As reported everywhere, CrowdStreet investors recently suffered very large losses when a sponsor apparently absconded with their money. It’s a very bad thing, not only for those investors but for the real estate crowdfunding industry. You’d almost think this were crypto!
In the aftermath, many have called for crowdfunding sites to use escrow accounts. My point today is that escrow accounts by themselves aren’t enough.
CrowdStreet hosts offerings under Rule 506(c), where escrow accounts aren’t required. On the other side of the street, in the Reg CF world, funding portals must use an escrow agent. Rule 303(e) even specifies who can serve as the escrow agent (a broker-dealer, a bank, or a credit union) and directs which instructions the funding portal is required to give to the escrow agent under what circumstances. If and when the issuer reaches its target amount the funding portal must instruct the escrow agent to release the funds to the issuer, while if the investor cancels his, her, or its investment commitment or the offering is terminated, the funding portal must instruct the escrow agent to return the funds to the investor.
Now let’s assume exactly such an arrangement had been in place for the doomed offering on CrowdStreet.
The offering would have stipulated a “target amount” of $63 million, with the money held securely in escrow. With the target amount raised, CrowdStreet would have given the escrow agent instructions to release the money to the sponsor, following the regulations to the letter. And the sponsor would have stolen it.
By itself the escrow account wouldn’t have prevented the theft. Extrapolating to Reg CF, the escrow accounts used by funding portals do not prevent theft. They just make the unscrupulous sponsor wait until reaching the target amount to steal the money.
To prevent the theft you have to layer something on top of the escrow agent. In the CrowdStreet offering you could have prevented the theft by wiring the money not to the sponsor but to the title company conducting the closing, with instructions that it would be used only to acquire the property. In a typical Reg CF offering, where the money is being used by the issuer for marketing or other general business purposes, it’s much harder.
This is another reason why the “bad actor” rules are odd. They catch people who have violated the securities laws but not people who have robbed strangers at gunpoint.
Some Crowdfunding portals and issuers allow investors to designate a beneficiary, i.e., a person who will take ownership of the security (the LLC interest, debt instrument, whatever) should the investor die. Just be careful.
Most states (not Texas) allow the owners of securities, including privately-held securities, to designate a beneficiary outside the owner’s will, under a version of the Uniform TOD (Transfer on Death) Security Registration Act (the Delaware version is 12 DE Code §801 et seq). For the investor, the advantage of designating a beneficiary is that the security doesn’t go through the probate process but instead passes directly to the designated beneficiary.
For the Crowdfunding issuer or portal, there is a benefit to making life easier for investors. And it’s pretty straightforward to create a beneficiary designation form on your website.
Nevertheless, adding convenience for investors carries some risks. For example:
Suppose an investor wants to designate her cousin Jacob as the beneficiary of her LLC interest. She uses Jacob’s name on the beneficiary designation form but mistakenly uses her husband’s social security number, out of habit. What happens?
The investor correctly designates Jacob on the form but later changes her mind and designates her husband as the beneficiary of the LLC interest in her will. Unfortunately for her husband, the beneficiary designation made using your form cannot be undone by the will. Your form didn’t make that clear.
The investor properly designates Jacob as the beneficiary of her LLC interest and doesn’t change her mind, but she lives in a community property state and your form didn’t tell her she needed her husband’s consent.
The investor properly designates Jacob as the beneficiary of her LLC interest but he dies before she does, and she hasn’t designated a successor beneficiary.
Your site crashes and the investor’s beneficiary designation is lost.
What’s your budget for legal fees this year?
Designating a beneficiary on your site isn’t the investor’s only option. She can sign a simple will or codicil (if she already has a will) designating a beneficiary for her LLC interest and any other securities or other property, which probably makes more sense than designating beneficiaries security-by-security. And if her cousin and husband end up arguing over the codicil, you’re not involved.
If you’d like a sample of a Beneficiary Designation Form let me know.
Since the JOBS Act was signed by President Obama in 2012, advocates have been urging Congress to increase the overall limit of $1 million (now $1.07 million, after adjustment for inflation) to $5 million. But for many issuers, the overall limit is less important than the per-investor limits.
The maximum an investor can invest in all Title III offerings during any period of 12 months is:
If the investor’s annual income or net worth is less than $107,000, she may invest the greater of:
$2,200; or
5% of the lesser of her annual income or net worth.
If the investor’s annual income and net worth are both at least $107,000, she can invest the lesser of:
$107,000; or
10% of the lesser of her annual income or net worth.
These limits apply to everyone, including “accredited investors.” They’re adjusted periodically by the SEC based on inflation.
These limits make Title III much less attractive than it should be relative to Title II. Consider the typical small issuer, NewCo, LLC, deciding whether to use Title II or Title III to raise $1 million or less. On one hand, the CEO of NewCo might like the idea of raising money from non-accredited investors, whether because investors might also become customers (e.g., a restaurant or brewery), because the CEO is ideologically committed to making a good investment available to ordinary people, or otherwise. Yet by using Title III, NewCo is hurting its chances of raising capital.
Suppose a typical accredited investor has income of $300,000 and a net worth of $750,000. During any 12-month period she can invest only $30,000 in all Title III offerings. How much of that will she invest in NewCo? Half? A third? A quarter? In a Title II offering she could invest any amount.
Because of the per-investor limits, a Title III issuer has to attract a lot more investors than a Title II issuer. That drives up investor-acquisition costs and makes Title III more expensive than Title II, even before you get to the disclosures.
The solution, of course, is that Congress should make the Title III rule the same as the Tier 2 rule in Regulation A: namely, that non-accredited investors are limited, but accredited investors are not. I can’t see any policy argument against that rule.
In the meantime, almost every Title III issuer should conduct a concurrent Title II offering, and every Title III funding portal should build concurrent offerings into its functionality.
Crowdfunding is a marketing business. But when it comes to marketing an offering of securities by a Title III issuer, things get complicated. That’s why this is three times longer than any blog post should be.
Why It Matters
Section 5(c) of the Securities Act provides that an issuer may not make an “offer” of securities unless a full-blown registration statement is in effect, of the kind you would prepare for a public offering.
There are lots of exceptions to the general rule and Title III is one of them: you can make “offers” of securities without having a full-blown registration in effect, if you comply with the requirements of Title III.
On one hand that’s good, because if you market your offering as allowed by Title III, you’re in the clear. On the other hand, if you make “offer” of securities without meaning to, or without complying with the intricacies of Title III, you could be in trouble in two ways:
You might have violated section 5(c), putting yourself in jeopardy of enforcement action by the SEC and other liability.
By making an illegal offer, you might have jeopardized your ability to use Title III at all.
What is an “Offer” of Securities?
Section 2(a)(3) of the Securities Act defines “offer” very broadly, to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” And the SEC has defined “offer” even more broadly than those words suggest. Going back to 1957, the SEC said that any publicity that could “contribute to conditioning the public mind or arousing public interest” could be treated as an “offer.”
These examples illustrate the spectrum:
A company continues to advertise its services as usual, keeping its plans for an offering under wraps, then files an S-1 registration statement.
A company steps up its public relations efforts before a new product announcement, which happens to coincide with a new public offering.
For six months before it files a registration statement, a company triples its advertising budget, trying to build brand recognition specifically with the investing public.
A company puts up a website announcing “Please buy our common stock!”
The SEC has adopted a number of rules describing behavior that will not be treated as an “offer” for purposes of section 5(c). For example, Rule 135 allows so-called “tombstone” advertisements of registered offerings, Rule 135c allows notices of private offerings by publicly-reporting companies, and Rule 169 allows factual business information released by an issuer that has filed or intends to file a registration statement. But all these rules apply only to companies that are or intend to become public or publicly-reporting. There are no equivalent rules dealing with the behavior of small companies.
A Different Definition for Small Companies?
With that background, advice given by the SEC in 2015 catches your attention:
Question: Does a demo day or venture fair necessarily constitute a general solicitation for purposes of Rule 502(c)?
SEC Answer: No. Whether a demo day or venture fair constitutes a general solicitation for purposes of Rule 502(c) is a facts and circumstances determination. Of course, if a presentation by the issuer does not involve an offer of a security, then the requirements of the Securities Act are not implicated.
The italicized statement is true, by definition. If there is no “offer,” the securities laws don’t apply. Even so, it’s hard to reconcile with the SEC guidance for public companies. A “demo day” is, by any definition, an event where companies make presentations to investors. Not to customers, to investors. If merely “conditioning the public mind” can be an offer, it is very hard to understand how presenting to a roomful of investors could not be an offer.
Trying to reconcile the two, you might conclude that the SEC is, in effect, using different definitions of “offer” depending on the circumstances. During the period surrounding a public offering of securities a stringent definition applies (the 1957 ruling involved the period immediately following the filing of a registration statement) while outside that period a more lenient definition applies. If that were true, those of us trying to advise Title III issuers would sleep better.
There are two glitches with the theory, however:
Maybe the SEC will view the period surrounding a Title III listing in the same way it views the period surrounding a public registration statement.
The preamble to the final Title III regulations actually cites Rule 169 and cautions that “The Commission has interpreted the term ‘offer” broadly. . . .and has explained that ‘the publication of information and publicity efforts, made in advance of a proposed financing which have the effect of conditioning the public mind or arousing public interest in the issuer or in its securities constitutes an offer. . . .’” That sure doesn’t sound like a more lenient rule for Title III.
The Title III Rule for Advertising
Title III is about Crowdfunding, right? Doesn’t that mean Title III issuers are allowed to advertise anywhere and say anything, just like Title II issuers?
Not exactly.
A core principle of Title III is that everything happens on the portal, where everyone can see it, so nobody has better access to information than anyone else. A corollary is that that Title III issuers aren’t allowed to advertise freely. If a Title III issuer put information about its offering in the New York Times, for example, maybe readers of the New York Post (are there any?) wouldn’t see it.
A Title III issuer can advertise any where it wants – Twitter, newspapers, radio, web, etc. – but it can’t say any thing it wants. All it can do is provide a link to the Funding Portal with an ad that’s limited to:
A statement that the issuer is conducting an offering
The terms of the offering
Brief factual information about the issuer, e.g., name, address, and URL
In the public company world, those are referred to as “tombstone” ads and look just about that appealing. In the online world issuers can do much better. A colorful post on the issuer’s Twitter or Facebook pages saying “We’re raising money! Come join us at www.FundingPortal.com!” is just fine.
Insignificant Deviations From The Rules
Recognizing that Title III is very complicated and new, section 502 of the Title III regulations provides:
A failure to comply with a term, condition, or requirement. . . .will not result in the loss of the exemption. . . .if the issuer shows. . . .the failure to comply was insignificant with respect to the offering as a whole and the issuer made a good faith and reasonable attempt to comply. . . .”
The language is vague, as it has to be, but it certainly suggests that Title III issuers can make mistakes without losing the exemption. And there’s no reason why mistakes in advertising an offering should be treated more harshly than other mistakes.
The purpose of the advertising rule, as we’ve seen, is to ensure that every investor has access to the same information. If a Title III issuer mistakenly provides more information about its offering in a Facebook post than it should have, the infraction could be cured easily – for example, by ensuring that any information in the Facebook post appeared on the Funding Portal for at least 21 days before the offering goes live, or by correcting the Facebook post and directing Facebook friends to the Funding Portal.
Where Does That Leave Us?
Ideally, a company thinking about raising money using Title III would follow these simple rules:
Don’t attend demo days.
In fact, don’t mention your plan to raise money to any potential investors until you register with a Title III Funding Portal.
The minute you want to talk about raising money, register with a Title III Funding Portal.
After registering with a Title III Funding Portal, don’t mention your offering except in “tombstone” advertising.
After registering with a Title III Funding Portal, don’t meet, speak, or even exchange emails with investors, except through the chat room on the Funding Portal.
A company that follows those rules shouldn’t have problems.
That’s ideal, but what about a company that didn’t speak to a lawyer before attending a demo day? What about a company that posted about its offering on Facebook before registering with a Funding Portal, and included too much information? What about a company that’s spoken with some potential investors already? What about a real company?
Nobody knows for sure, but unless the SEC takes a very different position with regard to Title III than it has taken with regard to Regulation D, I think a company that has engaged in any of those activities, or even all of those activities, can still qualify for a successful Title III offering.
Let’s not forget, the SEC has been very accommodating toward Crowdfunding, from the no-action letters in March 2013 to taking on state securities regulators in Regulation A. With section 502 in its toolbox, it’s hard to believe that the SEC is going to smother Title III in its cradle by imposing on startups the same rules it imposes on public companies.
It’s instructive to look at the way the SEC has treated the concept of “general solicitation and advertising” under Regulation D.
By the letter of the law, any contact with potential investors with whom the issuer does not have a “pre-existing, substantive relationship” is treated “general solicitation,” disqualifying the issuer from an offering under Rule 506(b) (and all of Rule 506, before the JOBS Act). But the SEC has taken a much more pragmatic approach based on what it refers to as “long-standing practice” in the startup industry. In fact, in a 1995 no-action letter the SEC concluded that there had been no “general solicitation” for a demo day event even when investors had been invited through newspaper advertisements.
I think the SEC will recognize “long-standing practice” in interpreting Title III also.
Bearing in mind the language of section 502, I think the key will be that an issuer tried to comply with the rules once it knew about them, i.e., that a company didn’t violate the rules flagrantly or intentionally. If you’re a small company reading this post and start following the rules carefully today, I think you’ll end up with a viable offering. Yes, there might be some legal doubt, at least until the SEC issues clarifications, but entrepreneurs live with all kinds of doubt, legal and otherwise, all the time.
It’s Not Just the Issuer
The issuer isn’t the only party with a stake in the advertising rules. The Funding Portal might have even more on the line.
Here’s the challenge:
Before allowing an issuer on its platform, a Funding Portal is required to have a ”reasonable basis” for believing that the issuer has complied with all the requirements of Title III.
We’ve seen that one of the requirements of Title III is that all advertising must point back to the Funding Portal.
Before the issuer registered with a Funding Portal, advertising by the issuer couldn’t have pointed back to the Funding Portal.
Therefore, if a would-be issuer has engaged in advertising before registering with the Funding Portal, including any activity that could be construed as an “offer” for purposes of section 5(c), the Funding Portal might be required legally to turn the issuer away.
With their legal obligations in mind, dozens of Funding Portals are preparing questionnaires for would-be issuers as I write this, asking questions like “Have you made any offers of securities during the last 90 days? Have you participated in demo days?”
If the Funding Portal denies access to any issuer that answers “I don’t know” or “Yes,” it might end up with very few issuers on its platform. On the other hand, if it doesn’t ask the questions, or ignores the answers, it’s probably not satisfying its legal obligation, risking its SEC license as well as lawsuits from investors.
The Funding Portal will have to make some tough calls. But its answer doesn’t have to be limited to “Yes” or “No.” For one thing, using its own judgment, the Funding Portal might suggest ways for the issuer to “fix” any previous indiscretions. For another, rather than make the call itself, the Funding Portal might ask for an opinion from the issuer’s lawyer to the effect that the issuer is eligible to raise money using Title III.
Advertising Products and Services
We’ve seen that product advertisements by a company that has filed, or is about to file, a public registration statement can be viewed as an “offer” of securities for purposes of section 5(c) if the company uses the product advertisement to “arouse interest” in the offering. However, I don’t believe this will be a concern with Title III:
A company that has registered with a Funding Portal should be free to advertise its products and services however it pleases. There’s no “quiet period” or similar concept with Title III the way there is with a public registration.
A company that has not yet registered with a Funding Portal and is not otherwise offering its securities should also be free to advertise its products or services. Just not at a demo day!
Many companies in the Title III world will be looking to their customers as potential investors. For those companies it makes perfect sense to advertise an offering of securities in conjunction with an advertisement of products or services. Sign up with a Funding Portal, follow the rules for advertising, and “joint” advertisements of product and offering should be fine.
Will a Legend Do the Trick?
Suppose a company thinking about raising money using Title III Crowdfunding makes a presentation to a roomful of investors at a demo day, but includes on each slide of its deck the disclaimer: “This is Not An Offering Of Securities.”
The disclaimer doesn’t hurt and might tip the balance in a close case, but don’t rely on it.
An Issuer With A Past: Using Rule 506(c) to Clean Up
Photo Credit: Fast Company editor Jason Feifer
In Scott Fitzgerald’s TheGreat Gatsby, the main character reaches for a new future but, in the end, finds himself rowing “against the current, borne back ceaselessly into the past.” In this final section I’ll suggest a way that an issuer might raise money using Title III notwithstanding a troubled past, succeeding where Jay Gatsby could not.
Suppose an issuer registers with a Funding Portal, raises money using Title III, then fails. Looking for a basis to sue, investors learn that the issuer attended a demo day three weeks before registering with the Funding Portal. An illegal offer! Gotcha!
“No,” says the issuer, calmly. “You’re right that we attended a demo day and made an offer of securities, but that’s when we were thinking about a Rule 506(c) offering. As you know, offers made under Rule 506(c) are perfectly legal. It was only afterward that we started to think about Title III.”
As long as the record – emails, promotional materials, investor decks, and so forth – demonstrates that any “offers” were made in contemplation of Regulation D rather than Title III, I think the issuer wins that case. The case would be even stronger if the issuer actually sold securities using Rule 506(c) and filed a Form D to that effect, before registering with the Funding Portal.
An issuer with a troubled past – one that has attended lots of demo days, posted lots of information on Facebook and met with a bunch of different investors – might go so far as to engage in and complete a Rule 506(c) offering before registering on a Funding Portal. With the copy of the Form D in their files, the issuer and the Funding Portal might feel more comfortable that the troubled past is behind.
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?
Why has Home Depot made local hardware stores a thing of the past? Partly price, but mainly selection. And I think the same forces will require most Crowdfunding portals to offer investments under Title II, Title III, and Title IV, all at the same time.
Crowdfunding portals are like retail stores that sell securities. They have suppliers, which we call “sponsors” or “portfolio companies,” and they have customers, which we call “investors.” They pick the market they want to serve – hard money loans, for example – then try to stock their shelves with products from the best suppliers to attract the largest number of customers. Think of DSW, but selling securities rather than shoes.
Now consider these situations:
You’re a Title II portal and have established a relationship with Sandra Smith, a real estate developer you’ve learned to trust. She informs you she’d like to raise $30 million to build a shopping center in Chicago and needs to attract investors from the local community. You could tell her you only do Title II and send her across the street, but maybe she’ll find a competitor where she can get Title II and Title IV under one roof. So you’d really like to offering Title IV as well, which means attracting non-accredited investors.
You’re a Title II portal raising money for biotech. A company approaches you with a new therapy for cystic fibrosis. They have 117,000 Facebook followers and wide support in the cystic fibrosis community, and have already raised $30,000 in a Kickstarter campaign. They want to raise $800,000 for clinical tests, then come back and raise $5 million if the tests are successful. Sure, you could tell them to go somewhere else for the $800,000 raise and come back for the larger (and more profitable) $5 million round, but once they leave they’re probably not coming back.
You’re a Title III portal with lots of investors signed up. Turned away by the portal she’s used to working with, Sandra Smith asks for your help in the $30 million Title IV raise. Any reason to turn her down?
Those of us in the industry see Title II, Title III, and Title IV as separate things, but to the suppliers and customers of the industry they’re all the same thing. The differences between Title II and Title IV are nothing compared to the differences between sneakers and 6-inch heels! Yet DSW sells them both and everything in between because in the eyes of customers, they’re all shoes.
It doesn’t matter to suppliers and customers that Title II and Title III require different technology and business models. It doesn’t matter that one is more profitable than the other. Mercedes might lose money selling its lower-end cars but doesn’t mind doing so because customers who buy the lower-end Mercedes today buy the higher-end Mercedes 10 years from now. The Vanguard Group probably loses money on some of its funds but sells them anyway to keep customers in the fold. As the Crowdfunding market develops, I think the same will be true of the interplay with Title II, Title III, and Title IV.
For portals that have achieved success in Title II, it might be unwelcome news that Title II isn’t enough. But on the positive side, Fundrise has managed to leverage its reputation in Title II into a well-received REIT under Title IV. In any case, I think it’s inevitable.
Everyone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.
The basics of the 100 investor rule:
A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.
Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.
In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?
Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?
Fortunately, the answer is No.
For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.
That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.
Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.
Workers Compensation and Employers liability Insurance (usually mandatory by law)
Excess or Umbrella Liability coverage (providing additional coverage limits for liability claims, and in the case of umbrella coverage, coverage for some claims not provided by a commercial general liability policy)
However, the “standard” coverage probably won’t cover everything a portal does. For that, a portal will need insurance specific to the world of buying and selling securities.
Someday, maybe soon, the insurance industry will create a product specifically for Crowdfunding portals and buying the right policy will be easier. But that hasn’t happened yet. Today, you have to pick a policy type that seems close – maybe a policy for managing a private investment fund – and then seek to modify the policy yourself. For example, the policy might cover making investments in portfolio companies. You would have to seek to modify that policy to explicitly cover “Raising money for debt and equity investments under SEC Rule 506 and Regulation A, and all related activities.”
Don’t assume that a “standard” policy will cover lawsuits from unhappy investors, for example. Also don’t assume that your insurance agent understands exactly what a Crowdfunding portal does. Sure, the insurance company will sell you the policy and accept the premium, but that’s only the first chapter in the story. The rubber hits the road when you’re sued and submit a claim. That’s a really bad time to find out your coverage is inadequate.
Portals should also consider:
Director and officer insurance, which protect the officers, directors, and managers of the entity from claims made on behalf of the entity
Fiduciary Liability insurance, which covers misappropriations by employees.
How much insurance should you buy? You’ve got to consider the size of your deals, how many deals you do each year, the amount of the typical investment, and the risk profile of your deals. You’ll find that the first dollar of coverage is the most expensive, while each additional dollar is relatively less expensive.
As anyone who’s been through litigation knows, being sued is very expensive. That’s why it’s critical that your insurance cover not only payment of the actual claims (if you lose or settle), but the cost of defending the claims. Sometimes the costs of defense are subtracted from the policy limits, and therefore effectively erode those limits.
EXAMPLE: Your nominal policy limit is $3 million, but defense costs are subtracted. The carrier spends $350,000 to defend a claim (yes, that’s possible). Now your policy limit is $2,650,000.
Other key points to consider in an insurance policy:
Whether the coverage is “occurrence” or “claims made” (the former covers all claims that relate to periods while the coverage was in effect; the latter covers only claims made while the coverage is still in effect)
Whether and to what extent the coverage includes “prior acts” (things that happened before the coverage was in effect)
The deductibles (the amount you have to pay before the insurance kicks in)
Whether you have the right to select legal counsel or must accept the lawyer chosen for you by the insurance company
My colleague, Mitch Kizner, spends most of his time arguing with insurance carriers about terms and coverage. If you’re wondering whether you’re covered, Mitch is a good guy to speak to. His email address is mitch.kizner@flastergreenberg.com and his direct dial is (856) 382-2247. You can also follow his blog at www.mitchkizner.com or on twitter @MitchKizner.
The Crowdfunding market continues to grow rapidly, increasing in deal size, deal volume, and sophistication. The rapid growth will likely continue for the foreseeable future, as more investors and entrepreneurs learn about the opportunities. And the growth will accelerate if and when:
The SEC finalizes regulations under Title IV
Congress refurbishes Title III
Portals move toward pooled assets
Portals are created in more vertical markets
Deals become standardized across portals
Formally or informally, we get a secondary market for Crowdfunded investments
All those things will move the dial toward a larger, more robust Crowdfunding market. But to penetrate the mass market – to truly scale – Crowdfunding needs something more, and that thing is coming.
Like a telescope, a Crowdfunding portal has two ends: an investor end and a deal flow end. Today, the investor end of the telescope is almost infinitely scalable while the deal flow end has proven much more difficult. Even given the best technology and the best people, how do you push more deals through the narrow opening? More exactly, how do you perform effective due diligence on all those deals?
Look at the P2P sites, Lending Club and Prosper. They’re doing Crowdfunding, too, and they pushed more than $5 billion of consumer loans through their due diligence processes during 2014. They did it mainly by reducing due diligence to a series of algorithms. In fact, they perform so little due diligence of the old- fashioned variety that some states don’t allow them to sell securities.
Three factors have allowed Lending Club and Prosper to streamline due diligence and scale up:
They started with a built-in technology for determining a consumer’s creditworthiness: namely, a FICO score.
Starting with FICO scores, they created their own proprietary scoring systems using their own data. The more data they accumulate the better their scoring systems become, in a virtuous cycle.
They have educated their investors. Rather than allocate their entire investment to a single loan, investors diversify, trusting the averages.
In some respects what Lending Club and Prosper have done with consumer debt is no different than what Billy Beane did with baseball players: replacing a traditional process that relied on human expertise (scouts) with a new process that relies on data (sabermetrics).
At first glance, the typical Title II Crowdfunding site, whether real estate sites like Patch of Land and iFunding or venture capital sites like FundersClub, look a lot different than a P2P site. Fundamentally, however, they are in the same business. The question is not whether Title II (and Title III and IV) sites will move toward the P2P model, the question is is how quickly and in what ways.
I believe the convergence will happen from both ends.
First, portals are going to create the equivalent of FICO scores and the scoring systems of Prosper and Lending Club, even for complex real estate projects and hi-tech startups. Living in a world of big data, I believe this is not only possible but inevitable. As we speak, lots of smart people are looking at lots of data and trying to draw meaningful correlations between data and outcomes.
Is there a correlation between the FICO score of a real estate developer and the success of his next two projects? If an entrepreneur has had one successful exit is she more likely to have a second? If an angel has invested in three successful deals is he likely to have a fourth?
The world is flooded with data and fast computers. I believe Crowdfunding portals will crack the code, a little bit at a time, moving from a traditional, hands-on due diligence process to a data-driven, algorithmic process. Like old-time baseball scouts, those comfortable with the traditional processes are likely to cry foul, pointing out the inevitable gaps in statistics. They’ll be right in a narrow sense, but the world will move on nonetheless.
Second, because of the pressure to scale, portals will gravitate toward products that lend themselves to being scaled. It’s not a coincidence that Lending Club and Prosper sell consumer debt! The market suggests that real estate debt is likely to be the next product to scale, with real estate equity going to the back of the line. Going a step further, I’m guessing that the more difficult to crack the code in a given product, the higher the margin and the lower the volume.
If I knew exactly how the market will play out I wouldn’t be a lawyer! Nevertheless, it’s an incredibly exciting time.
Fortunately for me, there are a lot of complicated legal issues around Crowdfunding, including:
The differences among Title II, Title III, and Title IV
The differences between Rule 506(b) offerings and Rule 506(c) offerings
The differences between accredited investors and non-accredited investors
The Trust Indenture Act of 1939
The Investment Company Act of 1940
Applying broker-dealer and investment adviser laws to Crowdfunding portals
But at a higher level Crowdfunding isn’t complicated at all. Crowdfunding is just the Internet coming to the capital formation industry.
What happens when the Internet comes to an industry? Look at the publishing industry and the travel industry and the music industry and, increasingly, the entire retail industry:
Buyer and sellers connect directly
Middlemen are displaced
Prices decrease as the industry becomes more efficient
The middlemen being displaced are sure it won’t happen as it’s happening
In the end, the industry looks completely different and we all take it for granted
In Crowdfunding, the “sellers” are entrepreneurs and real estate developers seeking capital and the “buyers” are investors. The middlemen are the lawyers, bankers, finders, brokers, venture capital funds, investment advisors, and all the others who for the last 80 years have played an indispensable part in connecting entrepreneurs with investors. Today, for the first time, entrepreneurs and investors can connect directly, via the Internet. The middlemen have already started to be pushed to the side. The picture in my mind is an ice field slowly breaking apart as temperatures warm.
People sometimes ask whether Crowdfunding will last. I respond “When was the last time you planned a vacation through a bricks-and-mortar agency?” The Internet is here to stay!
The capital formation industry is enormous – far, far bigger than the book selling industry or the travel industry. And the middlemen in the capital formation industry enjoy far greater political power than Barnes & Noble. But in the end, resistance is futile.
As you’re planning and managing your own portal, or any other Crowdfunding business, pause every now and then and remember that for all the legal complexity, for all the nuts-and-bolts, day-to-day grind of generating cash flow, Crowdfunding is nothing more or less than the Internet come to the capital formation industry.
