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/eLearnSuccessor 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 of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
In articles (2) and (3) of this series of articles, we dissected Section 15 (a) (1) of the Securities and Exchange Act and the definition of the term "broker" in the Exchange Act, and how the SEC and some courts disagree about how to interpret the Exchange Act.In this article we'll discuss Section 201 (c) of the JOBS Act, which provides exemptions from registration as a broker-dealer under Section 15 (a) (1) of the Securities Exchange Act of 1934 in Rule 506 offerings for people who conduct the activities described in the statute.
That might sound boring. But it's not.
Section 201 (c) goes to the heart of how Wall Street, Silicon Valley and Main Street are fighting to define their territories (including in Internet based offerings) – each of the dogs are marking their territories. As usual, the Securities and Exchange Commission is lining up to support Wall Street in this epic battle.
But what does Section 201 (c) of the JOBS Act have to do with this battle over territory?
Section 201 (c) of the JOBS Act amended Section 4 (b) of the Securities Act to state: "no person . . . shall be subject to registration as a broker or dealer pursuant to Section 15 (a) (1) of this title, solely because:
- that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means;
· that person or any person associated with that person co-invests in such securities; or
· that person or any person associated with that person provides "ancillary services" with respect to such securities.
"For the purposes of this subsection, the term ‘ancillary services’ means—
(A) the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and
(B) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.’’.
The exemption provided in Section 201 (c) applies only if:
- "such person and each person associated with that person receives no compensation in connection the purchase or sale of such security;"
- "such person and each person associated with that person does not have possession of customer funds or securities in connection with the purchase or sale of such security; and"
- "such person is not subject to a statutory disqualification as defined in section 3(a)(39) of this title and does not have any person associated with that person to such a statutory disqualification."
The limitation on receiving "compensation in connection with the purchase or sale" of securities is the primary limiting factor for Section 201 (c). If you cannot receive compensation, then why would anyone bother to maintain a platform or provide necessary services, unless you are the issuer trying to sell securities or an investor trying to help the company grow?
The SEC contends that all compensation a technology platform provider receives would be "compensation in connection with the purchase or sale" of securities, but is that really true?
Section 201 (c) of the JOBS Act does not say that someone is not a "broker" and is not a "dealer." Section 201 (c) only modifies the registration requirement. The parts of the Exchange Act that apply to unregistered brokers will still apply. Likewise state broker and dealer laws will still apply.
SEC FAQs Fees, Platforms and Ancillary Services – Investment Advice and Recommendations
As we will discuss below, the SEC indicates in FAQs that, because the SEC believes that all compensation (not just "success fees") is prohibited by Section 201 (c), "as a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration." According to the SEC, Section 201 (c) only protects investors whose only benefit is that their shares in the issuer may appreciate in value.
The SEC's views about Section 201 (c) are expressed in the following FAQs:
QUESTION 4: Section 4(b)(1)(A) allows a person to “maintain a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitation, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through other means.” Would an Internet website or social media qualify as a “platform or mechanism”?
ANSWER 4: Yes. We believe that Congress specifically intended to capture social media and Internet websites when it enacted Section 4(b)(1)(A).
QUESTION 5: The exemption in Securities Act Section 4(b) is not available to anyone who receives (or whose associated persons receive) “compensation in connection with the purchase or sale of such security.” What forms of compensation would cause me to be unable to rely on the exemption?
ANSWER 5: Congress conditioned the exemption on a person and its associated persons not receiving any “compensation” in connection with the purchase or sale of such security. Congress did not limit the condition to transaction-based compensation. The staff interprets the term “compensation” broadly, to include any direct or indirect economic benefit to the person or any of its associated persons. At the same time, we recognize that Congress expressly permitted co-investment in the securities offered on the platform or mechanism. We do not believe that profits associated with these investments would be impermissible compensation for purposes of Securities Act Section 4(b).
QUESTION 6: May an entity, such as a venture capital fund or its adviser, operate an Internet website where it lists offerings of securities by potential portfolio companies (in compliance with Rule 506), co-invest in those securities with other investors, and provide standardized documents for use by issuers and investors, rely on Securities Act Section 4(b) to not register as a broker-dealer?
ANSWER 6: Yes. These activities are permitted under Section 4(b), subject to the conditions set forth in Section 4(b)(2), including the prohibition on receiving compensation in connection with the purchase or sale of securities. As a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.
QUESTION 7: Could an associated person of an issuer of Rule 506 securities rely on the exemption under Section 4(b) to maintain a “platform or mechanism” for the issuer’s securities?
ANSWER 7: Yes. Assuming the associated person otherwise qualifies for the exemption, including the condition prohibiting the receipt of any compensation in connection with the purchase or sale of securities, Section 4(b) does not limit the types of persons who are permitted to maintain a platform or mechanism.
QUESTION 8: In some instances, a complex of privately offered funds may have an internal marketing department or use the investor relations department of an affiliated adviser or other entity whose staff is paid a salary to promote, offer, and sell shares of the privately offered funds. Can these persons rely on the exemption from broker-dealer registration in Section 4(b) if the funds are offered and sold pursuant to Rule 506?
QUESTION 9: No. Any salary paid to a person for engaging in these activities is compensation to that person in connection with the purchase or sale of securities. As a result, that person would not be able to rely on the exemption from registration as a broker-dealer provided in Section 4(b).
The Commission has previously noted that persons who market interests in a private fund may be subject to the registration requirements of Section 15(a)(1) under the Exchange Act.2
The SEC's FAQs clearly states the SEC's position that no one can rely on the exemptions from registration afforded by Section 201 (c) of the JOBS Act if the receive any payment for their services.
By is that really what Section 201 (c) of the JOBS Act means?
The courts have not yet decided how to apply Section 201 (c)'s exemption from broker and dealer registration requirements.
Rule 506 Offerings Usually Carry Fewer Restrictions
The first step in trying to predict how courts will interpret Section 201 (c) of the JOBS Act is to focus on the fact that Section 201 (c) of the JOBS Act applies only to Rule services provided ot companies that are engaged in Rule 506 private placement offerings.
Since for decades over 90% of private placements have used Rule 506, Section 201 (c) places limits on how the SEC's views about broker and dealer registration requirements apply to most private placement offerings.
The JOBS Act created both crowdfunding (Title 3 of the JOBS Act) and new Rule 506 (c), (Title 2 of the JOBS Act) which permits issuers to advertise and conduct a general solicitation to find investors in private placements, if they only sell to accredited investors and they take reasonable steps to verify that all the investors are accredited.
Since Rule 506 (c) offerings can only include investors who are both "sophisticated" and accredited" and requires verification of accredited investor status, one would expect that the rules related to who can provide services that assist issuers and investors in Rule 506 (c) offerings would be more flexible and less onerous than for people who provide services in Title 3 crowdfunding offerings.
That is true for issuers under the Securities Act. Issuers have much greater flexibility in Rule 506 offerings than in crowdfunding offerings. But the SEC's interpretation of Section 201 (c) of the JOBS Act imposes stricter registration rules under the Exchange Act by requiring full broker registration for Title 2 platform operators under Section 15 (a) (1) of the Exchange Act and less stringent registration under Title 3 of the JOBS Act crowdfunding portal operators.
This puts the SEC in the strange position of arguing that the JOBS Act:
- Requires greater regulation of people who provide services to businesses that are trying to raise capital from sophisticated accredited investors.
- Less regulation of people who provide services to businesses that are trying to raise capital from unsophisticated unaccredited investors.
Does that make sense?
Why would Congress decide to reverse several decades of public policy that there should be less regulation of offerings to sophisticated accredited investors?
The SEC's Exchange Act broker registration views work against implementing the Securities Act reforms Congress tried to achieve in the JOBS Act.
Permitting issuers to advertise and conduct general solicitations will not help issuers that large registered brokers traditionally ignore, if large registered brokers continue to focus on bigger deals for bigger businesses. Individual issuers that might conduct one offering or several offerings over a two-year period are not likely to invest in the technology and advertising. Someone needs to invest in the technology and pay to attract investors on a regular basis to showcase issuers to create an efficient market.
Therefore, Section 201 (c) of the JOBS Act also created an exemption from the requirement to register as a broker or a dealer under Section 15 (a) (1) of the Securities Exchange Act of 1934 to expand the nature of services that non-registered people can provide to help businesses raise capital.
Goal of Promoting Technolgy Use to Raise Capital
The SEC's interpretation of Section 506 (c) would have us believe that Congress both wanted to achieve two conflicting goals:
· Promote the use of technology in Rule 506 offerings.
· Prohibit all payments to anyone (other than a registered broker) who provides this technology.
But people have always been allowed to provide free technology and free services to others without registering as a broker. Even the SECs very broad interpretation of "being in the business" did not include free services. This raises the question: Why would Congress create an exemption for free services when no one thought free services required you to register?
The SEC would probably answer that question by saying that Congress was trying to protect people who co-invest. But professional venture capital firms have been organizing investment syndicates for decades. No one ever prosecuted a venture capital firm for failing to register as a broker. Why would Congress be concerned about that now?
A basic principle of business is that you get what you pay for.
If people cannot collect a fee from someone, they are not likely to provide the product or service – or they will provide an inferior product or service.
Even Congress knows this basic fact of life.
Where would this leave the progress of technology in capital raising?
Five Possible Justifications for SEC's No Fees Policy
Let's analyze five possible explanations for justifying a no fees policy, none of which are consistent with Congressional purposes.
- The SEC's interpretation is that only venture capital funds (and registered brokers) can operate technology platforms to raise money for their portfolio companies. But the venture capital industry has been shrinking for over a decade. And most of the remaining venture capital funds prefer to invest in later stage companies. Would it make sense for Congress to try to limit the use of technology platforms to companies that had already raised venture capital and leave young cash starved companies out in the cold? I think not. That's why the SEC's restrictive interpretation of Section 201 (c) does not make sense.
- Each young business that is not already backed by a venture capital fund will be required to build its own technology platform to market their offerings and spend additional money to drive traffic to their platform. How efficient is that – each young company being forced to duplicate the efforts of others? And where would young companies get the money to do this? Requiring a build your own platform approach just makes no economic sense. Why would Congress impose greater transaction expenses on companies that are not backed by venture capital funds? Wouldn't such companies have less money to spend than businesses that have raised venture capital? Did Congress intend to give venture capital backed businesses an advantage over other businssses?
fees would mean that the law requires people to invest in building and
operating technology platforms and in driving investor traffic to these
platforms without a return on their investment of time, effort and
money. Wouldn't it be nice of
someone did all that for free? But
does it really make sense to require young companies raising capital to
depend on the kindness of strangers?
Remember that the JOBS Act was enacted to create JOBS. Is that a reasonable economic
- All capital raising on technology platforms should be reserved for crowdfunding offerings that includes investors who are not accredited. The accredited investor market that dominates Rule 506 offering would not use technology platforms. Given the controversy about crowdfunding and protecting small investors, it is difficult to believe that Congress (or the SEC for that matter) thinks technology platforms should be limited to crowdfunding for any investor of any economic means or level of sophistication. Why would accredited sophisticated investors need greater protection than everyone else?
- Congress wanted registered Wall Street brokers to retain a monopoly on raising money using technology platforms even though when the JOBS Act passed most of the country was upset with Wall Street and Wall Street had essentially abandoned capital raising for young businesses to hunt for bigger profits in worldwide securities markets. Did Congress really want to protect Wall Street's monopoly? This interpretation makes no sense, because registered brokers do not need the exemption from registration that Section 201 (c) provides. Registered brokers have always been legally permitted to use technology platforms.
Alternative Interpretation of Section 201 (c)
For these reasons we believe the most reasonable interpretation of Section 201 (c) is that:
· Technology platform providers do not lose the protection of Section 201 (c) merely because the technology platform provider charges a reasonable fee for its services.
· People other than venture capital investors are free to operate technology platforms without registering as brokers, if they carefully tailor their services and types of compensation to the requirements of Section 201 (c), which although broader than what the SEC states still do not permit unregistered platform operators to do everything a registered broker is permitted to do.
Now, let's explore the primary reasons why the SEC wants to limit who can use the exemption from registration as a broker afforded by Section201 (c) of the JOBS's Act.
Competition Between Rule 506 Platforms and Crowdfunding Platforms
One explanation for the SEC's position about operators of technology platforms in Rule 506 offerings is that the SEC thinks the same rules that apply to crowdfunding platforms should apply to Rule 506 platforms.
In footnote 519 on page 201 of the SEC's Crowdfunding rules proposal release (No. 33-9470 and 34-7041 dated October 23, 2013), the SEC indicates that except as required by the statute, it believes the same rules should apply to technology platforms under Rule 506 (c) as crowdfunding platforms:
"See NSBA Letter; RocketHub Letter 1. See also Applied Dynamite Letter (stating that the requirements for those who wish to be intermediaries in offerings pursuant to Rule 506 of Regulation D should be harmonized with those for funding portals, and that we should provide for a common registration process for the two). We note, however, that Securities Act Section 4(b)(1) provides an exemption from broker-dealer registration for certain portals facilitating transactions pursuant to Rule 506 of Regulation D, as revised by Section 201 of the JOBS Act."In footnote 519 of its Crowdfunding rules release quoted above, the SEC is indicating that if you fall outside the protection of Section 201 (c) of the JOBS Act, you should be required to register to operate a technology platform. By trying to limit the scope of the exemption from registration as a broker afforded by Section 201 (c) of the JOBS Act, the SEC is trying to expand the number of platforms that will be registered similar to the way crowdfunding platforms will be registered.
Also, as we explain in article (5) of this series of articles, the SEC believes that if a platform operator highlights one offering over another offering or indicates the platform operator has performed due diligence or has selected some issuers over others for quality reasons, the platform operator is making a "recommendation" or is providing "investment advice." The SEC believes such operators should be registered as brokers under Section 15 (a) (1) of the Securities Exchange Act of 1934, whether the offering is conducted under Rule 506 or under the crowdfunding rules.
The SEC's approach that the same rules should apply to Rule 506 offering platforms as to crowdfunding platforms has the appeal of offering balance. From a technology point of view, the two types of platforms will be very similar. The platforms will also probably market themselves to issuers and investors in similar ways.
As we discuss in article (5) of this series of articles, technology platforms that operate under the very restrictive crowdfunding rules will be at a very big disadvantage when competing with technology platforms that conduct Rule 506 offerings, because of the tight rules that apply to crowdfunding platforms and not to Rule 506 platform operators, which include:
· Restrictions on platform operators doing due diligence to screen issuers on crowdfunding platforms.
· Rules that require equal presentation for all issuers on crowdfunding platforms.
· Restrictions on what issuers can do off-platform to drive investors to their offering on crowdfunding platforms.
· Financial statement requirements for issuers on crowdfunding platforms.
· Ongoing requirements to file reports with the SEC after a crowdfunding offering.
All these crowdfunding platform offering restrictions make Rule 506 platforms a better choice for both most issuers, most investors and platform operators than crowdfunding platforms. When crowdfunding platforms start operating, these disadvantages will become self-evident to most people. When that occurs, there will be increased pressure to relax the crowdfunding rules to let crowdfunding platforms operate like Rule 506 platforms.When the SEC indicates that the SEC wants to harmonize the rules for both crowdfunding platforms and Rule 506 platforms, the SEC means it wants to increase the restrictions on Rule 506 platforms, not decrease restrictions on crowdfunding platforms.
This explains the SEC's motive.The only impediment to the SEC achieving its goals is that Congress created two different sets of rules.
And there was good reason for having two sets of rules. Rule 506 platforms will serve investors who are both "accredited" and "sophisticated," while crowdfunding is open to all investors. Rule 506 has always offered much greater flexibility in offerings that are limited to "accredited investors."So, the SEC has embarked on a campaign to limit the number of Rule 506 platforms that are not operated by registered broker-dealers by saying that use of Section 201 (c) is limited to venture capital funds and delaying the effectiveness of crowdfunding rules.
Effects of Section 201 (c) of JOBS Act on Traditional Finders
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.
Therefore, if you combine Section 201 (c) with the court cases described in article (3) of this series of articles that hold that being paid for making introductions does not require you to register as a broker, then the area of exempt activity includes all finders who are paid to make introductions and who co-invest, provide due diligence services and provide standard forms to help close transactions. That would be a powerful exemption for all finders, not just technology platform operators
This explains why the SEC is taking pre-emptive action to discourage people from relying on Section 201 (c) by issuing statements that claim Section 201 (c) can only be used by venture capital investors. But Section 201 (c) is self-executing. It became effective the day the JOBS Act became law. It does not require SEC rules to implement this exemption like crowdfunding requires. Section 201 (c) of the JOBS Act means what the courts say it means.
Because Section 201 (c) is the biggest change to occur in broker registration requirements for at least several decades we will devote several articles in this articles to putting Section 201 (c) in context and understanding the reasons why courts may disagree with the SEC's views about who can use this exemption.
We'll discuss in article (5) what a "platform or mechanism" means and compare new types of "platforms and mechanisms" to older types of platforms and mechanisms that have been used to offer securities like radio, television and telephones. When considered in that context, it will become apparent that reasonable charges for listing on platforms, due diligence and standard documents do to disqualify anyone from the exemption afforded by Section 201 (c) of the JOBS Act.
In article (6) of this series of articles, we'll analyze how prior private placement offering practices and prior court cases should affect how we interpret the exemptions afforded by Section 201 (c) of the JOBS Act to be much broader than the SEC indicates in its statements about Section 201 (c). We'll also expand the discussion to how Section 201 (c) of the JOBS Act applies to traditional finders who do not operate technology platforms or mechanisms.
If you would like to learn more, 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 at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at