Tag: crowdfunding vehicles

Caution: Don't Use Series LLC As A Crowdfunding Vehicle

FINRA: Don’t Use Series LLC As A Crowdfunding Vehicle

On By crowdfundattnyIn Crowdfunding, FINRA, Series LLCLeave a comment

At least one high-volume Crowdfunding portal once used a “series LLC” for each crowdfunding vehicle and used a crowdfunding vehicle for almost every offering. Maybe that portal and others still do.

In a post that has yet to be picked up by the Associated Press, this blog once explained why that was a bad idea from a legal liability point of view. Now FINRA has chimed in.

The Series LLC

Some states, notably Delaware, allow a single limited liability company to be divided into “series,” the way an auditorium could be physically divided into cubicles. If operated correctly, Delaware provides that the creditors of one series can’t get at the assets of another series. So if one series of the LLC operates an asbestos plant and is hit with a giant lawsuit, the plaintiffs can’t get at the assets of the real estate owned by a different series of the same LLC.

Why Not to Use a Series LLC

I argued that it would be foolish to use a series LLC as a crowdfunding vehicle because:

  1. The series LLC concept has never been tested in a bankruptcy court, so we’re still not 100% sure the walls between cubicles will hold up.
  2. Some states, like Arizona, don’t even recognize the series LLC concept. So if an Arizona resident invests in a series LLC that goes bad, she can theoretically get to the assets owned by every other series of the same LLC. When you have a high-volume portal using a new series over and over, that could be a nightmare.
  3. Using a series LLC rather than a brand new LLC saves less than $200.

FINRA Chimes In

According to a recent statement by FINRA, a series LLC would not satisfy 17 CFR §270.3a-9(a)(6), which requires a crowdfunding vehicle to “Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”

FINRA is saying, in effect, that while one series of an LLC might be protected from the liabilities of a different series under Delaware law, the series is not itself an “issuer.” The “issuer” is the LLC itself, i.e., the “parent” limited liability company formed by the portal. Because the securities of that parent do not reflect a one-to-one correspondence with the securities of any particular company raising money on the platform, it doesn’t qualify as a crowdfunding vehicle – it’s a plain vanilla investment company. And investments companies aren’t allowed to use Reg CF (they’re also subject to a bunch of other rules).

For what it’s worth, FINRA’s position about who can be an “issuer” is consistent with SEC practice.

The Upshot

If FINRA is right, it probably means that every offering that used a series LLC as a crowdfunding vehicle was illegal. 

Some possible ramifications:

  • Any investor who lost money can sue the issuer and the funding portal, and possibly their principals.
  • Every issuer can sue the funding portal.
  • Funding portals might be sanctioned by FINRA.

In short, a bonanza for plaintiffs’ lawyers and a black eye for the Crowdfunding industry.

Questions? Let me know. 

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

On By crowdfundattnyIn Crowdfunding, Crowdfunding Vehicles2 Comments

Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.

Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through  successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.

A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.

For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.

But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law. 

A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:

Seek instructions from the holders of its securities with regard to:

  • The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
  • Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.

So let’s think of two scenarios.

In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.

Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.

The first scenario clearly complies with Rule 3a-9. Does the second?

To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.

Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.

When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.

Questions? Let me know.