In this blog post I summarized the potential legal liability of issuers raising capital using Title II Crowdfunding (aka Rule 506(c)), Title III Crowdfunding (aka Reg CF), and Title IV Crowdfunding (aka Regulation A). Here, I’ll summarize the potential legal liability of a registered Title III funding portal.
To start, let’s distinguish between two kinds of liability: liability to the government (e.g., to the SEC) for breaking rules; and liability to private parties. Most people think about the first kind of liability but often the second is more important. The government doesn’t know about most violations of securities laws and even if it knows must pick and choose which cases to prosecute. Conversely, private parties – issuers and investors – are likely to know about actual or potential violations and there are plenty of plaintiffs’ lawyers willing to take a shot.
Section 4A(c) of the Securities Act
Section 4A(c) of the Securities Act of 1933 makes an “issuer” liable to an investor where:
- The issuer made an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading;
- The investor didn’t know of the untruth or omission; and
- The issuer cannot demonstrate that the issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.
The statute defines “issuer” to include:
- Any person who is a director or partner of the issuer;
- The principal executive officer, principal financial officer, and controller or principal accounting officer of the issuer;
- Any person occupying a similar status or performing a similar function, regardless of title; and
- Any person who offers or sells the security in the Reg CF offering.
The SEC has declined to say one way or another whether a funding portal is an “issuer” for these purposes. Given the role of funding portals in presenting securities to the public, however, it seems likely except in unusual circumstances.
If a funding portal is an issuer and a Form C contains false statements or omits important information, the funding portal would be liable to private lawsuits from investors unless the funding portal can prove that it didn’t know about the false statements or omissions and couldn’t have learned about them by exercising reasonable care.
The language of section 4A(c) is very similar to the language of section 12(a)(2) of the Securities Act, which applies to public companies. But the playing field is different. The document used in a public filing – a prospectus – is typically subject to layer upon layer of due diligence, not only by the issuer and its lawyers but also by the underwriter and others. In contrast, many of the Form Cs we see on funding portals are prepared by people with little or no experience in securities, typically online. I expect to see lots of litigation under section 4A(c), as courts decide what “reasonable care” means for funding portals.
Private Lawsuits: Yes
Rule 10b-5
17 C.F.R. §240.10b-5, issued by the SEC under section 10(b) of the Exchange Act, makes it unlawful, in connection with the purchase or sale of any security:
- To employ any device, scheme, or artifice to defraud,
- To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
- To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
Liability arises under Rule 10b-5 only with the intent to deceive, known in legal jargon as “scienter.”
The Supreme Court has held that only the person who “makes” a deceptive statement or omission can be liable under the second prong of Rule 10b-5 – not a person who merely disseminates the statement innocently. But that begs the question: does a funding portal merely disseminate information from issuers, or does it “make” the statements along with the issuer? Given the role of funding portals in Reg CF, very possibly the latter, although that could depend on the facts of a given case.
But that question could be moot. Under recent court decisions, a funding portal that knows about the misleading statements or omissions and allows them on its website anyway could be liable under either the first or third prongs of Rule 10b-5.
Private Lawsuits: Yes
Section 17(a) of the Securities Act
Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer or sale of securities, to:
- Employ any device, scheme, or artifice to defraud, or
- Obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
- Engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Even if it is not the issuer, a funding portal participating in a scheme to mislead investor could be subject to section 17(a) of the Act just as it could be liable to investors under Rule 10b-5.
Private Lawsuits: No
Crowdfunding and FINRA Regulations
A funding portal that violates the regulations issued by the SEC or FINRA could be sanctioned or, in the extreme case, have its registration with the SEC and/or its membership in FINRA suspended, effectively putting it out of business.
An investor who loses money and learns that the funding portal violated SEC regulations will probably claim that the regulatory violation gives rise to a private right of action – that is, that if she was harmed by the regulatory violation then she can sue the funding portal. Although we can never say never, her claim should fail.
Private Lawsuits: No
State Common Law
A funding portal could be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including fraud and misrepresentation. In the typical case, the investor would try to show that (i) the issuer did something wrong, and (ii) the funding portal is responsible for it.
Private Lawsuits: Yes
Liability to Issuers
Funding portals will be sued by issuers. Among the possible claims:
- The funding portal made promises about the offering that proved false (e.g., “You’re sure to raise at least $2 million!”);
- The funding portal conducted the offering ineffectively (e.g., failing to notify subscribers by email);
- The funding portal made factual misrepresentations (e.g., the number of its registered users or the percentage of its successful raises); and
- Actions by the funding portal caused the issuer to face lawsuits from investors (e.g., the funding listed the issuer’s year-over-year revenue growth as 1,300% rather than 130%).
Private Lawsuits: Yes
Criminal Rules
If a funding portal really screws up, it could even be subject to Federal and state criminal penalties, including:
- Criminal penalties for intentionally violating securities laws
- Criminal penalties for mail fraud
- Criminal penalties for wire fraud
- Criminal penalties for violating the Racketeer Influenced and Corrupt Organizations
Liability of People
Entrepreneurs too often believe that operating through a corporation or other legal entity protects them from personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a gaggle of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!”
No. She did it, so she’s personally liable, corporation or no corporation. If her employee did it, the story might be different (unless he was drunk when she handed him the keys).
The same is true in securities laws. To the extent you’re personally making decisions for the funding portal, all the potential liability I’ve described applies to you personally as well.
Reducing Your Risk
A funding portal can and should take steps to reduce its legal risk. These include:
- Strong Contract with Issuers: Funding portals should have a strong contract with issuers, clearly defining who is responsible for what and disclaiming liability on the funding portal’s part.
- Training: A junior employee of a funding portal once told my client to do something that clearly violated the securities laws. Recognizing that funding portals, like other employers, are liable for the acts of their employees, funding portals should have in place a strong training program. Among other things, employees should know about the funding portal’s potential liability and be familiar with its Manual of Policies & Procedures.
- Due Diligence Processes: Funding portals should have in place processes and policies for conducting due diligence. How much due diligence is required is an open question, but if a funding portal is sued for failing to discover a misstatement in a Form C, it’s going to be asked about its due diligence policies. The answer can’t be “None.”
- Insurance: Like any other business, funding portals should carry insurance. Even a very weak lawsuit can cost hundreds of thousands of dollars to defend.
- Culture: The sea at the tip of South America is among the roughest in the world, as two oceans collide. Crowdfunding is like that, sort of. On one hand, Crowdfunding is new and disruptive and attracts people who want to do something. On the other hand, the legal landscape in which Crowdfunding takes place is old and well-worn, developed before many American homes had radio. Leaping into the brave new world of online capital formation, eager to move fast and at least dent things, funding portals must nevertheless create a culture that takes seriously the often-tedious responsibility associated with selling securities.