By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or purchase my books http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at
This article is one of 14 articles in a series about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERAIn article (4) of this series of articles, we discussed the SEC's narrow interpretation of the exemption from broker registration afforded by Section 201 (c) of the JOBS Act.
In article (5) of his series of articles, we discussed how Section 201 (c) of the JOBS Act provides a uniform exemption from registration as a broker for operators of all types of "platforms and mechanisms," from the latest Internet platform to old fashioned radio, television, newspapers and telephones.
In article (5) we discussed why it is necessary to have uniform regulations for operators of old and new platforms is necessary, because these platforms and mechanisms and are constantly changing and are becoming more like one another. The Internet streams videos, television is becoming more interactive, smart phones are replacing simple telephones and people are using these platforms and devices in new combinations.
With people now Tweeting during television shows, it may not be long before participants television shows like Shark Tank begin to raise capital from viewers who Tweet or Text their orders.
In analyzing the SEC's vision for how Section 201 (c) of the JOBS Act should apply to Internet platforms that showcase companies that are seeking capital, we concluded that the SEC's views that only venture capital funds could use the exemption from registration as a broker afforded by Section 201 (c) was inconsistent with how the SEC has long treated operators of traditional media and that such inconsistent treatment by the SEC would not withstand judicial scrutiny because the JOBS Act did not set up different sets of rules for different platforms and mechanisms.
Now, let's expand our analysis of the exemption from broker registration afforded by Section 201 (c) of the JOBS Act to examine how the SEC's views are inconsistent with past practices in private placements, especially the services that people normally pay for.
Before, we do that, let's quickly review the scope of the exemptions afforded by the JOBS Act.
Section 201 (c) allows people to do any one or more of four things in a Rule 506 offering without registering as a broker, if you comply with the conditions imposed by Section 201 (c):
- Operate a technology platform or mechanism that permits companies to make offers sd sales to investors.
- Co-invest in the offering.
- Provide due diligence services.
- Provide form documents to implement the investment.
Although Section 201 (c) includes an exemption for technology platform operators, Section 201 (c) does not limit the other three exempted activities to technology platform operators.
Let’s explore issues related to platform operators first and then consider ancillary services.
Different Types of Regulations for Different Types of Platform Operators Makes Sense
For the reasons we will explain in this article, the most reasonable interpretation of Section 201 (c) of the JOBS Act is that there are four classes of platform operators, each of which is subject to a different set of regulations, because they:
· Provide different types of services.
· Serve different types of investors.
· Can charge different types of fees.
The four types of technology platform operators are:
- Crowdfunding platform operators will showcase issuers, who are allowed to sell securities to any investor subject to investment dollar amount limits, are required to register as a "crowdfunding portal" under Title 3 of the JOBS Act and must comply with the other requirements of Title 3 of the JOBS Act, including not charging success fees and not providing some useful search tools to investors.
- Rule 506 platform operators, who do not need to register (either as a crowdfunding portal or as a broker), if they only provide listing/advertising services (like Television, newspapers and other media), plus the limited ancillary services described in Title 2 of the JOBS Act, in connection with Rule 506 offerings that target sophisticated accredited investors without investment dollar amount limits and do not charge success fees or other fees for "investment advice" or "recommendations."
- Platform operators, who are allowed to provide multiple types of services (including effecting the entire investment transaction online), are not limited by Title 3 of the JOBS Act and can charge a success fee, but they must register as brokers under Section 15 (a) (1) of the Exchange Act.
The fourth type of platform operator is more controversial than the others, because it relies on court cases that indicate success fees for introductions are permitted as long as the finder does not become involved in other important parts of the chain of distribution. The SEC is likely to contest such operators and the courts would decide the issue.
- Rule 506 platform operators, who do not need to register (either as a crowdfunding portal or as a broker), if they only provide listing/advertising services (like Television, newspapers and other media) or introductions like finders, in connection with Rule 506 offerings that target sophisticated accredited investors without investment dollar amount limits and charge success fees, but do not charge fees for "investment advice or recommendations."
Allowing these three or four types of platforms would afford investors real choices about what tools they need and how much they want to pay for these tools.
Multiple types of platforms would also help fill the vacuum in the market that Wall Street has abandoned because the deals are too small.
Although technology platforms are useful tools, most deals won't get done solely through platforms. There still is a real world that requires off-platform activity.
Someone might invest $10,000 in an offering conducted on a Title 3 crowdfunding platform or portal without talking with the issuer's management in person, but people who invest $250,000 in a Rule 506 offering are probably going to require greater interaction with the issuer's management.
Sophisticated investors usually invest in management teams more than in ideas and business plans. The JOBS Act, technology platforms and advertising will not change that. Consequently, most Rule 506 offerings will continue to require substantial off-platform interaction, including discussions with the issues management.
Consequently, any system of broker registration requirements must address hybrid offerings where part of the activity occurs on line and part of the activity occurs in person.
So, let's briefly review the court cases that disagree with the SEC's interpretation of the broker registration requirements.
Applying Recent Case Law about Finders to Interpret Section 201 (c) and Rule 506 Offerings
In article (3) in this series of articles, we summarized several recent court cases in which the courts applied different standards than the SEC applies in determining what people can do without registering as a broker. Two lines of cases indicated that:
· The frequency with which a person accepts "transaction based compensation" matters when you are trying to determine whether a finder is engaging "in the business" of "effecting transactions" in securities.
· Finders that accept success fees or other compensation for introducing investors to issuers are not "effecting transactions" in securities, unless they are also active in the process of selling the specific terms of the transaction to investors they introduce.
The court cases described in article (3) of this series of articles did not interpret Section 201 (c), but we should keep these two principles in mind as we analyze the SEC's views about Section 201 (c) of the JOBS Act. These cases dealt with finders who had personal contact with investors and issuers and did not deal with operators of technology platforms. However, to the extent both finders and technology platforms bring investors and issuers together, the reasoning these courts used provides useful insights into how the Exchange Act applies to people who operate technology platforms that help investors and issuers find one another.
Knowing what finders are able to do beyond introductions without registering as a broker under the Exchange Act is useful, because it establishes a base for what technology platforms can do. If finders are allowed to accept fees for in-person introductions, then there is no reason technology platform operators or finders cannot accept fees for making general solicitations over the Internet, if finders are allowed to accept fees for in-person introductions.
But the SEC disagrees about finders being able to accept introduction success fees and has launched efforts to discourage the use of the Section 201 (c) exemptions by issuing statements that Section 201 (c) applies in only very limited circumstances.
SEC's Narrow Interpretation Section 201 (c)
The SEC's initial interpretation of Section 201 (c) is that:
· The exemption afforded by Section 201 (c) does not apply, if you accept any compensation for any technology or services you provide for a Rule 506 offering.
· The only benefit you are allowed to receive is that if you own stock of the issuer or are buying stock in the offering, the offering can make your shares more valuable.
· You cannot charge any fees for performing due diligence services or providing standardized documents.
For these reasons, the SEC says that Section 201 (c) is of practical use only to venture capital funds that recruit other investors for their portfolio companies. We discuss the SEC's views about Section 201 (c) in greater detail in article (4) of this series of articles.
The SEC's limitation of Section 201 (c) to venture capital investors effectively means that all other people who provide technology platforms or due diligence services or standardize documents may have to register as brokers under Section 15 (a) (1) of the Exchange Act, unless the SEC gives them another exemption or finders and platform operators use the courts to define what Section 201 (c) means.
What is clear from the language of the statute, is that Section 201 (c) clearly only grants an exemption from registration without imposing any greater obligation to register, if you fall outside of Section 201 (c). Therefore, Section 201 (c) of the JOBS ACT clearly cannot: be interpreted to:
· Impose greater restrictions on technology platform operators than the Exchange Act already imposed before the JOBS Act.
· Impose greater restrictions on technology platform operators than on finders who introduce people to one another.
Consequently, if we apply the distinction discussed in the finder cases summarized in article (3) of this series of articles between introducing investors to issuers and the Exchange Act's requirement that brokers must be in the business of "effecting transactions," what the SEC has said about Section 201 (c) of the JOBS Act would make little sense.
Having established that base of what was already permitted by the Exchange Act, we can then discuss the extent to which the nature of technology platform based offerings should be less restrictive than in-person introductions. Technology based offerings have the following characteristics that in-person offerings conducted by registered brokers or by unregistered finders do not have:
- Technology platforms operate in the open. There is total transparency to the SEC and state securities regulators, as well as to legal and other advisers to investors.
- Technology platforms work the same way in every deal. People do things differently each time they do it. Technology platforms eliminate the variability of sales techniques that individual sales people bring to in-person offerings. Every investor receives the same sales experience from a technology platform.
- Technology platforms create a record of all investor interactions. Operators cannot say they did one thing and do another without being contradicted by computer records.
- Technology platforms cannot use personality or pressure tactics to coerce investors.
The remainder of this article is devoted to explaining why the SEC's interpretation of Section 201 (c):
· Is not supported by the statute's actual language.
· Is not consistent with the overall intent of Congress to encourage using technology in capital raising.
· Is not a rational regulatory policy for different types of technology platforms that provide different levels of services to different types of investors.
· Is not consistent with several recent court cases that deal with finders that make distinctions between introducing people and "effecting transactions," which is the Exchange Act's definition of a broker.
· Is not consistent with the way securities laws have always treated people who operate media and communications systems.
· Does not make sense in light of how most Rule 506 offerings have been conducted.
· Is detrimental to investors, because it deprives sophisticated investors of tools they have long utilized in Rule 506 offerings.
Now, let's begin to analyze Section 201 (c) of the JOBS Act in greater detail to understand how it works.
Section 201 (c) Permitted Services
Section 201 (c) provides an exemption from registration as a broker for people who perform one or more of four types of activities that are related to investments in Rule 506 private placements:
- People who maintain technology platforms and devices that "permit" offerings and/ or
· People who co-invest in offerings, and/or
· People who provide due diligence and/or
· People who provide form documents for securities sales in the offering.
We will focus first on the people who maintain technology platforms and devices, but it is important to note that Section 201 (c) grants the exemption from registration to people who perform one of more of these activities, if they comply with the terms of the exemption. For example, Section 201 (c) creates an exemption for people who provide ancillary services like due diligence and/or provide document forms even, if they do not co-invest or maintain a technology platform or device.
We note that although most of the focus is on offerings that conduct general solicitations or advertise under Rule 506 (c), the exemption afforded by Section 201 (c) also applies to offerings under Rule 506 (b) in which no general solicitation or advertising occurs. Co-investing, due diligence and providing standard documents are activities that can apply to all types of Rule 506 offerings.
Technology platforms are likely to apply more to Rule 506 (c) offerings. But technology platforms that utilize passwords to give access only to pre-screened in investors were used in Rule 506 offerings before Rule 506 (c) permitted general solicitations and remain legal in Rule 506 (b) offerings to the same extent as before general solicitation and advertising were permitted under Rule 506 (c).
SEC No Fees Position
With this understanding in mind we'll discuss the SEC's position that Section 201 (c)'s exemption from registration does not apply, if the operator charges any fees for using the technology platform or any fees for ancillary services and the reasons why this interpretation by the SEC:
· Is not supported by the statute's actual language.
· Is inconsistent with the overall intent of Congress to encourage the use of technology in capital raising.
· Is not a rational regulatory policy for different types of technology platforms that provide different levels of services to different types of investors
· Is inconsistent with the way securities laws have always treated people who operate media and communications systems.
· Is detrimental to investors, because it deprives investors who are both "sophisticated" and "accredited" of tools they have long utilized in Rule 506 offerings.
The devil is often in the details. So, in our analysis, we'll examine:
· The differences between operating a technology platform or device that permits other people to buy or sell securities and effecting transactions or selling securities yourself.
· Practical inconsistencies between the tools and practices investors have always used to protect themselves in securities transactions and the barriers the SEC is erecting that will prevent investors from utilizing these tools in investment opportunities they find by using Internet based technology platforms. If the SEC is supposed to protect investors, why would the SEC make it more difficult and expensive for investors to purchase due diligence services and deal terms advice from professional negotiators?
Fees Paid for Listing Services
Allowing operators of platforms or mechanisms permitted by Section 201 (c) to charge a listing fee is consistent with how securities laws have treated both newspapers and other listing services.
The SEC has long taken the position that online listing services can charge a fee, but are not required to register as long as the fees are related to the listing service and are not success fees.. See the Angel Capital Electronic Network no-action letter (December 1997). The fact that other platforms like AngelList chose to make money by co-investing rather than charging a fee should not limit the revenue models for technology platforms that list offerings. Certainly there is no evidence that Congress intended Section 201 (c) to limit activity that was previously legal. Therefore, it seems unreasonable to think that Congress intended to ban all fees for platform operators who list Rule 506 offerings.
The next question then, is whether Congress intended to ban fees for listings on platforms that do more than merely let businesses say anything they want about themselves. When we discuss the SEC's crowdfunding rules authorized by Title 3 of the JOBS Act, we'll see that except for a general duty to prevent known fraud, crowdfunding platform operators are prohibited from providing any guidance to investors. The SEC's rationale is that saying anything about a listed company would be making a "recommendation" or giving "investment advice."
Although Section 201 (c) of the JOBS Act does not contain a similar prohibition against giving guidance to investors, the SEC's position is that you would lose the ability to charge a listing fee in a Rule 506 offering if you provide editorial comments.
Is that what Congress intended Section 506 (c) of the JOBS Act to do?
That would be a strange outcome for a law that was intended to increase the ability of companies to raise capital.
It's also strange from a disclosure viewpoint. Platform operators would be faced with an all or none situation. Either platform operators let companies raising capital in a Rule 506 offering on their platform say whatever they want about themselves or the platform operator lets them say nothing.
How does this all or none rule protect investors?
How does this all or none rule encourage people to operate platforms that help businesses raise capital?
Wouldn't it be more reasonable to permit platform operators to shape the disclosures their platforms facilitate? Doesn't it seem reasonable that platform operators could charge a fee for a service that provides better disclosure to investors?
If these public policy questions cause you to question whether the SEC is interpreting Section 201 (c) correctly, why not begin analyzing what Section 201 (c) actually says, instead of stopping at what the SEC says Section 201 (c) means?
Platform Listing vs Effecting Transactions
First, let's examine the differences in language between Section 201 (c) of the JOBS Act, which says "in connection with the purchase or sale" of securities compared to the Exchange Act's language which says: "effecting transactions" in securities.
We know that the SEC has always had a very broad interpretation of the words "effecting transactions." But Congress did not use this historically open ended term ("effecting transactions") in Section 201 (c) of the JOBS Act.
Was this omission by Congress of long-standing broad language in the Exchange Act just an accident? Did Congress really mean to incorporate all the activities the SEC thinks are included in the phrase "effecting transactions?"
Or does the prohibition against receiving compensation "in connection with the purchase or sale" of securities mean something different than the very broad traditional terminology: "effecting transactions."
Now, let's return to the language of Section 201 (c) of the JOBS Act.
Success Fees for Purchases and Sales vs. Compensation for Offering Services
The condition that disqualifies you from relying on the exemption afforded by Section 201 (c) is accepting compensation "in connection with the purchase or sale of securities." Nothing in Section 201 (c) mentions compensation in connection with "offering" securities.
The SEC has always interpreted the offer of securities to be part of the process of "effecting transaction." Did Congress intend to allow the exemption afforded by Section 201 (c) to apply if you receive compensation for offering securities? Is that why Section 201 (c) only refers to purchases and sales and not to offers?
We know that when it enacted the JOBS Act Congress was aware of technology platforms (like AngelList) did not execute sales online. Such technology platforms, which were not as complex as the full crowdfunding platforms authorized by Title 3 of the JOBS Act, merely introduced companies and potential investors, but deals were negotiated and closed offline. Title 3 of the JOBS Act created crowdfunding platforms, where deals would be fully executed on the technology platform.
Let's talk about the nature of the compensation to explore this issue further.
As we discuss in article (2) of this series of articles, the type of compensation that the SEC thinks almost always causes someone to be required to register as a broker is a "success fee," which includes any fee that is contingent on a sale occurring and is usually measured as a percentage of the dollar amount of securities sold in an offering or that are directly traceable to a particular salesman. Other types of compensation for services in a securities offering can sometimes indicate a need to register as a broker, but a success fee is the most problematic.
Of course, a fee that is paid to offer securities is not a success fee, because the obligation to pay is not contingent on a sale occurring.
Making a distinction between fees paid for offering services vs. a success fee that is contingent on sales occurring makes sense in the context of our earlier discussion about why TV and other media and communications systems and services do not have to register as a broker even if their service "permits" or otherwise helps someone to sell securities.
The media is usually paid whether or not advertisement actually sells any product. However, online media is generally more interactive and old media and revenue models often compensate websites for clicks or purchases. Therefore, some media advertising revenue is results oriented.
Now, let's return to Section 201 (c) (1) (A) of the JOBS Act, which covers all solicitations and advertising, "whether online, in person or by any other means."
Would anyone dispute that Section 201 (c) (1) (A) applies to TV and other traditional media and communications systems? Of course not. Section 201 (c) is a blanket permission for issuers to use any media of any type, including both traditional media and Internet based technology platforms.
But then why does the SEC single out Internet based technology platforms in its FAQs when the SEC says that platform operators cannot accept any compensation for permitting an issuer to conduct an offering? In answer to Question 7 on the SEC's website that is quoted above, the SEC's staff indicates that Section 201 (c) does not limit who can maintain the platform or mechanism. Why would there be no limit on who can maintain a platform or mechanism, if only venture capital investors are allowed to benefit from it?
We discuss the need for cross media uniformity in greater detail in Article (5) of this series of articles. So, we won't repeat that analysis here except to remind ourselves that the SEC's position in its FAQs treats Internet based technology platforms differently than other media when the language of the statute clearly treats all media and methods of communications the same demonstrates that the SEC's FAQs are not consistent with the statute.
In light of the foregoing, doesn't it make sense to interpret the language in Section 201 (c) to exclude you from the protection offered by Section 201 (c):
· Collecting fees "in connection with purchases and sales" where the technology platform is operating like the full service crowdfunding platforms authorized in Title 3 of the JOBS Act, in which all activity occurs on the platform including orders and payment?
· Charging success fees rather than a simple listing fees ?
Of course, not all activities that fall outside the exemptions afforded by Section 201 (c) mean that you must register as a broker. You are simply thrown back into the disagreement between the Sec and courts that we discuss in article (3) of this series of articles
What is clear is that Congress did not intend for Section 201 (c) to protect people who charge a fee for engaging in every part of securities transactions. As we discuss in article 95) of this series of articles, permitting someone else to sell is different that actually doing the selling. This interpretation would also be consistent with the second activity that precludes you from the protection of Section 201 (c) (2) (B) - that you not "have possession of customer funds or securities in connection with the purchase or sale of such security."
This limitation on the exemptions afforded by Section 201 (c) , would treat all media the same. If a TV station, if it collects money from investors or charges a success fee, the TV station would fall outside the protection of Section 201 (c).
Consistency across all types of media is an important factor in a world where media and communications systems are constantly changing, converging and diverging. Any law or regulation that does not treat all media equally would soon be obsolete.
Section 201 (c) of the JOBS Act take a media neutral approach that regulates based on what functions you perform and whether your fees are for activities that do not require you to register as a broker.
A media neutral approach requires you to treat the offering process and compensation for facilitating the offering different than you treat the process of closing the investment transaction.
In summary, the most reasonable interpretation of Section 201 (c) is that you do not have to register as a broker, if you charge fees for operating the platform and for providing ancillary services (whether or not you co-invest), if your platform does not perform the whole process of the offering from attracting potential investors to actually closing the deal like a crowdfunding platform authorized by Title 3 of the JOBS Act does. To accept a fee for doing this entire process you must either be registered as a broker under Section 15 (a) (1) of the Exchange Act or comply with the limits imposed on crowdfunding portal operators pursuant to Title 3 of the JOBS Act.
But saying that Section 201 (c) prohibits people from earning fees for doing the whole transaction is different than saying Section 201 (c) prohibits people from charging fees for discrete parts of the securities offering process.
Section 201 (c) protects more than just operating a platform. It also protects providing "ancillary services," because the platform operator is likely to be the most cost-efficient provider of these ancillary services that help investors accomplish their goals.
Ancillary Services – Due Diligence and Standard Documents
Now, let's shift our discussion from the technology platform and media to talking about how Section 201 (c) deals with off-platform activity.
First, we should note that Section 201 (c) applies to anyone who performs any one or more of the four activities:
· Maintains a technology platform or device.
· Co-invests in offerings.
· Provides ancillary services.
· Provides standard documents
Since Section 201 (c) uses the word
"or" and not the word "and," Section 201 (c) protects people who provide ancillary services even if they do not "maintain a platform or mechanism." There is no bias in Section 201 (c) about the source of ancillary services.
So what are "ancillary services"?
Section 201 (c) says that "ancillary services" means:
· "Providing due diligence services in connection with the offer, sale, purchase, or negotiation of such security, so long as the services do not include, for separate compensation, investment advice or recommendations to issuers or investors."
· "Providing standardized documents to the issuers and investors, so long as you do not negotiate the terms of the issuance for and on behalf of third parties and issuers and you do not require the issuer or investors to use the standardized documents as a condition of using the service."
Before we can understand whether compensation can be paid for ancillary services, we should understand what ancillary services are.
What Are "Ancillary Services" Ancillary To?
Let's begin by exploring the question: What are these services "ancillary" to?
The common definition of the word "ancillary" is something that is necessary to support another more primary activity.
So, what is the primary activity that due diligence services support?
Section 201 (c) (1) (C) says "provides ancillary services with respect to such securities." Earlier in Section 201 (c) (1), the statute says "with respect to securities offered or sold in compliance with Rule 506 of Regulation D.
From this, we reasonably conclude that "ancillary services" that do not require you to register as a broker include all services referred to in Section 201 (c) (3) (due diligence and form documents) that are necessary or appropriate to support the offer and sale of securities in a Rule 506 offering, unless the person who provides the ancillary services fails comply with subsections (2) or (3) of Section 201 (c).
But the SEC interprets Section 201 (c) in such a way that it effectively means that if you maintain the platform or mechanism, you must co-invest to be protected by Section 201 (c), because the SEC says that the only economic benefit you can receive is the increase in the value of your investment. That's why the SEC says Section 201 (c) is really only practical for venture capital funds.
But is the SEC's position that the only economic benefit you can derive from providing a technology platform or device or due diligence services or form documents really supported by what Section 201 (c) of the JOBS Act says?
Fees for Ancillary Services
We note that Section 201 (c) of the JOBS Act does not explicitly state:
· that you cannot charge for ancillary services, or
· that you cannot provide investment advice or recommendations.
Section 201 (c) only says that if you provide due diligence services you cannot charge a "separate fee" for providing "investment advice or recommendations" to either issuers or to investors.
This raises a question: If Section 201 (c) does not permit charging any fees, then why does Section 201 talk about charging a "separate fee?" This language raises the question: Separate from what?
We see two possible answers:
· Does this mean separate from a listing fee for permitting an issuer to list its offering on your technology platform? If so, that would negate the SEC's FAQs interpretation that the platform operator is not protected by Section 201 (c), if the platform operator charges a listing fee.
· But as we discussed above, Section 201 (c) applies to people who provide due diligence services even if they do not operate a technology platform. For people who provide due diligence services, but do not operate a technology platform, it is reasonable to conclude that the words "separate fee" refers to fees for services that include investment advice or recommendations that are separate from fees for due diligence that does not include "investment advice or recommendations" to issuers or investors.
Section 201 (c) prohibits fees for "investment advice or recommendations." That makes sense, because providing "investment advice" and making investment "recommendations" about buying and selling securities and the value of securities goes to the heart of what brokers do.
Is All Due Diligence "Investment Advice and Recommendations"?
This leads us to our next task – to determine what constitutes "investment advice and recommendations" and just as importantly, to analyze how investment advice and recommendations relates to due diligence services.
Certainly, some due diligence services could constitute "investment advice and recommendations." But the SEC appears to assume that all due diligence services constitute "investment advice or recommendations."
The SEC's position is clearly contrary to long-standing practices in how private placements are conducted. Many types of service providers charge fees for due diligence services that do not constitute "investment advice" or "recommendations."
Before we review common due diligence practices in private placements, lets remind ourselves of the breadth of the SEC's views about what constitutes "investment advice" or "recommendations" by examining the SEC's Crowdfunding rules proposal, in which the SEC indicates that highlighting certain listed offerings over other offerings could be viewed as making "recommendations" or providing "investment advice." Even stating that you have standards for companies whose offerings can be listed may be a form of "investment advice or recommendation" according to the SEC. For these reasons, the SEC's proposed Crowdfunding rules prohibit crowdfunding platform operators from highlighting offerings, providing investors with certain search tools or touting their listing standards.
In article (7) of this series of articles, we discuss why depriving investors of search tools in Title 3 crowdfunding platforms harms investors. In this article we simply note that there is a difference between Title 3 of the JOBS Act, which includes offerings to all types of investors, and Title 2 of the JOBS Act, which includes offerings only to sophisticated accredited investors. Section 201 (c), which is part of Title 2 of the JOBS Act, does not prohibit platform operators from highlighting offerings, providing useful search tools to investors or from having standards about who can conduct offerings on their platforms.
In taking this position about how offerings appear on technology platforms, the SEC seems to be implicitly saying that any information or even a search tool that could possibly influence any investor is "investment advice or recommendations," which definitely is not appropriate for Title 2 offerings under Rule 506 to sophisticated accredited investors.
Such a broad definition of "investment advice or recommendations" would incorporate all the services many service providers have traditionally provided without being required to register as a broker. Lawyers, accountants, engineers and other people routinely help issuers and investors identify and understand the implications of facts related to the issuer, its industry and its business. Without such services it would be impossible to close many investment transactions.
All of such service providers provide advice and recommendations of one kind or another. Likewise, investors rely on such advice and recommendations when they make investment decisions. But the advice or recommendations they make do not include whether people should invest or not invest. In many cases, service providers explicitly disclaim any opinion about whether someone should invest or not.
To understand the difference between due diligence services that include "investment advice or recommendations" and due diligence services that do not include "investment advice or recommendations," we should draw reasonable distinctions between two distinct things:
· What the due diligence report says.
· What the person who reads the due diligence report decides to do after reading the due diligence report.
How should we resolve these conflicts between the SEC's broad statements and the realities of how deals are done?
Past Practices in Rule 506 Offerings
The first thing to focus on when we try to determine whether you can charge for any ancillary service is to remember we have a long history of how Rule 506 deals are done. For several decades over 90% of private placements have been conducted using Rule 506. It would be foolish to try to interpret Section 201 (c) without looking to that long history for guidance, because the is no evidence that Congress intended to change long-standing due diligence practices in Rule 506 private placements.
Let's start by focusing on several common practices in Rule 506 offerings:
- Only "sophisticated" investors are allowed to invest in Rule 506 offerings. Most people measure "sophistication" by language in Rule 506 (b) (2) (ii) says that the investor "has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment."
- In most Rule 506 deals, someone does due diligence and you start with some sort of standard documents that are adapted to the needs of the particular deal.
- Either conducting due diligence or hiring someone to conduct due diligence is usually regarded as a sign an investor is "sophisticated." That's why Section 201 (c) permits due diligence to be part of the permitted ancillary services.
- Likewise, many Rule 506 deals start with a set of standard documents that are modified to fit the specific deal terms. Deal documents may evolve over time, but there has been remarkable consistency over the decades.
- Another standard practice in Rule 506 offerings is that someone usually pays for both due diligence and for documents.
- It's also true that the people doing the transaction often try to obtain efficiencies by sharing the cost of both due diligence and documents and agreeing on common service providers. The company sometimes agrees to pay for one law firm to represent all investors in the investor group.
So, having established a long pattern in Rule 506 offering practices, let's evaluate whether he SEC's FAQs positions are consistent with the practices investors have long employed to conduct their business and protect themselves.
The SEC's interpretation is that Section 201 (c) of the JOBS Act requires either that both due diligence and documents:
· Be free of charge to both the company that raises money and to the investors.
· Or that a platform operator cannot provide these services or arrange for someone to provide these services so that multiple investors can benefit from cost sharing.
This strained interpretation of the Section 201 (c) creates transaction inefficiencies, because the logical and most efficient provider will often be the platform operator or a co-investor. If before Section 201 (c) investors were allowed pay for these services to be provided by anyone the investors decided was the most efficient provider, why can't investors pay the most efficient provider for these services after Section 201 (c)?
Why should we interpret securities laws to impose cost burdens on investors merely because the investors find the investment opportunity online?
And, of course, investors often require the company that raises capital to pay the legal fees of the investors and sometimes for due diligence expenses – often up to a negotiated dollar amount. Therefore, it should be irrelevant whether the investor or the issuer writes the check. The investor's money always pays for it all – either directly or by requiring the issuer to use investment proceeds to pay for investment transaction fees and expenses.
The only difference is that if the investor pays the service provider directly, the investor receives no securities for the money the investor pays. But if the company pays for the services from the offering proceeds, the investor receives securities. Why would securities laws that are supposed to protect investors require investors to receive fewer securities for the same investment amount?
Fact Based Due Diligence Services Need Not Include Recommendations to Buy Securities
Now, let's talk about the nature of due diligence services.
Does due diligence always include investment advice?
Not always. Especially, where (as in all Rule 506 offerings) the investor is "sophisticated," because the investor "has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment," the investor often uses due diligence primarily to verify facts the issuer provides. In other situations, investors use due diligence to learn more about the industry than the issuer knows – which is often the case with start-up companies where the investors have more experience than the issuer's management team. The investor then conducts its own investment analysis based on the facts the investor either verifies of collects on its own.
Virtually all due diligence reports make recommendations and include advice. But the recommendation or advice need not be whether to buy or to sell securities or the value of securities. Due diligence is a disciplined process that investors use to verify facts that when considered with all other facts can influence decisions about value and whether to buy or sell securities. Due diligence is often used to:
· Verify facts the person selling securities has told investors.
· Provide investors with new insights about what the facts sellers tell them really mean by adding more facts to the mix investors have access to.
Whether facts are "material" is usually determined by how the facts fit into the total mix of facts investors evaluate. Usually, the SEC wants investors to have as much information as possible. So, any interpretation of Section 201 (c) that places practical limits on the scope of the total mix of facts investors can evaluate is highly suspect. Most people who do deals would say that, if you limit investors' access to due diligence reports, you will also be limiting both the facts investors have and the tools investors need to evaluate facts.
Investors often hire different experts to do different parts of due diligence. For example:
- A patent lawyer might analyze a patent portfolio of a company that is raising capital to verify the patents have issued, the patent claims are what the company describes to investors and to express opinions about whether the issuer can practice the invention described in the patent claims without violating patents owned by competitors.
- Engineers or scientists might use the legal analysis to advise about whether the patent claims can be easily worked around and whether the technology described by the claims is likely to be useful in the industry five years from now given the direction and the pace of change in the industry.
- Someone else might conduct a survey of some of the customers of the business raising capital to verify they are customers and the volume of orders and to understand why each type of customer buys from the business that is trying to raise capital.
- Another person might run background checks on the business' management to check for criminal backgrounds or to verify their past employment.
All of these types of due diligence reports share several things in common:
· The reports affect the decisions investors make about value and whether or not to invest.
· The people doing the work have to be paid.
· But none of these due diligence reports are advising about the value of securities and whether or not to buy or sell securities, because investors evaluate each fact in the context of the total mix of facts they are analyzing. When a patent lawyer gives an investor a legal opinion about an issuer's patents, the opinion relates to a limited number of facts. Investors often decide not to invest in issuers that have strong patents, because of other factors. For example, the investor might believe the issuer's management team lacks the experience necessary to compete in the industry.
The primary question to ask is whether Congress intended to make it easier for investors to obtain these types of due diligence services or more difficult to obtain these services when Congress wrote the provision of Section 201 (c) that deals with due diligence services.
The SEC's interpretation of Section 201 (c) of the JOBS Act is that:
· a group of investors attracted by an internet platform is supposed to arrange for all this due diligence without any help from the platform operator, or
· that the platform operator or the service provider must do all this work for free.
Does either alternative seem realistic?
Is either alternative likely to make it easier to use technology platforms to do Rule 506 (c) transactions?
How would twelve investors coordinate due diligence, if their only connection is the website where they found the company that is raising capital coordinate due diligence?
Does leaving investors to fend for themselves without due diligence really serve the anti-fraud goals of securities laws?
If the SEC is not providing a realistic interpretation that promotes the general purposes of the JOBS Act, then what interpretation of Section 201 (c)'s provisions about ancillary services would make more sense?
"Providing due diligence services in connection with the offer, sale, purchase, or negotiation of such security, so long as the services do not include, for separate compensation, "investment advice" or "recommendations" to issuers or investors."
Isn't it more reasonable to recognize that this provision is meant to prevent people from using due diligence reports as a Trojan Horse to hide valuations of securities and advice about whether to buy or sell securities that investment bankers usually provide?
Wouldn't it be more reasonable to look at the nature of the due diligence report to determine whether it is really verifying facts or is really providing "investment advice or recommendations" than to assume all due diligence reports contain investment advice and recommendations merely because the person who provides the report collects a fee?
Primary Issue: How Much You Charge Not Whether You Charge
The primary legitimate concern about due diligence and document and fees is that due diligence and documents might be used to hide a success fee or other fee for investment advice.
That's why the primary issue related to ancillary services and other issues related to Section 201 (c) of the JOBS Act should be the size of the fees people charge. Due diligence services and documents have market values. Clients will only pay so much for these services. It is reasonable to suspect that people who try to charge above market fees for these ancillary services are really hiding fees for services that require them to register.
Undoubtedly, the SEC would prefer not to have to argue about whether a fee is reasonable for the legitimate ancillary service, but in other situations the SEC has to deal with the reasonableness of fees compared to the market rate for services to determine whether people are hiding illegal fees by overcharging for other services.
For example, registered brokers cannot share commissions with unregistered people, but registered brokers can pay unregistered service providers reasonable fees for services. The SEC also has to deal with the issue of fee reasonableness in most commission sharing cases. So, it is not impossible to determine reasonableness to uncover disguised commissions.
The Investment Advisers Act excludes from the definition of "investment adviser: any lawyer, accountant, engineer or teacher whose performance of [investment advice] services solely incidental to the practice of his profession." In determining whether a professional meets this "solely incidental" test, the SEC looks to three factors:
· Does the professional hold himself out to the public as providing investment advice to the public?
· Is the investment advice connected with and reasonably related to providing the professional service normally provided by lawyers, accountants, engineers and teachers?
· Is the fee the professional charges for the services that relate providing investment advice based on the same factors the professional uses to determine fees for other professional services?
The investment adviser example shows there are reasonable ways to determine whether any service provider is charging disguised commissions for investment advice. Of course, the Investment Advisers Act forced the SEC to develop reasonable rules, because the Investment Advisers Act contains a provision excluding certain professionals from regulation.
The SEC developed these reasonable rules to prevent a professional from using their profession as a shield to provide investment adviser services as the primary part of their business. That makes regulatory sense.
But in determining whether we should apply the same principles to Section 201 (c)'s exemption from broker-dealer registration, we should ask ourselves:
· Should the SEC apply reasonable tests only when there is no alternative under the statute?
· Does administrative convenience for the SEC preclude reasonableness as a guiding regulatory principle?
· Did Congress intend to make this easy for the SEC to administer?
· Or did Congress intend to help businesses raise capital by tearing down walls the SEC had built?
· Is the JOBS Act's exemption for providing a technology platform or ancillary services , such as due diligence and standardized documents referred to in the JOBS Act, really so different from the Investment Advisers Act's exclusion of certain professions from regulation that we should abandon reason as the guiding regulatory principle?
· Is the "separate compensation" provision of Section 201 (c) of the JOBS Act really different than the compensation test the SEC applies under the Investment Advisers Act?
The JOBS Act was intended help companies to use technology platforms in Rule 506 offerings. Helping multiple investors who have no connection to one another to obtain ancillary services by creating a market of service providers is a reasonable step to achieving Congress' intentions as long as the fees these service providers are not hiding places for fees for other activities.
A further indication that the intent is to prohibit hiding fees in bundles of services is the part of the definition of ancillary services that prohibits requiring companies to use standardized documents as a condition to use of the service.
Anti-bundling laws are generally meant to prohibit you from requiring people to pay for something they don't want in order to get something they want. Prohibiting bundling services where all the services are free does not make sense. Why would Congress be concerned about bundling documents with other services, if Section 201 (c) was intended to prohibit people from charging any fees at all?
In summary, people who are not registered are at risk of SEC action against them if they charge fees for Section 201 (c) services, because of how the SEC interprets Section 201 (c). But unregistered platform operators and people who co-invest and people who provide "ancillary services" have reasonable arguments to convince courts that the SEC is overstepping its authority in asserting that all fees are prohibited.
Thus far, the SEC has stated its interpretation of Section 201 (c) in FAQs on its website and in speeches by its personnel. The SEC is free to put on its website anything and have its employees say anything the SEC thinks would make its life easier. No doubt, the SEC's narrow interpretation of Section 201 (c) would make the SEC's life easier. But that would exclude numerous deal makers from the market and ultimately limit the tools and choices investors have. Therefore, administrative convenience should not win the day.
Issuing actual rules is a more deliberate exercise than issuing FAQs on a website, because rules have to correlate to what a statute actually says. SEC rules are subject to challenges in court about whether the rules are consistent with the statute's language. FAQs on a website cannot be challenged in court.
For these reasons, we should not give the SEC's FAQs the same weight as we do SEC rules.
While it is true that winning in court against the SEC can be expensive, it is also true that the SEC may be reluctant to bring enforcement actions based on its broad no fees allowed policy pronouncements. The SEC may prefer to loudly discourage fees without risking that the courts will rule against it.
If you would like to learn more, you can reach me at JFV@WardandSmith.com.
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