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 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 article (1) in this series of
articles, we discussed the public policy reasons securities law reforms should
create more competition among deal makers by letting smaller deal makers
compete with Wall Street – especially in deals by smaller companies which are
not economically attractive for big investment banks.
In articles (2) and (3) of this series of
articles, we discussed how the SEC broadly interprets the broker registration
requirements of Section 15 (a) (1) of the Securities Exchange Act of 1934 to
require virtually everyone who accepts a fee for introducing people who need
capital to investors.
In articles (4), (5) and (6) of this
series of articles, we discussed Section 201 (c) of the JOBS ACT, which created
new exemptions from registration requirements for brokers and dealers and the
SEC's attempts to limit the applicability of this new exemption.
Now, let's talk about the SEC's proposed
Crowdfuding rules from the perspective of the people who operate crowdfunding portals.
Technology
+ Deal Making = Crowdfunding
The SEC's proposed crowdfunding rules
merge technology with deal making in a more structured way than is required for
Rule 506 (c) offerings, which also permits you to use technology portals to
raise capital. Crowdfunding has more
restrictive rules for what dealmakers can do than Rule 506 (c) has. In return, crowdfunding allows you to conduct
a general solicitation on the crowdfunding portal and sell securities to people
who are not accredited investors. Every
aspect of the transaction is conducted on the crowdfunding portal.
Under the SEC's proposed crowdfunding
rules, people who operate crowdfunding portals will do short-form registrations
with the SEC and FINRA that does not subject them to all the rules
broker-dealers and investment advisers are required to follow. These limited registrations do not permit you to:
- Charge a
success fee based on a percentage of the money raised through the funding
portal.
- Accept equity
compensation for services.
- Raise
money for businesses in which the funding portal operator owns an
interest.
- Provide
"investment advice" or "recommendations" to investors.
- Actively
soliciting purchases, sales or offers to buy securities offered or displayed
on the funding portal beyond listing the offering and executing the
transaction through the portal.
- Hold money or securities (a third party depository must handle all transaction payments).
Proposed
Rule 402 states:
"(a) General. Under
Section 3(a)(80) of the Exchange Act (15 U.S.C. 78c(a)(80)), a funding portal
acting as an intermediary in a transaction involving the offer or sale of
securities in reliance on Section 4(a)(6) of the Securities Act (15 U.S.C.
77d(a)(6)) may not: offer investment advice or recommendations; solicit
purchases, sales, or offers to buy the securities offered or displayed on its portal
or portal; compensate employees, agents, or other persons for such solicitation
or based on the sale of securities displayed or referenced on its portal or
portal; hold, manage, possess, or otherwise handle investor funds or
securities; or engage in such other activities as the Commission, by rule,
determines appropriate."
Given the SEC's broad interpretation of what constitutes
making recommendations and providing investment advice and soliciting, Rule 402
(b) offers a safe harbor for certain permitted activities.
Permitted activities under proposed Rule 402 (b) include
applying objective criteria for:
- Accepting or rejecting
issuers.
- Highlighting offerings.
- Providing investors with search tools.
Generally the criteria a funding portal operator uses must
be disclosed to investors, be designed to result in a broad selection of
issuers and be consistently applied, but operators cannot deny access based on
the advisability of investing in the issuer, except to avoid fraud.
Portal operators must provide
communications channels for investors and issuers, but operators cannot make
comments about any issuer or offering.
The thrust of these crowdfunding rules is
that the issuers are doing the selling.
Operators of crowdfunding portals are merely providing the technology portal
that facilitates sales activities by the issuer. And issuers cannot actively promote their
offering outside the funding portal.
Of course, funding portal operators are
allowed to promote their portal to attract both investors and issuers to the
portal. Promoting the funding portal to
attract investors indirectly helps issuers to sell through the portal. But portal operators must be careful about
compensating for promotion. Proposed
Rule 305 states:
(a) Prohibition
on Payments for Personally Identifiable Information. An intermediary may
not compensate any person for providing the intermediary with the personally
identifiable information of any investor or potential investor in securities
offered and sold in reliance on Section 4(a)(6) of the Securities Act (15
U.S.C. 77d(a)(6)).
(b) Certain
permitted payments. Subject to paragraph (a) of this section, an
intermediary may compensate a person for directing issuers or potential
investors to the intermediary’s portal, provided that unless the
compensation is made to a registered broker or dealer, the compensation is not
based, directly or indirectly, on the purchase or sale of a security offered in
reliance on Section 4(a)(6) of the Securities Act (15 U.S.C. 77d(a)(6)) on or
through the intermediary’s portal.
(c) For
purposes of this rule, personally identifiable information means information
that can be used to distinguish or trace an individual’s identity, either alone
or when combined with other personal or identifying information that is linked
or linkable to a specific individual.
Although the issuer is doing the selling,
crowdfunding portal operators have a duty to investigate issuers and prevent
fraud.
Note that the technology portals that
Section 201 (c) of the JOBS Act permits for Rule 506 offerings are not subject
to any of these specific rules. General
fraud rules apply and unregistered Rule 506 (c) portal operators are prohibited
from receiving "compensation in connection with the purchase or sale of
securities" or for separate compensation providing services that include "investment
advice" or "recommendations."
Therefore, the primary difference between
Rule 506 portal operators and registered crowdfunding portal operators are that
Rule 506 portal operators have greater freedom in what they do and how they do
it, but are at greater risk because the SEC may determine they crossed a line regarding
compensation or services that requires registration.
Permitted
Crowdfunding Portal Fees
If "crowdfunding portal
operators" can't provide "investment advice" or make
"recommendations" to buy securities, how will crowdfunding portals
work?
What can operators do to make money?
Crowdfunding portal operators are
permitted to:
·
Charge fees for
permitting people to sell securities through their portal.
·
Charge fees for
"ancillary services."
The ancillary services the SEC permits
crowdfunding operators to provide are broader than the definition of ancillary
services permitted by Section 201 (c) of the JOBS Act, which we discussed at
length in Part (3) of this series of articles – due diligence and providing
standard forms. On crowdfunding portals,
ancillary services can include:
·
Advice about offering
content.
·
Advice about deal
structure.
·
Helping the issuer
prepare its offering documents.
The proposed crowdfunding rules do not
specify the amount or timing or nature of fees other than to prohibit success
fees. Therefore, the market will
probably set the fees for these services.
Crowdfunding portal operators also cannot
use their portal to raise money for businesses in which they or their
affiliates own any interest, unlike Section 201 (c) of the JOBS Act that covers
Rule 506 offerings, which permits co-investment by unregistered deal
makers. This restriction on ownership
and co-investment eliminates the ability to use equity interests to create an
indirect success fee from the appreciation in value the deal creates.
Success
Fee Prohibition Means High Volume is Required for Crowdfunding Portals
The prohibitions on crowdfunding portal
operators charging success fees and raising capital for affiliated companies
mean that crowdfunding portals will probably have to attract many issuers to be
profitable. Small companies that raise
money are usually reluctant to pay large fixed fees. They often can't afford to pay much unless
they raise money. This fact of life in
the small issuer marketplace sets practical limits on how much crowdfunding portal
operators are likely to be able charge for each offering their portal
hosts. The $1 million annual limit on
how much issuers can raise also imposes practical limits on how much each
issuer will be willing to pay.
It's something like buying a lottery
ticket for a $1 Millon prize. How
much would you pay to try to raise $1 Million with no guaranty of success
and an absolute obligation to pay even if you raise no money?
These practical limitations on how much
money crowdfunding operators can make from any single issuer mean that
crowdfunding portals will probably have to attract a high volume of issuers to
be profitable.
Rules
Limit the Value Crowdfunding Portal Operators Can Add to Offerings
The high volume of deals required to make
crowdfunding portals profitable means that crowdfunding portals will probably
eventually become as crowded as the old classified advertisements in
newspapers.
Overcrowding is likely to make it
difficult for investors to find the diamonds in the rough.
There will likely be a lot of rough to
sort through.
Other provisions of the SEC's proposed
rules prohibit crowdfunding portals operators from doing other things to help
investors, such as:
·
Making recommendations
to investors.
·
Categorizing companies
selling securities by risk or size.
·
Telling investors they
screen deals for quality.
The SEC views all these activities as
providing "investment advice," or "recommendations," which
the portal operator will not be licensed to provide. Deal makers who do not operate crowdfunding portals
should keep in mind the SEC's views about what may constitute "investment
advice" or a "recommendation" to investors when they determine
whether their activity may require them to register as a broker-dealer.
Objective
Criteria
Crowdfunding portal operators are only
allowed to classify issuers offering securities based on what the SEC calls
"objective criteria," which would not be interpreted by investors as
offering investment advice. Objective
criteria include:
·
Industry,
·
Geographic location,
and
·
Types of securities offered.
Portal operators can also use objective
criteria to highlight the offering size and the progress the deal is making
with securing investor commitments. For
example, portal operators will be permitted to highlight offerings that achieve
30% of their investment goals (or 70% or 90% or any percentage). Knowing whether an offering is attracting
other investors is an important sales tool.
I note that crowdfunding portals that sell products and services often
use the 30% number as a screen to avoid overcrowding by eliminating offerings
that fail to achieve 30% of their goal within a fixed time period.
Portal operators cannot charge either
issuers or investors for highlighting an offering using these objective
criteria.
Companies that sell through crowdfunding portals
can't sell their deals outside the crowdfunding portal. Issuers are limited to issuing bland
communications that only identify the issuer and the crowdfunding portal the
issuer is using.
The SEC's proposed rules clearly try to
level the playing field among issuers, but in doing so they make it more
difficult for investors to find the deals they like. Most the companies will look very similar in
the crowdfunding portal's index of offerings until you dig deeper into the
issuer's offering materials. Looking at
a full screen of listings can cause the listings to blur together.
This often happens if you look at online
real estate listings. But real estate
listings are allowed to provide search tools that let users narrow their
searches by using criteria that real estate buyers consider most important to
their discussions, such as price, location, number of bedrooms etc.
Search tools for crowdfunding portal
cannot be based on useful criteria like:
·
Does the company have
revenue?
·
Is the company
profitable?
·
Has the management team
done a successful start-up before?
·
How much money has the
company raised before?
·
Does the company have
patent protection?
Crowdfunding portals that can provide only
limited generic search tools will be less valuable to investors. To answer the questions they care about,
investors will have to spend the time sorting through lengthy descriptions in
numerous offerings.
Is this limitation on search tools really
in the interests of investors?
Or is the SEC simply trying to discourage
investors from using crowdfunding portals?
These are legitimate questions, because of
the SEC's long delay in implementing crowdfunding rules. Four years of waiting for the SEC to approve
rules is primarily the result of the SEC's basic hi-hostility to the concept of
crowdfunding.
Opportunity
for Deal Makers
By limiting the amount of value that
crowdfunding portal operators can add to offerings with strict rules about how
crowdfunding portals can operate, the SEC's regulatory rules create a market
opportunity for other deal makers to compete with crowdfunding portals by
offering useful services to both investors and companies raising capital.
This is another reason why many deal
makers will choose to conduct offerings under Rule 506 (c), which permits deal
makers to utilize the best combination of:
- In
person sales efforts.
- Traditional
advertising.
- Internet and Social Media communications.
Deal makers will, however, have to be
careful to avoid making "recommendations" or providing
"investment advice," if they are not registered as broker-dealers,
keeping in mind the SEC's broad views (expressed in its Crowdfunding Release)
about what types of statements and technology features may constitute a
"recommendation" or "investment advice."
or read my newspaper
articles at
550196-01011
ND: 4841-0336-9243, v. 1
ND: 4841-0336-9243, v. 1
No comments:
Post a Comment