Crowdfunding, Reg D and Reg A

Indeed, even the SEC, proponents of the new Regs, saw the increased risk of fraud. In its 2017 Investor Bulletin, the SEC warned: "In light of the relative ease with which early-stage companies can raise funds through crowdfunding, it may be the case that certain opportunities turn out to be money-losing fraudulent schemes. As with other investments, there is no guarantee that crowdfunding investments will be immune from fraud."

The increased risk of fraud is not surprising. Whereas traditional Reg D offerings are generally made via private placement memoranda drafted carefully by attorneys who are mindful of the need for material disclosures, an investment disclosure document is not required. And although Reg CF and Reg A require mandated disclosure to investors, the SEC does not review the Reg CF offering material before it is released. And other than traditional Reg D offerings that limit marketing to accredited investors with whom the issuer has a pre-existing business relationship, the other routes can be marketed publicly, the only restraint being on Reg CF offerings that most of the marketing be limited to the on-line funding portal.

Furthermore, all these new routes are still subject to liability under Section 17/Rule 10b-5 and similar antifraud provisions. Couple that with issuers increased use of social media and the risk is obvious. A misleading statement or omission of a material fact about the offering on social media can get the issuer into hot water.

Similarly, intermediaries assisting issuers, such as funding portals and Internet platforms posting issuers' offerings, can also land in hot water for an issuers' conduct.

Under Reg CF, a funding portal hosting issuers' offerings on line, "cannot provide access to its platform to any company that has a reasonable basis for believing presents the potential for fraud or raises other investor protection concerns."

How much due diligence does a portal have to conduct in order not to be found liable when it turns out one of the issuers raising capital on its site is engaged in investor fraud? All Reg CF requires is a simple background check. But is that enough? According to the June 2019 SEC Staff Report regarding Reg CF, there has been no enforcement activity to date, other than by FINRA. Does that, in and of itself, suggest enforcement activity is forthcoming?

Similarly, a host platform for Reg D or Reg A offerings, could be criminally charged with wire fraud or under an aiding and abetting theory if the platform knew or should have known that the issuer was engaged in some kind of fraud but, nevertheless, allowed the issuer to raise capital on the platform's website.

At the very least, under the U.S. Supreme Court's recent decision in the Lorenzo case, (Lorenzo v SEC, No 17-1077, March 27, 2019), the SEC could bring a 10b-5 action against such a platform simply for the act of dissemination of false information on its website even if it was not involved in any way in the creation of the content.

What should an intermediary such as a website platform or funding portal do to protect itself from liability under these new Regs for the actions of issuers that raise capital on their websites? Guidance can be found in the April 2019 U.S. Department of Justice's Criminal Division Evaluation of Corporate Compliance Programs Guidance Document. The Guidance goes into detail regarding expectations for corporations dealing with third parties.

"Real Actions and Consequences – Does the company track red flags that are identified from due diligence of third parties and how those red flags are addressed? Does the company keep track of third parties that do not pass the company's due diligence or that are terminated, and does the company take steps to ensure that those third parties are not [contracted with] at a later date? If third parties were involved in the misconduct at issue in the investigation, were red flags identified from the due diligence or after … and how were they resolved? Has a similar third party been suspended, terminated, or audited as a result of compliance issues?"

In other words, due diligence by the host or funding portal prior to allowing the posts may be necessary but it also may be prudent to monitor for red flags so that the host can take action if necessary. An interesting conundrum presents itself to hosts and portals — conduct the due diligence and monitoring to protect itself from government regulatory action or do as little as required by the statutes themselves and seek to avail itself of the protections of the Communications Decency Act as a mere platform host should a private lawsuit be brought against it.

The other risk area for intermediaries is the broker-dealer conundrum; when does a platform acting as a mere "bulletin board" for offerings become a broker? And the obvious follow-up question: if it is a broker, is it registered as such? If not, the potential downside can be severe, including exposure to penalties and other enforcement action as well as opening the door to investors rescinding their investments.

Amended Rule 506 of Reg D specifically allows a platform to host issuers offering unregistered securities falling within the safe harbor of Reg D without having to register as a broker provided the platform does not retain custody of any investor funds or securities, does not receive compensation "in connection with the purchase or sale of securities," and is not subject to statutory disqualification. 15 USC 77d(b)(c)(1)(A), et seq.

Much of the litigation and enforcement has been focused on the area of compensation "in connection with" the purchase or sale of securities. Although case law historically has interpreted such compensation as needing to be "transaction based' in order to potentially cause an intermediary to be viewed as a broker, the SEC's JOBS Act FAQs make a point that the phrase "in connection with the purchase or sale of securities" is not limited to transaction based compensation, widening the broker net.

How can an intermediary ensure that it not be viewed as operating as an unregistered broker? One avenue is to argue that under SEC No-Action letters and certain court opinions, the fact that one has received a transaction-based fee is merely a marker that the party receiving the fee may be engaged in broker activities but that, ultimately, the SEC has to establish that the intermediary is actually engaging in traditional brokerage services — not technology services. Another avenue is to simply structure any fee received by the intermediary as comparable to that charged for technology services rather than fees for assisting in marketing the offerings. But note that each State has its own definition of "broker-dealer" and can charge an intermediary as being unregistered even where the SEC may not agree.

Another potential risk area is that relating to advertising by the intermediary; that is can the platform or funding portal "sell" the quality of the issuers or offerings on its website? What if the intermediary has conducted significant due diligence regarding the issuer and the offering; all to protect the investor? Can the site tout that due diligence?

Amended Rule 506 of Reg D specifically allows for general solicitation and general advertising of unregistered securities offerings falling within the safe harbor of Reg D. A platform host is not required to register as a broker solely because it "permits the offer, sale, purchase or negotiation 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." Note that the exemption applies to the issuer's general solicitation — not the host platform's general solicitation.

Similarly, under Reg CF: "If the intermediary is a funding portal, it is prohibited from participating in the communication channel on its platform, other than to establish guidelines for communication and remove abusive or potentially fraudulent communications."

Therefore, a platform host, by advertising more than simply posting the issuers' ads, could be viewed as acting as an unregistered broker, even when the advertising — touting the host's extensive due diligence regarding the offering and the issuer — is ostensibly for the benefit of potential investors. Similarly, a funding portal, by advertising, could be viewed as acting in violation of Reg CF — again, even if it is to convey the due diligence conducted, arguably vouching for the offerings on the site.

While a new JOBS Act languishes, maybe Congress will take a look at these potential risks against the goal of increasing access to capital while at the same time protecting investors, and provide additional guidance to issuers and intermediaries to allow them to stay out of harm's way.

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Jacqueline C. Wolff, a member of this newsletter's Board of Editors, is a partner in the Investigations and White Collar Defense practice at Manatt, Phelps and Phillips LLP, and resident in its New York office. Brian S. Korn is a partner and Head of the Fintech practice group at Manatt, resident in the New York office. He represents online lenders, investors and service providers in all ranges of lending, capital markets and fund transactions, including blockchain technology.