Section 10(b) of the Exchange Act prohibits use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security.
The SEC has issued several regulations under section 10(b), prohibiting deceptive practices in various specific circumstances. By far the best-known and most-feared is 17 CFR §240.10b-5, aka Rule 10b-5, which makes it unlawful:
- 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; and
- To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
But Crowdfunding issuers and funding portals should know about another regulation issued by the SEC under section 10(b), Rule 10b-9.
On its face Rule 10b-9 is straightforward. It says (I’m paraphrasing) that if you set a minimum amount for an offering and don’t reach the minimum, you have to return everyone’s money.
Back in the old days, pre-JOBS Act, when many educated Americans spoke a dialect that rarely included the phrase “100%,” almost every offering had a stated minimum. For example, say a developer wanted to buy a multifamily project for $5M, of which $3.5M would be financed and $1.5M would be raised as equity. In her equity offering the developer would state $1.5M as the minimum raise because without the full $1.5M the deal isn’t viable. If she didn’t raise the full $1.5m by the deadline everyone who had invested would get their money back.
Pretty simple, right?
Now suppose that the developer is three days from her deadline and has raised $1,490,000. To meet the $1.5M minimum she writes a $10,000 check herself.
Under the language of Rule 10b-9 itself, as well as early SEC interpretations of the rule, that should be fine. The developer has reached the $1.5M minimum, albeit with $10,000 of her own money, so the project is viable and investors are getting the economic deal they thought they were getting.
But in a case called SEC v. Blinder, Robinson & Co., Inc. the court discovered a different rationale for Rule 10b-9. The purpose wasn’t just to ensure an offering was fully funded, but also to assure each investor that others had made the same investment decision:
“Each investor is comforted by the knowledge that unless his judgment to take the risk is shared by enough others to sell out the issue, his money will be returned.”
This language, which implicitly appealed to the “wisdom of the crowd” long before Crowdfunding was a thing, is now cited by the SEC, FINRA, and other courts interpreting Rule 10b-9.
Now we see the developer’s $10,000 investment in a different light. She wrote the $10,000 check not because she’s willing to take the same economic deal as other investors but because she’s entitled to fees from the deal and this is her livelihood. No other investors can take comfort from that!
If this is true for a multifamily real estate project it is true many times over for the local brewery raising money using Reg CF. Although Alfred is unrelated to the founder of the brewery, he invested mainly because he likes getting free beer on Thursday nights – one of the perks – and enjoys the comradery, not because he’s expecting a great financial return. No investor can take comfort from that!
With little better to do, lawyers worry about this kind of thing. Although I think the risk of enforcement action by the SEC is small, out of an abundance of caution I would consider two disclosures in every offering:
- A disclosure that investments made by the sponsor and its affiliates will count toward the offering minimum (the “target offering amount” in Reg CF); and
- A disclosure that investors shouldn’t take comfort from investments made by others.
This is what makes the list of Risk Factors so long: we keep adding things and rarely take anything out.
Questions? Let me know.