FINRA Annual Compliance Conference JOBS Act Panel

Transcription

1 FINRA Annual Compliance Conference JOBS Act Panel May 19, 2014 Richard B. Levin and Aaron A. O Brien Baker & Hostetler, LLP

2 Game-Changer * Right now, you can only turn to a limited group of investors -- including banks and wealthy individuals -- to get funding. Laws that are nearly eight decades old make it impossible for others to invest. But a lot has changed in 80 years, and it s time our laws did as well. Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors -- namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in. President Obama January 2012 *President Obama Signs JOBS Act Into Law, ABC News on-line (April 15, 2012) (available at 2

3 Regulation of the Sale of Securities Any offer and sale of a security must either be registered or exempt from registration under the applicable securities laws - See Section 5 of the Securities Act of 1933 (the Securities Act ). This panel is focusing on the sale of unregistered securities pursuant to Rule 506 of Regulation D and the new crowdfunding exemptionfrom registration under the SecuritiesAct. Securities sold by means of the above exemptions are restricted securities and may not be sold without registration or an applicableexemption. Restricted securities are unregistered securities acquired directly or indirectly from the issuer, or an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering (SEC Rule 144). 3

4 JOBS Act On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the JOBS Act ) which made a number of important changes to the federal securities laws. 1 At the signing of the bill, President Obama described the JOBS Act as a game changer noting that [b]ecause of this bill, start-ups and small business will now have access to a big, new pool of potential investors namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in. 2 Title III of the JOBS Act exempts certain crowdfunding offerings from registration and effectively opens the door to crowdfund investing by exempting transactions, securities, issuers and intermediaries from certain basic federal and state filing requirements. Under the new exemption, issuers will be able to raise up to $1 million over a 12-month period. 1 P.L , 126 Stat. 305 (2012). 2 President Obama Signs JOBS Act Into Law, ABC News Online (April 15, 2012). 4

5 JOBS Act Summary The JOBS Act made a number of important changes to federal securities laws that are meant to ease and expand methods of capital raising by private companies. Key provisions of the JOBSAct: Removed the prohibition on general solicitation in connection with transactions effected pursuant to Rule 506 of Regulation D or Rule 144A under the Securities Act, provided that sales are limited to qualifying investors; Created an exemption from broker-dealer registration available to certain intermediaries facilitating offerings that use general solicitation under Title II of the JOBS Act, and Added a crowdfund investing exemption to the Securities Act. A copy of the JOBS Act is available at: 112hr3606enr.pdf 5

6 JOBS Act Summary (Continued) Prior to the passage of the JOBS Act, Rule 506 permitted issuers to sell an unlimited amount of securities to accredited investors without requiring the registration of those securities under the Securities Act. However, issuers could not use general solicitation to sell securities under Rule 506. The JOBS Act lifted the ban on the use of general solicitation in Rule 506 offerings. These modifications to Rule 506 provide substantial freedom for issuers to promote their offering to a wider group of potential investors under federal law. However, state Blue Sky laws still play a role in these new offerings, as state broker-dealer laws and regulations are not preempted by the Act. Issuers and their agents must be sure to understand whether engaging in a general solicitation will cause them to be required to register as a broker, dealer, sales agent, or other representative in states where they offer and sell securities. 6

7 JOBS Act Summary (Continued) This represents a major policy shift in the scope of private offerings. In the past, the SEC interpreted the ban on general solicitation or general advertising to limit offers to only a distinct group of sophisticated persons with whom the issuer has a pre-existing relationship, meaning that the securities could not be offered through any advertisements, articles, or notices published in any newspaper, magazine, publicly accessible website, or broadcast over television or radio. Following the adoption of Rule 506(c), all of these outlets are permissible media for publicity of Rule 506(c) offerings. Any issuer that chooses to avail itself of this new privilege, however, is prohibited from selling securities to any person who is not an accredited investor. Issuers who advertise to the general public in reliance on this new exemption must engage in meaningful due diligence with respect to accredited investor status of any new investors before finalizing a sale. 7

8 Regulation D Regulation D of the Securities Act contains three rules that exempt an offering from the registration requirements under the Securities Act. Rules 504, 505, and 506 provide exemptions from registration so long as specific requirements are met, with each rule having its own requirements and limitations. Rules 504 and 505 were established to help small businesses raise capital, and thus their offering sizes were limited to $1 million and $5 million, respectively. Rule 506, however, is a non-exclusive safe harbor that has no limit on the size of the offering. Issuers participating in Regulation D offerings have been limited in the number of potential investors they can reach. An issuer may sell to 35 non-accredited investors if the issuer reasonably believes with regard to each such purchaser that it has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or... immediately prior to making any sale that such purchaser comes within this description. 8

9 Rule 506 Sales to Accredited Investors Rule 506 is a primary means by which companies raise capital through the sale of unregistered securities. The rule exempts from registration with the SEC offerings that do not involve public distribution or general solicitation. One of the most important requirements of an offering under Regulation D has historically been that the securities are not sold via general solicitation or general advertising (except for a narrow exception under Rule 504). While there is no specific definition of what constitutes general solicitation and general advertising, Rule 502(c) provides several examples, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited by general solicitation or general advertising, as well as other uses of publicly available media, such as unrestricted websites. 9

10 What is an Accredited Investor? The Securities Act defines an accredited investor as an individual who: has an annual income for the past two years exceeding $200,000, or $300,000 with his or her spouse, each year, with a reasonable expectation of earning that amount in the current year; or has a net worth or joint net worth with his or her spouse exceeding $1,000,000, excluding the value of his or her primary residence and certain other debt. Entities can also be accredited investors based on their net worth, the accredited investor status of their owners, or if they are a bank, savings and loan, broker-dealer, insurance company, registered investment company, business development company, licensed small business investment company or certain employee benefit plans. 10

11 Rule 506(c) Sales to Accredited Investors Using General Solicitation At its July 2013 open meeting, the SEC approved a rule proposal to amend Rule 506 and Rule 144A under the Securities Act. The rule proposal was required by the JOBS Act. The amendments lifted the ban on general solicitation in offerings under Rule 506 and 144A (and added Rule 144A requirements to initial sales thereunder). The amended rule represents an important change to the process by which securities may be sold by private investment funds, such as hedge funds, private equity funds, and venture capital funds. New Rule 506(c) permits issuers, including private investment funds, to use general solicitation to engage a larger group of potential investors without engaging in a registered public offering. In order to generally solicit and advertise to investors in reliance upon Rule 506(c), all terms and conditions of Rule 501, 502(a), and 502(d), which set forth definitions, general conditions to be met, and limitations on resale, respectively, also must be satisfied and all purchasers must be accredited investors. Issuers relying on Rule 506(c) are no longer subject to the prohibition against general solicitation found in Rule 502(c). 11

12 Reasonable Steps to Verify Accredited Investor Status Issuers relying on Rule 506(c) must take "reasonable steps to verify" that purchasers are accredited investors. Rule 506(c) includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement (as it relates to accredited investor status) for purchasers who are natural persons. It is important that issuers recognize that this step must be taken and that an issuer will not avoid an enforcement action on other grounds simply because the purchasers ultimately were all accredited investors. The Adopting Release indicates that "reasonable" is an "objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction." In evaluating the status of an investor, issuers should consider the following factors: The nature of the purchaser and the type of accredited investor that the purchaser claims to be; The amount and type of information that the issuer has about the purchaser; and The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as whether it requires a minimum investment amount.. 12

13 Non-Exclusive List of Methods to Confirm Accredited Investor Status The SEC offered a non-exclusive list of four specific methods for satisfying the verification requirement of Rule 506(c). Issuers employing any of the following methods will be deemed to satisfy the verification requirement, unless the issuer or its agent has knowledge that the purchaser is not an accredited investor: Verifying whether a natural person is an accredited investor on the basis of income through reliance on a combination of tax reporting forms and written investor representations. Verifying whether a natural person is an accredited investor on the basis of net worth through reliance on (i) recent statements from financial institutions, tax assessments, third party appraisals or a recent credit report and (ii) related investor representations. By relying upon written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a certified public accountant that a person or entity has taken reasonable steps to verify that a purchaser is an accredited investor within the prior three months and has determined that such a purchaser is an accredited investor. 13

14 Amended Rule 506 and General Solicitation Portals Section 201(c) of the JOBS Act adds new Section 4(b) to the Securities Act which provides than an individual or entity that maintains a platform or other mechanism that permits the offer or sale of securities, or general solicitation by issuers, whether online, in person, or by any other means is exempt from registration as a broker dealer (the Section 4(b) Exemption ). The Section 4(b) Exemption is meant to allow parties to operate a platform to facilitate the sale of securities in Rule 506 offerings that use general solicitation without becoming subject to broker-dealer registration and the obligations attendant thereto. The entity seeking to rely on the Section 4(b) Exemption: cannot have possession of customer funds or securities; cannot be subject to statutory bad-boy disqualifications; and cannot receive compensation in connection with the purchase or sale of securities. A flat fee for an issuer to list securities, or for an investor to access a site, on the other hand, will likely be permissible fees inside of the exemption. 14

15 Rule 506 Title II FAQ On February 5, 2013, the staff of the SEC s Division of Trading and Markets published a series of frequently asked questions (the FAQ ) regarding Section 201(c) of the JOBS Act and Rule 506 offerings. A copy of the FAQ is available at: The FAQ addressed some of the questions that have arisen with regard to the Section 4(b) Exemption for platforms planning to facilitate new Rule 506(c) offerings that use generalsolicitation. The FAQ notes that the Section 4(b) Exemption is a narrowly prescribed given the restrictions on permissible compensation. The FAQ highlights the fact that the Section 4(b) Exemption does not extend the exemption from federal broker-dealer registration to registration as a broker or a dealer under applicable state laws. While many states have certain limited exemptions to registration as a broker or a dealer, it is questionable whether such exemptions will apply to a platform that is using the Internet to potentially solicit a large number of investors in multiple states. 15

16 Rule 506 Title II FAQ (Continued) The FAQ also addressed the types of compensation such platforms can receive. The SEC noted that it broadly interprets compensation as any form of direct or indirect economic benefit to persons operating a platform or to associated persons. The receipt of any such compensation would generally disqualify the platform from the Section 4(b) Exemption. Despite this, the staff acknowledges that Congress expressly included co-investment in securities offered on a platform as a permitted form of compensation under Section 4(b). The FAQ states that an entity, such as a venture capital fund, could operate an Internet website to list securities offered by its portfolio companies (in compliance with Rule 506(c)) without registering as a broker-dealer if the compensation the venture capital fund receives in connection with the offering of such securities is realized as a result of co-investment by the fund in those securities with other investors. The staff explained, "[w]e 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." While the staff s explicit acknowledgment of co-investment clarifies that this form of compensation is permissible under Section 4(b), it fails to directly address the question of what, if any, other types of compensation, such as a listing fee or an introduction fee, might be permissible under the broker-dealer registration exemption. 16

17 What is Crowdfunding? Crowdfunding is a capital raising technique whereby small and start-up businesses raise money through small contributions from a large number of investors. Crowdfunding, which is typically conducted on the internet via third-party platforms, is the most recent trend in seed and growth funding, and could revolutionize small-business and non-profit fundraising. Prior to passage of the JOBS Act, crowdfunding was generally limited to four models: the philanthropic model, where investors donate their contributions to businesses and receive nothing in return; the reward model, where investors receive a reward, such as a coffee mug or their name in a film s credits, in return for their contribution; the pre-purchase model, where investors receive the product the enterprise is intending to sell in return for contributions; and the lending model, where investors make loans to enterprises and are repaid the principal amount with or without interest. Capital raising campaigns using these crowdfunding models were conducted at well-known online sites such as RocketHub, Kiva, Kickstarter, and Indiegogo. 17

18 How Does Crowdfunding Work? Such offerings, in the aggregate, are often enough to fund the low capital seeding needs of musicians, artists, and very small businesses seeking to build affinity relationships with consumers, while at the same time permitting people who are not professional investors to "vote with their dollars." In a typical online crowdfunding, an entrepreneur will publish a request for funding on a web-based platform (or bulletin board). The request will describe: the project; the manner in which the entrepreneur intends to use the proceeds of the crowdfunding; and the return, if any, that contributors to the crowdfund will receive in exchange for their contributions. Through crowdfunding, entrepreneurs and non-profit organizations, which have traditionally had difficulty obtaining capital due to regulatory constraints and registration costs, may take advantage of the Internet s pervasiveness to access potential investors and supporters anywhere in the world with whom they may have no substantive relationship. Recently WhatsApp, after initially raising funds through crowdfunding, was acquired by Facebook for $19 billion. 18

19 What is Crowdfund Investing? The JOBS Act amends Section 4 of the Securities Act to create a new exemption from registration for crowdfund investing. Under the new exemption, issuers will be able to raise up to $1 million over a 12-month period. Subject to the integration rules, investors in securities issued in crowdfund investing transactions will be limited in their annual investments to: the greater of $2,000 or five percent of an investor s annual income or net worth for investors with an annual income or net worth of less than $100,000 or the lesser of $100,000 or 10 percent of an investor s annual income or net worth for investors with an annual income or net worth of greater than $100,000. Crowdfund investing transactions will require the use of an intermediary, and any such intermediary must be registered with the SEC as either a broker-dealer or a funding portal. Funding portals will also need to become members of a self-regulatory organization (SRO). 19

20 What is Crowdfund Investing? The JOBS Act requires the SEC and a national securities association (i.e., FINRA) to write new rules to implement the crowdfund investing provisions of the JOBS Act, including rules addressing the form of and process for the registration of FundingPortals. Issuers who are seeking to sell securities in limited amounts to a wider group of investors will soon be able to engage in crowdfunding offerings. The consummation of the sale to all investors is made contingent on the offering reaching a certain dollar thresholdof committed subscriptions set by the issuer prior to the commencement of the offering. This new exemption will allow private issuers to access capital from a larger group of potential investors, but will require issuers to abide by a significant set of rules aimed at protecting investors. Foreign issuers, reporting companies, and investment companies will not be allowed to use this exemption. Each issuer must also limit the total amount of securities it sells to individual investors based on that investors annual income and net worth. 20

21 Proposed Crowdfunding Rules On October 23, 2013, at an open meeting the Securities and Exchange Commission (the SEC ) unanimously approved Proposed Rules to implement Title III of the JOBS. The proposed crowdfunding rules (the Proposed Rules ) implement Section 4(a)(6) and Section 4A of the Securities Act of 1933 (the Securities Act ) and Sections 3(h) and 12(g)(6) of the Securities Exchange Act of 1934 (the Exchange Act ). The SEC accepted public comments on the Proposed Rules, referred to as Regulation Crowdfunding, for 90 days following their publication date (accordingly, the comment period expired on February 5, 2014). Issuers may not rely upon the Section 4(a)(6) exemptions (the Crowdfunding Exemption ) to make offers and sales of securities to the general public until the Proposed Rules have been approved and adopted making the exemption, thereafter, effective. 21

22 Proposed Crowdfunding Rules The Proposed Rules create an opportunity for eligible companies to raise up to $1 million during any 12-month period from a large pool of individual investors via trading platforms over the Internet. The Proposed Rules set out the criteria for the sale of securities in certain limited-value securities offerings to purchasers who need not be accredited or sophisticated but who are subject to prescribed limits on their ability to invest. 3 The Proposed Rules also create a new disclosure form (Form C), to be used by issuers to provide notice of the issuer s reliance upon Section 4(a)(6) and to meet the disclosure requirements under that Section. The Proposed Rules provide a framework and guidance for the operation of online intermediaries (funding portals or broker-dealers operating online platforms). The Proposed Rules impose limits on the amount an issuer can raise, the amount an investor can invest, the disclosure that the issuer will be required to provide, the manner in which the funding portal will be qualified and operate. 3 Crowdfunding Proposed Rule, SEC Release No and (Oct. 23, 2013); 78 Fed. Reg. 66,428 (Nov. 5, 2013). A copy of the Proposed Rules. 22

23 Crowdfund Investing Investor Sophistication The Proposed Rules do not require investors in a crowdfunding offering to meet any sophistication or wealth thresholds, although they do limit the amount of money a person may invest in any 12-month period. Persons who have both annual income and net worth of less than $100,000 a year may only invest up to the greater of $2,000 or 5% of the investor s annual net worth, per year. Persons who have either annual income or net worth which exceed $100,000 may invest up to the greater of $100,000 or 10% of their annual net worth. Before an investor may invest in a crowdfunding offering, the investor must first open an account with the intermediary and consent to delivery of electronic materials. 23

24 Crowdfund Investing Required Disclosures Crowdfunding transactions will require the issuer to prepare disclosure documents, which must be filed with the SEC and provided to any potential investor, including: Information on the issuer, such as its name, legal status, address, and website; Names of the issuer s directors and officers, and any person who owns more than 20% of the issuer; Financial statements of the issuer, either certified by an officer, reviewed by an independent accountant, or audited by an independent accountant, basedon the size of the crowdfunding offering; A description of the issuer s business and its anticipated business plan; A description of the purpose of the offering and intended use of proceeds; The target offering amount and a deadline to reach that amount; and The price to the public for the securities, or the method that will be used to determine the price. 24

25 Crowdfund Investing Required Disclosures (Continued) Issuers must provide disclosure on the terms of the securities being offered and the rights of present and future security holders, including: A description of the ownership and capital structure of the issuer; The terms of the securities being offered as well as all classes of securities of the issuer; An explanation of how the terms of the offered securities may be modified, with information on how the rights of the offered securities may be limited, diluted, or qualified; and The risks to purchasers in the offering related to their role as minority owners of the issuer. 25

26 Crowdfund Investing Restrictions on the Issuer and investors In addition to the substantial mandatory disclosures, issuers must beware of a number of restrictions that will be imposed on the offering. Issuers must disclose the target offering amount, the offering deadline and whether they will accept funds beyond the target number (and, if so, how much) prior to launching the crowdfunding offering. Issuers may not advertise the offering, except to direct purchasers to the intermediary conducting the offering. Compensation to promoters of the offering will be severely circumscribed to prevent the provision of undisclosed compensation to third parties for finding investors. Investors will have rescission rights prior to the closing of the offering. The investor then must be given a reasonable period to rescind the commitment to purchase the securities. Issuers are prohibited from conducting multiple crowdfunding offerings via a single intermediary or simultaneous offerings via more than one intermediary. Investors who acquire securities in a crowdfunding transaction must observe a one year period where most transfers of the securities will be restricted. 26

27 Crowdfund Investing - Intermediaries One of the key restrictions on crowdfunding is that issuers must use an intermediary. A crowdfunding intermediary can either be a registered broker or a Funding Portal (a new intermediary created by the JOBS Act for the crowdfunding exemption) that complies with Section 4A(a). Under the Proposed Rules the Intermediary: Must be registered with a self-regulatory organization (FINRA). Is required to provide disclosure to investors regarding investment risks, and require each investor to answer questions demonstrating that investor understands the risks of investing in early stage companies and illiquid securities. Is prohibited from having a financial interest in any issuer using its services. Must perform a background check on each officer, director, and significant owner of the issuer. Intermediaries that register as Funding Portals will not be required to register with the SEC and FINRA as broker-dealers. 27

28 Crowdfunding Intermediaries (Continued) The activities of Funding Portals who are not-broker dealers will be narrowly circumscribed. Funding Portals must refrain from: providing any advice or recommendations regarding the securities on their portal, soliciting purchases, sales, or offers for securities listed on their portal, compensating employees or agents based on sales of securities listed on the portal, and holding investor funds or securities. An intermediary who wants to offer a full range of crowdfunding services, and be able to maintain flexibility in its revenue and compensation program, will want to seriously consider becoming or working with a registered brokerdealer. The JOBSAct provides that state securities registration of crowdfunding transactionswill be preempted. However, states will have authority regarding fraudulent transactions and broker-dealer registration. Notice filing requirements are circumscribed, as the issuer will only need to perform a notice filing in its home state and any state where over fifty percent of the aggregate amount of the offering is sold, if any. 28

29 Proposed Rules for Crowdfund Investing Under the Proposed Rules, a funding portal is deemed a person engaged in the business of effecting transactions in securities for the account of others, and meets the definition of a broker under the Exchange Act. Funding portals are defined as brokers that effect transactions solely pursuant to the crowdfunding exemption. By recognizing funding portals as brokers, the SEC has opened the door to requiring such platforms to comply with some of the requirements imposed on broker-dealers. A funding portal, however, may not: provide investment advice, solicit purchases, sales or offers to buy the securities displayed on its platform or portal, or compensate its employees, agents or other persons in connection with the sale of securities displayed on the platform or portal or (d) hold, manage or otherwise handle investor funds or securities. The Proposed Rules create specific registrations requirements for funding portals that operate to exempt the funding portal from the requirement to register as a broker-dealer 29

30 Registration Requirements Before an intermediary may be utilized for a crowdfunding offering, the intermediary must register with the SEC as either a broker-dealer or as a funding portal and also become a member of FINRA. The Proposed Rules create a streamlined registration process for funding portals. Funding portals will be required to register with the SEC by completing a Form Funding Portal and to disclose information concerning the portal, its structure, business activities, type of compensation the funding portal would receive, escrow arrangements, as well as any relevant disclosuresregardingdisciplinary history. Form Funding Portal includes information similar to Form BD, for broker-dealers. A funding portal will be deemed registered either 30 calendar days following receipt of registration by the SEC or the date the funding portal is approved for membership in FINRA. It is unclear how much time will be required for FINRA to approve membership applications submitted by funding portals. This form will need to be updated periodically 30

31 Registration Requirements Intermediaries are subject to the same disqualification provisions as brokers under Section 3(a)(39) of the Exchange Act. Nonresident aliensmay notoperateintermediaries. The information a funding portal must disclose includes: Legal organization and its disciplinary history, if any; Business activities, including the types of compensation the funding portal would receive; Control affiliates of the funding portal and disclosure of their disciplinary history, if any; FINRA membership or membership with any other registered national securities association; and The funding portal s website address(es) or other means of access. Further disclosures to prevent any conflicts of interest require that the intermediary disclose the manner in which it will be compensated in connection with the offerings. 31

32 Compensation Like a broker-dealer, registered intermediaries may receive compensation in connection with offerings and sales of securities in a crowdfunding offering made in reliance upon Section 4(a)(6), so long as the intermediary discloses to the investor, at the time the customer account is established, the manner that the intermediary will be compensated. Intermediaries in crowdfunding offerings are permitted to use a third party to promote the offering, so long as: The person does not provide the intermediary with any personally identifiable information concerning potential investors, The intermediary discloses the promoter s compensation and The compensation, unless it is paid to a registered broker or dealer, is not based, directly or indirectly, on the purchase or sale of a security offered in reliance on the Proposed SEC Rules on or through the intermediary s platform. An intermediary may not compensate a third party by commission or other transaction-based compensation unless the third party is a registered broker or dealer. 32

33 Compliance Obligations Disclosure of User Information The Proposed Rules require intermediaries to make any information provided to the intermediary by an issuer available to the SEC and potential investors at least twenty-one days prior to the first sale of securities of the issuer to an investor. The purpose of these disclosures is to ensure the investor has adequate opportunity to evaluate the investment without impediment. Funding portals will be required to post such information on their platforms. Intermediaries must also disclose to investors, when establishing the client account, the intermediary s compensation in connection with an offering and any relevant conflicts of interest, if any. Anti-Money Laundering The SEC has taken the position that the intermediary is in the best position to know its customer and to also identify and monitor for suspicious or illicit activity. Accordingly, the Proposed Rules require funding portals to establish and maintain anti-money laundering policies and customer identification programs and to, also, file suspicious activity reports. 33

34 Compliance Obligations (Continued) Communications Intermediaries are also required to provide a means for investors to communicate with one another and also with the issuer s representatives regarding offerings made available on the intermediary s platform. Through the use of an online message board or other publicly facing messaging system, an intermediary can satisfy this rule requirement and further facilitate transparent discussions within the crowd about potential investment opportunities. The intermediary may not participate in any communications between investors or issuers. All communications must be accessible by the public but only those persons who have open accounts with the intermediary may post comments. Fidelity Bond Funding portals will be required to maintain a fidelity bond that has a minimum coverage of $100,000 and covers any associated person of the funding portal under the Proposed Rules. 34

35 Compliance Obligations (Continued) Prohibitions on Intermediaries As another means to protect investors, the Proposed Rules prohibit directors, officers, and partners of an intermediary from having a financial interest in an issuer using the intermediary s services. This prohibition occurs in two forms: Prohibition against financial interests, and Prohibition against receiving a financial interest in the issuer as compensation for services provided. As this provision is meant to protect investors from conflicts of interest that can arise when those who facilitate a crowdfunding venture have a stake in the outcome, the prohibition extends to the intermediary entity itself along with its directors, officers, and partners. Fidelity Bond Funding portals will be required to maintain a fidelity bond that has a minimum coverage of $100,000 and covers any associated person of the funding portal under the Proposed Rules. 35

36 Compliance Obligations (Continued) Other Regulatory Requirements While the Proposed Rules exempt funding portals from broker-dealer registration, funding portal intermediaries remain subject to the full range of SEC examination and enforcement authority. Furthermore, the Proposed Rules create a series of recordkeeping and reporting procedures in connection with sales transactions in crowdfunding offerings and other related compliance obligations, to include: Delivery of notices (and related information) to investors upon receipt of an investment commitment, Delivery of confirmation of sales transactions, Implementation of written policies and procedures designed to achieve compliance with federal securities laws and regulation, Taking steps to protect the privacy of information collected from investors in accordance with Regulations S- P (Privacy of Consumer Financial Information and Safeguarding Personal Information), Regulation S-AM (Limitations on Affiliate Marketing) and Regulation S-ID (Identity Theft Red Flags). 36

37 Risk and Fraud Protection The risk of fraud in crowdfunding offerings are widely-discussed and understood. The SEC considers the intermediary to be in the best position to track the ownership of securities sold through crowdfunding offerings on the intermediary s platform. It views accurate recording and maintaining of shareholder records as essential to prevent fraudulent transfers and aid investors seeking to prove their ownership in connection with a sale of their securities. The recordkeeping function may be provided by the issuer, a broker, a transfer agent or some other registered or unregistered person. Intermediaries are required to take measures to reduce the risk of fraud in crowdfunding offerings. The Proposed Rules require intermediaries to have a reasonable basis for believing that an issuer is in compliance with relevant regulations and has established and maintains a system for accurate records of holders of the securities it offers and sales. Intermediaries are permitted to reasonably rely upon the issuers representations to satisfy this due diligence requirement. 37

38 Risk and Fraud Protection (Continued) The Proposed Rules also require an intermediary to deny an issuer access to its platform if the intermediary has a reasonable basis to believe the issuer or any of its officers, directors or shareholders holding at least 20% of the company s shares, is subject to disqualification under the Proposed Rules. 4 Thus, to satisfy this requirement, the intermediary must subject each issuer and its officers, directors and 20% shareholders to background and securities enforcement regulatory history checks before the securities of the company may be displayed on the platform. We suspect that intermediaries will likely engage third party service providers to gather information in connection with background and regulator checks on issuers and issuer control persons. The services agreement with the third party should be appropriately structured to support a determination that the intermediary s reliance on the third party to assist with such checks was reasonable and appropriate. 4 Proposed Rule 301(c) 38

39 Risk and Fraud Protection (Continued) Proposed Rule 302(a)(2) requires Intermediaries to deliver to investors, via electronic delivery means, at account opening, educational materials. Those materials that help to prevent fraud include: The process for the offer, purchase and issuance of securities through the intermediary; The risks associated with investing in securities offered and sold in reliance on Section 4(a)(6); The types of securities that may be offered on the intermediary s platform and the risks associated with each type of security, including the risk of having limited voting power as a result of dilution; The types of information that an issuer is required to provide in annual reports, the frequency of the delivery of that information, and the possibility that the issuer s obligation to file annual reports may terminate in the future; The limitations on the amounts investors may invest, as set forth in Section 4(a)(6)(B); and The circumstances in which the issuer may cancel an investment commitment. 39

40 State Regulation Federal laws regarding crowdfunding under Section 4(a)(6) of the Securities Act pre-empt state law and the states abilities to regulate crowdfunding pursuant to Section 4(a)(6) even when the offering touches the state. Section 4(a)(6) pertains to transactions involving the offer or sale of securities by an issuer; thus, these new federal rules preempt state rules for issuers, but not the intermediaries. The JOBS Act amended the section 18(b)(4) Securities Act to preempt the ability of states to regulate certain aspects of crowdfunding conducted pursuant to Section 4(a)(6). This amendment benefits issuers by making transactions less expensive because the issuers will not have to register transactions pursuant to individual state laws. Several states have also proposed or adopted their own crowdfunding rules that are potentially less onerous and burdensome, in order to offer issuers an alternative to relying on the federal crowdfunding private offering exemption. 40

41 State Regulation (Continued) However, the North American Securities Administrators Association ( NASAA ) has opposed the changes required by the JOBS Act. The former President of NASAA has stated that the JOBS Act needlessly preempts states from reviewing crowdfunding offerings before they are sold to investors. NASAA has stated that Congress should allow the states to take a leading role in implementing an appropriate regulatory framework for crowdfund investing. NASAA and others opponents of the JOBS Act believe states are the only regulators in a position to effectively police the small emerging crowdfund investing market and protect its participants. Ultimately, NASAA and its members are concerned the JOBS Act will weaken investor protection conducted by the states. Portals and broker-dealers that plan to offer crowdfund investing must wait for final rulemaking by the SEC, written rules and regulations of FINRA, and followed closely thereafter by state legislation, which will attempt to assert some degree of police power of crowdfunding offerings not reached by the SEC. Ohio Division of Securities v. Somolend 41

42 The information contained herein is intended to inform the reader of current legal developments of general interest. This presentation should not be construed as legal advice by Baker & Hostetler, LLP and readers should not act upon the information contained in these publications without professional counsel. The hiring of a lawyer is an important decision that should not be based solely upon advertisements. Before you decide, ask us to send you written information about our qualifications and experience. 42