Potential Pitfalls of Regulation CF – Part II: Practical Concerns for Funding Portals

As discussed in part one, the SEC’s final Regulation Crowdfunding rules require thorough analysis to not fall prey to potential traps. While I firmly believe that we can make crowdfunding work regardless of the roadblocks set forth, it does not mean that we can afford to play fast and loose with the rules in effect. Below are some potential hazards for funding portals wishing to enter this space and facilitate the online transactions between issuers and investors. Funding portals are subject to both the SEC and FINRA regulations with respect to their operations and thus, have a doubly burdensome row to hoe. It will be important for all funding portals to become familiar with these rules and to institute procedures and technology to ensure compliance.

Background Checks

A funding portal is required to deny access to its platform to any issuer if it has a reasonable basis to believe that the issuer, any of its officers or directors, any 20% Beneficial Owner or an person getting compensated to promote the transaction is a “Bad Actor.” A Bad Actor is a lengthy defined term, which should be reviewed in detail, but basically is anyone who has been convicted of financial fraud or SEC violations, or been evicted from an SRO such as FINRA or made false representations to the postal service. Issuers are not allowed to use Regulation Crowdfunding if they are Bad Actors or if they have any officers, directors or 20% Beneficial Owners or any people getting compensated to promote the offering, that are Bad Actors. How is a funding portal supposed to establish such a reasonable basis? Well in addition to denying access, funding portals are required to conduct a background and securities enforcement regulatory history check (or pay a third party to conduct such check) on the issuer and its officers, directors and 20% Beneficial Owners. The combination of a negative background check and an executed questionnaire on behalf of the issuer and each party in question should be sufficient to provide a reasonable basis on the part of the funding portal absent other facts and circumstances known by the funding portal that would suggest otherwise. These procedures and the related expenses are necessary actions for each offering conducted and should be calculated into the time and cost of operating a funding portal. Also, there is a caveat, if the conviction or finding relating to the Bad Actor occurred prior to May 16, 2016, then the issuer may still use Regulation Crowdfunding, but must disclose the presence of the Bad Actor and the details of such conviction or finding.

Potential for Fraud

A much more nebulous requirement is that funding portals must deny access or remove any issuer that it has a reasonable basis to believe presents the risk of fraud to investors. At first blush, this seems like we are asking funding portals to police the capital markets, but the regulations and guidance provide some clarity, stating that access should be denied if the funding portal is unable to assess the risk of fraud or if any information comes to light after the deal is posted and live on the funding portal. This is a pretty broad mandate and one of the biggest traps for potential funding portals, especially when you consider that all of these requirements will be contested in the wake of a fraud, when the “warning signs” become so “obvious.” The best way for a funding portal to protect itself is to have standardized diligence and disclosure procedures in place to which all potential issuers are subject. Requiring documents and asking questions goes a long way to ferreting out unscrupulous issuers. Importantly, when fraud occurs (and unfortunately it will), we must not be so quick to blame the gatekeeper and realize that the funding portal was likely duped just like everyone else. Even good processes can have bad outcomes, but the procedures must be in place.

Educational Materials

The new regulations require a laundry list of educational information to be provided to potential investors. While I do not think this is overly burdensome and, to the contrary, believe this is quite necessary, there is a lot of information that needs to be provided and funding portals need to ensure each item is addressed. Also, I see this as a potential point of differentiation among funding portals, allowing those who truly educate this new class of investors in an innovative and interactive way to rise to the top.

Compensation Disclosure

This is a hot button issue for the SEC. The funding portal needs to clearly disclose how it will be compensated for the transactions on its platform at the time the investor signs up to use or opens an account with the funding portal. In addition, with respect to each deal, all fees and any equity (or other types of securities) that the funding portal is receiving from the issuer must be clearly disclosed. These multiple disclosures may seem like overkill, but the SEC is concerned with the compensation structure of funding portals and any conflicts of interest that may arise. The SEC wants to make sure that potential investors are fully aware of how the platforms are incented and compensated. Having the investor acknowledge in some way that they are aware of the compensation structure of each deal they invest in would be helpful to ensure compliance with this requirement.

Mechanics, Notices and Confirmations

There are many time-specific notices and confirmations that must be delivered to potential investors during the course of an offering such as when the target amount is reached, if a material change occurs and a reconfirmation is required, if the deadline is extended, etc. Funding platforms should utilize technology to automate this process from an efficiency standpoint, and also to eliminate any human error.


This is not a “hidden” trap, but this is a requirement that must be allocated ample time for compliance. Registration must be filed with both the SEC and FINRA and requires affirmative approval from FINRA. FINRA has not finalized its requirements yet, but prospective funding portals should begin preparing their infrastructure and internal procedures now to ensure they will be ready when the rules become effective. Funding portals will be able to file their respective registration forms January 29, 2016 to start the review and approval process. FINRA has established a $2,700 filing fee for funding portals.

Written Policies

Funding portals must have written policies with respect to almost every aspect of their operations. This may seem onerous, but the SEC believes that written policies “provide important investor protections…[and] necessitate that funding portals remain aware of the various regulatory requirements to which they are subject and take appropriate steps for complying with such requirements.” These policies need to cover not just the basic mechanics of onboarding investors and issuers but also for example, the circumstances on which it may rely on the representations made by others, in what situations it will take further steps to diligence such information and the criteria it will use to limit, highlight or advertise issuers and their offerings. Having a formal set of policies accessible by all employees (and investors and issuers in many cases), mandatory employee training sessions and periodically reviewing and updating such policies will be essential for all funding portals utilizing Title III.

Record Keeping

This is one of the most important provisions and requirements for funding portals. The SEC is requiring extensive record keeping of all investors who purchase or attempt to purchase securities (not just completed transactions), all issuers who offer, sell or attempt to offer or sell securities and their control persons, all communications that occur on or through the platform, all records relating to the promotion of an offering using the platform, all records demonstrating and validating compliance with other sections of the regulations (such as the registration requirements), all notices provided to issuers or investors, all written agreements the funding portal enters into, daily, weekly and monthly transaction summaries, and a log reflecting the progress of each issuer as funds are received into escrow over the course of the offering. This is a huge amount of material, which must be “promptly” accessible for the first two years and stored for at least five years. The records must be maintained in the original, non-alterable format in which they were created. This will require significant infrastructure on the part of a funding portal and platform operators should expect to devote substantial resources to developing this functionality.

Secondary Markets

A big open question remains with respect to a secondary market for crowdfunded securities. Technically they are freely tradeable after one year from the date of issuance, however, it is not clear and seems unlikely that funding portals would be allowed to establish a secondary market for securities issued on their platforms. Broker-dealers would be able to establish such markets, but state blue-sky laws may come into play, which could hamper the effectiveness of such markets. Many are concerned that allowing the securities to be traded will negatively affect the issuer by distracting it from its business, others feel that providing liquidity to retail investors is an essential part of the bargain. Regardless it is not certain that an efficient marketplace will materialize.

As you can see the regulations are extensive but manageable. This analysis is no substitute for detailed review of the rules and consultation with legal counsel, but hopefully, will alert potential funding portals to some of the issues they will face. As I have said before, it is up to us to make crowdfunding work and understanding and complying with both the letter and the spirit of these new regulations is the first step.

READ Part 1: Potential Pitfalls of Regulation CF – Part I: Practical Concerns for an Issuer

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