Equity crowdfunding platforms, or “funding portals” as defined in the Jumpstart Our Business Startups Act (JOBS Act), may soon find themselves subject to the same anti-money laundering (AML) requirements applicable to broker-dealers, including reporting, recordkeeping, record retention, and establishment of an AML program. On April 4, 2016, the Financial Crimes Enforcement Network (FinCEN) published in the Federal Register a notice of proposed rulemaking to expand the definitions of “broker or dealer in securities” and “broker-dealer” under the regulations implementing the Bank Secrecy Act, specifically 31 C.F.R. Parts 1010 and 1023, to include such funding portals (the Proposal). FinCEN intends for the Proposal to help prevent money laundering, terrorist financing, and other financial crimes that may be facilitated through funding portals.
The Proposal is issued just months after the Securities and Exchange Commission (SEC) voted to adopt final rules, Regulation Crowdfunding, implementing portions of the JOBS Act that permit equity crowdfunding, or the ability for small, start-up businesses to raise money through a high volume of small-dollar investments in exchange for a share in the company’s profits. This equity alternative is distinct from existing crowdfunding mediums, such as Kickstarter or Indiegogo, which may provide a t-shirt or other token exchange, but are not allowed to provide the donor with an equity stake.
The timing of the Proposal, which comes during the relative infancy of equity crowdfunding platforms, is not unusual for FinCEN. In 2001, when FinCEN first proposed AML rules for broker-dealers requiring them to report suspicious activities, FinCEN reasoned that “there may be reason to fear a potential increased use of broker-dealers for laundering purposes in the wake of the growth of the broker-dealer industry and as criminals develop new ways to launder money.” In the preamble to the Proposal, FinCEN appears to be returning to that rationale for funding portals, noting that “[c]rowdfunding is a new and evolving method to raise money using the Internet….” Moreover, as discussed below, registration of funding portals opened on January 29, and registered funding portals may begin facilitating crowdfunding transactions on May 16, the effective date of Regulation Crowdfunding.
Background of Crowdfunding and Registration of Funding Portals
Regulation Crowdfunding was adopted by the SEC on October 30, 2015 and allows issuers to engage in securities-based crowdfunding through the Internet without having to register the securities with the SEC or state securities regulators. Subject to certain limitations, Regulation Crowdfunding allows an issuer to raise up to US$1 million in any 12-month period with the investors retaining an equity interest in the issuer. Such issuer must use an intermediary, which the SEC requires to register as a broker-dealer or a funding portal. A funding portal intermediary acts as an Internet-based platform that facilitates transactions between investors and an issuer.
To ease the compliance burden for start-up companies, the JOBS Act added a new section 3(h) to the Securities Exchange Act of 1934, which exempts a registered funding portal from the requirement to register with the SEC as a broker or dealer. As of January 29, 2016, the effective date for funding portal registration requirements under Regulation Crowdfunding, persons or companies operating as a funding portal must register with the SEC on Form Funding Portal and apply to FINRA to become a funding portal member. On May 16, 2016, registered, FINRA-member funding portals may begin facilitating the offering and selling of securities.
As discussed below, registered broker-dealers are required to meet certain AML requirements. By exempting funding portals from registering as a broker or dealer, the SEC, at least temporarily, exempted funding portals from the AML requirements applicable to broker-dealers. Thus, although the JOBS Act exemption would have allowed registered funding portals to avoid the AML requirements applicable to broker-dealer intermediaries, FinCEN’s Proposal seeks to bring funding portals back within the ambit of the regulation.
Who Would be Covered?
Crowdfunding may be broadly defined as the use of the Internet to raise money through small contributions from a large number of investors, but FinCEN’s Proposal is not intended to address all crowdfunding participants. FinCEN stated that the Proposal is meant to address only instances in which crowdfunding involves facilitating an offer or sale of securities to raise money for a business under section 4(a)(6) of the Securities Act of 1933 (Securities Act). Accordingly, the definitions of “broker or dealer in securities” under 31 C.F.R. Part 1010 and “broker-dealer” under 31 C.F.R. Part 1023 would be revised to include any person registered or required to be registered under section 4(a)(6).
Under the JOBS Act, a funding portal means “any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(a)(6) of the Securities Act that does not: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (iv) hold, manage, possess, or otherwise handle investor funds or securities; or (v) engage in such other activities as the SEC, by rule, determines appropriate.”
What Does the Proposal Mean for Covered Funding Portals?
If the Proposal is adopted by FinCEN in its current form, it would require funding portals to meet the AML requirements as described in 31 C.F.R. Part 1023, which involves a significant devotion of time and resources. First, the funding portal would be required to establish an AML program that includes, at minimum, the development of internal policies, procedures and controls, the designation of a compliance officer, an ongoing employee training program, and an independent audit function to test programs. Funding portals would also be required to establish a written customer identification program, report suspicious transactions and currency transactions exceeding US$10,000, collect and retain information on certain funds transfers and transmittals of funds, and comply with special information sharing procedures and standards.
Significantly, despite not registering as a broker or dealer, intermediaries that opt to register as a funding portal would become subject to examination and enforcement by the same authorities as broker-dealers: the SEC, FINRA, and FinCEN. Although the SEC and FINRA have historically taken the lead on enforcement matters against broker-dealers, it remains to be seen what posture each of the three agencies will take with respect to funding portals.
Comments and Considerations
The Proposal states that FinCEN is specifically interested in receiving comments addressing the following two issues:
- Is the application of all Bank Secrecy Act (BSA) regulations currently covering brokers or dealers in securities to funding portals appropriate?
- Are there exceptions to the regulations that should be granted to funding portals? If so, why would any such exceptions be appropriate?
Due to the unique role funding portals will play in the marketplace, serious consideration should be given to these questions. In some respects, valid arguments exist supporting the concept that low-priced and privately-placed securities pose a money laundering risk because they are susceptible to fraud and market manipulation. As stated in the Proposal, funding portals may be utilized as an entry point to the US financial system and “unlawfully acquired assets can be used to purchase these securities in order to resell them and create the appearance of legitimately sourced funds.”
However, important distinctions exist between the complexity of funding portals and broker-dealers, which the JOBS Act identified, and those distinctions may support AML rules and requirements for funding portals less burdensome than those applicable to broker-dealers. Indeed, just as financial institutions are required to implement AML programs appropriate for their composition and activities, the BSA also requires that FinCEN consider the extent to which the AML requirements imposed are commensurate with the size, location, and activities of the financial institutions to which such regulations apply.
Comments on the Proposal must be submitted to FinCEN by June 3, 2016.