Intermediaries In Crowdfunding: The Dos and Don'ts
New Securities and Exchange Commission rules took effect this year that authorize equity crowdfunding and allow accredited and unaccredited investors alike the opportunity to invest in startups. The rules, titled Regulation Crowdfunding, require the issuer to conduct its offering through an online platform operated by an intermediary that is registered with the SEC either as a broker-dealer or as a funding portal. These crowdfunding intermediaries must also be a member of the Financial Industry Regulatory Authority, or FINRA.
Funding portals, a new type of registrant under the Jumpstart Our Business Startups Act, are more limited in terms what they are allowed to do in a crowdfunding transaction, as compared to broker-dealers. They cannot, for example, offer investment advice or recommendations. Funding portals also cannot solicit purchases or offers to buy securities offered on their platform, compensate someone for that sort of solicitation, or handle inventor funds or securities. If the funding portal plans to engage in any of these activities, it must register with the SEC as a broker-dealer. That being said, Regulation Crowdfunding does provide a safe harbor under which funding portals could engage in certain activities consistent with these restrictions.
Whether a broker-dealer or funding portal, all crowdfunding intermediaries are required to, among other things:
- Provide investors with educational materials about the general risks of investing and specifics about the crowdfunding offering, as well as with other information that could help the prospective investor decide whether to participate in the offering;
- Confirm investors have reviewed the educational materials and understand the investment risks. Investments can only be accepted once an investor affirms their understanding of the risk of loss and has opened an account;
- Make information about the issuer and offering available to investors and prospective investors;
- Provide communication channels on its platform for investors and the issuer to exchange comments about the offering (In the case of a funding portal, the intermediary is generally not allowed to participate in the communication channel);
- Make available on its platform information that the issuer is required to disclose to the public. This must be posted at least 21 days before securities are sold and remain available throughout the offering period;
- Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with Regulation Crowdfunding, and implement written policies designed to ensure compliance with federal securities laws;
- Have a reasonable basis for believing an investor complies with the investment limitations;
- Disclose to investors the compensation the intermediary receives; and
- Maintain certain records relating to its business for at least five years.
Under Regulation Crowdfunding, intermediaries are prohibited from:
- Providing access to their platforms to companies they have a reasonable basis for believing have the potential for fraud or other investor protection concerns. To satisfy that requirement, an intermediary must, at a minimum, perform a background check on each issuer, its officers and directors;
- Having a financial interest in a company that is offering or selling securities on its platform, unless the intermediary receives the financial interest as compensation for its services;
- Compensating someone for providing the intermediary with personally identifiable information of any investor or potential investor.
Regulation Crowdfunding also prohibits anyone subject to a statutory disqualification, as defined in Exchange Act Section 3(a)(39), from acting as in intermediary or being associated with one.