Category: Crowdfunding Liabilities

The Legal Liability of Funding Portals: Update for TruCrowd Complaint

On By crowdfundattnyIn Crowdfunding, Crowdfunding Liabilities, Crowdfunding Portals2 Comments

A few weeks ago I posted about the potential legal liability of funding portals. Lo and behold, on September 20, 2021 the SEC brought an enforcement action against an issuer and its principals, and also against the funding portal, TruCrowd, Inc., dba Fundanna, and its owner, Vincent Petrescu.

Here’s a link to the Complaint. If you take the Complaint at face value – and readers should bear in mind that there are least two sides to every story – this is a lesson in how a funding portal can get into hot water with a questionable issuer.

The allegations against the issuer and its principals are straightforward:  they failed to disclose the criminal record of one of the principals; they used investor money for personal purposes; they misled investors about a purported real estate project.

More interesting for our purposes are the allegations against the funding portal and its owner. Calling TruCrowd and Mr. Petrescu “gatekeepers,” the SEC alleges, among other things, that:

  • TruCrowd and Mr. Petrescu allowed the offerings to proceed despite multiple warning signs of possible fraud or other harm to investors.
  • Mr. Petrescu participated in drafting the inaccurate Form C and offering statement.
  • TruCrowd and Mr. Petrescu failed to order a “bad actor” check.
  • Mr. Petrescu ignored warning from a securities lawyer.

It’s hard to walk away from a big commission. But this enforcement action illustrates that sometimes you have to.

How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many,

The Big Problem For Crowdfunding That Really Isn’t A Problem

On By crowdfundattnyIn Crowdfunding, Crowdfunding Articles, Crowdfunding Liabilities, Crowdfunding.Biz, Entrepreneurs5 Comments

Ask 10 entrepreneurs why they haven’t used Crowdfunding. Three will answer they haven’t heard of it while seven will say “Crowdfunding will screw up my cap table.” Once and for all, let’s lay that fallacy to rest.

We’ll start by noting that many companies have raised money from Crowdfunding and gone on to later rounds of funding, including public offerings. That proves that what passes for common knowledge in some circles can’t actually be true. But let’s drill down a bit more.

What is it about Crowdfunding that could screw up a cap table?

It couldn’t be the number of investors. Public companies with hundreds of thousands of shareholders have no problem managing their cap tables or raising more capital when they need it. Beyond that, technology has made keeping track of investors pretty simple. You can send 1099s to 2,000 shareholders as easily as you can send them to 20, while Excel spreadsheets have 1,048,576 rows. Cap table management tools like Carta make the process even easier.

Don’t want to manage the cap table yourself? Fund managers like Assure Fund Management will handle it for you.

If having lots of investors doesn’t screw up a cap table, what does?

The answer is that a cap table is screwed up by the terms of the securities issued to investors. For example:

  • A company issues 52% of its voting stock to early investors.
  • A company issues stock to early investors with an agreement giving the investors veto rights over a sale of the company.
  • A company issues stock giving early investors a “put” after five years.

In those circumstances and many others, the rights given to early investors inhibit or even preclude the company from raising money in the future. Who’s going to invest in a company where the founder no longer has voting control?

But for purposes of this post, the important observation is that none of those examples depends on the number of rows in your Excel spreadsheet or how the money was raised. If the first round of funding came from just 10 friends and family members who together received 52% of the voting stock, that company has a screwed up cap table and will have a hard time raising more money. By contrast, the company that raised money from 1,000 strangers in Title III by issuing non-voting stock does not have a screwed up cap table and can raise money from anyone in the future, no problem.

To avoid screwing up your cap table, don’t worry about the number of investors and certainly don’t avoid Crowdfunding. Instead, focus on what matters:  the kinds of securities you issue and the rights you give investors. 

Where did the fallacy come from? The venture capital and organized angel investor folks, i.e., the same folks who predicted a few billion dollars ago that Rule 506(c) would never work because accredited investors wouldn’t submit to verification. Considering themselves indispensable middlemen, these folks view Crowdfunding as a threat. (I’ve always thought they should use Crowdfunding as a tool instead of fighting the tide, but that’s a different blog post.)

The fallacy has proven very hard to shoot down, perhaps because of the outsized influence venture capital and organized angel investor folks enjoy in the capital formation industry. In fact, it’s proven so hard to shoot down that the soon-to-be-released SEC rules allowing SPVs in Title III were written in response. If we’re smart about the kinds of securities we issue we don’t need an SPV, while if we issue the wrong kind of security then an SPV doesn’t help. The new SEC rules were written solely for the sake of perception, “solving” a problem that didn’t really exist.

Similarly, the perception that Crowdfunding screws up your cap table led one of the largest Title III platforms, WeFunder, to create an even more convoluted “solution.” WeFunder has investors appoint a transfer agent to hold their securities. Under 17 CFR §240.12g5-1, this means that all the securities are “held of record” by one person for purposes of section 12(g) of the Exchange Act. Based on the section 12(g) definition WeFunder then claims that a round of financing on its platform leaves the issuer with “a single entry on your cap table.” That’s a creative claim, given that the term “cap table” has no legal meaning and if an issuer is an LLC and raises money from 600 investors there are going to be 600 K-1s.  But the point is that WeFunder goes to this trouble and the attendant costs over a problem of perception, not reality.

How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many, that’s for sure.

Questions? Let me know.

The Liability Of Issuers In Crowdfunding (Parental Discretion Advised)

On By crowdfundattnyIn Crowdfunding, Crowdfunding Liabilities, Crowdfunding Portals5 Comments

You’re thinking about raising money using Crowdfunding, but are concerned about legal liability. Here is a non-exclusive list of ways you can be liable as an issuer.

When I say “Exchange Act” I mean the Securities Exchange Act of 1934, and when I say “Securities Act” I mean the Securities Act of 1933. The “CFR” is the Code of Federal Regulations.

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:

(a)  To employ any device, scheme, or artifice to defraud,

(b)  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

(c)  To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Back in 1946, courts established a “private right of action” under Rule 10b-5, meaning that an investor who has been damaged by a violation of Rule 10b-5 can sue the person who made the misstatement. That often means the issuer, but can also mean an officer or other representative.

Rule 10b-5 applies to all Crowdfunding offerings.

Section 12(a)(2) of Securities Act

Section 12(a)(2) of the Securities Act imposes liability on an issuer or other seller of securities who:

Offers or sells a security. . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

Rule 12(a)(2) applies to Title IV but not to Tile II or Title III.

Section 17(a) of Securities Act

Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer of sale of securities, to:

(1) employ any device, scheme, or artifice to defraud, or

(2) 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

(3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Section 17(a) applies to all Crowdfunding offerings.

Special Liability Provision of Title III

New section 4A(c) of the Securities Act extends a similar concept into Title III. A Title III issuer is liable if:

The issuer makes an untrue statement of a material fact or omits 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, provided that the purchaser did not know of such untruth or omission; and does not sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.

This new provision defines “issuer” broadly:

As used in this subsection, the term “issuer” includes any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any person occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of section 4(a)(6) of this title, and any person who offers or sells the security in such offering.

The SEC says that even funding portal itself would likely fall within the definition of “issuer” and thus be subject to statutory liability under section 4A(c).

Section 4A(c) applies only to Title III.

NOTE: Rule 10b-5, section 12(a)(2), section 17(a), and section 4A(c) are very similar, but with a few key differences, including these:

  • A plaintiff making a claim under Rule 10b-5 must prove the defendant acted knowingly or was reckless.
  • A plaintiff making a claim under section 12(a)(2) or section 4A(c) must show only that the statement in question was false, leaving the defendant to prove that it did not know, and with the exercise of reasonable care could not have known, that it was false.
  • Section 12(a)(2) allows claims against the person who sold the security to the plaintiff. Section 4A(c), on the other hand, could impose liability on the issuer even in the case of a “secondary” sale, meaning a sale by an existing stockholder.
  • Section 12(a)(2) applies only to misstatements or omissions in a prospectus or made orally. Section 4A(c), on the other hand, applies to misstatements or omissions anywhere.
  • Section 17(a) does not provide a private right of action, meaning it’s about a penalty imposed by the SEC, not a lawsuit brought by an investor.
  • In making a claim under section 17(a), the SEC need show only negligence on the part of the defendant.

Failure to Register Offering

Section 5 of the Securities Act generally requires all offerings of securities to be registered with the SEC. All Crowdfunding offerings rely on statutory or regulatory exemptions from the registration requirement. Rule 506(c), Regulation A, intrastate Crowdfunding, Title III – these all provide exemptions from the registration requirement of section 5.

But all those exemptions are conditioned on satisfying certain requirements. To qualify for the exemption under Rule 506(c), for example the issuer must take reasonable steps to ensure that every investor is accredited and form a reasonable belief that every investor is accredited. If an issuer fails to satisfy all the requirements of an exemption, then the issuer has engaged in an illegal, unregistered offering and is liable under section 12(a)(1) of the Securities Act.

Failure to Use Licensed Broker

Section 15(a) of the Exchange Act requires any person acting as broker to register with the SEC. If an issuer sells securities through a person who should be licensed as a broker but is not, the issuer could be liable under any of several legal theories:

  • Use of an unlicensed broker could cause the issuer to lose the exemption from registration.
  • The failure to notify investors that the issuer is using an unlicensed broker could give rise to liability under Rule 10b-5 or section 12(a)(2).
  • The issuer could be liable for aiding and abetting the unlawful actions of the unlicensed brokers.

Failure of Principals to Register as Brokers

Section 3(a)(4)(A) of the Exchange Act generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for others.” The issuer itself is not required to register as a broker, because the issuer is effecting transactions in securities for itself, not for others. This is commonly referred to as the “issuer exemption.”

But the issuer exemption doesn’t protect employees of the issuer who engaged in selling the issuer’s securities, including the founder, the President, the CEO, the Marketing Director, and the Director of Investor Relations. A different SEC regulation, 17 CFR §240.3a4-1, provides a limited safe-harbor exemption for these so-called “associated persons.” However, it’s not hard for an issuer’s associated persons to fail to qualify for that exemption.

If an associated person should be registered as a broker but isn’t, not only is he or she personally liable, but the issuer itself now faces all the potential liabilities associated with using an unlicensed broker!

State Common Law Rules

Issuers can be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including:

  • Fraud
  • Misrepresentation
  • Breaches of fiduciary obligations
  • Breaches of contractual obligations (g., under an Operating Agreement)
  • Breach of the implied covenant of good faith and fair dealing

State Statutory Rules

States regulate the sale of securities as well. An issuer can be liable under state securities laws for:

  • The failure to register an offering under state law.

NOTE: Suppose you’re selling securities under Title II Crowdfunding (Rule 506(c)). The starting place is that sales of securities under Rule 506(c) are not subject to state registration. But if you fail to take reasonable steps to ensure that all your investors are accredited, not only do you lose your Federal exemption, you also lose your exemption form state registration as well!

  • The use of an unlicensed broker-dealer.
  • The use of deceptive offering materials.

Criminal Rules

If an issuer 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 sometimes are under the mistaken impression that operating through a corporation or other legal entity protects them from all personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a bevy of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!” she says.

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. Assume that if you’re running the issuer, all the potential liability I’ve described applies to you personally as well.

Is Crowdfunding Too Dangerous?

No, definitely not.

With the exception of section 4A(c) of the Securities Act, which is limited to Title III, you’ll notice that all of the potential liabilities I’ve described apply to old-fashioned private placements and public offerings, not just to Crowdfunding. Crowdfunding introduces two new variables:   the number of investors and the anonymity of investors. But the legal framework is identical.

Did I ever mention that issuers should buy insurance?

Questions? Let me know.