The Securities and Exchange Commission issued final rules to implement the equity crowdfunding provisions under the JOBS Act on October 30, 2015, termed Regulation Crowdfunding.  This post analyzes the rules and requirements under Regulation Crowdfunding that apply to the intermediaries that facilitate the offerings.

Intermediaries and Requirements

Section 4(a)(6)(C) of the Securities Act requires that a crowdfunded offering must be conducted through a registered broker-dealer or funding portal registered with the SEC pursuant to Section 4A(a)(1) of the Securities Act and Rule 400 of Regulation Crowdfunding (each an “intermediary”). A crowdfunding intermediary must also be a member of a national securities association that is registered with the SEC under Section 15A of the Exchange Act – currently the only such association in existence is FINRA. Regulation Crowdfunding does not impose any licensing, testing, or qualification requirements with respect to associated persons of funding portals, instead relying on FINRA or another registered national securities association to provide for such requirements if it deems them necessary.

Restriction on Financial Interests

Section 4A(a)(11) of the Securities Act requires intermediaries to prohibit their directors, officers, partners, or persons occupying similar roles from having any “financial interest” (basically an equity interest) in an issuer, and Rule 300(b) implements this prohibition. Although the proposed rules prohibited intermediaries from having any financial interest in an issuer, as well, final Rule 300(b) allows an intermediary to receive a financial interest in an issuer using its services provided that: (i) the financial interest is received as compensation for services in connection with the crowdfunded offering on the intermediary’s platform, and (ii) the financial interest consists only of the same securities offered to investors in the offering.  Note that if an intermediary will receive a financial interest as compensation for its services, the intermediary will need to disclose this arrangement to investors at the time of account opening under Rule 302(d) and upon confirmations of investments under Rule 303(f).

Measures to Reduce the Risk of Fraud

Regulation Crowdfunding requires intermediaries to take certain steps to reduce the risk of fraud. A number of these measures require the intermediary to have a “reasonable basis” for believing certain information.  In this context, having a reasonable basis does not require any particular prescribed level of due diligence by the intermediary, and the intermediary is permitted to “reasonably rely” on the representations of an issuer or an investor, provided that the intermediary does not have knowledge to the contrary or knowledge of facts and circumstances that would cause a reasonable person to doubt the credibility of the representations.

An intermediary must have a reasonable basis to believe that a crowdfunding issuer is in compliance with Section 4(a)(6) of the Securities Act and Regulation Crowdfunding. An intermediary has a responsibility to assess whether it can reasonably rely on the representations, and should consider, for example, whether the representation given by the issuer is detailed enough to indicate that the issuer is aware of its obligations.

An intermediary must have a reasonable basis to believe that the issuer has established a system for keeping accurate records relating to the holders of securities offered through the intermediary. In a change from the proposed rule, the intermediary will be deemed to have satisfied its “reasonable basis” belief obligation if the issuer engages the services of a transfer agent registered under Section 17A of the Exchange Act.

An intermediary is required to deny access to its platform if it has a reasonable basis to believe that an issuer or any officer, director, or 20% owner is subject to a disqualification under Rule 503 of Regulation Crowdfunding (the bad actor disqualifications). In addition, an intermediary is require to conduct background and securities enforcement regulatory history checks on each issuer and its officers, directors, and 20% owners.

An intermediary must deny access to an issuer when the intermediary (i) has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or raises other investor protection concerns, (ii) reasonably believes it is unable to adequately or effectively assess the risk of fraud of the issuer or the offering, or (iii) becomes aware (after the issuer has already been granted access to the platform) of information that causes the intermediary to reasonably believe the issuer or the offering presents the potential for fraud or raises other investor protection concerns.

An intermediary does not need to make public or report the fact that it has denied access to an issuer.

Account Opening and Educational Materials

An investor seeking to purchase securities through an intermediary must comply with the intermediary’s account opening procedures and agrees to accept electronic delivery of documents and communications with the intermediary. At the time of account opening, the intermediary is required to inform investors that any person who uses the intermediary’s platform to promote an offering and either does so for past or prospective compensation, or is a founder or employee of the issuer, must clearly disclose such compensation or relationship in all communications on the platform. The intermediary must also disclose, at the time of account opening, the manner in which the intermediary will be compensated in connection with offerings on its platform.

An intermediary is required to provide investors with certain educational material regarding its platform and crowdfunded equity offerings in general. As long as the educational materials meet minimum standards prescribed by the SEC and are in plain language, the intermediary has discretion over the form, content, and presentation of the educational materials.  The educational materials must be accurate, requiring periodic update by the intermediary.  When a material update is made to the educational materials, the intermediary may not accept any further investment commitments until the revised materials have been distributed to all investors. An intermediary is required to obtain a representation from each investor that the investor has reviewed the most recent version of the educational materials. The minimum content requirements for the educational materials are:

  • the process for the offer, purchase and issuance of securities through the intermediary;
  • the risks associated with investing in securities offered and sold in reliance on Section 4(a)(6);
  • the types of securities that may be offered on the intermediary’s platform and the risks associated with each type of security, including the risk of having limited voting power as a result of dilution;
  • the restrictions on the resale of securities offered and sold in reliance on Section 4(a)(6);
  • the types of information that an issuer is required to provide in annual reports, the frequency of the delivery of that information, and the possibility that the issuer’s obligation to file annual reports may terminate in the future;
  • the limitations on the amounts investors may invest, as set forth in Section 4(a)(6)(B);
  • the circumstances in which the issuer may cancel an investment commitment;
  • the limitations on an investor’s right to cancel an investment commitment;
  • the need for the investor to consider whether investing in a security offered and sold in reliance on Section 4(a)(6) is appropriate for him or her;
  • that following completion of an offering, there may or may not be any ongoing relationship between the issuer and intermediary; and
  • that in some cases an issuer may cease publishing annual reports and, as a result, the investor may not continually have current financial information about the issuer.

Transaction Requirements

Intermediaries have a number of obligations relating to issuer information, investor qualification, investor communication, funds management, and investor notices.

Issuer Information

Rule 303(a) of Regulation Crowdfunding requires an intermediary to publicly display on its website any information required to be provided by issuers under Rules 201 and 203(a) of Regulation Crowdfunding (a long list of information about the issuer and its insiders, and SEC Form C: Offering Statement). The information must be made available in a format that can be easily printed, downloaded, and saved, it must be available for at least 21 days prior to selling any securities in the offering, and it must remain available until the offering is completed or cancelled.

Investor Qualification

Intermediaries have responsibility for ensuring that investors do not exceed the maximum aggregate investment limitations for crowdfunded offerings in a 12 month period. Rule 303(b)(1) requires that, before accepting each investment commitment, the intermediary must have a reasonable basis to believe the investor has not exceeded the applicable limitations in Section 4(a)(6)(B) of the Securities Act.  The intermediary will be permitted to reasonably rely on investor representations as to annual income, net worth, and the amount of other crowdfunding investments in the last 12 months, as well as on information received from centralized data depository of crowdfunding investor information (in the event one is created in the future).

Acknowledgement of Risk

Rule 303(b)(2) requires an intermediary to obtain, before each investment commitment, a representation from the investor that the investor (i) has reviewed the educational materials described above, and (ii) understands that the entire investment may be lost and is in a financial condition to bear such loss. An intermediary is also required, prior to accepting each investment commitment, to obtain answers from the investor to questions demonstrating an understanding that there are limitations on the right to cancel the investment, that the securities are subject to restrictions on transfer, and that the investor should not invest in any crowdfunded offering unless the investor can afford the entire loss of the investment.  The form of the questionnaire and acknowledgement are within the discretion of the intermediary.

Communication Channels

Rule 303(c) requires intermediaries to provide communication channels to permit discussions among investors and between investors and the issuer about offerings on the platform. The discussion channel itself and all comments must be publicly available, but only those persons with an account with the intermediary can be permitted to post comments.  The intermediary must require that commenters disclose whether they are compensated promoters of the offering or founders or employees of the issuer in any comments.

Investor Communications and Notices

Rule 303(d) requires an intermediary to provide a notification (by email or other electronic media) to an investor after the investor’s investment commitment has been received. The notice must contain the dollar amount of the investment, the price of the securities, the name of the issuer, and the date and time by which the investor can cancel the investment commitment.

In connection with the completion of an investor’s purchase of securities through an intermediary’s platform the intermediary must provide the investor with a notice containing information about the purchase, such as the date, type of security, purchase price, specified terms of the security, number of securities sold by the issuer, and the source, form, and amount of compensation earned by the intermediary in connection with the transaction. An intermediary that is a registered broker-dealer is exempt from its obligations under Rule 10b-10 with respect to a transaction for which it complies with this required notification.

If an offering fails to close (for example, because an offering minimum was not achieved), an intermediary must, within five business days, provide investors with notification that the offering has terminated, direct the qualified third party holding investor funds to return those funds to the investors.

Maintenance and Transmission of Funds

The handling of investor funds by broker-dealers, including a broker-dealer acting as an intermediary in a crowdfunded offering, is governed by Exchange Act Rule 15c2-4. For funding portals, though, Regulation Crowdfunding establishes separate requirements in Rule 303(e)(2), which requires the funding portal to manage an escrow arrangement with a qualified third party (which includes banks, certain credit unions, and registered broker-dealers that hold funds for customer, broker, or dealer accounts) and to direct the disbursement of funds to the issuer only when (i) the offering target amount has been satisfied, (ii) the cancellation period for all investment commitments has expired, and (iii) at least 21 days have passed since the public posting of offering materials.

Investor Rescission Rights

Investors who have committed to purchase securities in a crowdfunded offering have the unconditional right to rescind that commitment until 48 hours prior to the announced offering closing date. If an issuer proposes to close an offering early (for example, because the target offering amount has been achieved early), all investors must be given at least five business days’ notice of the new offering closing date, and the rescission right will apply until 48 hours prior to the new offering closing date.

If there is a material change to the terms of an offering, all investors who have committed to purchase securities in the offering must be provided with a notification indicating the change and stating that, unless the investor re-affirms the intent to invest, the investment commitment will be deemed rescinded.

Payments to Third Parties

Under Rule 305(a), an intermediary cannot compensate any person for providing it with “personally identifiable information” of an investor. Personally identifiable information is broadly defined to include any 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.” In other words, an intermediary can’t pay for investor leads or referrals.  An intermediary can pay a fixed fee for the service of directing persons to the intermediary’s platform (such as through general advertising or hyperlinks).

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You can view our complete analysis of Regulation Crowdfunding here.