Wednesday, December 24, 2014

Crowdfunding Portals and the Securities Laws

The SEC has recently intensified its enforcement efforts against crowdfunding portals. The SEC's main focus is on these two legal issues: whether the crowdfunding portals offer and sell securities in unregistered transactions to US persons in violation of the Securities Act, and whether the crowdfunding portals act as unregistered broker-dealers to US persons. A recent example of an enforcement action against Eureeca Capital SPC is a good illustration.

On November 10, 2014, the SEC issued an order instituting administrative and cease-and-desist proceedings against Eureeca Capital SPC (“Eureeca”).  Eureeca was formed in the Cayman Islands in May 2013.  It operated an online equity crowdfunding platform connecting foreign issuers with investors. The offerings posted on the Eureeca website were general solicitation of US persons because they were accessible to the US residents and included information about the offerings, such as amounts and informational videos, that was not restricted or protected by password.  Potential investors were then asked to register to get more information by providing their names, dates of birth, email, country of residence and phone number.  They were not asked to certify that they were accredited investors.  Although Eureeca did have a disclaimer of its website that its services were not being offered to US persons, it did not implement procedures to prevent US investors from using the platform.  As of May 2014, Eureeca permitted over 50 persons who chose “United States” as their country of residence, to register on the platform.  Three of them ended up investing approximately $20,000 in total in four offerings advertised on the platform.  Eureeca sent emails to the registered users with detailed investment status and overview of the offerings and encouraged investment into these offerings.  To invest, registered users had to wire the money into Eureeca’s escrow account.  Then, users could allocate the money among different offerings.  If the offerings were fully funded, Eureeca then completed “the final legal requirements and managed the swap of funds for the equity agreed.”  Eureca received a percentage of the funds of the fully funded offerings of securities as compensation for its services upon closing of a deal. 

First, the SEC concluded that Eureeca violated Section 5(c) of the Securities Act by offering the sale of securities to three US investors because, after generally soliciting them, it did not take reasonable steps to verify that the purchasers of the securities were accredited investors. Two of the three investors self-certified by email that they were accredited investors, although such term was not explained to them. The third investor did not do even that.

Rule 506(c) allows issuers to use general solicitation and advertising in conducting private placements so long as their actual investors are accredited. Companies that conduct 506(c) offerings must take “reasonable steps” to verify that all investors in their offerings are accredited and have a reasonable belief that such investors are accredited at the time of the sale of securities. Before the JOBS Act, and still while conducting Rule 506(b) offerings, companies could rely on investors’ self-certification (for example, questionnaires where investors self-report their income and net worth). This is no longer enough for a successful Rule 506(c) offering. Instead, the companies or someone on their behalf must request and review evidence of investors’ income or net worth. I wrote a detailed blog about how the “reasonable steps” here.

Next, the SEC concluded that Eureeca violated Section 15(a) of the Exchange Act by acting as an unregistered broker-dealer to US persons since it solicited investors and participated in key parts of the transactions.

Although much clarification is still needed, the SEC position with respect to whether crowdfunding portals are expected to register as broker-dealers has been based on the following. First, there is Section 201(c) of the JOBS Act that introduced paragraph (b) to Section 4 of the Securities Act. This exemption states that a person who conducts a Rule 506 offering will not be required to register as a broker-dealer solely because they maintain an online investment portal or engage in general solicitations of securities. Such person may not receive “compensation in connection with the purchase or sale of the security,” have possession of customer funds or securities, or be subject to a statutory disqualification. It is permitted for such person to co-invest in the securities and provide “ancillary services”. I discussed this in more detail here.

Second, the SEC issued FAQs in February 2013, clarifying the broker-dealer exemption described above. Here, the Staff clarified that the prohibition of transaction-based compensation extends to “any direct or indirect economic benefits to the person or any of its associated persons” but that any profits derived from co-investing would be permissible.

Third, there is a series of no-action letters on the topic: IPOnet (July 26, 1996), Lamp Technologies, Inc. (May 29, 1997), Angel Capital Electronic Network (October 25, 1996), FundersClub Inc. and FundersClub Management LLC (March 26, 2013) and AngelList LLC and AngelList Advisors LLC (March 28, 2013). I discussed the latter two no-action letters here.

Overall, the SEC position with respect to the need for a crowdfunding portal to register as a broker-dealer appears to be as follows. There may not be a need for registration so long as the following restrictions are observed:

1. There is no transaction-based compensation (i.e., fees are not contingent upon the outcome or success of the offerings).

2. The portals do not participate in any negotiations between the companies and the investors or structuring of the deals.

3. The portals do not handle funds or securities involved in the transactions.

4. The portals do not hold themselves out as providing any securities-related service other than a listing or a matching service.

5. The portals do not provide advice about the merits of a particular opportunity or investment.

Clearly, Eureeca violated a number of these provisions. Eureeca’s compensation was based on the success of the offerings. It handled investors’ money and the securities. Finally, it encouraged investors to invest in the offerings.

In conclusion, it seems advisable for entrepreneurs who are interested in setting up a crowndfunding portal to engage the services of an experienced attorney who specializes in securities laws.  If Eureeca had done it, its legal troubles would have been avoided.

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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