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 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.
OR
·
Co-invests in offerings.
OR
·
Provides ancillary services.
OR
·
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.
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