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 purchase my books http://www.amazon.com/Jim-Verdonik/e/B0040GUBRWor 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) 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 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.
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.
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.
·
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?
- Prohibiting
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
development policy?
- 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.
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
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.
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.
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
http://www.bizjournals.com/triangle/search/results/_author/Jim+Verdonik?q=%22Jim+Verdonik%22&title=
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