Broker-Dealer Considerations: When Website Operators Should be Registered and a Discussion of the Sale of Securities over the Internet

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2 The JOBS Act - Background The Jumpstart Our Business Startups Act, H.R (the JOBS Act ), was passed by the House of Representatives on March 8, On March 22, 2012, the Senate passed H.R with an amendment to Title III (crowdfunding exemption). On March 27, 2012, the House of Representatives accepted the Senate s amendment. On April 5, 2012, President Obama signed the JOBS Act. The JOBS Act was the culmination of a year-long bipartisan effort in both the House and Senate to address concerns about capital formation and unduly burdensome SEC regulations. This is MoFo. 2

3 JOBS Act Title III: Crowdfunding Exemption This is MoFo. 3

4 JOBS Act - Crowdfunding Title III provides an exemption that could apply to crowdfunding offerings, to be implemented by SEC rules adopted within 270 days. The aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption during the 12-month period preceding the date of the transaction, is not more than $1,000,000. The aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the exemption during the 12-month period preceding the date of the transaction, does not exceed: the greater of $2,000 or 5 percent of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; or 10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000. This is MoFo. 4

5 JOBS Act - Crowdfunding The transaction must be conducted through a registered broker or funding portal. Funding portals would not be subject to registration as a brokerdealer, but would be subject to an alternative regulatory regime, subject to SEC and SRO authority, to be determined by rulemaking by the SEC and SRO. A funding portal is defined as an intermediary for exempt crowdfunding offerings that does not: offer investment advice or recommendations; solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; compensate employees, agents, or other persons for such solicitation or based on the sale securities displayed or referenced on its website or portal; hold, manage, possess, or otherwise handle investor funds or securities; or engage in other activities as the SEC may determine by rulemaking. This is MoFo. 5

6 JOBS Act - Crowdfunding Among the requirements for exempt crowdfunding offerings would be that an intermediary: Registers with the SEC as a broker or a funding portal, as such term is defined in the amendment; Registers with an applicable national securities association; Provides disclosures to investors, as well as questionnaires, regarding the level of risk involved with the offerings; Takes measures, including obtaining background checks and other actions that the SEC can specify, of officers, directors, and significant shareholders; Ensures that all offering proceeds are only provided to issuers when the amount equals or exceeds the target offering amount, and allows for cancellation of commitments to purchase in the offering; Ensures that no investor in a 12-month period has invested in excess of the limit described above in all issuers conducting exempt crowdfunding offerings; Takes steps to protect privacy of information; Does not compensate promoters, finders, or lead generators for providing personal identifying information of personal investors; Prohibits insiders from having any financial interest in an issuer using that intermediary s services; and Meets any other requirements that the SEC may prescribe. This is MoFo. 6

7 Broker-Dealer Registration This is MoFo. 7

8 Broker-Dealer Basics Most "brokers" and "dealers" must register with the SEC and join a "self-regulatory organization," or SRO. Section 3(a)(4)(A) of the Securities Exchange Act of 1934 (the Exchange Act ) generally defines a broker" broadly as: any person engaged in the business of effecting transactions in securities for the account of others. Unlike a broker, who acts as agent, a dealer acts as principal. Section 3(a)(5)(A) of the Exchange Act generally defines a "dealer" as: any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. This is MoFo. 8

9 Broker-Dealer Basics Questions for determining if you are a broker: Do you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction? Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal? Do you receive trailing commissions, such as 12b-1 fees? Do you receive any other transaction-related compensation? Are you otherwise engaged in the business of effecting or facilitating securities transactions? Do you handle the securities or funds of others in connection with securities transactions? This is MoFo. 9

10 Broker-Dealer Basics Questions for determining if you are a dealer: Do you advertise or otherwise let others know that you are in the business of buying and selling securities? Do you do business with the public (either retail or institutional)? Do you make a market in, or quote prices for both purchases and sales of, one or more securities? Do you participate in a "selling group" or otherwise underwrite securities? Do you provide services to investors, such as handling money and securities, extending credit, or giving investment advice? Do you write derivatives contracts that are securities? This is MoFo. 10

11 Broker-Dealer Registration Section 15(a)(1) of the Exchange Act generally makes it unlawful for any broker or dealer to use the mails (or any other means of interstate commerce, such as the telephone, facsimiles, or the Internet) to "effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security" unless that broker or dealer is registered with the SEC in accordance with Section 15(b) of the Exchange Act. Associated persons of a broker-dealer usually do not have to register separately with the SEC, however they must be properly supervised by a currently registered broker-dealer. A broker-dealer that conducts all of its business in one state does not have to register with the SEC. This is MoFo. 11

12 Broker-Dealer Registration Issuers generally are not "brokers" because they sell securities for their own accounts and not for the accounts of others. Issuers generally are not "dealers" because they do not buy and sell their securities for their own accounts as part of a regular business. Exchange Act Rule 3a4-1 provides that an associated person (or employee) of an issuer who participates in the sale of the issuer's securities would not have to register as a broker-dealer if that person, at the time of participation: (1) is not subject to a "statutory disqualification," as defined in Section 3(a)(39) of the Act; (2) is not compensated by payment of commissions or other remuneration based directly or indirectly on securities transactions; (3) is not an associated person of a broker or dealer; and (4) limits its sales activities as set forth in the rule. This is MoFo. 12

13 Broker-Dealer Registration The SEC generally uses a territorial approach in applying registration requirements to the international operations of broker-dealers. Under this approach, all broker-dealers physically operating within the United States that induce or attempt to induce securities transactions must register with the SEC, even if their activities are directed only to foreign investors outside of the United States. Foreign broker-dealers that, from outside of the United States, induce or attempt to induce securities transactions by any person in the United States, or that use the means or instrumentalities of interstate commerce of the United States for this purpose, also must register. This includes the use of the internet to offer securities, solicit securities transactions, or advertise investment services to U.S. persons. This is MoFo. 13

14 Registration Process A broker-dealer may not begin business until: it has properly filed Form BD, and the SEC has granted its registration; it has become a member of an SRO, e.g., FINRA; it has become a member of SIPC, the Securities Investor Protection Corporation; it complies with all applicable state requirements; and its "associated persons" have satisfied applicable qualification requirements. This is MoFo. 14

15 Regulatory Environment Antifraud Provisions Duty of Fair Dealing Suitability Requirements Duty of Best Execution Customer Confirmation Rule Disclosure of Credit Terms Restrictions on Short Sales Trading During an Offering Restrictions on Insider Trading Restrictions on Private Securities Transactions Fiduciary Duty? This is MoFo. 15

16 Regulatory Environment Broker-dealers must meet certain financial responsibility requirements, including: maintaining minimum amounts of liquid assets, or net capital; taking certain steps to safeguard the customer funds and securities; and making and preserving accurate books and records. This is MoFo. 16

17 Regulatory Environment In addition, broker-dealers must comply with other requirements. These include: submitting to Commission and SRO examinations; participating in the lost and stolen securities program; complying with the fingerprinting requirement; maintaining and reporting information regarding their affiliates; following certain guidelines when using electronic media to deliver information; and maintaining an anti-money laundering program. This is MoFo. 17

18 Funding Portals This is MoFo. 18

19 Funding Portals: What s Next? SEC and FINRA to adopt rules regarding registration and regulation of funding portals. The JOBS Act provides that state securities or Blue Sky laws are pre-empted with regard to registered Funding Portals; however, preemption does not extend to the laws of the state in which the principal place of business of the registered Funding Portal is located. Any applicable Blue Sky law must not be in addition to, or be different from, the requirements for registered Funding Portals established by the SEC. This is MoFo. 19

20 Comparison Regulatory Environment Conduct of Business Costs Availability of Crowdfunding Exemption Broker-Dealer Well-established SEC and FINRA rules regarding registration and ongoing obligations Handling customer funds and securities, making recommendations, compensating for sales of securities, etc. Significant registration costs, as well as ongoing compliance costs Available for issuers using broker-dealer s platform. Funding Portal To be-established SEC and FINRA rules regarding registration and ongoing obligations. Restrictions on activities traditionally considered to be those of a brokerdealer. Expected to be less ongoing obligations, thus less costs involved. Available for issuers using funding portal s platform. This is MoFo. 20