Accredited Crowdfunding Portals Receive No-Action Relief from the SEC

In my previous blog, I described the FAQs released by the Staff of the Securities and Exchange Commission (the “SEC”) earlier this year addressing the new exemption from broker-dealer registration found in Title II of the JOBS Act (codified as Section 4(b) of the Securities Act). On March 26, 2013, the SEC granted no-action relief to FundersClub, Inc., an operator of a web portal that intends to comply with this new exemption. On March 28, 2013, the SEC granted a similar no-action relief to AngelList. These no-action letters are an excellent illustration of how the new exemption will work in practice.

Let’s first take a look at the FundersClub letter. The proposed structure looks like this. FundersClub, Inc. is a Delaware corporation and is the sole owner of FundersClub Management LLC, which is the manager of investment funds formed to invest in start-up companies (usually one fund per start-up). The parent entity operates a website portal that provides information about pre-selected start-up companies. Only accredited investors can become members of the club. Once FundersClub Management LLC decides to invest in a start-up, it enters into a non-binding agreement with that company, identifying the target amount of investment. Then, FundersClub posts information provided by the start-up company on its website, www.thefundersclub.com, which is only available to members.  Members submit non-binding indications of interest. Once sufficient interest is reached, FundersClub forms an investment fund (a Delaware LLC) where members invest. All money is kept in a custodial account with a bank or a trust company and later invested into the start-up. FundersClub Management LLC exercises management rights and provides the start-up with strategic and networking assistance. It can vote the investment fund’s shares and can even sell them because the individual members are not record or beneficial shareholders of the start-up company. There may be an initial administrative fee charged by the fund to its members to cover the organizational expenses. The manager intends to be compensated by receiving a carried interest of 20-30% upon the fund’s liquidation. In particular, the waterfall would look as follows: upon liquidation, the proceeds of the fund would (i) first, be used to pay any expenses of the fund and the administrative fee, if not yet paid; (ii) second, to repay the capital contributions of each member; (iii) third, to pay a percentage of profits to the members on a pro-rata basis; and the remainder would be paid to FundersClub Management LLC as carried interest.

The Staff granted the FundersClub entities no-action relief for not registering as broker-dealers pursuant to the exemption found in Section 4(b) of the Securities Act. In arriving at the decision, the Staff noted that (i) the FundersClub entities are advisers solely to venture capital funds; (ii) their compensation (carried interest) is advisory in nature, and is not transaction-based; (iii) the amount of compensation is fully disclosed to the investors at the time of investment; (iv) the administrative fee is used to reimburse third-party expenses and is not paid to the FundersClub entities or their affiliates or principles; and (v) all investment money is kept in a separate custodial account and cannot be accessed by the FundersClub entities for their own use.

Now, let’s take a look at the no-action letter issued to AngelList. Currently, AngelList LLC operates a website angel.co that permits start-up companies to network with angel investors. AngelList provides companies and investors with standard form documents for investments and refers them to Second Market, a registered broker-dealer, to complete the investments. AngelList proposes to form AngelList Advisors LLC as its wholly-owned subsidiary. AngelList Advisors will be a registered investment adviser either with the SEC or in one or more states. AngelList Advisors will establish a separate website (or a portion of the existing website) which will assist investors and start-up companies. All portfolio companies that can participate on the website will have to go through a due diligence process and meet certain criteria. Lead Angel investors (accredited investors leading the deal) will also be subject to due diligence and approval by AngelList Advisors. Upon approval of both the portfolio company and the Lead Angel, AngelList Advisors will form a separate investment vehicle (either an LLC or an LP) for the purpose of investing in that one portfolio company. AngelList Advisors will provide initial capital needed in setting up the fund. Once the fund is formed, AngelList Advisors will make the potential investment opportunity be known to the investors who participate on the platform (only accredited investors are allowed to participate). Interested investors will submit a non-binding request for information, along with a questionnaire certifying that the investor is an accredited person. Investors have to agree to wait at least thirty days from that time to complete the investment. There are two investment models described by AngelList Advisors in the no-action letter. The first model is very similar to the one to be used by FundersClub. The second model is referred to as “Angel Advised”, whereby the Lead Angel takes on an active role in negotiating the investment, provides material managerial assistance to the portfolio company, invests at least 20% of the target amount, and in compensation, shares the carried interest with the AngelList Advisors.

As you can see, both no-action letters provide practical guidance to other accredited investor portals on how to avail themselves of the exemption from broker-dealer registration that has become available as part of the JOBS Act. Although the analysis is very fact-specific, there are main overarching factors that are instrumental in structuring the portals: (i) no transaction-based compensation but carried interest is permissible; (ii) no handling of investor money; (iii) all investors must be accredited, and (iv) the offerings must be conducted pursuant to Rule 506.

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.

The SEC’s Frequently Asked Questions Regarding the Broker-Dealer Registration Exemption

 The legal world is patiently waiting for the Securities and Exchange Commission (the “SEC”) to enact rules implementing Title II of the JOBS Act.  One of the recent developments in this field is the issuance by the SEC Staff of frequently asked questions (FAQs) regarding the broker-dealer registration exemption found in Section 201(c) of Title II of the JOBS Act that adds a new paragraph (b) to Section 4 of the Securities Act. 

Generally, intermediaries are required to register with the SEC as broker-dealers when they are engaging in certain matchmaking activities between the issuers and the investors.  This Guide provides an overview of the activities that may require registration as a broker-dealer.  The JOBS Act introduced an exception to this general rule when it directed the SEC to eliminate the ban on general solicitation and advertising for Rule 506 offers and sales where all investors are accredited.  The exemption is very limited and applies only in Rule 506 offerings and only in the three circumstances listed below.  So, according to the new Section 4(b) of the Securities Act, a person will not be required to register as a broker-dealer solely because:

·         “that person maintains a platform or mechanism that permits the offer, sale, purchase or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person or through any other means;”

·         “that person or any person associated with that person co-invests in such securities”, or

·         “that person or any person associated with that person provides ancillary services with respect to such securities.”  Ancillary services are defined as providing due diligence services (but not investment advice or recommendations for separate compensation) and providing standard deal documents (as long as such person does not negotiate these documents and the issuers are not required to use these documents as a condition of using the service.

Importantly, such person may not receive compensation in connection with the purchase or sale of such securities and may not have possession of customer funds or securities in connection of such transactions, and they are not subject to statutory disqualification.   

What types of entities would be likely to rely on such exemption?  These would most likely be VC funds and their advisers.   Actually, the SEC Staff noted that the compensation prohibition “makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.”  But practical use of this exemption still remains to be seen.

As I have previously written, the SEC had three months from April 5, 2012 to issue rules implementing the elimination of the ban on general solicitation and advertising in Rule 506 offerings.  However, such rules have not yet been implemented, which means that the general solicitation and advertising in Rule 506 offerings to accredited investors are not yet permitted.  Interestingly, the broker-dealer exemption addressed in Section 201 of the JOBS Act went into effect immediately upon adoption of the JOBS Act. 

To clarify the situation, on February 3, 2013 the SEC issued the FAQ regarding this broker-dealer exemption.  It consists of 10 questions.  Below is the summary:

1.       The Staff explained that although the exemption from broker-dealer registration contained in Section 4(b) of the Securities Act is now in effect, the elimination of the ban on general solicitation and advertising in Rule 506 offerings is not.

2.       The scope of the exemption is very narrow: it is only available in connection with the offerings conducted under Rule 506 of Regulation D.

3.       Persons who are eligible for exemption can maintain an Internet website or a social media site and still use the exemption (no need for a more formal portal).

4.       Persons who want to avail themselves of this exemption cannot be compensated in connection with the purchase or sale of these securities.  Here, the Staff interprets “compensation” broadly to include direct or indirect economic benefits. 

5.       The exemption permits co-investing in the securities offered by the platform.  Any economic or financial benefits derived from such investments are not considered impermissible “compensation”.

6.       Someone who is associated with the issuer can maintain a platform to sell the issuer’s securities, as long as no compensation is paid in connection with the purchase or sale of these securities.

7.       The exemption in Section 4(b) does not exempt from state registration requirements.

8.       The exemption is not an exclusion from the definition of the term “broker” or “dealer”, so some federal securities laws would still apply to the exempt persons regardless of registration.

The adoption of the SEC rules regarding the elimination on the ban of general solicitation and advertising, coupled with this exemption from broker-dealer registration, is set to drastically change the way Rule 506 offerings are conducted.  All we have to do now is patiently wait for the enactment of the SEC rules.

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.

When Do You Need to Register Your [Delaware] Corporation in New York and Why?

I frequently explain to my startup clients that forming their business in Delaware (or another state they choose if it is not their home state) may not be enough: they also need to register it in every state where they intend to do business. This means that if they intend to conduct business in New York, they are required to qualify their company as a foreign corporation or LLC in the State of New York.

First, it is important to distinguish three separate concepts: (1) when do an entity’s activities in New York become sufficient to subject it to personal jurisdiction of New York courts (a jurisdictional doing business test); (2) when do an entity’s activities in New York become sufficient to require it to pay taxes in New York (a taxation doing business test), and (3) when does an entity need to apply for authority to do business in New York (a qualification doing business test). In short, in analyzing the jurisdictional test, courts look at the company’s activities within the state as well as activities outside of the state but directed at the state (Civil Practice Law and Rules Sections 301 and 302). Courts have applied the Commerce clause to address the taxation doing business test. Its approach is outlined in Complete Auto Transit v. Brady, 430 U.S. 274 (1977) that sets a 4-prong test. It is important to understand that even if a company is subject to New York jurisdiction and / or taxation, it does not necessary mean that it has to also qualify to do business in New York. But the opposite is true: if a company is qualified to do business in New York, New York courts have personal jurisdiction over it, and it is required to pay taxes in New York.

Now, let’s look at the qualification doing business test: what does it means to be “doing business” in New York.

The definition of “doing business” in New York is often a source of confusion. The laws do not provide us with a clear definition but instead provide a non-exclusive list of activities that do not constitute doing business. So, according to the New York Business Corporations Law Section 13-1301, a corporation is NOT doing business within the State if it conducts one or more of the following activities: holds meetings of its shareholders and directors here, maintains bank accounts, maintains an office only for the transfer, exchange and registration of its securities, appoints and maintains trustees or depositories with relation to its securities, or maintains or defends any action or proceeding, whether judicial, administrative, arbitrative or otherwise, or settles claims or disputes.

Most of the definition of what constitutes “doing business” in New York comes from court decisions and is very fact specific. To summarize, to be “doing business” in New York, a foreign organization’s activities must be (1) of local, intrastate character; (2) regular, permanent, continuous and systematic; and (3) vital and essential to the organization’s business (not merely incidental). Let’s look at some examples:

• A foreign organization engaged in manufacturing in New York was “doing business” here because that is a substantial part of the ordinary business of a manufacturing corporation. On the other hand, the conducting of research and the training of employees in New York does not constitute business sufficient to require a foreign entity to register if it is not organized for the purpose of doing research and training. 
• An occasional or casual corporate presence in New York, without more, is not considered “doing business.”  
• The presence of three full-time and four part-time employees, working out of a one-room New York office rented by an airline which has no flights leaving or arriving in New York, and which maintained the office merely to receive requests for space on flights originating outside the U.S. and to relay confirmations of availability when received from the European office, was considered to be “doing business” in New York. 
• Solicitation and servicing by a foreign sales agency of New York accounts through sales representatives present in New York, if systematic and continuous, was considered “doing business” in New York. 
• Entering into one or two contracts in New York does not usually constitute “doing business”. 
• The mere advertisement of a foreign company’s business in New York newspapers does not constitute “doing business”. However, the fact that an organization had advertised in New York papers and employed an answering service was found to evidence sufficient intent to do business in New York. 
• A correspondence school, chartered in another state, whose in-state activities were limited to the soliciting of students, the forwarding of the necessary materials and the collection of fees was not “doing business” in New York. 
• The fact that the school maintained numerous offices (thirty) within the state staffed by its employees who gave instruction at the various offices within New York constituted “doing business” in the state. 
• Mere ownership and leasing of real estate, incidental to another enterprise, is not “doing business”. However, if a foreign entity is organized for the very purpose of leasing or acquiring title to land as its business, it would be “doing business” in New York. 
• Evidence of occasional or casual sales does not typically constitute “doing business” in New York. New York courts do not view factors such as fact that a foreign corporation has customers in New York, or that it makes deliveries into the state from its out-of-state factory, to be controlling. However, a systematic selling of merchandise may constitute the “doing of business” in New York. 

In conclusion, determination of what constitutes “doing business” in New York depends on the facts of the case.  Failure to qualify in New York as a foreign entity while doing business here will leave a company without access to New York courts until it obtains authority and pays all due fees, taxes and penalties.

 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.