Crowdfunding Offerings: Broker-Dealer and Funding Portals

Regulatory Obligations

Title III of the Jumpstart Our Business Startups (JOBS) Act enacted in 2012 contains provisions relating to securities offered or sold through crowdfunding. The SEC’s Regulation Crowdfunding allows eligible issuers to offer and sell securities exclusively through the platform of an intermediary (i.e., a firm that is registered with the SEC—either as a broker-dealer or as a funding portal—and is also a FINRA member).

Regulation Crowdfunding and FINRA’s corresponding set of Funding Portal Rules set forth the principal requirements that apply to funding portal members. Funding portals must register with the SEC and become a member of FINRA. Broker-dealer firms contemplating engaging in the sale of securities in reliance on Title III of the JOBS Act must notify FINRA in accordance with FINRA Rule 4518 (Notification to FINRA in Connection with the JOBS Act).  

In addition to providing the required notification to FINRA, depending on the facts and circumstances, broker-dealer firms may also need to apply for approval of a material change in business operations by filing a Form CMA, and paying related fees, unless they are already approved by FINRA to engage in private placements or underwriting.1

Regulation Crowdfunding imposes certain gatekeeper responsibilities on intermediaries. Rule 301(a) under Regulation Crowdfunding provides in part that an intermediary must have a reasonable basis for believing that an issuer seeking to offer and sell securities through the intermediary’s platform complies with the requirements of Regulation Crowdfunding. Furthermore, Rule 301(c)(2) requires an intermediary to deny access to its platform if it has a reasonable basis for believing the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection. Moreover, with respect to an intermediary that is a funding portal, Rule 300(c)(2)(iv) prohibits it from holding, managing, possessing or otherwise handling investor funds or securities. Rule 303(e)(2) requires the funding portal to direct investors to transmit the money or other consideration directly to a “qualified third party” that has agreed in writing to hold the funds for the benefit of, and to promptly transmit or return the funds to, the persons entitled thereto. 

Additionally, Rule 404 under Regulation Crowdfunding imposes certain recordkeeping requirements on funding portals. (Broker-dealer firms that engage in Regulation Crowdfunding transactions are subject to the full recordkeeping requirements under SEA Rules 17a-3 and 17a-4, as well as FINRA Rule 3110(b) (Supervision) and the 4510 (Books and Records) Rule Series.) Rule 404 requires funding portal members to make and preserve certain records relating to their funding portal activities. Using a third party to prepare and maintain records on behalf of a funding portal does not relieve the funding portal of its recordkeeping responsibilities. 

Findings and Effective Practices 

Findings

  • Inadequate Supervision:
    • Not establishing and maintaining a supervisory system that is reasonably designed to ensure the content of email communications with investors complies with the requirements of Regulation Crowdfunding.
    • Not establishing a system to track investments.
    • Not supervising access to the funding portal’s bank accounts. 
  • Failure to Obtain Written Undertaking: Not obtaining the written undertaking required by Regulation Crowdfunding Rule 404 when using a third-party vendor to store the required records. 
  • Missing Disclosures: Offerings on the platform do not contain all required disclosures as codified in Regulation Crowdfunding, in particular: 
    • names of officers and directors of the issuer, and the positions these individuals held for the past three years; 
    • descriptions of the purpose and intended use of proceeds, the process to complete the offering transaction or cancel an investment commitment, the ownership and capital structure, and the material terms of any indebtedness of the issuer; and 
    • financial statements, as required by Regulation Crowdfunding Rule 201(t). 
  • Failing to Report Written Customer Complaints: Not reporting written customer complaints regarding investor funds through FINRA Gateway. 
  • Late Filings: Not making required filings in a timely manner—such as filing the funding portal’s Statement of Gross Revenue by the March 1 deadline—and not filing updates or changes to contact information within 30 days of the change. 
  • Not Filing CMAs: Funding portals effecting changes in ownership without obtaining prior approval from FINRA, as required by Funding Portal Rule 110(a)(4). 
  • Offering Investment Advice or Recommendations; Soliciting Purchases, Sales or Offers: Sending electronic correspondence to customers that recommend investments or otherwise solicit purchases of securities, thereby violating the prohibitions under Regulation Crowdfunding Rule 402(a) against funding portals engaging in such activity. 
  • Misleading Statements: Failing to correct misleading statements that appeared on funding portals’ websites for offerings on their platforms. 
  • Failing to Transmit Funds: Failing to promptly direct the transmission of funds to the issuers upon the successful completion of the offerings, or to return funds to investors upon cancellation of the offerings or in the event of oversubscription. 
  • Failing to Take Measures to Reduce Risk of Fraud: Not denying issuers or offerings access to funding portals’ platforms, after funding portals had become aware of warning signs of potentially fraudulent activity during the onboarding process and during issuers’ campaigns. 
  • Issues Regarding Maintenance and Transmission of Funds: 
    • Directing investors to transmit funds, in connection with a Regulation Crowdfunding offering, through an entity that is not the qualified third party. 
    • Failing to promptly direct the transmission of funds to the issuers upon the successful completion of the offerings, or to return funds to investors upon cancellation of the offerings, left in dormant escrow accounts or in the event of oversubscription.
    • Directing an escrow agent to release investor funds to an account controlled by the firm’s parent, rather than the issuer or investor.

Effective Practices

  • Compliance Resources: 
    • Developing annual compliance questionnaires to verify the accuracy of the funding portal’s reporting regarding its associated persons for purposes of Funding Portal Rule 300(c). 
    • Developing potential follow-up questions (such as whether the associated persons of the funding portal have ever filed for bankruptcy, have any pending lawsuits, are subject to unsatisfied judgments or liens or received any written customer complaints).
    • Using compliance checklists and schedules to confirm that issuer disclosures required under Regulation Crowdfunding Rule 201 are being made available to investors on the funding portal’s platform in compliance with Regulation Crowdfunding Rule 303(a).
  • Supervision: Implementing supervisory review procedures for communications requirements that, for example, clearly define permissible and prohibited communications and identify whether any contemplated structural or organizational changes necessitate the filing of a CMA. 
  • Transmission of Funds: Reviewing existing funds instructions to ensure investors are only being directed to send funds for their investment(s) to a qualified third party (and no other entity) acting as escrow agent for the offering.
  • Checklist: Utilizing the Written Supervisory Procedures Checklist for Funding Portals to ensure the firm’s written supervisory procedures address applicable areas of Regulation Crowdfunding and the FINRA Funding Portal Rules.   

Additional Resources  

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1 Generally, a firm that is already approved by FINRA to engage in private placements or underwriting would not need to file a CMA if they plan to engage in Regulation Crowdfunding activity. For more information, please refer to Regulatory Notice 16-07 (FINRA Rule 4518 (Notification to FINRA in Connection with the JOBS Act)).