What “Solicit” Means Under Title III

Before the JOBS Act came along, listing a security on a public website would itself have been treated as an act of “solicitation.” That’s the odd thing: Title III portals aren’t allowed to “solicit,” yet in the traditional sense of the term that’s the most important thing Congress created them to do.

The fact is that Congress was ambivalent when it created Title III portals. They are allowed to list offerings of securities, but are not allowed to do other things often associated with the sale of securities, including holding investor funds or offering investment advice. They are regulated by the SEC and FINRA, but with a light touch compared with other regulated entities. They are privately-owned, but are required to provide educational materials to investors, police issuers, provide an online communication platform, and ensure that investors don’t exceed their investment limits – in short, they are required to assume a quasi-governmental role.

Title III portals are a new animal, part fish, part bird. Which makes it that much more difficult to decide what “solicit” means when they do it.

Based on the statute, the SEC regulations, the legislative background of the JOBS Act, and the history and overall context of the U.S. securities laws, I think a Title III portal engages in prohibited “solicitation” anytime it tries to steer an investor to a particular security. If it’s not trying to steer an investor to a particular security, then it’s probably okay.

I’ve included some practical guidelines in the chart below. Although there are plenty of gaps, I hope this helps.

Click the following for a print ready version of the complete chart: Rules for Title III Portals

Rules for Title III Portals

 

 

Crowdfunding Interview

Last Thursday I joined Jack Miller, the host of “Down to Business” on 880 AM The Biz in Miami, for a discussion about Crowdfunding and what it means for entrepreneurs and investors. Jack is a terrific interviewer and an entrepreneur himself, and brings a great perspective to the subject.

We had a lot of fun and might have even shed some light on this brave new world for Jack’s listeners.

Cautionmaterial not appropriate for all ages.

Questions? Let me know.

A Regulation A+ Primer

Regulation A Plus Women GossipingNo disrespect to Kim Kardashian, but I think the SEC’s proposals for Regulation A+ have come closer to breaking the Internet than the photos I heard about last year – although that could be a function of the circles I travel in.

My contribution started as a blog post but got too long for a blog post. Hence, I’m providing this Regulation A+ Primer as a separate link. Within the Primer are links to:

I am trying to provide not just technical details in the Primer – which are important – but also practical advice about the cost of Regulation A+ offerings, the advantages and disadvantages, and examples.

If you have thoughts, as many of you will, I am eager to hear them and plan to supplement the Primer.

Questions? Let me know.

Why the Jobs Act Broker-Dealer Exception Doesn’t Matter (Much)

US CApitol Building Illuminated at Night

Under section 201(c) of the JOBS Act, an electronic platform is not required to register as a broker-dealer solely because the platform offers securities under Title II, co-invests in the securities, or provides due diligence services or standardized documents. That’s good.

What Congress giveth, however, Congress can taketh away. The exemption from broker-dealer registration is not available if:

  • The platform or anyone associated with the platform receives compensation in connection with the purchase or sale of securities; OR
  • The platform helps to negotiate deals; OR
  • The platform requires issuers to use its standardized documents; OR
  • The platform is separately compensated for giving investment advice; OR
  • The platform or anyone associated with the platform takes possession of investor funds or securities; OR
  • The platform or anyone associated with the platform is disqualified under the “bad actor” rules.

Theoretically, the JOBS Act broker-dealer exemption paved the way for Crowdfunding platforms to sell securities free from the constraints of Depression-era securities laws. In practice, however, platforms have found it very difficult, almost impossible, to build a profitable business around the exemption because of all the gaps in the exemption and the list of things you can’t do.

For example:

  • To claim the exemption, a platform may not receive any compensation in connection with the purchase or sale of securities. That doesn’t just mean “transaction-based compensation” like commissions, it means any compensation. If the platform receives a carried interest or promote, for example, the exemption disappears.
  • From a business perspective it makes sense for the platform to employ an investor-relations specialist, someone to reach out to prospective investors. But if that person receives any compensation, even a salary, the exemption disappears.
  • Suppose the platform organizes a special-purpose entity for its investors and negotiates the terms of the deal with the issuer. Buzz! The exemption disappears.
  • The exemption doesn’t even apply to employees of the platform. If they engage in activities that are not protected by SEC Rule 3a4-1, they themselves could be required to register as broker-dealers.
  • Even if you qualify for the Federal exemption, it doesn’t mean you’re exempt from state broker-dealer registration.

Here’s how the SEC answered a question about the scope of the exemption:

QUESTION

May an entity, such as a venture capital fund or its adviser, operate an Internet website where it lists offerings of securities by potential portfolio companies (in compliance with Rule 506), co-invest in those securities with other investors, and provide standardized documents for use by issuers and investors, rely on Securities Act Section 4(b) to not register as a broker-dealer?

ANSWER

Yes. These activities are permitted under Section 4(b), subject to the conditions set forth in Section 4(b)(2), including the prohibition on receiving compensation in connection with the purchase or sale of securities. As a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.

That’s pretty clear.

Now, the fact that a platform doesn’t qualify for the JOBS Act exemption doesn’t automatically mean the platform has to register as a broker-dealer. Whether the platform has to register as a broker-dealer would be tested under the body of laws stretching back 80 years. My point is that the JOBS Act exemption itself will be irrelevant for most platforms.

As someone once said, Crowdfunding is nothing more or less than the Internet come to the capital formation industry. Crowdfunding platforms sit astride the Internet pipeline directly connecting entrepreneurs with investors. Matching buyer to seller, they function as “brokers” in the most fundamental sense of the word.

In this sense, changing the business practices of a Crowdfunding platform to comply with the JOBS Act broker-dealer exemption is like pounding a round peg into a square hole. Pound long and hard enough and it’s possible. But it’s far better to run the platform business the way you want to run it, i.e., to make the most money. If you have to register as or affiliate with a broker-dealer, just do it.

Questions? Contact Mark Roderick.

Improving Legal Documents in Crowdfunding: Capital Calls

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? Contact Mark Roderick.

Do the Officers of a Crowdfunding Issuer Have to Register as Broker-Dealers?

thinking woman in jarToday, the most challenging legal question in Title II Crowdfunding is who is required to be a broker-dealer and under what circumstances. The question is most acute for the officers of an issuer, those who direct the issuer’s activities and put the offerings together.

Section 3(a)(4)(A) of the Securities and Exchange Act 1934 generally defines “broker” to mean “any person engaged in the business of effecting transactions in securities for others.” Section 15(a)(1) of the Exchange Act makes it illegal for any “broker. . . .to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless registered with the SEC.

Simply put, anybody in the business of effecting securities transactions for others must be registered. There is a lot of law around what it means to be “engaged in the business of effecting securities transactions for others.” Based on decided cases and SEC announcements, important factors include:

  • The frequency of the transactions.
  • Whether the individual‘s responsibilities include structuring the transaction, identifying and soliciting potential investors, advising investors on the merits of the investment, participating in the order-taking process, and other services critical to the offering.
  • Whether the individual receives commissions or other transaction-based compensation for her efforts.

Perhaps the most important rule is that the issuer itself – the entity that actually issues the stock – does not have to register as a broker-dealer. The logic is that the issuer is effecting the transaction for itself, not for others.

But what about the President of the issuer, and the Vice President, and all the other employees who send the mailings and put the deal on the website and answer questions from prospective investors? Are they required to register as – or, more accurately, become affiliated with – broker-dealers?

The answer is complicated.

SEC Rule 3a4-1, issued under the Exchange Act, provides a “safe harbor” from registration. Under Rule 3a4-1, an employee of an issuer will not have to register if she is not compensated by commissions, and EITHER:

Her duties are limited to:

  • Preparing any written communication or delivering such communication through the mails or other means that does not involve oral solicitation of a potential purchaser, as long as the content of all such communications are approved by a partner, officer or director of the issuer; or
  • Responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser, as long as her response is limited to providing information contained in an offering statement; or
  • Performing ministerial and clerical work.

OR

  • She performs substantial services other than in connection with offerings; and
  • She has not been a broker-dealer within the preceding 12 months; and
  • She does not participate in more than one offering per year, except for offerings where her duties are limited as described above.

Consider the President of the typical Title II portal offering borrower-dependent notes to accredited investors. Her duties are certainly not limited as described above, and she might participate in – actually direct – dozens of offerings per year. Does that mean she has to register as a broker-dealer?

Not necessarily. Rule 3a4-1 is only a safe harbor. If you satisfy the requirements of Rule 3a4-1 then you are automatically okay, i.e., you don’t have to register. But if you don’t satisfy the requirements of Rule 3a4-1, it doesn’t automatically mean you are required to register. Instead, it means your obligation to register will be determined under the large body of law developed by the SEC and courts over the last 80 years.

Courts and the SEC have identified these primary factors among others:

  • The duties of the employee before she became affiliated with the issuer. Was she a broker-dealer?
  • Whether she was hired for the specific purpose of participating in the offerings.
  • Whether she has substantial duties other than participating in the offerings.
  • How she is paid, and in particular whether she receives commission for raising capital.
  • Whether she intends to remain employed by the portal when the offering is finished.

Within the last couple years, a high-ranking lawyer in the SEC spoke publicly but informally about broker-dealer registration in the context of private funds, an area similar to Crowdfunding in some respects. He expressed concern at the way that some funds market interests to investors and suggested that some in-house marketing personnel might be required to register. At the same time, he suggested that an “investor relations” group within a private fund – individuals who spend some of their time soliciting investors – wouldn’t necessarily be required to register if the individuals spend the majority of their time on activities that do not involve solicitation. On one point he was quite clear: the SEC believes that if an individual receives commissions for capital raised, he or she should probably be registered.

Whether an officer or other employee of a Crowdfunding issuer must register as a broker-dealer will be highly sensitive to the facts; change the facts a little and you might get a different answer. With that caveat, I offer these general guidelines:

  • If an employee receives commissions, he has to register no matter what.
  • If an employee performs solely clerical functions, he does not have to register.
  • If an employee participates in only a handful of offerings, he does not have to register.
  • If an employee spends only a small portion of his time soliciting investors, he does not have to register.
  • If an employee advises investors on the merits of an investment, he’s walking close to the line. Describing facts, especially facts that are already available in an offering document or online, in response to an investor inquiry, doesn’t count as advising investors on the merits of an investment.

Here are two corollaries to those guidelines.

  • As long as he’s not paying himself commissions, the Founder and CEO of an issuer that is a bona fide operating company (not merely a shell to raise money) doesn’t have to register.
  • If the CEO hires Janet to solicit investors, and that’s all Janet does, and she speaks regularly with investors over the phone and helps them decide between Project A and Project B, the SEC is probably going to want Janet to be registered.

Of course, the most conservative approach for Crowdfunding issuers to run every transaction through a licensed broker-dealer. However, that adds cost and most issuers are trying to keep costs down.

This area is ripe for guidance from the SEC, and maybe even a new exemption for bona fide employees of small issuers. Stay tuned.

NOTE: I want to give a shout-out to Rich Weintraub, Esq. of Weintraub Law Group in San Diego. He and I had several very stimulating and thought-provoking conversations on this topic. If there are mistakes in the post, they’re all mine.

Questions? Contact Mark Roderick.

Wells Fargo Withdraws from Crowdfunding Space

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? Contact Mark Roderick at Flaster/Greenberg PC.

Crowdfunding and Fiduciary Obligations

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? Contact Mark Roderick at Flaster/Greenberg PC.

Crowdfunding and the Trust Indenture Act of 1939

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? Contact Mark Roderick at Flaster/Greenberg PC.

IMPROVING LEGAL DOCUMENTS IN CROWDFUNDING: MODEL WHITE LABEL CONTRACT

I see a lot of contracts between would-be Crowdfunding portals and “white label” portal software providers. It would help the industry, in my opinion, if everyone used or at least started with the same agreement. So I’ve drafted a model agreement, accessible as a Microsoft Word document here.

An agreement for a white label platform is a software license agreement. I’ve drafted more software license agreements than I can count, representing both licensors and licensees. That gives me a very good feel for what’s important, what’s not so important, and what’s fair.

My model agreement is designed to be a very fair document. It protects what’s important to the white label provider, and also protects what’s important to the would-be portal licensing the platform. It is also designed to be a comprehensive document, meaning it covers what’s important without overkill. I hope it’s easy to read and understand, as legal contracts go. And it’s completely flexible in terms of what the customer gets and how much the customer pays.

Multi-million-dollar portal businesses are being created based on the relationship created by this contract. It’s not a back-of-the-napkin kind of thing.

Because there could be special situations that the model agreement doesn’t cover, white label providers and their customers should have this model agreement reviewed by their own lawyers. Also, I haven’t provided a Service Level Agreement, because response times might vary significantly among white label providers.

But using one standard agreement should make things easier for everyone. Fewer transaction costs, less friction, greater certainty, faster to market. That’s what the industry needs.