Howard E. Berkenblit
Beginning in May, private companies will be able to offer securities directly to investors via SEC-registered Internet portals, thanks to long-awaited crowdfunding rules. But for entrepreneurs looking forward to cashing in and internet platforms eager to engage a new marketplace, the SEC rules come with complexities.
Throughout its rulemaking, the SEC sought to balance the legislative objective of the JOBS Act (to facilitate greater capital formation for smaller companies) with robust investor protection. The result is a labyrinth of requirements aimed at reducing the risk of fraud.
To navigate this maze, the rules require crowdfunding to be conducted through one of two types of SEC-registered intermediaries – broker-dealers or “funding portals.” This article focuses on the latter.
Designed to facilitate crowdfunding transactions and help protect mom-and-pop investors from fraud, funding portals enjoy unique powers accompanied by the potential for legal liability. Funding portals are required to investigate certain aspects of issuers and investors before executing crowdfunding transactions. In light of these requirements, Internet platforms hoping to register as funding portals should start preparing now.
Richard Goulding
Initially, a funding portal must register with the SEC by filing a Form Funding Portal, which requires disclosure of disciplinary history, legal status, business activities and compensation structure. A funding portal must also join a national securities association (currently FINRA).
Once registered, funding portals must perform various administrative functions, including:
Making available required disclosures about the companies seeking crowdfunding during the offering period and for at least 21 days prior to selling any security;
Offering channels for investors to discuss offerings with other investors and issuer representatives;
Delivering educational materials that explain the types of securities being offered, resale restrictions and investment limits imposed by the rules and how to invest;
Accepting an investor’s commitment only after that investor has opened an investment account;
Delivering notices and confirmations of investments; and
Adhering to numerous requirements regarding the transmission and maintenance of funds and the cancellation and completion of offerings.
The rules also prohibit funding portals from engaging in several activities, including compensating anyone for providing an investor’s or potential investor’s personal information; offering investment advice; soliciting purchases, offers or sales to buy securities on the portal; and holding a financial interest in companies using the portal unless the financial interest is compensation for the portal’s services (subject to restrictions).
To safeguard crowdfunding investors against fraud, the SEC rules require funding portals to investigate certain representations of both investors and issuers and determine whether they have a “reasonable basis” for believing them. A funding portal’s failure to satisfy this standard before consummating a transaction can result in legal liability under the Securities Act.
The rules, however, neither prescribe adequate procedures nor describe the appropriate scope for a funding portal’s investigative efforts. According to the SEC staff, funding portals may rely on representations of the issuer unless the portal has reason to question their reliability. The SEC was clear to “emphasize” that a funding portal has an independent responsibility to assess the reliability of the issuer representations. The SEC also strongly suggests that portals develop adequate policies and procedures to assess when additional investigative steps may be appropriate. Furthermore, the SEC staff encourages portals to develop and implement a “tiered approach to compliance obligations” requiring “more rigorous compliance reviews and background checks as risk factors increase.”
Funding portals must also investigate certain investor representations under the reasonable basis standard. A portal may rely on the prospective investor’s representations concerning their income, net worth and the amounts of other crowdfunding investments unless the portal has reason to question their reliability. Although the SEC staff highlighted procedures that might aid verification, including using a centralized data repository where investors could upload financial documents or creating a tool to assemble necessary data, exact authentication measures are left to the portal’s discretion. Importantly, the SEC staff noted that it expects to review the books and records practices of funding portals as an integral part of its three-year review of regulation crowdfunding.
Legal Matters
While crowdfunding is new legal territory and much remains uncertain, one thing the SEC made clear is that investor protection will be a priority. Therefore, satisfying the fraud prevention rules that employ the “reasonable basis” standard will be essential to avoiding liability. This will require developing comprehensive, dynamic and efficient due diligence procedures and policies, which should differentiate between various stakeholders and be tailored to the presence or absence of identifiable risk factors, and internal systems to ensure compliance with all of the administrative requirements. Prospective portals should consider engaging experienced outside securities counsel to be certain nothing slips through the cracks.
Howard E. Berkenblit is a partner and leader of the capital markets group of the law firm of Sullivan & Worcester LLP, based in Boston. Richard A. Goulding is an associate in the corporate department of Sullivan & Worcester’s Boston office.
