The United States Securities and Exchange Commission has issued final rules on Regulation Crowdfunding. This post analyzes the “Additional Funding Portal Requirements” and “Miscellaneous” sections of the SEC’s adopting release.
Additional Funding Portal Requirements
Securities Act Section 4A(a)(1) requires that an intermediary facilitating a transaction made in reliance on Securities Act Section 4(a)(6) register with the Commission as a broker or a funding portal. The statute does not, however, prescribe the manner in which a funding portal would register with the Commission. Registration will be made through the EDGAR system. The registration requirements for funding portals are generally consistent with those imposed on broker-dealers, while not as extensive in every aspect.
Form Funding Portal
A funding portal will register with the SEC by filing Form Funding Portal. Form Funding Portal is generally modeled on Form BD, used for the registration of broker-dealers. Before a funding portal will be able to access EDGAR and electronically file Form Funding Portal, it will have to obtain EDGAR access codes and a central index key, or CIK, by creating and submitting a Form ID with the Commission for authorization to access EDGAR. When a funding portal’s registration becomes effective, the information on Form Funding Portal will be made available to the public through EDGAR, with the exception of certain personally identifiable information or other information with significant potential for misuse.
The final rule permits a funding portal to operate multiple website addresses under a single funding portal registration. Funding portals cannot license or sell their registrations as registrations are not transferrable among entities.
In a departure from the proposed rules, the SEC decided not to adopt a requirement that funding portals post a fidelity bond.
Exemption from Broker-Dealer Registration
Exchange Act Section 3(h)(1), which was added by Section 304(a) of the JOBS Act, directs the Commission by rule to exempt, conditionally or unconditionally, a registered funding portal from the requirement to register as a broker or dealer under Exchange Act Section 15(a), subject to certain limitations.
The exemption adopted by the SEC is set forth in Rule 401. The exemption applies only to funding portals that are registered with the SEC.
Safe Harbor for Certain Activities
A funding portal cannot give investment advice or make recommendations. Selecting which entities may use the portal’s platform could be considered a recommendation. The final rule makes it clear that a funding portal may exercise its discretion, subject to the prohibition in the statute on providing investment advice or recommendations, to limit the offerings and issuers that it allows on its platform under the safe harbor, as long as it complies with all other provisions of Regulation Crowdfunding. A funding portal cannot advertise, make statements or otherwise represent that the offerings listed on its platform are safer or better investments than those listed on other platforms.
Highlighting Particular Issuers
Rule 402(b)(2) allows a funding portal to highlight particular issuers or offerings of securities made in reliance on Section 4(a)(6) on its platform based on objective criteria where the criteria are reasonably designed to highlight a broad selection of issuers offering securities through the funding portal’s platform, are applied consistently to all issuers and offerings and are clearly displayed on the funding portal’s platform. The objective criteria may include, for example: the type of securities being offered (e.g., common stock, preferred stock or debt securities); the geographic location of the issuer; the industry or business segment of the issuer; the number or amount of investment commitments made; the progress in meeting the target offering amount or, if applicable, the maximum offering amount; and the minimum or maximum investment amount.
The final rule permits a funding portal to provide search functions or other tools on its platform that users could use to search, sort or categorize available offerings according to objective criteria. The final rule also permits search functions that, for example, will allow an investor 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, the final rule makes clear that the 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.
Rule 402(b)(4) addresses the terms under which a funding portal can 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. The safe harbor specifies that a funding portal (including its associated persons, such as its employees) may not participate in these communications, other than to establish guidelines about communication and to remove abusive or potentially fraudulent communications. Under Rule 402(b)(4), a funding portal must make communication channels available to the general public and restrict the posting of comments on those channels to those who have accounts on the funding portal’s platform. In addition, the funding portal must require each person posting comments to disclose clearly with each posting in the channel whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated or will receive any compensation for promoting an issuer.
Advising the Issuer
Rule 402(b)(5) permits a funding portal to advise an issuer about the structure or content of the issuer’s offering, including assisting the issuer in preparing offering documentation. A funding portal can, for example, provide pre-drafted templates or forms for an issuer to use in its offering that will help it comply with its proposed disclosure obligations. Other examples of permissible assistance can include advice about the types of securities the issuer can offer, the terms of those securities and the procedures and regulations associated with crowdfunding.
Paying for Referrals
Rule 402(b)(6) permits a funding portal to 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 or dealer, is not based, directly or indirectly, on the purchase or sale of a security in reliance on Section 4(a)(6) of the Securities Act offered on or through the funding portal’s platform.
Compensation Arrangements With Registered Broker-Dealers
Subject to certain limitations, Rule 402(b)(7) specifies that a funding portal may pay or offer to pay compensation to a registered broker or dealer for services, including for referring a person to the funding portal, in connection with the offer or sale of securities by the funding portal in reliance on Section 4(a)(6) of the Securities Act.
In addition, Rule 402(b)(8) permits a funding portal to provide services to, and receive compensation from, a registered broker-dealer in connection with the funding portal’s offer or sale of securities in reliance on Section 4(a)(6), subject to certain limitations.
Rule 402(b)(9) permits a funding portal to advertise its existence and identify one or more issuers or offerings available on the portal on the basis of objective criteria, as long as:
- the criteria are reasonably designed to identify a broad selection of issuers offering securities through the funding portal’s platform and are applied consistently to all potential issuers and offerings;
- the criteria may include, among other things, the type of securities being offered (for example, common stock, preferred stock or debt securities); the geographic location of the issuer; the industry or business segment of the issuer; the expressed interest by investors, as measured by number or amount of investment commitments made, progress in meeting the issuer’s target offering amount or, if applicable, the maximum offering amount; and the minimum or maximum investment amount; and
- the funding portal does not receive special or additional compensation for identifying the issuer or offering in this manner.
Denying Access to the Platform
Rule 402(b)(10) permits a funding portal to deny access to its platform to, or cancel an offering of, an issuer that the funding portal believes may present the potential for fraud or otherwise raises investor protection concerns. The Rule is consistent with Rule 301(c)(2), which requires an intermediary to deny access if it 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
Rule 402(b)(11) permits a funding portal to accept, on behalf of an issuer, an investment commitment for securities offered in reliance on Section 4(a)(6) of the Securities Act by that issuer on the funding portal’s platform. The safe harbor does not permit funding portals to handle customer funds.
Directing Transmission of Funds
Proposed Rule 402(b)(12) permits a funding portal to direct investors where to transmit funds or remit payment in connection with the purchase of securities offered and sold in reliance on Section 4(a)(6) of the Securities Act.
402(b)(13) permits a funding portal to direct a qualified third party, as required by Rule 303(e), to release proceeds to an issuer upon completion of a crowdfunding offering or to return proceeds to investors in the event an investment commitment or an offering is cancelled.
The final rules do not include a safe harbor that permits a funding portal to post news, such as market news and news about a particular issuer or industry, on its platform. The SEC believes the permissibility of posting news should be a facts and circumstances determination. When posting news, funding portals will need to ensure that they do not violate the prohibition on giving investment advice and recommendations. For example, if a funding portal selectively determines which news articles to post or posts only flattering or positive news, then the funding portal is more likely to be giving impermissible investment advice or recommendations.
Policies and Procedures
Rule 403(a) requires a funding portal to implement written policies and procedures reasonably designed to achieve compliance with the federal securities laws and the rules and regulations thereunder relating to its business as a funding portal.
A funding portal may rely on the representations of others when meeting certain requirements under Regulation Crowdfunding, unless the funding portal has reason to question the reliability of those representations. The SEC believes that when a funding portal relies on the representations of others to form a reasonable basis, the funding portal should have policies and procedures regarding under what circumstances it can reasonably rely on such representations and when additional investigative steps may be appropriate. The SEC also believes that a funding portal’s policies and procedures should cover not only permitted activities, but also address prohibited activities. For example, a funding portal should have policies and procedures on the criteria used to limit, highlight and advertise issuers and offerings.
Rule 403 subjects funding portals to the same privacy rules as those applicable to brokers. Regulation S-P governs the treatment of nonpublic personal information by brokers, among others. Regulation S-AM allows a consumer, in certain limited situations, to block affiliates of covered persons (i.e., brokers, dealers, investment companies and both investment advisers and transfer agents registered with the Commission) from soliciting the consumer based on eligibility information. Regulation S-ID generally requires brokers to develop and implement a written identity theft prevention program that is designed to detect, prevent and mitigate identity theft in connection with certain existing accounts or the opening of new accounts.
Inspections and Examinations
Under Rule 403(c) of Regulation Crowdfunding, a funding portal is required to permit the examination and inspection of all of its business and business operations that relate to its activities as a funding portal, such as its premises, systems, platforms and records, by the SEC’s representatives and by representatives of the registered national securities association of which it is a member.
Records to be Created and Maintained by Funding Portals
Rule 404(a) requires funding portals to make and preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years.
Insignificant Deviations from Regulation Crowdfunding
Rule 502 of Regulation Crowdfunding provides issuers a safe harbor for insignificant deviations from a term, condition or requirement of Regulation Crowdfunding. To qualify for the safe harbor, the issuer relying on the exemption has to show that:
- the failure to comply with a term, condition or requirement was insignificant with respect to the offering as a whole;
- the issuer made a good faith and reasonable attempt to comply with all applicable terms, conditions and requirements of Regulation Crowdfunding; and
- the issuer did not know of the failure to comply, where the failure to comply with a term, condition or requirement was the result of the failure of the intermediary to comply with the requirements of Section 4A(a) and the related rules, or such failure by the intermediary occurred solely in offerings other than the issuer’s offering.
Restrictions on Resales
Rule 501 provides that securities issued in a transaction pursuant to Section 4(a)(6) may not be transferred by any purchaser of such securities during the one-year period following the purchase of securities unless such securities are transferred:
- to the issuer of the securities;
- to an accredited investor;
- as part of an offering registered with the Commission; or
- to a member of the family of the purchaser or the equivalent, to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser or the equivalent, or in connection with the death or divorce of the purchaser or other similar circumstance.
Information Available to States
Under Section 4A(d), the SEC must make available, or cause to be made available by the relevant intermediary, the information required under Section 4A(b). Accordingly, the rules require issuers to file on EDGAR the information required by Section 4A(b) and the related rules. Information filed on EDGAR is publicly available and would, therefore, be available to each state, territory and the District of Columbia.
Exemption from Section 12(g)
Rule 12g-6 provides that securities issued pursuant to an offering made under Section 4(a)(6) are exempted from the record holder count under Section 12(g), provided that the issuer is current in its ongoing annual reports required pursuant to Rule 202 of Regulation Crowdfunding, has total assets as of the end of its last fiscal year not in excess of $25 million, and has engaged the services of a transfer agent registered with the Commission pursuant to Section 17A of the Exchange Act.
Section 12(g) registration will be required only if, on the last day of the fiscal year the company has total assets in excess of the $25 million total asset threshold, or the class of equity securities is held by more than 2,000 persons or 500 persons who are not accredited investors. In such circumstances, an issuer that exceeds the thresholds in Section 12(g) and has total assets of $25 million or more will be required to begin reporting under the Exchange Act the fiscal year immediately following the end of the two-year transition period. An issuer entering Exchange Act reporting will be considered an “emerging growth company” to the extent the issuer otherwise qualifies for such status.
An issuer seeking to exclude a person from the record holder count has the responsibility for demonstrating that the securities held by the person were initially issued in an offering made under Section 4(a)(6).
Scope of Statutory Liability
Securities Act Section 4A(c) provides that an issuer will be liable to a purchaser of its securities in a transaction exempted by Section 4(a)(6) if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of the untruth or omission, and the issuer does not sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.
Section 4A(c)(3) defines, for purposes of the liability provisions of Section 4A, an issuer as including “any person who offers or sells the security in such offering.” The SEC specifically declined to exempt funding portals (or any intermediaries) from the statutory liability provision of Section 4A(c) or to interpret this provision as categorically excluding such intermediaries. The SEC believes that the determination of “issuer” liability for an intermediary under Section 4A(c) will turn on the facts and circumstances of the particular matter in question. The SEC believes that there are appropriate steps that intermediaries might take in exercising reasonable care in light of this liability provision. These steps may include establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.
The final rules provide for issuer “bad actor” disqualification provisions that are closely aligned with similar provisions in Rules 262 and 506. The final rules also establish “bad actor” disqualification provisions under which an intermediary would not be eligible to effect or participate in transactions conducted pursuant to Securities Act Section 4(a)(6).
Secondary Market Trading
Exchange Act Rule 15c2-11 governs broker-dealers’ publication of quotations for certain over-the-counter securities in a quotation medium other than a national securities exchange. The rule prohibits broker-dealers from publishing quotations (or submitting quotations for publication) in a “quotation medium” for covered over-the-counter securities without first reviewing basic information about the issuer, subject to certain exceptions. A broker-dealer also must have a reasonable basis for believing that the issuer information is accurate in all material respects and that it was obtained from a reliable source. Regulation Crowdfunding does not affect the obligations of a broker-dealer under Exchange Rule 15c2-11 to have a reasonable basis under the circumstances for believing that the information required by Rule 15c2-11 is accurate in all material respects, and that the sources of the information are reliable, prior to publishing any quotation, absent an exception, for a covered security in any quotation medium.
You can view our complete analysis of Regulation Crowdfunding here.
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