Tag: crowdfunding

How to Present Investor Disclosures in Crowdfunding Offerings (And How Not To)

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Investing, Investor Disclosures, Portals, SEC, Title II, Title II CrowdfundingLeave a comment

Title II Crowdfunding is often referred to, more or less accurately, as “online private placements.” It’s time the industry turned the online, digital, aspect of the offerings more to its advantage.

Remember when newspapers first came online? Remember how interesting they were visually? I’m being sarcastic. They were nothing more than photographs of the paper version, failing to take advantage of the digital platform and its unique capabilities.

Too many (not all) Crowdfunding portals take the same approach to providing investor disclosures. You click through the process and suddenly see an enormous PDF document that is nothing more or less than a paper private placement memorandum, complete with Schedules and Exhibits. You’reOnline document supposed to scroll down and “sign” at the bottom. On some platforms the investor actually has to click I’m Ready to Invest before he sees the disclosures!

There are at least three things wrong with this approach:

• Investors can’t be happy with it.

• It doesn’t convey information effectively.

• The disclosure might be legally ineffective. I think about a plaintiff’s lawyer cross-examining the portal operator, pointing to a disclosure on page 67 and asking “Did you really expect my client to read all that at the end of the click-through process?”

It doesn’t have to be that way! There are much better ways to provide information online. Take a look at today’s online version of the New York Times or Wall Street Journal to see how far we’ve come.

Crowdfunding portals can do the same thing. The first step is to move the mental image of that paper PPM into Trash or the Recycle Bin (depending on whether you’re Mac or PC) and start from scratch. What are we trying to accomplish here? What are the tools at our disposal? Pose that question to some creative people and you’ll get a whole range of possibilities, all of them better for investor, sponsor, and portal.

Questions? Let me know.

Title II Needs Company

On By crowdfundattnyIn Crowdfunding, Entrepreneurs, Fundrise, Title II, Title II CrowdfundingLeave a comment

Statue of Lib CF_Purchased

Title II Crowdfunding is great, and it’s booming. For the first time in history entrepreneurs have access to every accredited investor in the world, and every accredited investor in the world has access to deals once reserved for the very wealthy. New Crowdfunding portals – I call them “stores” – are opening all the time, serving more and wider markets. The stores are growing in sophistication and attracting a growing number of customers, i.e., investors. Register with Fundrise and you can invest in 3 World Trade Center!

But as long as Crowdfunding remains limited to Title II, it’s not going to achieve its potential. And that’s not only, not even primarily, because allowing non-accredited investors to participate would deepen the pool of available capital.

It’s not primarily about capital, but about the Crowdfunding ecosystem. Accredited investors represent a small fraction of Americans. Open the ecosystem to another 100 million potential investors and everything changes. Awareness changes. New ideas are borne and flourish. New businesses are created that wouldn’t have been created otherwise. New experts come into the field, new business models are tested. Behavior and expectations change.

I’m sure there are better and more sophisticated ways to describe what happens when more people join an ecosystem. Maybe things like “network effects” and “information feedback loops.”

Whatever it’s called, we need non-accredited investors in the market for Crowdfunding to achieve its potential. To get non-accredited investors into the market we need the SEC to issue final regulations under Title III and Title IV, and for that to happen it looks as if we’re going to need urging from the Legislative branch.

If you have a moment and the inclination, please click on the link below to find the names and email addresses of your Congressman and Senators, and drop them an email. I’ve included a sample form but of course feel free to create your own.

Title II has been lonely for too long!

Find My Congressman and Senators

Sample Email

Questions? Let me know.

Can A Crowdfunding Portal Avoid Broker-Dealer Registration By Registering As An Investment Adviser?

On By crowdfundattnyIn Broker-Dealer, Crowdfunding, Crowdfunding Laws, No-Action LettersLeave a comment

No.

In early 2013 the SEC issued no-action letters concluding that FundersClub and AngelList were not required to register as broker-dealers. Both companies were “venture capital fund advisers,” a special flavor of investment adviser, and some people read into the no-action letters a cause-and-effect, concluding that if a Crowdfunding portal registers as an investment adviser, which is relatively easy, then it doesn’t have to register as a broker-dealer, which is very hard.

When the SEC issues no-action letters, it doesn’t explain its reasoning. It provides the facts and the legal conclusion and leaves it to readers to figure out what was important and wapples and orangeshat wasn’t.

It’s possible that as the SEC weighed the requests by FundersClub and AngelList, a regulator thought “This is a close call, and because they’re already regulated as investment advisers we’ll give them a pass on broker-dealer registration.” But that’s just speculation, not a legal argument. A portal operating exactly in the manner described in the no-action letters might take comfort. Others, including any real estate portal, should not.

Under the securities laws, investment advisers are one thing and broker-dealers are something complete different – different functions, different rules, different risks. If you want to give investment advice, register as an investment adviser. If you’re in the portal business and think you need a broker-dealer, then either register yourself or use a provider like WealthForge or FundAmerica.

Questions? Let me know.

Are Crowdfunding Portals Investment Advisers?

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, FundersClub, Investment Advisers Act of 1940 (IAA)Leave a comment

Looking for the solution of the mazeInvestment advisers are regulated by the Investment Advisers Act of 1940 – another of those old laws that govern today’s securities markets – and by also by the states. Do these laws apply to Crowdfunding portals?

It depends.

The IAA generally applies to anyone who:

  • “[E]ngage[s] in the business of advising others. . . .as to the value of securities or as to the advisability of investing in securities. . . .” or
  • “[I]ssues or promulgates analyses or reports concerning securities.”

On the other hand, the IAA generally does not apply to “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation,” a term broad enough to include websites.

Not surprisingly, neither the SEC nor any court has yet applied those definitions to a Crowdfunding portal. The best sources of information are no-action letters issued by the SEC to electronic “matching” services and a handful of court decisions. Under these authorities:

  • A portal that merely posts investment opportunities using information provided by the issuer is probably not an investment adviser.
  • A portal that explains why every investor should have a portion of her portfolio in real estate, or in startups, is moving toward investment adviser territory.
  • A portal that advertises its industry experience and its expertise in “vetting” deals is moving toward investment adviser territory.
  • A portal that assigns ratings to investment opportunities or otherwise provides investors with the tools to select one opportunity over another is very close to the line.
  • A portal that seeks to match an investor’s personal investment preferences to opportunities on the site is an investment adviser.
  • A portal that collects money from investors and uses its own discretion in selecting investment opportunities is an investment advisor.

A portal that doesn’t want to register as an investment adviser faces a dilemma: no matter how many disclaimers the portal posts on its site, users might view the portal as an investment adviser anyway. For example, a user might decide to invest $5,000 in every deal listed by Fundrise and Patch of Land, believing she’s creating her own Fundrise and Patch of Land “mutual funds” and leaving it to her “advisers” at the portals to select individual securities. On one hand, you spend every hour of every day developing a brand that’s based on finding great deals for your registered users. On the other hand, the more successful your brand the more you look like an investment adviser.

Why not just bite the bullet and register as an investment adviser? Three primary reasons:

  • Paperwork and Cost. Unsurprisingly, investment advisers are subject to lots of regulation and oversight. It’s nothing like registering as a broker-dealer, but it’s plenty cumbersome.
  • Additional Liability. An investment adviser owes statutory and fiduciary duties to its clients.
  • Disruption of Business Model. A Crowdfunding portal that is also an investment adviser might not be able to operate the way it wants to operate. For example, an investment adviser registered with the SEC generally may not receive compensation in the form of a carried interest. 

I believe the future of Crowdfunding involves pools of assets rather than individual assets. Many portals have already moved in that direction. On FundersClub, for example, investors can choose to invest in funds that select individual securities after the fact, agnostic as to industry, i.e., a Crowdfunded venture capital fund.

Once a portal takes that step – accepting investor dollars and deciding how to invest them – the portal has stepped decisively across the line into investment adviser territory. Ideally you take that step rationally, having decided that the benefits, meaning primarily the ability to attract additional capital, outweigh the costs.

Questions? Let me know.

C Corp Vs. LLC: What’s The Right Choice?

On By crowdfundattnyIn C corporations, Crowdfunding, Entrepreneurs, Investor, LLCs, Uncategorized1 Comment

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an overview, Choosing The Right Legal Entity MSR describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Let me know.

Why Delaware?

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Delaware, Delaware Crowdfunding1 Comment

Why are most Crowdfunding entities formed in Delaware? Two reasons.

First, Delaware has very good business laws and a very good system for adjudicating business disputes. Here’s what I mean:

  • Delaware’s business laws – and by that I mean the laws governing limited liability companies and corporations – are very flexible. In the hands of a capable corporate lawyer, Delaware’s laws can be used to do just about anything you want to do, i.e., can implement just about any business deal.Delaware_CF State
  • For better or worse, Delaware’s laws are tilted in favor of management. That means those running the show – and those running the show pick where the entity is incorporated – can get more or less what they want. As an example, Delaware allows the manager of a limited liability company to disclaim all fiduciary responsibilities to the members. Most states do not.
  • Delaware has a whole court system devoted to adjudicating disputes among business entities and their owners and managers. In most states, the judge hearing a business dispute in the morning is hearing auto accident cases all afternoon and is probably a former personal injury lawyer herself. First among the country’s business-only courts, Delaware’s Court of Chancery enjoys a deserved reputation for professionalism.

Second, because Delaware entities are used so widely, lawyers across the country are familiar with Delaware law. If two real estate investments are offered on a Crowdfunding portal, one incorporated under Delaware law and the other incorporated under Missouri law, the Delaware company has a head start in attracting investors solely on the basis of familiarity, at least outside Missouri.

There is one important exception. Under Federal Rule 147, an entity raising money through the intrastate Crowdfunding exemption of State X must be incorporated in State X, not in Delaware.

Questions? Let me know.

Improving Legal Documents In Crowdfunding: Capital Calls

On By crowdfundattnyIn Crowdfunding, Legal Documents, UncategorizedLeave a comment

man beggingYou raise $2 million of equity from investors to buy an apartment complex and two years later want to make $500,000 of capital improvements. Where do you get the money?

Traditionally, your Operating Agreement might give you the right to make a “capital call,” asking your existing investors for the additional $500,000. Suppose you had 20 investors, each contributing $100,000 in the beginning. Exercising your right to make capital calls, you would ask each for another $25,000 (20 x $25,000 = $500,000).

If the Operating Agreement includes a capital call feature, then it should also describe the consequences if one or more investors fail to contribute. The simplest approach, which I have seen used in Crowdfunding offerings, provides for simple dilution based on capital contributed. Let’s say 19 investors send $25,000 checks but one does not. The Operating Agreement would provide that his ownership interest is reduced by 1% (100 basis points), the percentage that his failed contribution ($25,000) bears to the total capital contributed ($2,500,000).

A few things to bear in mind using capital calls in Crowdfunding:

  • If I am the Crowdfunding investor, I do not want a capital call. Once I write my initial check, I don’t want to be asked for more money.
  • If I am the sponsor, I don’t want to be obligated to ask my existing investors for additional capital, which is just another way of saying I don’t want to give my existing investors a so-called “preemptive right.” There might be 157 existing investors. It might be much easier to get the $500,000 from a single source, or even a new Crowdfunding round. I want to leave my options open.
  • If we include a capital call, simple dilution is often not the right answer. Suppose the real estate market deteriorates and I desperately need the $500,000 to keep the project afloat. If an investor fails to make good on the capital call, a much higher rate of dilution might be appropriate, 150% or 200%, or even more. I have drafted agreements where the failure to make good on a capital call results in the wholesale forfeiture of an interest.

Crowdfunding is like traditional private placements in many ways, but in other ways it isn’t. When we draft legal documents for Crowdfunding deals we need to figure out which is which.

Questions? Let me know.

Wells Fargo Withdraws From Crowdfunding Space

On By crowdfundattnyIn Crowdfunding, P2P LendingLeave a comment

takeoffWells Fargo has been an active player in the Crowdfunding space, serving as the indenture Trustee for both Lending Club and Prosper and owning a chunk of Lending Club through its venture capital arm, Norwest Venture Partners X. Recently, however, Wells Fargo decided it is no longer comfortable with the “risk profile” of retail Crowdfunding. Wells Fargo has been replaced by CSC Trust Company of Delaware as indenture Trustee for both P2P lenders.

To me it’s an interesting move, coming just as institutional investors begin pouring into the space.

Its possible Wells Fargo views the P2P lenders as competitors and isn’t interested in helping cannibalize its own consumer lending business, but that horse is out of the barn. Or maybe, with all its experience in the space, Wells Fargo is planning a more significant move.

I’ve contacted a few large institutional trustees recently and haven’t found a huge appetite for exposure to the Crowdfunding space, so I’m happy to see CSC step up to the plate.

Questions? Let me know.

Crowdfunding And Fiduciary Obligations

On By crowdfundattnyIn Crowdfunding, Crowdfunding Laws, Fiduciary Obligations, JOBS ActLeave a comment

The term “fiduciary obligations” sends a chill down the spine of corporate lawyers – although some may object to using the word “spine” and “corporate lawyer” in the same sentence.

A person with a fiduciary obligation has a special legal duty. A trustee has a fiduciary obligation to the beneficiaries of the trust. The executor of an estate has a fiduciary obligation to the beneficiaries of the estate. The fiduciary obligation is not an obligation to always be successful, or always be right, but rather an obligation to try your best, or something close to that. A trustee who fails to anticipate the stock market crash of 2008 has not breached her fiduciary obligation. A trustee who fails to read published reports of a company’s impending bankruptcy before buying its stock probably has.

A person with a fiduciary obligation is required to be loyal, to look out for the interests of those under her care, to put their interests before her own.

By law and longstanding principle, the directors of a corporation have a fiduciary obligation to the corporation and its shareholders. In the classic case, a director of a corporation in the energy business took for his own benefit the opportunity to develop certain oil wells. Foul! cried the court. He has breached his fiduciary obligation by failing to pass the opportunity along to the corporation, to which he is a fiduciary.

Modern corporate statutes allow the fiduciary obligations of directors to be modified, but not eliminated, even if all the shareholders would sign off. If the corporation is publicly-traded, the exchange likely imposes obligations on the director (and the President, and the CEO, etc.) in addition to the fiduciary obligations imposed by state corporate law.

Which takes us to Crowdfunding. crowd funding word cloud

Most deals in the Crowdfunding space are done in a Delaware limited liability company. The Delaware Limited Liability Company Act allows a manager – the equivalent of a director in a corporation – to eliminate his fiduciary obligation altogether. If I’m representing the sponsor of the deal then of course I want to protect my client as fully as possible. And yet, I’m not sure that’s the best answer for the industry overall.

The U.S. public capital markets thrive mainly because investors trust them, just as the U.S. consumer products industry thrives because people feel safe shopping (that’s why securities laws and consumer-protection laws, as aggravating as they can be, actually help business). My client’s investors may or may not pay attention to the fiduciary duty sections of his LLC Agreement, but I wonder whether the Crowdfunding market as a whole can scale if those running the show regularly operate at a lower level of legal responsibility than the managers of public companies. Will it drive investors away?

Part of my brain says that it will, and yet, over the last 25 years or so, as corporate laws have become more indulgent toward management and executive pay has skyrocketed, lots of people have wondered when investors will say “Enough!” It hasn’t happened so far.

Questions? Let me know.

Crowdfunding And The Trust Indenture Act Of 1939

On By crowdfundattnyIn Crowdfunding, JOBS Act, Regulation A, Trust Indenture Act of 1939Leave a comment

Handing over moneyThe Securities Act of 1933. The Exchange Act of 1934. The Investment Company Act of 1940. Those are the pillars of the U.S. securities laws, as relevant today as they were 80 years ago. And here’s one more old law relevant to Crowdfunding: the Trust Indenture Act of 1939.

Here’s the idea. A company issues its promissory notes (obligations) to a large group of investors. If the company defaults on one or two notes, it might not be financially feasible for those particular investors to take legal action. Even if the company defaults on all the notes it will be a mess sorting out the competing claims. Which investor goes first? If there is collateral, which investor has priority? At best it’s highly inefficient, economically.

The Trust Indenture Act of 1939 imposes order and economic efficiency. It provides that where a company issues debt securities, like promissory notes, it must do so pursuant to a legal document called an “indenture” and, most important, with a trustee, normally a bank, to represent the interests of all the investors together. The TIA goes farther:

  • It provides that the indenture document must be reviewed and approved by the SEC in advance.
  • It ensures that the trustee is independent of the issuer.
  • It requires certain information to be provided to investors.
  • It prohibits the trustee from limiting its own liability.

Why don’t Patch of Land and other Crowdfunding portals that issue debt securities comply with the TIA? Because offerings under Rule 506 are not generally covered by the law. Conversely, because Lending Club and Prosper sell publicly-registered securities (their “platform notes”), they are covered, and have filed lengthy indenture documents with the SEC.

The real surprise is with Regulation A+. If a Regulation A+ issuer uses an indenture instrument to protect the interests of investors then it will be subject to the TIA and its extensive investor-protection requirements. If the issuer does not use an indenture, on the other hand hand, it will not be subject to the TIA as long as it has outstanding less than $50 million of debt. That’s a strange result – giving issuers an incentive not to use an indenture even though indentures protect investors.

That’s what happens sometimes when you apply very old laws to very new forms of economic activity. Welcome to Crowdfunding.

Questions? Let me know.