. Like some of the accredited crowdfunding sites, the Lamp letters state that a general solicitation does not occur if potential investors complete a questionnaire to allow Lamp to form a “reasonable basis” that the subscriber is an accredited investor, the qualified investors are given a password to access the information, and a waiting period occurs before any investment is made.
Perhaps some key differences from Lamp and the practices of accredited crowdfunding sites are:
- The SEC took no position that the information obtained by Lamp is sufficient to form a reasonable basis for believing that the investor is accredited.
- Lamp’s business was fundamentally different than an accredited crowdfunding site’s business. Lamp’s business was to make hedge fund data readily available and easily accessible to professionals so it could be monitored by those in the hedge fund industry, and not to sell securities.
- It is unknown what sort of advertising Lamp employed to attract users to its web site.
- Lamp also represented it would review the questionnaires and that access to the site would be limited to a select group of advisers that have been pre-qualified.
The Lamp letters closely follow no-action relief granted to IPONET (publicly available July 26, 1996). (As an aside, we couldn’t find this posted on-line so no link is provided.) IPONET offered pre-qualifed investors access to password protected private placement memorandums. IPONET allowed prospective participants to complete the questionnaire on-line. The business of IPONET more closely matches the business of the accredited crowdfunding sites, all of which is good. But here again, the SEC stated it took no position on whether the information obtained by the site sponsor was sufficient to form a reasonable basis for believing an investor to be “accredited or sophisticated.” IPONET also represented that it will “verify the information in the questionnaire to determine that the member is an accredited investor.”
The SEC then took up the issues raised by Lamp and IPONET in Release No. 33-7856. The release states “Moreover, some non-broker-dealer web site operators are not even requiring prospective investors to complete questionnaires providing information needed to form a reasonable belief regarding their accreditation or sophistication. Instead, these web sites permit interested persons to certify themselves as accredited or sophisticated merely by checking a box.” Here the SEC is referring to checking a single box that says “I am accredited.” But remember, the SEC has never said how many boxes is enough or whether computer automated verification is sufficient, to our knowledge.
The release continues “These web sites, particularly those allowing for self-accreditation, raise significant concerns as to whether the offerings that they facilitate involve general solicitations. In these instances, one method of ensuring that a general solicitation is not involved is to establish the existence of a “pre-existing, substantive relationship.” . . . Generally, staff interpretations of whether a “pre-existing, substantive relationship” exists have been limited to procedures established by broker-dealers in connection with their customers. This is because traditional broker-dealer relationships require that a broker-dealer deal fairly with, and make suitable recommendations to, customers, and, thus, implies that a substantive relationship exists between the broker-dealer and its customers. We have long stated, however, that the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case. Thus, there may be facts and circumstances in which a third party, other than a registered broker-dealer, could establish a “pre-existing, substantive relationship” sufficient to avoid a “general solicitation.””
Footnote 88 to the release elaborates “We understand that securities lawyers may have interpreted staff responses to Lamp Technologies, Inc. as extending the “pre-existing, substantive relationship” doctrine to solicitations conducted by third parties other than a registered broker-dealer. . .We disagree. In the Lamp Technologies no-action letters, the staff of the Divisions of Investment Management and Corporation Finance recognized a separate means to satisfy the “no general solicitation” requirement solely in the context of offerings by private hedge funds that are excluded from regulation as investment companies pursuant to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.”
So perhaps the accredited crowdfunding sites fall within the release because they ask prospective participants to check enough boxes in the accreditation process, the waiting period obviates the need for a pre-existing relationship, and after all the accredited crowdfunding sites appear to be organizing funds consisting of a single issuer’s securities pursuant to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.
But also consider the statement that “the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case.” In addition, our guess is the single issuer funds being organized by the accredited crowdfunding sites are significantly different than the “private hedge funds” referred to in Lamp.
Footnote 88 also states “We encourage web site operators offering these services to work with the Commission staff to resolve any securities law issues raised by their activities.” If only it were so easy.
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