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How to Raise Money Online Under Title II of the Jobs Act

Richard A Weintraub, Esq. and Amber L. Condron, Esq.       13 July 2018

INTRODUCTION

Despite the monumental developments in business and technology that have occurred since the Great Depression, the federal securities laws were not brought into the 21st century until 2012 with the enactment of the Jumpstart Our Business Startups Act (JOBS Act) (Pub L 112-106, 126 Stat 306). The JOBS Act passed with bipartisan support and was signed into law by President Obama on April 5, 2012 (although not all titles became effective at that time). The JOBS Act substantially changed a number of securities laws and regulations to make it easier for companies not only to go public but also to raise capital privately and stay private longer.

The JOBS Act was adopted in different phases and is divided into seven parts, as follows: Title I (Reopening American Capital Markets to Emerging Growth Companies), Title II (Access to Capital for Job Creators), Title III (Crowdfunding), Title IV (Small Company Capital Formation), Title V (Private Company Flexibility and Growth), Title VI (Capital Expansion), and Title VII (Outreach on Changes to the Law or Commission). The first six titles are named after the original bills they are based on and the last title constitutes instructions to the Securities and Exchange Commission (SEC). 

This article focuses only on Title II of the JOBS Act and how an issuer may utilize Title II to raise capital online. This article will also look at how the broker-dealer provisions of the Securities Exchange Act of 1934 (Exchange Act) (15 USC §§78a–78pp) and the Investment Advisers Act of 1940 (Advisers Act) (15 USC §§80b-1–80b-21) may impact an issuer that intends to raise money online under Title II.

BACKGROUND AND OVERVIEW OF TITLE II

Traditional Syndication Before Title II: “Herding Cats”

Before the enactment of the JOBS Act, issuers could raise money under the Rule 506 private-offering exemption set forth in Regulation D (17 CFR §§230.501–230.508), but they could not use general solicitation or advertising in connection with the offering. This restriction essentially prohibited use of the Internet. Before the JOBS Act, to contact a potential investor and present an investment opportunity, the issuer had to have a pre-existing substantive business or personal relationship with the potential investor. The issuer often sent offering documents in paper form, each numbered, and asked that the documents be returned at the end of the offering, even if an investment was not made. The whole system of raising capital was a bit like “herding cats.” It was very time-intensive, and unless an issuer had a large pool of potential investors with whom it had substantive pre-existing relationships, often proved fruitless or costly. 

Title II: Access to Capital for Job Creators

The JOBS Act made tremendous strides in allowing issuers to use the Internet and technology to raise money privately. It was intended to encourage funding of small U.S. businesses by easing various securities regulations. In Title II of the JOBS Act, Congress instructed the SEC to lift the ban on general solicitation and advertising in offerings of securities under Rule 506 of Regulation D (17 CFR §230.506), subject to certain conditions. Congress thus intended to allow broader marketing of private placements, including online marketing.

Title II has two major components. First was Congress’ instruction to the SEC described above, which led the SEC to add Rule 506(c) to Regulation D (17 CFR §230.506(c)). Rule 506(c) allows an issuer to employ general solicitation to market securities offerings, provided that the issuer sells the securities only to “accredited investors” and otherwise follows the requirements of Regulation D. Rule 501(a) of Regulation D (17 CFR §230.501(a)) defines “accredited investor” as an individual who has either a net worth of $1,000,000 (exclusive of their principal residence), or who made greater than $200,000 a year in the prior two years and expects the same in the current year. The issuer must take “reasonable steps” to verify that each investor who purchases securities is in fact accredited. 17 CFR §230.506(c)(2).

The second major component of Title II is the addition of subsection (c) (previously, subsection (b)) to §4 of the Securities Act of 1933 (Securities Act) (15 USC §§77a–77aa). Securities Act §4(c) (15 USC §77d(c)) (referred to in this article as the §4(c) exemption) provides an exemption from registration as a broker or dealer under Exchange Act §15(a)(1) (15 USC §78o(a)(1)) for a person that maintains a platform or mechanism (whether online, in person, or through other means) to offer and sell securities in compliance with Rule 506 of Regulation D. A person relying on the §4(c) exemption may co-invest with the issuer in the securities offered and provide certain related services; however, the person may neither receive compensation, take possession of funds or securities, nor be a “bad actor” (as discussed below). 15 USC §77d(c).

Title II also added Rule 506(d) (17 CFR §230.506(d)), disqualifying certain “bad actors” from using the exemptions created by Title II. Rule 506(d) lists certain “disqualifying events” and “bad acts” that would disqualify issuers from conducting a Rule 506 offering if it or one of its “covered persons” is engaging or has engaged in a “bad act.” Failing to comply with Rule 506(d) will disqualify the entire offering.

Under these new exemptions, issuers that are not “bad actors” can use the Internet or other media to advertise their securities offerings. Issuers thus have the chance to attract a large number of potential new investors in a short period of time. However, only “accredited investors” can purchase the securities offered. 

Quick Summary of Title II

Rule 506(c)

  • Issuers can generally solicit and advertise publicly.
  • Only accredited Investors can actually invest.
    • Accredited, for an individual, means having $1 million in net worth, or making over $200,000 a year for the past 2 years and current year.
  • Issuers must disclose details about the solicitation to the SEC within 15 days from the first solicitation.
  • The issuer must perform strict investor accreditation verifications.
  • Investors will need to prove accredited investor status, which can be done by reviewing W-2s, tax returns, bank and brokerage statements, credit reports, and the like, or a written confirmation by a CPA, attorney, investment advisor, or broker-dealer.
  • Issuers must file Form D with the SEC before soliciting, indicating that the offering will be generally solicited (proposed rule, not currently effective).
  • The penalty for noncompliance with the general solicitation requirements is that the issuer will be banned from fundraising for a full year.

Rule 506(d) (“bad actor” provisions)

  • Issuers cannot rely on Rule 506 if the issuer or any other “covered person” has a relevant criminal conviction, regulatory or court order, or other disqualifying event that occurred on or after September 23, 2013.
  • “Covered persons” include:
    • the issuer, including its predecessors and affiliated issuers;
    • directors, general partners, and managing members of the issuer;
    • executive officers of the issuer, and other officers of the issuers that participate in the offering;
    • 20 percent beneficial owners of the issuer, calculated on the basis of total voting power;
    • promoters connected to the issuer;
    • for pooled investment fund issuers, the fund’s investment manager and its principals;
    • persons compensated for soliciting investors, including their directors, general partners, and managing members.
  • Disqualifying events include:
    • Certain criminal convictions;
    • Certain court injunctions and restraining orders;
    • Final orders of certain state and federal regulators;
    • Certain SEC disciplinary orders;
    • Certain SEC cease-and-desist orders;
    • SEC stop orders and orders suspending the Regulation A exemption;
    • Suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from an association with an SRO member;
    • U.S. Postal Service false representation orders.

Section 4(c)

  • No person shall be subject to registration as a broker or dealer under §78(a)(1) of the Exchange Act solely because:
    • that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of securities in accordance with Rule 506 of Regulation D, 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.
  • This exemption is only available if such person and each person associated with that person:
  • “Ancillary services” means:
    • the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to Issuers or Investors; and
    • the provision of standardized documents to the Issuers and Investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and Issuers are not required to use the standardized documents as a condition of using the service.


 RULE 506 OF REGULATION D

Regulation D includes two exemptions from Securities Act registration: Rules 504 and 506. However, the §4(c) exemption from broker-dealer registration is available only for securities offered and sold in compliance with Rule 506, which is the most commonly used exemption under Regulation D. Following the enactment of Title II, Rule 506 now provides two different ways of conducting a securities offering that is exempt from registration: Rule 506(b) and Rule 506(c). Rule 506(b) is the long-standing rule that existed prior to the JOBS Act. Rule 506(c) is the new exemption created in accordance with the JOBS Act that allows general solicitation and advertising for offerings made solely to accredited investors.

The only filing requirement under Rule 506 is a requirement to file a notice on Form D with the SEC. See 17 CFR §230.503(a). Generally, the notice must be filed within 15 days after the first sale of securities in the offering. Many states also require a “Blue Sky filing”, the filing of a Form D notice with the state  securities regulator. See, e.g., Corp C §25102.1. The main purpose of the Form D filing is to notify federal (and state) authorities of the amount and nature of the offering being undertaken in reliance on Regulation D. Purchasers receive “restricted securities” in a Rule 506 offering. 17 CFR §§230.144(a)(3), 502(d). Therefore, they may not freely resell the securities purchased.

Rule 506(b) specifies particular disclosures that must be made to non-accredited investors. See 17 CFR §§230.502(b), 230.506(b)(1). No particular disclosure is required to be made to accredited investors. However, to the extent disclosures are made to either type of investor, the same disclosure should be made to both. See Note following 17 CFR §230.502(b)(1). Even if the issuer sells securities solely to accredited investors and thus is not subject to specific disclosure requirements, all sales of securities are subject to the antifraud provisions of the securities laws. The issuer should take care that sufficient information is available to all investors and that any information provided is free from false or misleading statements. Similarly, information should not be omitted if, as a result of the omission, the information provided to investors would be false or misleading.

As noted above, felons and other “bad actors” are disqualified from involvement in Rule 506 offerings. 17 CFR §230.506(d)(1). An issuer conducting a Rule 506 offering is required to determine whether the issuer or any of its “covered persons” has had a “disqualifying event.” The issuer should therefore conduct reasonable background checks. An issuer that is disqualified from using Regulation D may still apply for a waiver of disqualification. See 17 CFR §230.506(d)(2).

Offerings Not Using General Solicitation or Advertising 
Under Rule 506(b)

Rule 506(b) is a safe harbor for the non-public offering exemption in §4(a)(2) of the Securities Act (15 USC §77d(a)(2)), which means that, if Rule 506(b)’s specific requirements are followed, the securities transaction falls within the §4(a)(2) exemption. See 17 CFR §230.506(a). Rule 506(b) does not limit the amount of money that the issuer can raise or the number of accredited investors to whom it can sell securities. To qualify for the Rule 506(b) safe harbor, the issuer must:

  • not use general solicitation or advertising to market the securities;  
  • not sell securities to more than 35 non-accredited investors, who, either alone or with a purchaser representative, meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment; 
  • give non-accredited investors specified information about the issuer that is generally the same information provided in registered offerings (the issuer is not required to provide specific information to accredited investors, but if it does so, it should make the same information available to the non-accredited Investors);  
  • be available to answer questions from prospective purchasers who are non-accredited investors; and 
  • provide financial statement information as required by Rule 502(b)(2)(B) (17 CFR §502(b)(2)(B)).

Rule 506(b) offerings have the benefit of allowing up to 35 non-accredited investors (plus an unlimited number of accredited investors) and allowing the issuer to rely on an investor’s representation that it is an accredited investor without need to take any particular steps to verify the truth of the representation. However, there have been numerous inefficiencies related to securities offerings under Rule 506(b).

One of the biggest challenges in Rule 506(b) offerings is that the issuer cannot solicit or advertise its offering to the public. See 17 CFR §502(c). The issuer must have a pre-existing substantive relationship with each potential investor to whom it presents its offering. See SEC No-Action Letter, E. F. Hutton Co. Inc. (Dec. 3, 1985), 1985 WL 55680. The SEC has defined a "substantive" relationship as one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does in fact evaluate, a prospective offeree's financial circumstances and sophistication in determining his or her status as an accredited or sophisticated Investor. See, e.g., SEC No-Action Letter, Citizen VC, Inc. (Aug. 6, 2015), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502.htm (Citizen VC No-Action Letter); SEC No-Action Letter, Bateman Eichler, Hill Richards, Inc. (Dec. 3, 1985), 1985 WL 55679. 

Until two years ago, an issuer’s development of a substantive pre-existing relationship with a prospective investor often involved a complicated back-and-forth process lasting at least 30 days or the use of a registered broker-dealer at a steep cost to the issuer. However, on August 6, 2015, the SEC’s Division of Trading and Markets issued the Citizen VC No-Action Letter, which described the steps an issuer can take to establish a substantive pre-existing relationship with a potential Investor. 

Impact of Citizen VC No-Action Letter

Citizen VC, Inc. was an online venture capital firm that developed qualification policies and procedures that it used to establish substantive relationships with, and to confirm the suitability of, prospective investors who visited its online venture capital investment platform. These policies and procedures were designed to evaluate a prospective investor's sophistication, financial circumstances, and ability to understand the nature and risks of the securities offered.

In the Citizen VC No-Action Letter, the SEC agreed that the quality of the relationship between an issuer (or its agent) and an investor is the most important factor in determining whether a substantive relationship exists and there is no specific duration of time or particular short-form accreditation questionnaire that can be solely relied on to create such a relationship.

The Citizen VC No-Action Letter applies to issuers of securities and their ability to develop a substantive pre-existing relationship with potential investors. It may also apply to broker-dealers by analogy. Previous no-action letters applied only to broker-dealers. The Citizen VC No-Action Letter has been a huge boon for issuers relying on Rule 506(b) to conduct offerings through use of online platforms. It sets forth manageable steps that an issuer can take to ensure that it establishes a substantive pre-existing relationship with a potential investor before making an offering to that investor. If an issuer follows the policies and procedures described in the Citizen VC No-Action Letter, it should be able to establish the required relationship in a matter of days rather than months.

Offerings Using General Solicitation and Advertising
Under Rule 506(c)

New Rule 506(c) permits issuers to use general solicitation and general advertising to offer their securities, provided that (1) the issuer satisfies the requirements of Rules 501, 502(a), and 502(d); (2) all purchasers are accredited investors; and (3) the issuer takes reasonable steps to verify that the investors are accredited investors. Notably, there is no restriction on whom an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities. Only “accredited investors,” as defined in Rule 501 (17 CFR §230.501), can actually purchase the advertised securities.

Definition of “Accredited Investor”

An “accredited investor” is:

  • a bank, insurance company, registered investment company, business development company, or small business investment company; 
  • an employee benefit plan (within the meaning of the Employee Retirement Income Security Act) if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; 
  • a tax-exempt charitable organization, corporation, or partnership with assets in excess of $5 million; 
  • a director, executive officer, or general partner of the company selling the securities; 
  • an enterprise in which all of the equity owners are accredited Investors;
  • an individual with a net worth of at least $1 million, not including the value of his or her primary residence; 
  • an individual with income exceeding $200,000 in each of the two most recent calendar years or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year; or
  • a trust with assets of at least $5 million, not formed only to acquire the securities offered, and whose purchases are directed by a person who meets the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment.

Unlike Rule 506(b), which allows an issuer to rely on an investor’s representation that it is accredited, Rule 506(c) requires an issuer to take reasonable steps to verify that a prospective investor is accredited. 17 CFR §230.506(c)(2). Whether the steps taken by the issuer are “reasonable” is an objective assessment, based on the particular facts and circumstances of each purchaser and the transaction. Factors that issuers should consider when determining the reasonableness of the steps to verify that a purchaser is an accredited investor include: (1) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (2) the amount and type of information that the issuer has about the purchaser; and (3) the nature of the offering, such as the manner in which the purchaser was solicited and the terms of the offering (e.g., the size of the minimum investment). Rule 506(c) also provides a non-exclusive list of methods that issuers may use to satisfy the verification requirements for natural persons. Certain online service providers, such as VerifyInvestor.com, offer third-party verification services by licensed attorneys for a nominal fee and can help automate the online investment process.

Non-Exclusive Safe Harbor Methods to Verify Investor Accreditation

On the basis of income: Reviewing copies of any IRS form that reports income (e.g., W-2, 1099, 1065, or 1040) for the two most recent years, plus a written representation (affidavit) from the investor that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year. (The issuer must obtain both husband’s and wife’s information and statement even if only one is investing.)

On the basis of net worth: Reviewing one or more of the following types of documentation, dated within three months prior, and by obtaining a written representation (affidavit) from the investor that all liabilities necessary to make a determination of net worth have been disclosed:

  • For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties,
  • For liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.

Third party verification: By obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the investor is an accredited investor within the past three months and has determined that the investor is an accredited investor.

Prior investor: With respect to any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor before the effective date of Rule 506(c) and remains an investor of the issuer, for any Rule 506(c) offering conducted by the same issuer, the issuer is deemed to satisfy the verification requirement in Rule 506(c) with respect to that person by obtaining a certification by that person at the time of sale that he or she qualifies as an accredited investor.

Issuers conducting Rule 506(b) offerings without the use of general solicitation or general advertising can continue to conduct securities offering in the same manner and are not subject to the new verification rule.

Use of Social Media and the Internet

Issuers raising capital under Rule 506(c) can use social media, the Internet, email, and television to solicit and raise capital from the general public. See SEC Release No. 33-9415 (July 10, 2013), 78 Fed Reg 44771-01. Issuers raising capital under Rule 506(b) can also use online platforms to raise capital, but cannot generally solicit potential investors or advertise the offering. As discussed above, Rule 506(b) issuers must have a substantive pre-existing relationship with the potential investors whom they allow on their platform.

Issuers under either rule can use their own websites to make offering documentation and information available to potential investors. There are many companies selling software as a service that will assist issuers in setting up a website to raise funds under Rules 506(b) or 506(c). These companies license software to the issuer on a subscription basis and centrally host a website in the name of the issuer from which the issuer can conduct its offering.

Issuers may also opt to use portals that operate online equity crowdfunding or investment platforms. See 15 USC §77d(c)(1)(A). Five of the more prevalent online equity crowdfunding platforms operating today include CircleUp, Crowdfunder, EquityNet, Fundable, and SeedInvest. Some of these platforms are fully integrated so that investors can make their investments online, while others require the actual investment to be made off-line.

Issuers using Rule 506(c) can send general solicitations in email blasts and post to LinkedIn, Facebook, Twitter, and similar sites. Although the SEC has provided little guidance on what an advertisement for a Rule 506(c) offering should look like, issuers can generally follow Rule 134 (17 CFR §230.134) in preparing an expanded tombstone ad. Rule 134 sets forth what items of information can be included in a communication to investors without having the communication be deemed a prospectus.

To date, the SEC has not provided guidance on the form of general solicitation or advertising under Rule 506(c); however, the SEC has issued a Proposed Rule 509. See SEC Release No. 33-9416 (July 10, 2013), available at https://www.sec.gov/rules/proposed/2013/33-9416.pdf. Proposed Rule 509, once effective, would require certain legends and other disclosures to be included in any written communication that constitutes general solicitation or general advertising in a Rule 506(c) offering and would require additional disclosures by private funds, such as private equity, venture capital, and hedge funds. If an issuer uses a simple banner ad or one- or two-line “teaser” ad, the issuer should have the landing page to which the ad is linked include the Rule 509 legend.

The Rule 509 legend for general use will look familiar to securities law practitioners. It includes statements regarding sale only to accredited investors, reliance on an exemption from the registration requirements of the Securities Act, and transfer restrictions under applicable securities laws. Private fund legends will be required to include additional disclosures indicating that the securities offered are not subject to the provisions of the Investment Company Act of 1940 (15 USC §§80a-1–-80a-64) and additional disclosures in any written general solicitation materials that include performance data.  

Sample Rule 509 Disclaimer for Rule 506(c) Advertisement

The securities referred to in this advertisement may be sold only to accredited investors, which for natural persons, are investors who meet certain minimum annual income or net worth thresholds. These securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act. The Securities and Exchange Commission has not passed on the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials. The securities are subject to legal restrictions on transfer and resale and investors should not assume that they will be able to resell their securities. Investing in securities involves risk, and investors should be able to bear the loss of their investment.


PROPRIETARY PORTALS
AND THE ISSUER EXEMPTIONThe SEC noted in Foot Note 62 of Release No. 33-9415, No. 34-69959, Final Rules, that broker-dealers participating in Rule 506(c) offerings in conjunction with issuers would continue to be subject to Financial Industry Regulatory Authority (FINRA) rules regarding communications with the public. Among other things, those rules (1) generally require all member communications to be based on principles of fair dealing and good faith, to be fair and balanced, and to provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service; and (2) prohibit broker-dealers from making false, exaggerated, unwarranted, promissory, or misleading statements or claims in any communications. See FINRA Rule 2210(d).

With the enactment of Title II, issuers can now freely use online platforms and mechanisms to conduct their Rule 506 offerings, potentially automating or streamlining the process of raising capital. See 15 USC §77d(c)(1)(A). An issuer using such an online platform or mechanism (which the Author refers to as a “proprietary portal”) to sell its own securities would not be required to register as a broker or a dealer under the Exchange Act. See 15 USC §77d(c)(1). The SEC has noted that “the [Securities Exchange] Act has customarily been interpreted not to require the issuer itself to register as either a broker or a dealer” because the issuer sells securities for its own account and not for the accounts of others and does not buy and sell its securities for its own account as part of a regular business. See SEC Release No. 34-13195 (Jan. 21, 1977); SEC, Division of Trading and Markets, Guide to Broker-Dealer Registration (April 2008), available at https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html. Issuers whose activities go beyond selling their own securities, however, need to consider whether they should register as broker-dealers. Id. 

Nonetheless, persons acting on behalf of an issuer and engaged in distributing the issuer’s securities, including the issuer’s own directors, officers, or employees, may be either “brokers” or “dealers” under §3(a) of the Exchange Act (15 USC §78c(a)). See SEC Release No. 34-22172 (June 27, 1985), available at https://www.sec.gov/rules/final/1985/34-22172.pdf. However, Exchange Act Rule 3a4–1 (17 CFR §240.3a4-1) provides a nonexclusive safe harbor for persons associated with certain issuers to participate in the sale of an issuer’s securities without registering as a broker-dealer. This safe harbor is commonly known as the “issuer exemption.”

The Rule 3a4-1 Safe Harbor

The issuer exemption typically applies to individual employees or agents of the issuer rather than the issuer itself. It is likely that certain officers and employees of an issuer will be involved in the offer or sale of the issuer’s securities in a public or private offering because they may be required to speak with prospective investors about the business strategy or financial condition of the issuer. Rule 3a4-1 (17 CFR §240.3a4-1) is a non-exclusive safe harbor under which an “associated person” of an issuer who performs limited securities sales for the issuer as prescribed by the rule would be deemed not to be a “broker” under Exchange Act §3(a)(4) (15 USC §78c(a)(4)) and thus not required to register in accordance with Exchange Act §15 (15 USC §78o).

For the safe harbor to apply, each of three preliminary requirements and one of three alternative conditions must be satisfied. The three preliminary requirements are as follows: (1) the associated person must not be subject to a statutory disqualification, (2) the associated person must not receive transaction-based compensation, and (3) the associated person must not be an associated person of a broker or dealer. Any person who is registered as a broker or dealer or is an associated person of a broker or dealer (i.e., a “licensed person”) would not meet the third requirement and therefore would be prevented from relying on the Rule 3a4-1 exemption. 17 CFR §240.3a4-1(a). In addition to satisfying the foregoing three requirements, one of three conditions must be satisfied for the safe harbor to apply: (1) the sales are restricted to certain classes of purchasers or certain transactions, (2) the person’s sales duties are limited in frequency and proportion, or (3) the person’s sales duties are passive. See 17 CFR §240.3a4-1(a)(4).

In determining whether payment of a salary or bonus could be deemed disguised or unpermitted transaction-based compensation, all of the facts and circumstances of the compensation arrangement must be considered. The Adopting Release recites the following as examples of relevant factors the SEC may consider in determining whether the payment of a bonus is permissible under Rule 3a4-1: (1) when the offering commences and concludes; (2) when the employee’s bonus is paid; (3) when it is determined that the employee’s bonus will be paid; (4) when associated persons are informed of the issuer’s intention to pay a bonus; and (5) whether the bonus paid to a particular associated person varies with his or her success in selling the issuer’s securities. See Rule 3a4-1(a)(2). Even an increase in an employee’s base salary beyond its normal amount to compensate for assuming the additional burdens of selling securities may be sufficient for the SEC to conclude that the compensation is indirectly related to transactions in securities, therefore disqualifying a person from relying on the issuer exemption. See David A. Lipton, Broker-Dealer Regulation (Clark Boardman Callaghan 2017) §1.10.

An issuer that permits its unregistered directors, officers, employees, or other associated persons to participate in the offer or sale of its securities outside the safe harbor afforded by Rule 3a4-1 runs the risk that the offering may be subject to rescission by investors whose purchases were induced by one or more of those persons.  (15 U.S. Code §78cc and Cal. Corp. Code §25501.5)

BROKER-DEALER REGISTRATION AND THE §4(c) EXEMPTION

In the past, persons operating an online platform or mechanism that permitted the offer, sale, or purchase of securities, other than their own, would be deemed a “broker” or “dealer” and would be required to register as such with the SEC.

Securities Exchange Act of 1934

Section 15(a)(1) of the Exchange Act (15 USC §78o(a)(1)) requires any person that acts as a “broker” or “dealer” in securities in interstate commerce to register with the SEC. Under §3(a)(4)(A) of the Exchange Act (15 USC §78c(4)(A)), a “broker” is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” Under §3(a)(5)(A) of the Exchange Act (15 USC §78c(5)(A)), a “dealer” is defined as “any person engaged in the business of buying and selling securities (not including security-based swaps, other than security based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.” The definition excludes “a person that buys or sells securities . . . for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” 15 USC §78c(5)(B).

The §4(c) Exemption

Title II of the JOBS Act added §4(b), now §4(c), to the Securities Act. See 15 USC §77d(c). Section 4(c) provides that, with respect to securities offered and sold in compliance with Rule 506 of Regulation D (17 CFR §230.506), a person (or entity) who meets specific conditions will not need to register as a broker-dealer solely because (15 USC §77d(c)(1)): 

  • the person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of securities, or that permits general solicitation or general advertising by issuers of such securities, whether online, in person, or through other means; 
  • the person or any associated person co-invests in the securities; or 
  • the person or any associated person provides ancillary services with respect to the securities.

Under §4(c)(2) (15 USC §77d(c)(2)), a person may rely on the §4(c) exemption only if (1) the person or any associated person does not receive any compensation in connection with the purchase or sale of the securities; (2) the person or any associated person does not have possession of customer funds or securities in connection with the purchase or sale of the securities; and (3) the person is not subject to a statutory disqualification under the Exchange Act. A person who satisfies these conditions should keep in mind that §4(c) provides only a federal exemption and does not impact any state broker-dealer registration requirements. Moreover, anyone who offers and sells securities outside of Rule 506 may not rely on this exemption.  

The SEC has stated that an Internet website and social media each qualify as a permitted “platform or mechanism” for purposes of §4(c). An associated person of an issuer of Rule 506 securities may rely on the §4(c) exemption to maintain a platform or mechanism as long the person otherwise qualifies for the exemption. An issuer or person associated with an issuer may engage in a Rule 506 offering involving general solicitation or general advertising if fully compliant with Rule 506(c). See SEC, Division of Trading and Markets, Jumpstart Our Business Startups Act: Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act (Feb. 5, 2013), available at  https://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm).

SEC Defines “Compensation” Broadly for Purposes of §4(c)

The §4(c) exemption is not available to anyone who receives (or whose associated persons receive) “compensation in connection with the purchase or sale of such security.” 15 USC §77d(c)(2)(A). The SEC specifically noted that, for purposes of §4(c), compensation is not limited to transaction-based compensation. (https://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm) The SEC interprets the term “compensation” broadly, to include any direct or indirect economic benefit to the person or any of its associated persons. (https://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm) The SEC considers any salary paid to a person for engaging in the promotion, offering, or selling of securities as compensation in connection with the purchase and sale of securities. (https://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm) Accordingly, any person receiving such a salary would not be able to rely on the §4(c) exemption. Because the JOBS Act expressly permits co-investment in the securities offered (see 15 USC §77d(c)), any profit associated with such an investment is not considered impermissible compensation for purposes of the §4(c) exemption. 

A person or entity may provide ancillary services, receive reasonable compensation for those services, and still qualify for the §4(c) exemption. As set forth in §4(c)(3) (15 USC §77d(c)(3)), the term “ancillary services” means (1) the provision of due diligence services in connection with the offer, sale, purchase, or negotiation of a security, so long as the services do not include, for separate compensation, investment advice or recommendations to issuers or investors, and (2) the provision of standardized documents to the issuers and investors, so long as (a) the person or entity does not negotiate the terms of the issuance for and on behalf of third parties, and (b) issuers are not required to use the standardized documents as a condition of using the service. However, unreasonable fees for such ancillary services may be viewed as disguised transaction-based compensation or unpermitted compensation and negate the exemption.

A Person May Still Be a “Broker-Dealer” Even If It Qualifies for the §4(c) Exemption

Section 4(c) provides an exemption from registration; it does not provide an exclusion from the definition of the terms “broker” or “dealer.” A separate analysis of the specific facts and circumstances must be conducted to determine if a person qualifies as a “broker” or a “dealer” under the federal securities laws. See 15 USC §78c(a). A person that qualifies as a “broker” or “dealer,” but also qualifies for the §4(c) exemption from registration, remains subject to certain parts of the federal securities laws, including those pertaining to fraud, manipulation, and insider trading. See Securities Act §17(a) (15 USC §77q(a)); Exchange Act §§9(a), 10(b), and 15(c)(1)–(2) (15 USC §§78i(a), 78j(b), 78o(c)(1)-(2)). In addition, a person who qualifies as a “broker” or “dealer” may need to register under state law even if exempt under federal law. Note that an issuer may use a registered broker-dealer in connection with the offer and sale of securities online and that a registered broker-dealer may receive permissible transaction-based fees and commissions (or both).

MARKETPLACE PORTALS AND INVESTMENT ADVISERS

As discussed above, §4(c) of the Securities Act (15 USC §77d(c)) sets forth the conditions for a person to be exempt from the broker-dealer registration requirements of §15(a)(1) of the Exchange Act (15 USC §78o(a)(1)) when engaged in specific matchmaking activities associated with securities offered and sold in compliance with Rule 506 (e.g., operating a “platform or mechanism” to offer or sell securities in accordance with Rule 506(c) (17 CFR §230.506(c)). The exemption is not available to anyone who receives (or whose associated persons receive) “compensation in connection with the purchase or sale of such security.” 15 USC §77d(c)(2)(A).

As discussed above, the SEC interprets the term “compensation” broadly to include any direct or indirect economic benefit. “Compensation” is not limited to transaction-based compensation, but also includes salary. See SEC Division of Trading and Marketing, Jumpstart Our Business Startups Act: Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act (Feb. 5, 2013), available at https://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm (Title II FAQs). However, a platform operator may receive reasonable fees for ancillary services and reimbursement of out-of-pocket expenses and still rely of the §4(c) exemption. In addition, co-investment in the securities offered on the platform or mechanism is expressly permitted, and the SEC does not consider any profits associated with such an investment to be impermissible compensation for purposes of the exemption­—which makes the exemption attractive to venture capitalists and investment advisers. See Title II FAQs.

The SEC has stated that an entity, such as a venture capital fund or its adviser, that operates a website where it lists offerings of securities by potential portfolio companies in compliance with Rule 506, co-invests in those securities with other investors, and provides standardized documents for use by issuers and investors, may rely on the §4(c) exemption as long as it satisfies the conditions of the exemption, including the prohibition on compensation. See Title II FAQs. The SEC believes that as a practical matter, the prohibition on compensation makes it unlikely that a person outside the venture capital arena would be able to rely on the exemption from broker-dealer registration. Title II FAQs.

Investment Advisers Act of 1940

The Investment Advisers Act of 1940 (Advisers Act) (15 USC §§80b-1—80b-21) was enacted to monitor and regulate the activities of investment advisers (as defined). Subject to certain limited exclusions discussed below, §202(a)(11) of the Advisers Act (15 USC §80b-2(a)(11)) generally defines an “investment adviser” as any person or firm that: (1) for compensation (2) is engaged in the business of (3) providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications. A person or firm must satisfy all three elements to be subject to regulation under the Advisers Act. The SEC construes these elements broadly.

A person or firm is required to register with the SEC if he, she, or it is: (1) an “investment adviser” under §202(a)(11) of the Advisers Act; (2) not excepted from the definition of investment adviser by §202(a)(11)(A)–(E) of the Advisers Act; (3) not exempt from SEC registration under §203(b) of the Advisers Act (15 USC §80b-3(b)); and (4) not prohibited from SEC registration by §203a of the Advisers Act (15 USC §80b-3a). An employee of an SEC-registered investment adviser does not need to register separately, so long as all of the employee's investment advisory activities are within the scope of his or her employment. Generally excluded from coverage under the Advisers Act are those professionals whose investment advice to clients is “solely incidental” to the professional relationship. See 15 USC §80b-2(a)(11).

Title III of the Investment Advisers Supervision Coordination Act (Pub L 104-290, 110 Stat 3436) requires the SEC to supervise and register those investment advisers with $25 million or more in client assets under management. 15 USC 80b-3a. Those with less than $25 million under management are required to register with, and be supervised by, their proper state regulatory agency. If an investment adviser with $25 million or less under management resides in a state that does not require registration, he or she must register with the SEC. 17 C.F.R. 275.203A-1. However, in general, only advisers that have $100 million or more of assets under management or that provide advice to investment company clients are permitted to register with the SEC; advisers that have $150 million or more of assets under management are required to register with the SEC. 15 U.S.C.80b-3a; 17 C.F.R. 275.203A-1.

There are several exclusions and exemptions to the registration requirement including, but not limited to, §203(l) (15 USC §80b-3(l)), the “venture capital exemption,” and the new §203(m) (15 USC §80b-3(m)) “private fund adviser exemption.” Advisers that rely on the venture capital and private fund adviser exemptions are commonly referred to as “exempt reporting advisers” because §§203(l) and 203(m) each provide that the SEC shall require such advisers to maintain corresponding records and to submit reports “as the Commission determines necessary or appropriate in the public interest or for the protection of Investors.” Thus, an adviser that qualifies for any of the exemptions could choose to register (or remain registered) with the SEC, subject to §203a of the Advisers Act (15 USC §80b-3a).

 AngelsList and FundersClub No-Action Letters

In separate letters to the SEC, counsel for AngelList LLC and FundersClub, Inc. each argued that registration as a broker-dealer for their respective investment adviser clients was not appropriate. Each investment adviser was already regulated under the Advisers Act, and in counsels’ view, there was no policy rationale that supported requiring an investment adviser to be regulated both as an investment adviser and as a broker-dealer. Although not explicitly stated in the no-action letters issued by the SEC in response, the SEC may support this view, as evidenced by the outcomes discussed below. See SEC No-Action Letter re AngelList LLC and AngelList Advisors LLC (Mar. 28, 2013, available at https://www.sec.gov/divisions/marketreg/mr-noaction/2013/angellist-15a1.pdf (AngelList no-action letter); SEC No-Action Letter re FundersClub Inc. and FundersClub Management LLC (Mar. 26, 2013), available at https://www.sec.gov/divisions/marketreg/mr-noaction/2013/funders-club-032613-15a1.pdf (Funders Club no-action letter).

The AngelList and FundersClub no-action letters each concerned investment advisers that operated online platforms. In these no-action letters, the SEC staff expanded on the issuer exemption in relation to a §4(c) exempt platform by stating that the SEC would not recommend enforcement action. By doing so, the SEC approved two situations in which investment advisers operating funding platforms did not need to register as broker-dealers, even though they were functioning as “serial issuers” (as discussed below). 

As discussed above, the issuer exemption in Exchange Act Rule 3a4–1 (17 CFR §240.3a4-1) provides a nonexclusive safe harbor for persons associated with certain issuers to participate in the sale of an issuer’s securities without registering as a broker-dealer. Although the issuer exemption may provide relief for an issuer of a single offering, the exemption may be called into question when a person associated with an issuer seeks to participate in multiple offerings in a single calendar year (i.e., function as a “serial issuer”). Indeed, to qualify for the issuer exemption, persons associated with an issuer generally may not participate in the selling of securities for any issuer more than once every 12 months. 17 CFR §240.3a4-1(a)(4)(ii)(C).

Notably, AngelList Advisors LLC conceded in its submission to the SEC that it did not qualify for the Rule 3a4-1 safe harbor because of the likelihood that its employees might sell the securities of more than one issuer in a 12-month period. Although the AngelList entities did not meet the safe harbor and were functioning as “serial issuers,” the SEC stated that it would not recommend enforcement action against any of the AngelList entities if none of them registered as a broker-dealer.

AngelList Advisors LLC and the two FundersClub entities earned carried interest, but not management fees. Carried interest is one form of investment adviser compensation, and is not the same as the transaction-based compensation earned by broker-dealers. Rather, it is a return on investment as a result of a manager’s efforts to increase a fund’s investment performance. In the AngelList and FundersClub no-action letters, the SEC noted that carried interest was not transaction-based compensation and was thus acceptable.

Management fees are another type of investment adviser compensation; traditionally, they are not interpreted as transaction-based compensation. The SEC has not formally approved payment of management fees, which are typically standardized as 2 percent annually on the assets of investment funds, in connection with the §4(c) exemption. However, on September 25, 2013, in a Practicing Law Institute webinar, David Blass, the former SEC Chief Counsel for the Division of Trading and Markets, reminded listeners that “that compensation paid to advisers from the funds they manage based on assets under management and/or investment performance, absent other factors, likely would not trigger a requirement to register as a broker-dealer.” He did state that “pure transaction-based compensation paid to an adviser’s employees is generally a ‘clear cut example’ where registration would be required.” Kroll & Goldman, A Conversation With David Blass About Broker-Dealer Status Questions (Oct. 08, 2013), available at https://www.morganlewis.com/pubs/a-conversation-with-david-blass-about-broker-dealer. 

The AngelList and FundersClub no-action letters are instructional on the application of the §4(c) and issuer exemption to “serial issuers” such as investment advisers. They show that it is both possible and legal for an investment adviser to operate a funding platform without broker-dealer registration. 

Investment Adviser Funding Platform Model

For the first time, the AngelList and FundersClub no-action letters provide support for an investment adviser to operate a funding platform. Although the SEC’s broad interpretation of the term “compensation” limits the scope of the §4(c) exemption discussed above, the no-action letters nonetheless did not require AngelList LLC and FundersClub, Inc. to register as broker-dealers. The no-action letters do not set forth the SEC’s rationale, but do provide a template for an investment adviser funding platform model. An investment adviser may: (1) form investment funds (as special purpose vehicles), (2) use a funding platform to provide information and disclosures to accredited investors, (3) use the investment funds to invest in businesses or other assets on behalf of accredited investors, and (4) earn traditional investment adviser-type compensation (specifically, a carried interest). By not requiring broker-dealer registration, the AngelList and FundersClub no-action letters eliminate regulatory friction and provide the industry an opportunity to structure businesses that can actively engage in the capital formation process, receive compensation for doing so, and operate platforms outside the broker-dealer model. 

BLUE SKY LAWS

Issuers attempting to navigate a private offering will also need to comply with state securities laws, commonly referred to as blue sky laws. To the extent that the offering is offered and sold to residents of a particular state, the offering will be subject to that state’s blue sky laws, which may include a merit review of the security by a state government authority. However, §18 of the Securities Act (15 USC §77r) preempts blue sky merit review for certain kinds of federally exempt offerings, including private offerings under Regulation D. States are still permitted to impose notice filing requirements, collect fees, and investigate and bring enforcement actions for fraud. This means that an issuer conducting a Rule 506 offering need only comply with federal securities laws and provide a compliant notice filing with each state in which it sells securities. In California, the blue sky exemption for offerings under Rule 506 of Regulation D (17 CFR §230.506) is conditioned on the filing of a notice using SEC Form D (as accepted by the SEC) within 15 days of the first sale of the securities in California, together with a filing fee. See Corp C §25102.1.

CONCLUSION

The JOBS Act provided the mechanism for the offer and sale of securities over the Internet. Much as consumers were reluctant to use the Internet to acquire goods and services 15 to 20 years ago, investors have been reluctant to acquire securities directly from issuers online. Consumer confidence in online purchasing gradually increased to the significant levels of today. In the same way, investor confidence should grow over the next several years, and investor use of the Internet to acquire securities directly from issuers should increase significantly, making it all the more important for issuers to understand and comply with the securities laws that allow them to raise money online.

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