As Crowdfunding Gatekeepers, Intermediaries Are Held to High Standards

Sherwood Neiss | November 13, 2015


In adopting final securities-based crowdfunding rules, the S.E.C. mandated that crowdfunding transactions take place on an intermediary—either a funding portal or a broker-dealer, both of which must register with S.E.C. and relevant national regulatory bodies. That may potentially exclude investors without Internet access, the Commission acknowledged, but the use of online platforms will enhance the ability of issuers and investors to communicate transparently. In remarks adopting the final rules, the S.E.C. emphasized the role and responsibility of intermediaries as “gatekeepers” that must engender public trust if investment crowfdunding is to succeed.

In the last of a three-part series, Sherwood (Woodie) Neiss, a principal at Crowdfund Capital Advisors and noted crowdfunding expert, looks at that rules that govern these important gatekeepers.

If you think this is just about throwing up a website to match entrepreneurs to investors, you are grossly mistaken. The buying and selling of securities (and anything that promises a financial return, including debt and equity, is a security) as spelled out by Regulation Crowdfunding is highly regulated!

Related: More Crowdfunding coverage

Any intermediary who wants to play in this space will incur significant costs. In addition to technological investment needed to get a platform up and running, they’ll incur the costs of registering with the S.E.C. and FINRA (FINRA is the National Securities Agency that oversees funding portals and broker-dealers) as well as annual compliance expenses. The S.E.C. figures that intermediaries will pay around $167,000 for registration, FINRA membership, and compliance with Regulation Crowdfunding in Year 1.

Funding Portals 

There are some important differences between the two types of intermediaries. Funding portals—a new type of entity ushered in by the JOBS Act—have lower regulatory hurdles than broker-dealers, but are limited in their activities. For example, they cannot manage or hold investor funds or securities or provide investment advice or recommendations (Broker-dealers, in contrast, may do all of those things). Funding portals must use a qualified third party to manage investments and transfers—either a registered broker-dealer, a bank or (new in the final rules) a credit union insured by the National Credit Union Administration.

Given the small size of the deals (less than $1 million) and the limited success fees they can earn, the funding portals that are successful will be the ones that have enough transaction volume to recoup expenses.

Funding portals did win some important concessions in the final rules. They are given more discretion over what offerings they choose to list on their sites—eliminating a potential competitive disadvantage with broker-dealers. And the S.E.C. extended  a safe harbor that allows them to highlight certain offerings without running afoul of the ban of recommendations or advice.  Under the final rules, portals will be able to highlight deals based upon objective criteria such as the type of securities being offered (e.g., common stock, preferred stock or debt), the geographic location of the issuer, industry or business segment, the number or amount of investment commitments made, etc.

They’re also able to advise issuers on structuring their deal and to pay referral fees to third parties, as long as it is not contingent upon an investment.

This is an area fraught with potential conflicts. How do you prevent platforms from pumping deals, while allowing them to be financially sustainable and serve a broad range of companies? In the final rules, the S.E.C. balances these concerns by allowing intermediaries to receive their fee from issuers in the form of equity. However, their equity deal cannot be on more favorable terms than those offered to investors, so the same terms, conditions and rights apply. In addition, the equity compensation cannot be in exchange for promoting the deal.

In its comments, the S.E.C. noted that the compensation rules align the interest of intermediaries and investors, and may encourage the development of funding portals that are affiliated with organizations such as CDFIs (community development financial institutions). But keep in mind, the more equity-for-service deals you do as an intermediary, the less money you’ll have to operate your business and pay your annual SEC compliance fees.

Investor Education and Protection
Intermediaries must deliver educational materials to investors that explain how the offering process works and the risks associated with investing in crowdfunding securities. They must also provide communication channels so that potential investors may interact with companies seeking funds. Interestingly, they are also allowed to let investors rate issuers and offerings, opening the door to crowd-generated rating systems akin to those on Yelp or Amazon.

While the rules allow portals to rely on representations of the issuers, they are not off the hook for any material misstatements by issuers on their platforms. This liability will cause pause for intermediaries that are thinking of getting into crowdfunding. However, it will likely inspire crowdfunding insurance policies to offer protection in such instances. If intermediaries don’t have this insurance, you can be sure that they’ll be quick to exclude deals from going up on their platforms out of concerns for investor protection.

In addition, intermediaries are required to promptly remove any offering from their platforms if they become aware of information that indicates the issuer or the offering presents potential for fraud or otherwise raises concerns about investor protection.

The rules governing intermediaries, by the way, apply to all officers, partners or managers of the platform, excluding clerical-type employees.

Sherwood Neiss

Credit cards
One of the surprises in the final rules is that the SEC is allowing the use of credit cards as a means of payment. While we applaud their forward thinking, it does raise a few issues. First, credit cards have historically been off limits to buying securities because of the high risk/default potential of securities. Second, if a person uses a credit card and disputes the charge post-funding, what happens? Third, what if someone can’t pay their credit card but receives the securities?

For these reasons, I’m not sure I’d recommend that an intermediary take credit cards. A debit card, where the funds are immediately available for withdraw and pledge, however, I believe is fine.

Crowdfunding portals can begin registering on Jan. 29th, 2016, when Form Funding Portal goes into effect. That gives them time to prepare before the final Regulation Crowdfunding rules go into effect in the spring.

For full text of the funding portal rules, see this pdf.

Sherwood Neiss is a principal of Crowdfund Capital Advisors, a crowdfunding advisory, implementation and education firm.


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