Tuesday, September 3, 2013

The Case of SoMoLend: Crowdfunding Platforms and Other Startups Beware of Potential Securities Law Violations

SoMoLend – Social Mobile Local Lending – is a crowdfunding platform that has peer-to-peer lending technology that allows businesses to obtain loans from a network of lenders, typically located in the same geographic area (banks, credit unions, community-development financial institutions, cities, churches, foundations, chambers of commerce and individual investors). SoMoLend is like eHarmony for small businesses and lenders. It was founded by Candace Klein in 2011, who until recently served as its CEO. According to Entrepreneur.com, since the beta site launched in May 2012, SoMoLend has facilitated some 100 small-business loans totaling nearly $3.5 million. Loans range from $500 to $1 million, with interest rates ranging from 3% to 22% and terms – from six weeks to five years, depending on a business's needs and creditworthiness.

This is the way how SoMoLend works: a borrower first sets up a public profile. Then, it is asked to complete an equivalent of an SBA loan application, provide business plan, formation documentation, EIN, business financial statements as well as personal financials of every 20% plus owner. SoMoLend evaluates the borrowers using their own underwriting algorithm that focuses on social reputation of the business, not only the FICO score, so that even a business with a low score can get funding through the platform. Investors lend money directly to the borrowers through the platform, which packages the loans and sells them as notes. SoMoLend handles the contracts and the payment processing. SoMoLend is compensated for its services by charging borrowers a 4% and lenders 1.8% transaction fee on funds borrowed.

According to Forms D filed with the SEC, SoMoLend raised money twice: $1,170,000 during the period of September 2011 through April 2012, and $1,000,000 during August 2012 - February 2013.

It recently became known that in mid-June 2013 SoMoLend received a Notice of Intent toIssue Cease and Desist Order from the Ohio Division of Securities that raises issues that are not unique to SoMoLend or the crowdfunding platforms in general. All young companies have lots to learn by reading this Notice.

First, the Notice alleged that SoMoLend violated the state securities laws by conducting an offering through the use of general solicitation and advertising in Ohio and other states. Currently, the federal securities laws provide for an exemption from registration under Rule 506 that prohibits the use of general solicitation and advertising in the sale and offer of securities to accredited and sophisticated investors (Ohio has a corresponding exemption). This Rule has been significantly amended by the SEC (a blog that will review the new amendments that will become effective on September 23, 2013 is coming soon). However, as of now, this Rule stands “as is.” An issuer can generally avoid violating the ban on general solicitation and advertising if it reaches out only to potential investors with previous relationship to the issuer or the persons promoting the offering. SoMoLend, on the other hand, allegedly solicited investments through investor presentations and investor pitch events, videotaped recordings of investor presentations and events posted on the Internet, links to the social media sites, and press releases published in newspapers, magazines and other media.

Second, the Notice alleged that Ms. Klein and SoMoLend engaged in securities fraud by making false and misleading statements to potential investors regarding the company’s financial projections, current and past performance (including the number of loans made, their total value and the revenue derived from them), and the nature and extent of relationships with banks. For example, in October 2012, Ms. Klein claimed that SoMoLend had closed 31 loans for just under 50 businesses totaling $3.5 million and generating $50,000 in revenue, whereas SoMoLend at that time had closed only 13 loans for 9 businesses totaling $94,000 and generating $3,404 in revenue. In March 2013, Ms. Klein said in her interview with Entrepreneur Magazine that SoMoLend had raised $15 million for 100 businesses, whereas at that time it had closed only 25 loans for 18 businesses for an aggregate loan amount of only $234,000. Also in March 2013, Ms. Klein stated at the SXSW Pitch event that the funds came from 1,000 peer lenders and 50 different banks, whereas only one bank had ever made a loan through the SoMoLend platform. These do, of course, seem like material discrepancies and inconsistencies.

Startups and small businesses should be aware that, even through they are not public (yet), their activities still fall under the regulation of the Securities and Exchange Commission. One of the rules that apply to private companies as well as public ones when they are raising capital is Rule 10b-5. It states, in part, that “it shall be unlawful for any person, directly or indirectly, … (a) to employ any device, scheme, or artifice to defraud; (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading … “. This Rule is used in prosecuting insider-trading cases and also in cases where a company issues misleading information to the public, or keeps silent when it has a duty to disclose. A large number of indictments were brought under this Rule in connection with the 2001 Enron scandal, the 2009 Bernie Madoff Ponzi scheme, and the scheme by attorney Marc Dreier, who sold millions of dollars of bogus notes, among others.

Third, the Division of Securities alleged that SoMoLend failed to register as a broker/dealer with the Ohio and federal authorities since it received a commission in connection with the solicitation or sale of securities. I discussed requirements for broker/dealer registration in more detail here. Interestingly, the other crowdfunding platforms, the FundersClub and AngelList took a different approach to compensation by agreeing to be paid at the exit. They also first obtained a no-action letter from the SEC validating their models. I talked about the FundersClub and AngelList no-action relief here.

Finally, the Notice alleged that all those businesses that received loans through the SoMoLend platform had to register their offerings with the Ohio Division of Securities or qualify for an available exemption. The promissory notes are generally considered to be “securities” and we already know that any offer or sale of “securities” must be registered with the SEC (and if applicable, the corresponding state authorities) or be made pursuant to an exemption. See my earlier post about this here. According to the Notice, as a result of these actions, SoMoLend exposed approximately 200 small businesses to potential liability.

Klein resigned as the CEO and a board member of SoMoLend on August 14th, three days after The Enquirer first reported that Ohio’s Division of Securities was investigating SoMoLend for alleged fraudulent practices.

The next step for SoMoLend is to appear at a hearing that is scheduled for October. I hope that at least now, in preparation for the hearing, SoMoLend will engage qualified securities attorneys to resolve this action and advise the company on its future path.

This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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