Crowd Funding: New Tools, New Opportunities

CAROL BAVOUSETT MATTICKCarol Bavousett Mattick, PLLC

919 Congress Avenue, Ste 919Austin, TX 78701

State Bar of TexasANNUAL MEETING

June 16, 2016FT WORTH, TX

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CROWD FUNDING: NEW TOOLS, NEW OPPORTUNITIES

INTRODUCTION.................................................................................................................1

REGULATION CF................................................................................................................1A. Overall Requirements................................................................................................2

Which Issuers Cannot Use Regulation CF................................................................2Primary Requirements...............................................................................................2Limitations on Investment..........................................................................................3Any Kind of Security May Be Offered........................................................................4Liability for Persons Offering or Selling a Security..................................................4

B. Requirements for Eligible Issuers..............................................................................4The Offering Statement..............................................................................................4Non-Financial Information........................................................................................4Financial Information................................................................................................6Duty to Amend and Update........................................................................................6Duty to Engage in Annual Reporting and Termination

Of Annual Reporting............................................................................................7Advertising or Promoting the Offering......................................................................8The Chronology of a Regulation CF Offering

From the Issuer’s Point of View..........................................................................8

C. Requirements for All Intermediaries – Both RegisteredBroker Dealers and Funding Portals....................................................................9

Disqualification..........................................................................................................9Functional Requirements of the Electronic Platform................................................10Policing Compliance of Issuers and Investors...........................................................12

D. Additional Requirements for Funding Portals...........................................................13Scope of FP Registration and Allowed Activity.........................................................13Maintenance of Record of the Offering, Communications

Among Investors and Other Records...................................................................13Ability to Take Transaction Based Compensation.....................................................14FINRA Regulation......................................................................................................17

E. Other Key Features of Interstate Crowdfunding........................................................19Pre-Emption of State Substantive Law......................................................................19No Integration: Ability to Do Simultaneous/”Close in Time”

Offerings Under Other Exemptions.....................................................................20Non-Exclusive Method of Compliance.......................................................................20

F. Practical Questions Raised by Regulation CF.............................................................20Intermediaries Preparing Offering Documentation..................................................20Interstate and Intrastate Crowdfunding: Parallel Closed Systems...........................21Bottleneck: The Importance of Electronic Platforms and Intermediaries................21FINRA Regulation......................................................................................................21

G. Summary....................................................................................................................21

TEXAS INTRASTATE CROWDFUNDING RULES.........................................................22

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A. Overall Requirements of the Exemption.....................................................................22A Registered TCP or Texas General Dealer Must Be Involved.................................22All Offers and Sales are Made to Texas Residents....................................................22All Offers and Sales are Made Completely on a Website Operatied by a Registered Intermediary......................................................................................22Information Disclosure Required by the Issuer.........................................................23Aggregate Offering Limits Within Twelve (12) Months.............................................23Limits on the Amount of Investment by Each Investor...............................................23Escrow of Offering Proceeds.....................................................................................24

B. Requirements for Companies Raising Capital or “Issuers” of Securities...............24

C. Requirements for Texas Crowdfunding Portals......................................................24

D. Comparison Between TCPs and Texas General Dealers........................................25

E. Compliance with Federal Law – The Rule 147 Requirements................................25

F. Disqualifications......................................................................................................25

G. Notice of Offering and Resales of Securities..........................................................26

H. Summary...................................................................................................................26

EXHIBIT “A”: Disqualifying Events Under Reg CF, Rule 503...........................................27

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CROWDFUNDING: NEW TOOLS, NEW OPPORTUNITIES

Carol Bavousett Mattick1

Carol Bavousett Mattick, PLLC

Regulation CF (“CF” for crowdfunding) was finally adopted by the SEC on October 30, 2015.2 At the same time, the considerable effort expended by states, including Texas, to enact statutes or rules relating to intrastate crowdfunding is still relevant. Intrastate rules offer a parallel alternative in states where there resides enough investment capital to create a market of sorts. At the same time that the SEC adopted Regulation CF, it proposed significant changes to Rule 147, a federal offering exemption that needs to be paired with intrastate crowdfunding offerings.3 The changes are designed to make intrastate equity crowdfunding easier. Beyond offerings that are crowdfunded, there are Rule 506(c) offerings with general solicitation which can be conducted on websites with no substantive state regulation of the issuers and offerings but substantive state regulation of any intermediaries or platforms involved in the offerings.

One of the more interesting applications of interstate equity crowdfunding seems to be simultaneous Reg CF offerings to validate interest in a product while also conducting a Reg D Rule 506 offering to raise growth capital. Anecdotally, large companies like U-Haul are using a version of crowdfunding to get their customers to invest in (and thereby relieve the large company from having to invest in) capital equipment necessary for the business.

This article will set out the fundamental requirements involved in interstate and Texas intrastate equity crowdfunding offerings. It will be important to take another look at the intrastate alternative when practitioners and others comment on the proposed changes to SEC Rule 1474 and the SEC adopts some version of them. Intrastate crowdfunding offerings must also comply with some federal exemption. A streamlined and modernized version of Rule 147 should be helpful in increasing the use and popularity of intrastate crowdfunding.

I. REGULATION CF

New Regulation CF is found at 17 CFR Part 227 and follows this general organization:

Subpart A General227.100 Crowdfunding exemption and requirements

Subpart B Requirements for Issuers227.201 Disclosure requirements. 227.202 Ongoing reporting requirements.

1 Carol Mattick has been practicing corporate and securities law as a solo practitioner for over 25 years. Her practice is based in Austin and San Antonio. carol@cbmattick.com ; 2 SEC Release 33-9974, 80 FR 71388, Nov 16, 2015 (the “Regulation CF Adoption Release”) https://www.federalregister.gov/articles/2015/11/16/2015-28220/crowdfunding 3 SEC Release 33-9973, 80 FR 69786, Nov 10, 2015 (the “Rule 147/504 Proposal Release”) https://www.federalregister.gov/articles/2015/11/10/2015-28219/exemptions-to-facilitate-intrastate-and-regional-securities-offerings 4 Practitioners and others can comment on the proposed changes to Rule 147 at File No S7-22-15 online at the SEC website, rule-comments@sec.gov.

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227.203 Filing requirements and form. 227.204 Advertising. 227.205 Promoter compensation.

Subpart C Requirements for Intermediaries 227.300 Intermediaries. 227.301 Measures to reduce risk of fraud. 227.302 Account opening. 227.303 Requirements with respect to transactions. 227.304 Completion of offerings, cancellations and reconfirmations. 227.305 Payments to third parties.

Subpart D Funding Portal Regulation227.400 Registration of funding portals. 227.401 Exemption. 227.402 Conditional safe harbor. 227.403 Compliance.227.404 Records to be made and kept by funding portals.

Subpart E Miscellaneous Provisions 227.501 Restrictions on resales. 227.502 Insignificant deviations from a term, condition or requirement of Regulation

Crowdfunding. 227.503 Disqualification provisions.

One might think that the key provisions of Regulation CF (or “Reg CF”) must relate to issuers because this is an offering exemption. However, Regulation CF requires: 1) these offerings be conducted exclusively on an electronic platform that is required to do many things relating to the offering; and 2) that registered intermediaries operate and be responsible for those platforms. The registration and other regulatory requirements on intermediaries as well as the technical requirements for these platforms may well end up being the bottleneck in making this type of capital raising available to issuers.

A. Overall Requirements

Which Issuers Cannot Use Reg CF

Let’s start with which issuers cannot use Regulation CF. They include:

Non-U.S. Issuers. This means issuers not organized under and subject to, the laws of a State or territory of the United States or the District of Columbia.5 Theoretically, an issuer could be formed in a U.S. jurisdiction and have its principal place of business elsewhere.

’34 Act Reporting Issuers.An issuer can become subject to the requirement to report periodically under the Securities and Exchange Act of 1934 (the “’34 Act”) either by: 1) having a sufficient number of holders of a class of securities; 2) having at least $10 million in assets; or

5 17 C.F.R. § 227.100(b)(1)2

3) conducting an SEC registered offering6. However, with respect to counting the number of holders, the SEC has exempted holders who received their shares through a Reg CF offering.7

Investment Companies.

This category includes those registered under the Investment Company Act of 19408 as well as those exempted from such registration under §§3(b) and 3(c) of that Act. Of course, the entities that would have been most likely to seek to use this exemption would have been exempt or private investment companies, including 3(c)(1) and 3(c)(7) funds.

An Issuer Disqualified as a Bad Actor (or an issuer who has an affiliated person or entity that is disqualified as a bad actor) under the terms of Regulation CF Rule 5039

A Crowdfunding Issuer That Has Not Provided Annual Reports in Previous Two Years.

This applies to issuers that have made a Regulation CF offering in the past and are attempting to make another one.

and Issuers with No Specific Business Plan or That Intend to Merge With or Acquire an

Unidentified Company

No “blank check” , “blind pool” or “shell” companies are eligible to make a crowdfunding offering. Also, companies that might qualify to use programs like the Toronto Stock Exchange’s Canadian Capital Company program are not eligible.

Primary Requirements

For an eligible issuer, the primary requirements of a Regulation CF offering are:

1) that neither the issuer, its predecessor, nor any person who controls, is controlled by or under common control with the issuer10 offer an aggregate amount of securities under the

6 It is the class of securities that meets the number of holders test that must be registered under the ’34 Act. The rules relating to counting of holders were directed to be revised in the Wall Street Reform and Consumer Protection Act of 2010 (commonly known as “Dodd-Frank”). Generally, a company can now have as many as 2,000 holders or fewer than 500 holders that are not accredited investors. See ’34 Act §12(g) (15 U.S.C. § 78l(g)) There are also some tricky provisions relation to what counts as a voting security and “held of record”. Please review SEC Rule 12g-1 (17 C.F.R. § 240.12g-1, et. seq) and Rule 12h-1 (17 C.F.R. § 240.12h-1, et. seq). 7 SEC Rule 12g-6 (17 C.F.R. § 240.12g-6). The new SEC rule provides that holders that initially received their securities through an offering under Securities Act §4(a)6 (15 U.S.C. § 77(d)(a)(6)), the statutory basis for crowdfunding offerings, will be exempted from the record holder count so long as it is current with respect to annual reporting required by Reg CF Rule 202 (17 CFR 227.202); has total assets as of the last fiscal year not exceeding $25 million; and has engaged the services of a transfer agent registered with the SEC. However, as foreshadowed in the new rule, that exemption does not last forever. 8 15 U.S.C. 80a-39 17 C.F.R. § 227.503. See Exhibit “A” to this paper.

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statutory crowdfunding exemption of more than $1,000,000 in the twelve months preceding (and including)11 the offering at hand;

2) that the aggregate amount of securities purchased by any one investor in any crowdfunding offering by any issuer in the preceding twelve months not exceed certain limits described below;

3) that the issuer conduct the offering exclusively on one electronic platform and through one intermediary12; and

4) that both the intermediary operating the electronic platform and the issuer making the offering comply with all of the additional requirements that Regulation CF places on each of them which will be detailed below.

Limitations on Investment

Regulation CF divides investors into those with lesser means and those with more, but allows both accredited and non-accredited investors to invest without quotas on those two categories of investors. It requires that investors in crowdfunded offerings invest no more than the following amounts in the following circumstances:

1) If an investor’s net worth or annual income is less than $100,000, that investor may invest the greater of : a) $2,000.00 or b) five percent (5%) of the lesser of the investor’s net worth or annual income.

2) If an investor’s net worth and annual income is equal to or greater than $100,000, that investor may invest ten percent (10%) of the lesser of the investor’s net worth or annual income, not to exceed $100,000.

These limitations apply to all of an investor’s investments over the preceding twelve (12) months in offerings exempted under ‘33 Act §4(a)(6), the statutory crowdfunding exemption. The detailed requirements of issuers and intermediaries suggest that both are responsible for ensuring these limits are observed, but put the larger responsibility on the intermediary.13

Any Kind of Security May Be Offered

10 Regulation CF Rule 100(c), (17 C.F.R. § 227.100(c)). See instruction to paragraph (c), under which “control” can be direct or indirect and includes the power to direct or cause direction of management and polisies of the entity through ownership of voting securities, by contract or otherwise.11 If an issuer has raised capital through a crowdfunded offering within the previous 12 months, it must include the target amount for any new offering it contemplates in the $1,000,000 limit. 12 See the Instruction to paragraph (a)(3) to Regulation CF Rule 100(a)(3) (17 C.F.R. § 227.100)13 On one hand, issuers are always responsible for making sure that all of the terms of an offering exemption are met. After all, issuers are the ones seeking the exemption. However, Instruction 3 to paragraph (a)(2) under Regulation CF Rule 100 states that an issuer may rely on the efforts of an intermediary that is required by Regulation CF Rule 303(b) to ensure that these limits are met. Where it has actual knowledge that an investor has exceeded the limits applicable to him or her, the issuer will be responsible for speaking up and helping to enforce the limit on investment.

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One of the most versatile and flexible features of Regulation CF is present by omission. The regulation does not dictate or limit the type of security that may be offered in a crowdfunded offering. Common equity, debt and all kinds of hybrids should be possible.

Liability for Persons Offering or Selling a Security

The JOBS Act included a specific type of liability of (and established an explicit private right of action against) issuers and others who offer or sell a security under ’33 Act §4(a)(6) exempt offerings.14 The statute is confusing because it uses the term “issuer” and then defines that term as “any person who offers or sells a security” and specifically includes directors, partners, officers, principal financial officers, and controllers of issuers. The statute states that “If [the issuer] “in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, ” the [issuer] is liable. There are a couple of caveats: 1) by reference to ’34 Act §10(a)(2), the purchaser of the securities must not know of the omission or untruth; and 2) the [issuer] must fail to sustain the burden of proof that such issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission. The SEC ,in the Reg CF Adoption Release, specifically refused to exempt Funding Portals from this liability saying that any intermediary’s liability under the provision would turn on the facts and circumstances of the particular matter in question.

B. Requirements for Eligible Issuers

The Offering Statement

The issuer is responsible for compiling information for disclosure to potential investors, filing it with the SEC and delivering it to the intermediary and investors exclusively through the electronic platform. That comes primarily in the form of the issuer’s offering statement on Form C. It must include basic information about the issuer, its officers and directors and holders of 20% or more in equity voting power, including whether the issuer has previously failed to comply with Regulation CF’s ongoing reporting requirements. Basic information about the intermediary, its interest in the transaction and whether it holds any equity stake in the issuer must also be disclosed.

Non-Financial Information

The bulk of substantive disclosure in the offering statement comes in form and breadth similar to that required in a Form 1-A, the offering statement required in Regulation A and A+ offerings. Briefly, the subject matter includes:

The purpose and intended use of proceeds, in reasonable detail15

Information about the offering including a target offering amount16, the offering price, and procedures for making a subscription to the offering and having it returned

14 15 U.S.C. §4A(c)15 See Instruction to paragraph (i), Regulation CF Rule 201(i) (17 C.F.R. §227.201(i)) If there are different options for use of the proceeds, issuers should discuss factors that will impact how the issuer chooses to spend the monies raised.

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Description of the business of the issuer, the industry in which it fits and the issuer’s anticipated business plan

The number of employees, information on directors and officers, including their experience and what they have been doing for the past three years in particular and a list of those who hold at least 20% of the equity of the issuer prior to the offering, as measured by voting power.

Description of the ownership and capital structure, the terms of the securities offered, the rights and preferences of other issued securities, the effect of exercise of rights by existing holders, and related issues

A reasonably detailed description of the issuer’s indebtedness

A reasonably detailed description of all exempt offerings done by the issuer within the last three years

Information about transactions between the issuer on one hand and directors, officers, 20% holders, and other parties related to it and them on the other hand, but only to the extent that the dollar value involved in the transaction exceeds five percent (5%) of the total amount raised (or seeking to be raised in the current offering) by the issuer in crowdfunding offerings over the preceding twelve (12) months.

Material factors that make an investment in the issuer risky or speculative

Restrictions on transfer of the securities by an investor, including and beyond the one year restriction imposed by Regulation CF17

Discussion and analysis by the issuer’s management about the issuer’s financial condition, liquidity, capital resources and historical results of operations (an “MD&A” section)18

Financial Information

16 The target offering amount needs to be carefully thought out. Financial statement and other requirements depend on the target amount sought. Unlike traditional private placements with a minimum amount and maximum amount to be raised, the target offering amount acts as both minimum and maximum. If it decides to accept more than the target amount , an issuer is required to update investors about that fact and its repercussions. If a target amount is not met within the time period set by the issuer, all funds committed must be returned to the potential investors. It is unclear whether an issuer can do a continuous offering without a deadline but only a target offering amount.17 Regulation CF Rule 501(a) (17 C.F.R. §227.501(a)) in which investors may not transfer the equity shares purchased in a Reg CF offering to another purchaser within one year unless that purchaser is an accredited investor, a member of the investors family or the sale is part of a secondary public offering. 18 See Instruction 2 to paragraph s, Regulation CF Rule 201(s), (17 C.F.R. §227.201(s)) which requires issuers with little or no operational history to focus this disclosure on financial milestones as well as operational and liquidity challenges.

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The type of financial information that issuers must provide to potential investors depends on the target offering amount that the issuer sets:

If the target offering amount is set at less than or equal to $100,000, the issuer must provide potential investors with the amount of total income received, taxable income and total tax incurred by the issuer and financial statements. Such information must be certified by a principal executive officer to accurately reflect filed tax returns and certified to be true and correct.

If the target offering amount is set at greater than $100,000 but less than or equal to $500,000, the issuer must provide potential investors with a complete set of financial statements that have been reviewed by an independent certified public accountant.

If the target offering amount is set at greater than $500,000 but no more than $1,000,000 and the issuer has not offered securities under ’33 Act §4(a)(6) previously, the issuer must provide potential investors with a complete set of financial statements that have been reviewed by an independent certified public accountant.

If the target offering amount is set at greater than $500,000 but no more than $1,000,000 and the issuer does not fall in the previous category, the issuer must provide potential investors with a complete set of audited financial statements audited by an independent certified public accountant.19

Duty to Amend and Update

During the offering process, the issuer has the opportunity to amend the information previously provided and must amend it if there have been material changes in that information. The issuer provides the new information on Form C/A, filed with the SEC and provided on the electronic platform of the intermediary. If it is material, the issuer must alert investors that the change is material and seek a recommitment from any investor who has already committed to invest in the offering.20

During the course of the offering, an issuer must update investors about the progress of the offering by filing a Form C-U with the SEC and on the electronic platform of the intermediary. If the intermediary is updating the progress of the offering on a regular basis on its own, that activity relieves the issuer’s responsibility to provide updates to the intermediary and potential 19 This provision contained in Regulation CF Rule 201(t) (17 C.F.R. §227.201(t)) states that audited financial statements are the default choice unless the issuer has not previously done a crowdfunded offering. It appears the SEC is trying to lessen the burden on smaller issuers and assumes that smaller issuers would start with a crowdfunded offering. However, the formulation of this requirement suggests that issuers that have done other kinds of exempt offerings but not a 4(a)(6) offering would be allowed to provide reviewed rather than audited financials. There are a total of 10 Instructions to paragraph (t) under Reg CF Rule 201 which give significant specificity about how to interpret this requirement. For instance, the requirement is for two years of financial statements and if more rigorous financial information is available on an issuer at any target offering level, that information must be provided to potential investors. 20 The Form C/A, which can be found at 17 C.F.R. § 239.900, has a check box indicating whether the amendment is material. Reg CF Rule 203(a)(2) provides that an investor must affirmatively re-commit to invest in the offering within five days of the filing of Form C/A with material amendments or his/her/its investment will be automatically cancelled and his/her/its monies will be returned.

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investors but does not excuse a failure to file with the SEC.21 An issuer has an obligation to update within five days of the occurrence of the following:

Fifty percent (50%) of the commitments required to reach the target offering amount have been received

One hundred percent (100%) of the commitments required to reach the target offering amount have been received

The offering deadline, if the issuer decides to accept more than the targeted offering amount

The offering deadline, if the issuer decides to close the offering

Duty to Engage in Annual Reporting and Termination of Annual Reporting

One of the features of Regulation CF that mimics or is similar to the features of the new Regulation A and A+ is the requirement of Reg CF issuers to annually file with the SEC and post on the issuer’s website a report that contains: 1) most of the substantive information that the issuer provided in its original offering statement22; 2) its financial statements, certified by a principal executive officer of the issuer; and 3) a discussion of the issuer’s financial condition similar to that required in the original offering statement by Reg CF Rule 201(s).23 The annual report must be filed and posted within 120 days of the end of the fiscal year which is the subject of the report.

These annual reports must continue to be filed until the occurrence of one of the following events:

The issuer becomes subject to the requirement to file periodic reports under the ’34 Act;

After the issuer’s most recent offering under ’33 Act §4(a)(6), the issuer has filed at least one annual report and also has fewer than 300 holders of record;

After the issuer’s most recent offering under ’33 Act §4(a)(6), the issuer has filed at least three annual reports and also has less than $10 million in total assets;

The issuer repurchases or another party purchases all of the securities issued [by that issuer] pursuant to ’33 Act §4(a)(6), including repayment of debt securities and redemption of redeemable securities24

21 Reg CF Rule 203(a)(3)(iii), (17 C.F.R. §227.203(a)(3)(iii)). Form C-U is found at 17 C.F.R. §239.900.22 Per Rule 202(a), it must include the information required by Rule 201 (a), (b), (c), (d), (e), (f), (m), (p), (q), (r), and (x). The provisions missing are those relating directly to the offering

23 Regulation CF Rule 202(a)

24 This appears to require repurchase of all of the crowdfunded securities issued by this issuer but not any of the other securities offered under other exemptions that might have been issued by the issuer.

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or The issuer liquidates its assets or dissolves its business under state law.

Within five days of becoming eligible to terminate annual reporting, an issuer must file a notice of termination with the SEC on Form C-TR. 25 That information will be available electronically on the SEC website to inform investors of the termination of reporting.

Advertising or Promoting the Offering

A central tenant of Regulation CF offerings is that most of the communication about the offering occurs on the electronic platform between issuer and potential investor and among potential investors. Outside of official issuer communications, founders and employees of issuers must disclose their affiliation with the issuer when they communicate on the electronic platform with potential investors. An issuer can compensate other persons to promote the offering but only: 1) if the promotion occurs on the electronic platform/website; and 2) the issuer takes reasonable steps to ensure that the promoter discloses the fact that he/she/it is being paid by the issuer to promote the offering. Those “reasonable steps” can be accomplished through obtaining representations from promoters that they are in fact disclosing the compensation every time they communicate with a potential investor and monitoring the activity of promoters on the site.

Communication about the offering outside the electronic platform is limited. An issuer is allowed to advertise or provide information about the offering so long as it is limited to the basic facts of the offering, much like the communication of a “tombstone” ad relating to a public offering.

The Chronology of a Regulation CF Offering From the Issuer’s Point of View

Like the requirement to report electronically on Form D for Reg D offerings, Regulation CF issuers will have to apply for credentials to the Edgar system and submit Forms C, C/A, C-U and C-TR electronically.

The issuer must file Form C and the intermediary must make the issuer’s offering statement available to the SEC at least 21 days prior to any sale of the securities.

The SEC has directed issuers to provide specific information to investors in the offering statement regarding the chronology of the offering and offering mechanics:

The issuer must set a target offering amount and a deadline by which the target must be raised and state those in the offering statement26

The issuer must tell investors that:o They are able to cancel any investment to which they commit at any time prior to

forty eight (48) hours before the offering deadline27

o If the target offering amount is met early, the issuer must provide investors five (5) days notice28

2524 Regulation CF Rule 202(b)(3), (17 C.F.R. §227.202(b)(3))26 Regulation CF Rule 201(g), (17 C.F.R. §227.201(g))27 Regulation CF Rule 201(j)(1) and (4), (17 C.F.R. §227.201(j)(1), (4)28 Regulation CF Rule 201(j)(3), (17 C.F.R. §227.201(j)(3))

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o If the target offering amount is not met by the deadline, all funds will be returned to investors

ando If the issuer files an amendment to the offering statement that contains a material

change, the investor’s investment commitment will be cancelled and his/her/its funds will be returned unless he/she/it affirmatively re-commits to invest.

As it is living by the foregoing requirements, the issuer must make any amendments and report any updates electronically within the five (5) day timeframes given in the Rules.

The issuer must also monitor promoters and its business communications outside of the electronic platform to comply with the limitations on communications about the offering.

The requirements of a Regulation CF offering on both the issuer and the intermediary lend themselves to a structure where investors make commitments and the issuer calls for funding at a specific time such as the deadline date of the offering.

While a “Funding Portal” as defined under the ’34 Act29 cannot hold investor funds or securities, Reg CF Rule 303(e)30 requires a Funding Portal to direct investors to transmit their monies for investment commitments to a qualified third party. That includes: 1) a registered broker dealer with the ability to hold custody of client funds (a “clearing broker”); or 2) a bank or credit union acting as an escrow agent.

Since intermediaries participating in Regulation CF offerings must be either registered broker dealers or Funding Portals and since those intermediaries must either comply with ’34 Act Rule 15c2-4 regarding clearing or Reg CF Rule 303(e), issuers effectively cannot hold the commitments of potential investors themselves in a Regulation CF offering.

C. Requirements for All Intermediaries – Both Registered BDs and Funding Portals

Disqualification

Any intermediary, whether registered broker or Funding Portal, may not act as an intermediary in a transaction under ’33 Act §4(a)(6) if it is subject to a statutory disqualification under ’34 Act §3(a)(39).31

Regulation CF places a large amount of responsibility on intermediaries for the conduct of offerings under ’33 Act §4(a)(6) and the implementing regulation. Intermediaries are required by Regulation CF Rule 302(a)(2) to provide all information required under the Regulation CF Rules 301-305 “through electronic means”.

Functional Requirements of the Electronic Platform

These integrated electronic platforms must orchestrate a series of gateways in issuer dealings with potential investors and provide the following functionality in doing so:

29 ’34 Act §3(a)(80), (15 U.S.C. §78c(a)(80))30 17 C.F.R. §227.303(e)31 Regulation CF, Rule 503(d) (17 C.F.R. §277.503(d))

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It must make available to the SEC and investors any information the issuer is required to provide the SEC and investors under Reg CF Rule 201 and 20232 and any additional information provided by the issuero in a downloadable and savable form o for a period of at least 21 days prior to the sale of any securities on the platform

by the issuer and until the sale of securities is completed or cancelled. 33

But, it may not display the information unless and until it has a reasonable belief that the information does meet the requirements for the issuer under Rules 201 and 202 and the issuer and its related parties are not disqualified and pass a background check conducted or provided for by the intermediary.

It must provide a mechanism for potential investors to be able to communicate with the issuer and other potential investors through the electronic platform34 and by a link to the platform in any number of electronic means of communication including email and various types of social media.

It cannot require a potential investor to open an account in order to see the information provided by it and the issuer 35

But, it must require potential investors to open an account prior to being able to engage in that communication or make a commitment to invest 36 and must obtain consent for electronic delivery.37

It must provide a mechanism to require promoters and those affiliated with the issuer (but not official spokespeople for the issuer) and who open accounts to communicate with potential investors to disclose their status as promoters or affiliates and whether they are being compensated to promote the offering every time they post a comment in the communication channels. 38

It must provide certain information in conjunction with opening an account, including:

o Educational materials that disclose in plain English, clearly and effectively, nine different enumerated risks or warnings about investments in crowdfunding issuers. 39

32 This includes any amendments, updates, annual reports and notice of termination of annual reporting. 33 Regulation CF Rule 303(a)(1)-(3), (17 C.F.R. §227.303(a)(1)-(3))34 Regulation CF Rule 303(c), (17 C.F.R. §227.303(c )) While a registered BD can engage in that conversation, a registered Funding Portal may not except to police the communications between issuer and investors for inappropriate comments (Rule 303(c)(1))35 Regulation CF Rule 303(a)(4), (17 C.F.R. §227.303(a)(4)); Rule 303(c)(2), (17 C.F.R. §227.303(c)(2))36 Regulation CF Rule 303(c)(3), (17 C.F.R. §227.303(c)(3)); As a practical matter, both potential investors and others will open accounts. 37 Regulation CF Rule 302(a)(1), (17 C.F.R. §227.302(a)(1) Under Rule 302(a)(2), the intermediary must update those disclosures if they change and re-deliver them prior to obtaining a commitment to invest from a potential investor 38 Regulation CF Rule 303(c )(4), (17 C.F.R.§227.303(c)(4)) 39 Regulation CF Rule 302(b)(1), (17 C.F.R. §227.302(b)(1))

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o The disclosure of promoter or issuer affiliate status mentioned above.

o The manner and amount of compensation that the intermediary will receive in connection with ’33 Act §4(a)(6) offerings. 40 41

Before it accepts a commitment to invest in an offering, the intermediary must receive certain representations from a potential investor that he/she/it has reviewed the educational materials and understands the risk of loss and further has completed a questionnaire that demonstrates that the potential investor understands the restrictions on his/her/its ability to cancel the investment or resell it after the offering.42 The intermediary must create a mechanism in the platform to accomplish this requirement.

It must provide an electronic notice of commitment to the investor which includes the dollar amount invested; the price of the security bought, if known; the name of the issuer; and the date and time at which the investor will be free from any restrictions on the resale of the investment.

It must provide a mechanism for the investor to re-commit after the posting of a material amendment to the information provided by the issuer.

And It must provide a relationship with a qualified third party (“QTF”) and mechanism by

which an investor can transmit monies to the QTF and/or receive a refund from the QTF in the event of the investor’s failure to re-commit or the failure of the issuer to raise the target offering amount by the deadline.

Policing Compliance of Issuers and Investors

In addition to meeting the functional requirements of the electronic platform, the intermediary is called on by Regulation CF to police the compliance of issuer and investor with their own responsibilities under the Regulation:

An intermediary must have a reasonable belief that any issuer promoting an offering on its site is in compliance with the issuer’s own requirements under the Regulation.

40 Regulation CF Rule 302(d), (17 C.F.R. §227.302(d)). This is the only place in Regulation CF that the intermediary’s compensation is mentioned other than limitations on financial interests in the issuer as compensation. No one affiliated with the intermediary may take a financial interest in the issuer as compensation and the intermediary itself may only take a financial interest as compensation for services in connection with the offering and only if the financial interest is of (or related to) the same type of security offered to investors in the offering. Regulation CF Rule 300(b), (17 C.F.R. §227.300(b))41 Language in the JOBS Act led commentators to speculate whether the SEC was going to allow Funding Portals to take transaction based compensation in relation to the offerings listed on their electronic platforms. However, despite the indirect mention of compensation in the final regulation, SEC Staff have been quoted as saying that the SEC intended that Funding Portals could receive transaction based compensation. 42 Regulation CF Rule 303 (b)(2)(A)-(C), (17 C.F.R. _227-303(b)(2))

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Absent other knowledge it may have, the intermediary may rely on representations of the issuer by its principal officers.43

An intermediary must have a reasonable belief that an issuer has the means to keep an accurate record of its security holders. If an issuer engages a registered transfer agent, the intermediary is allowed to presume the issuer can do so.44

An intermediary must have a reasonable belief that neither an issuer nor any of its related or affiliated parties, its directors, officers, 20% equity holders or promoters have a criminal or securities regulatory record which would disqualify the issuer from being able to claim exemption from securities offering registration under Regulation CF. An intermediary must conduct a criminal and securities regulatory background check on each relevant party to support that reasonable belief. If it cannot maintain that reasonable belief, the intermediary must deny access on the platform to the issuer and its offering. 45

An intermediary must deny access on the platform to any issuer that the intermediary reasonably believes “presents the potential for fraud” , including when it believes it is unable to effectively assess the issuer’s risk for fraud. 46

An intermediary must have a reasonable belief , both at the time of original investment and at any follow-on investment, that each investor in each issuer’s offering is in compliance with Regulation CF’s limitations on the amount any one investor can invest in any ‘33Act §4(a)(6) offering within the twelve months preceding the inquiry and including the investment to be made in the offering at hand. An intermediary may rely on representations by the investor to support that reasonable belief, absent other information it possesses to the contrary.47

D. Additional Requirements for Funding Portals

Any funding portal must be registered as such with the SEC and also become a member of FINRA in order to be considered a Funding Portal which can host Regulation CF offerings.48 The SEC has created a parallel but more lightly regulated category of broker dealers.

Scope of Registration and Allowed Activity of Funding Portals43 Regulation CF Rule 301(a), (17 C.F.R. §227.301(a))44 Regulation CF Rule 301(b), (17 C.F.R.§227.301(b))45 Regulation CF Rule 301(c)(1), (17 C.F.R. §227.301(c)(1)); Rule 503, (17 C.F.R. § 227.503)46 Regulation CF, Rule 301(c)(2), (17 C.F.R. §227.301(c)(2))47 Regulation CF, Rule 303(b)(1), (17 C.F.R. §227.303(b)(1)). Although the Rule states that an intermediary can rely on investor representations, absent other knowledge, it is unclear how an intermediary would be able to verify the investor’s investments in §4(a)(6) offerings if they were made across a number of intermediaries’ platforms. 48 The provisions of the JOBS Act that created and defined “Funding Portals” contemplated that they would also be FINRA members but required FINRA to promulgate administrative rules designed specifically for crowdfunding issuers. Those FINRA regulations have not been yet been promulgated.

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The quid pro quo for the lighter regulation is the circumscribed ability of Funding Portals to act as a broker dealer. Registered Funding Portals may not : 1) offer investment advice; 2) solicit purchases, offers or sales of securities; or 3) compensate its employees, independent contractors, third party solicitors or others based on the sale of securities on its platform.49 In contrast, a registered broker dealer acting as a crowdfunding intermediary can do all of those activities as well as negotiate the terms of an investment on behalf of the issuer or investor, be involved in valuation of an issuer and other activities that might be required.

Candidates must register on a pared down registration form called Form Funding Portal on the online CRD system operated by FINRA. The information in Form Funding Portal will be publicly available online. The registration is effective within thirty (30) days after the later of the date of submission of the form or the date approved as a FINRA member. Any inaccuracy must be the subject of an amendment within thirty (30) days of discovery of the inaccuracy.50

Once the registration is effective, Funding Portals must provide the integrated electronic platform, meet the obligations to police requirements on issuers and investors and maintain books and records as outlined before. In addition, they are able to advise issuers about structuring their offerings and prepare offering documentation for them.51

Maintenance of Records of the Offering, the Communication Among Investors and Other Records

While registered broker dealers have their own books and records requirements, Regulation CF, Rules 403 and 404 provide the requirements for Funding Portals. Records of the following information and relating to a period of the previous five (5) years must be retained:

All records relating to potential and actual investors; All records relating issuers and their control persons All communications on or through the platform All records relating to persons promoting the issuers’ securities All records required to demonstate compliance by the Funding Portal All notices provided to issuers and investors All written agreements relating to the Funding Portal’s business All daily, monthly and quarterly summaries of transactions effected through the

platform Logs reflecting issuer progress toward their target offering amounts and

49 If, as we presume, Funding Portals can take transaction based compensation for the services they render in effecting crowdfunding offerings, it is unclear why they cannot compensate at least their employees (if not third parties) “based on the sale of securities on their platforms”. I am assuming that last phrase means transaction based compensation, but that is also not absolutely clear. 50 Regulation CF, Rule 400(b) (17 C.F.R. §227.400(b))51 FINRA, in particular, has taken the lead in requiring intermediaries to take on securities law responsibilities traditionally thought of as the responsibility of issuers and their counsel. Beginning with making it a broker responsibility to file information about OTC issuers whose securities the broker wants to quote under Rule 15c2-11 and Form 211 through the newer FINRA Rule 5123 which places more responsibility on brokers to vet issuers and recent FINRA enforcement action against brokers engaging in exempt offerings, both the SEC and FINRA have made brokers more responsible for the offerings which issuers make.

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Organizational documents, including certificate of formation, governing agreements and records of equity holder meetings or consents52

In addition, Funding Portals must have, comply with or allow:

A set of written policies and procedures designed to achieve compliance with the federal securities laws relating to its business as a Funding Portal

This puts in place a requirement similar to that to which registered investment advisers are subject.

Examination of the Funding Portal’s business operations such as its premises, systems, platforms and records by the SEC and FINRA

The requirements of 17 C.F.R. §248 relating to private information, including:

o Regulation S-P relating to safeguarding and privacy of consumer financial information, presumably that of potential and actual investors;

o Regulation S-AM, relating to usage of financial eligibility information obtained from a Funding Portal’s affiliate to make a solicitation to that consumer; and

o Regulation S-ID, relating to protection, detection and mitigation of identity theft, presumably of potential and actual investors.53

Ability to Take Transaction Based Compensation

It is difficult to believe, but it is not entirely clear from the statutes and the SEC releases proposing and then adopting Regulation CF whether Funding Portals can take transaction-based compensation for their services provided in connection with offerings on their electronic platforms.

The beginning of the inquiry is to look at the definition of “Funding Portal” in ’34 Act §3(a)(80) which was added as a part of the JOBS Act. The term ‘funding portal’ means:

“any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 1933 (15 U.S.C. 77d(6)), that does not:

(A) offer investment advice or recommendations;(B) solicit purchases, sales, or offers to buy the securities offered or displayed on

its website or portal;(C) compensate employees, agents, or other persons for such solicitation or based

on the sale of securities displayed or referenced on its website or portal;(D) hold, manage, possess, or otherwise handle investor funds or securities; or(E) engage in such other activities as the Commission, by rule, determines

appropriate.’’.

The statutory provision is restated verbatim in Regulation CF, Rule 300(c) and both are 52 Regulation CF, Rule 404(a)-(b), (17 C.F.R. §227.404(a)-(b))53 Regulation CF, Rule 403 (a)-(c), (17 C.F.R. §227.403 (a)-(c))

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problematic for the ability to take transaction-based compensation. Funding Portals cannot engage in the primary activity for which brokers typically earn transaction-based compensation: soliciting purchases, sales or offers. The definition also prohibits compensating employees of intermediaries and others based on the sale of securities ….referenced on the….portal . However, the definition: 1) doesn’t prohibit the Funding Portal itself from receiving compensation based on the sale of securities; and 2) it is not entirely clear that receiving compensation “based on the sale of securities” is the same as taking transaction-based compensation.

On the other hand, there are a number of provisions in Regulation CF relating to requirements of intermediaries which presume transaction-based compensation is being taken:

Reg CR, Rule 300(b)(1) makes clear that persons related to the intermediary such as officers, directors or partners cannot hold a financial interest in an issuer but that intermediaries themselves can hold such an interest so long as it is received as compensation for services provided to the issuer in connection with the sale of securities through the intermediary’s platform

Reg CF, Rule 302(d) provides the intermediary must clearly disclose the manner in which it is compensated in connection with ’33 Act §4(a)(6) offering

Reg CF, Rule 303(f)(1)(vi) provides that the intermediary must send a confirmation of the transaction, at or before completion, that discloses the source, form and amount of any remuneration received by the intermediary.

The 300 series of Rules under Reg CF sets forth the requirements for all intermediaries, including registered broker dealers and Funding Portals. Brokers registered under ’34 Act §15(a)(1) could, of course, take transaction based compensation.

The no-action letters54 and FAQ55 issued by the SEC relating to the JOBS Act and dealing with electronic platforms have so far focused on Section 201 of the JOBS Act which deals with general solicitation in Rule 506 offerings. The resulting Securities Act of 1933 §4(b)(2) states the conditions under which a website or platform not exclusively operated by an issuer but involved in the Rule 506 offering may operate without having to register as a broker dealer under ’34 Act §15(a)(1) and specifically states that such a website or platform must “receive no compensation in connection with the purchase or sale of such security”. Reg CF, Rule 401 exempts Funding Portals from the same broker registration requirements under ’34 Act §15(a)(1). However, ’33 Act §4(b)(2) deals specifically and only with Rule 506 offerings.

The 400 series of Rules under Regulation CF sets forth the specific additional requirements of Funding Portals. Reg CF, Rule 402(b)(7) allows Funding Portals to pay referral fees (whether for referring issuers or investors) to other persons.56 Regulation CF Rule 402(b)(6) also

54 See FundersClub Inc. and FundersClub Management LLC, SEC No-Action Letter (Mar. 26, 2013); AngelList LLC, SEC No-Action Letter (Mar. 28, 2013). 55 See Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act, available at http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm. 56 Regulation CF Rule 402(b)(7), (17 C.F.R. §227.402(b)(7)) It is unclear whether the SEC expects that these other persons will be registered as intermediary representatives or whether they can be unregistered

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explicitly states that Funding Portals may enter into agreements with registered broker dealers and share fees. This would facilitate the escrow of offering proceeds before the target offering amount is reached as well as other business arrangements. But, it would also be consistent with Funding Portals being able to take transaction-based compensation.

Perhaps the most confusing guidance is the fact that the Regulation CF Proposal Release contained a Rule 305(b) which stated that an intermediary:

“may compensate a person for directing issuers to the intermediary’s platform, provided that, unless the compensation is made to a registered broker or dealer , the compensation is not based, directly or indirectly, on the purchase or sale of a security offered in reliance on Section 4(a)(6) of the Securities Act on or through the intermediary’s platform. “

That would suggest that the SEC’s position is definitely that Funding Portals cannot take transaction based compensation. Footnote 907 in the Reg CF Adoption Release supports that view, stating:

“We note that the receipt of direct or indirect transaction-based compensation would strongly indicate that the recipient is acting as a broker. As such, the party receiving the compensation in the scenario described needs to consider whether it would be required to register as a broker. “

However, the Reg CF Adoption Release removed the proposed Rule 305(b), saying that the SEC felt it would be duplicative of the adopted Rule 402(b)(6), mentioned above. In the text adopting Reg CF, Rule 402, the SEC acknowledges that commenters are asking questions about the scope of permissible activities of Funding Portals, given the language of the statutory definition. The SEC’s response, to promote regulatory clarity, was to adopt Rule 402(b) as a non-exclusive conditional safe harbor. A Funding Portal engaged in these activities will be deemed to be in compliance with the prohibitions in the statutory definition of “Funding Portal”:

Determine whether and under what terms to allow an issuer to sell securities through its platform under ’33 act §4(a)(6)

Apply objective criteria to determine which offerings to highlight Provide search functions investors can use to search, sort and categorize offerings Provide communications channels by which investors can communicate with each

other and representatives of the issuer Advise an issuer about the structure or content of the issuer’s offering

persons. This overlaps with the long running discussion about allowing finders or intermediaries in non-public company transactions to operate under an exemption from federal broker dealer registration. In January 2014, the SEC issued a no-action letter, M&A Brokers (publicly avail. 1/31/2014), determining that where such intermediaries were involved in selling a majority interest in non-public companies, they were exempt from federal requirements to register as broker dealers. However, the SEC has not provided that interpretation for intermediaries who are placing investments in non-public companies rather than selling control of the businesses. Presumably, while the SEC may allow referral fees to unregistered referral sources for crowdfunding intermediaries, it would not allow those fees to be transaction based compensation nor would it allow such persons to be involved in negotiations, valuation or advising a party about sale or purchase of the issuer’s security – all indicia of acting as a broker dealer.

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Compensate a third party for referring a person to the platform so long as the third party complies with privacy standards and the compensation is not based on the purchase or sale of a security offered on the platform

Pay any compensation to (or receive compensation from) a registered broker in connection with the offer or sale of securities on the platform, provided thato Services are provided pursuant to a written agreemento Services and compensation are permitted under this parto Services and compensation comply with FINRA rules for Funding Portals..

Deny access to the platform on a reasonable basis Accept investment commitments Direct investors where to transmit funds Direct a qualified third party to release or return proceeds to investors.

However the SEC takes great pains to state, in Reg CF, Rule 402(a), that “no presumption shall arise that Funding Portal has violated the prohibitions under Section 3(a)(80) of the Exchange Act or this part by reason of the Funding Portal or its associated persons engaging in activities in connection with the offer or sale of securities in reliance on Section 4(a)(6) that do not meet the conditions specified in paragraph (b) of this section. “

If promoting regulatory clarity, why not come out and say Funding Portals “are” or “are not” able to take transaction-based compensation? Most practitioners who have written on this subject believe that Funding Portals cannot take transaction based compensation, except for an equity interest in companies selling securities on that Funding Portal. Nor may they engage in a number of other activities that form the core of what registered broker dealers do for privately held companies raising capital. These prohibitions suggest the SEC had in mind much more of a securities exchange model for Funding Portals than a broker dealer model. In the public company world, securities exchanges are owned by broker dealers and receive fees from issuers that list their stocks on the exchange. The fact that Funding Portals can be affiliated with brokers, can take fees from issuers and can give or take fees from registered brokers suggests a similar but not identical ordering of relationships.

FINRA Regulation

Section 304(a)(2) of the JOBS Act requires that Funding Portals be registered as members of FINRA but that FINRA ”…. shall only examine for and enforce against a registered funding portal rules of such national securities association written specifically for registered funding portals.” FINRA proposed such regulations and in January 2016, the SEC approved the rules that FINRA had proposed for Funding Portals.

The set of rules has a member application process, standards of conduct, a supervisory system, reporting requirements, recordkeeping in relation to persons associated with the portal, public access to information about the portal and its associated persons and provisions which give FINRA the power to investigate and sanction portals. The scheme includes a requirement to mediate and arbitrate disputes and provides a code of procedure to follow in resolving such disputes. In short, FINRA has taken their regulatory framework for broker dealers and tried to streamline it for Funding Portals. However, it has most if not all of the same components.

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The Funding Portal membership application process must be completed prior to engaging in the FP business and prior to the occurrence of any change in control of a Funding Portal. 57 In the process, FINRA satisfies itself that the applicant has all systems in place to conduct the business including contractual arrangements with banks, broker-dealers, clearing corporations, escrow agents, transfer agents and technology service providers; supervisory systems; record keeping systems; and direct and indirect sources of funding.58 FINRA has 60 days to accept or deny the application in a written decision with detailed reasons for denial if that is the decision. FINRA’s decision can be appealed to the SEC.59 If accepted, a Funding Portal must enter into a membership agreement with FINRA. A key point is that Funding Portals are not required to obtain a fidelity bond or comply with other financial wherewithal rules – at least yet.

Once operating, a Funding Portal must conduct its business in accordance with high standards of commercial honor and just and equitable principals of trade. No Funding Portal may effect a transaction by means of any manipulative, deceptive or fraudulent device. This is a streamlined version of the same standards that broker dealers must adhere to. Funding Portal Rule 200(c ) applies those standards to communications the Funding Portal might have with investors and prohibits false, exaggerated, promissory or misleading statements; misleading omissions; and predictions of performance or results. An FP must clearly identify it name in the communications it makes to investors but is not responsible for communications with investors made solely by issuers on its website. That said, a Funding Portal cannot allow an issuer to communicate something on the FP website that the FP knows or has reason to know contains an untrue statement of a material fact or is otherwise false or misleading. 60

A Funding Portal supervisory system must include a set of written procedures designed to achieve compliance of the portal and its associated persons with securities laws and regulations as well as the FINRA Funding Portal Rules. To that end, the Funding Portal must designate a person who has authority at the Funding Portal to carry out the supervisory responsibilities of the FP organization and the FP must make a reasonable effort to determine that the designated supervisor is qualified by experience or training to carry out the supervisory responsibilities. Like broker dealers, all Funding Portals are subject to FINRA examination and inspection of all business operations. 61

Regarding reporting and recordkeeping, a Funding Portal must report to FINRA any regulatory proceedings to which it or its associated persons are parties, disciplinary proceedings and the like within 30 days of it becoming aware of the event.62 If the event relates to the statutory disqualification of associated persons from being associated with the Funding Portal, the Funding Portal must notify FINRA promptly and at least within 10 days of becoming aware of the circumstances. At the same time, a Funding Portal must provide to the public all information on SEC Form Funding Portal through FINRA’s Broker Check or other similar means. A Funding Portal can comply with its obligation to report to FINRA by making the information

57 The membership application process (called “MAP” by FINRA) takes place by filing Form FP-NMA and by filing Form FP-CMA when seeking approval of a change in control. 58 Funding Portal Rule 110(a)(10)59 Funding Portal Rule 110(a)(12), (13).60 Funding Portal Rule 200(c)(3)61 Funding Portal Rule 300(a)62 Funding Portal Rule 300(c )(1)(A)

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available on its Form Funding Portal. 63 FPs are also required to provide information about their annual revenues to FINRA no later than sixty (60) days after the calendar year end.64.

If FINRA initiates an investigation, Funding Portals are subject to most of the same rules for broker dealers relating to investigations and sanctions of FINRA members and are subject to being fined by FINRA65. Specifically, associated persons who are listed on Schedule A of Form Funding Portal are required to provide information and testimony.66 There are also specific requirements that must be met if Funding Portals want to require all issuers or investors coming onto its website to mediate and arbitrate disputes. 67

In some ways, the streamlining of Funding Portal rules that Congress demanded of FINRA shows up in the requirements that are not imposed. For instance, there is no requirement that Funding Portals register or submit their information through FINRA’s Central Registration Depository (“CRD”). Persons associated with Funding Portals do not have to take examinations or be licensed themselves. Unlike many financial intermediaries, Funding Portals are not required to comply with anti-money laundering regulations or file suspicious activity reports with the U.S. Department of Treasury. And, Funding Portals (unlike registered broker dealers) are not required to file information about the issuers in private placements in which the intermediary will be involved.

E. Other Key Features

Pre-emption of State Substantive Law.

Section 305 of the JOBS Act adds ’33 Act Section 4(a)(6) offerings to the list of transactional exemptions that are considered “Covered Securities” under Section 18(b)(4) of the ’33 Act.68 That means that crowdfunding offerings that are exempt on the federal level are to be regulated in a substantive way solely on the federal level and state substantive law is pre-empted. It also means that state law does reach intermediaries and their electronic platforms in crowdfunding transactions. The same entities can fairly easily qualify as both federal Funding Portals and Texas Crowdfunding Portals. 69 The state regulations for Texas Crowdfunding Portals mirror or are very similar to the definition of and operational limitations of federal Funding Portals as set forth in the federal statute and now in Regulation CF.

63 Funding Portal Rules 800(b) and 300 (c ) (4)64 Funding Portal Rule 300(e)65 Funding Portal Rules 800 and 900. 66 Funding Portal Rule 100(b)(1)67 Funding Portal Rule 120068 15 U.S.C. § 77r(b)(4) 69 There is some confusion caused by duplicative numbering of statutory sections in the JOBS Act. The JOBS Act created a subsection (a) which contained all of the traditional exemptions from registration of the offering or “transactional” exemptions; renumbered the old Section 4(6) exemption to Section 4(a)(5) for offerings solely to accredited investors; and added an exemption for the federal crowdfunding offerings defined in JOBS Act Title III. It also added a subsection 4(b) dealing with requirements of intermediaries regarding registration as a broker in Rule 506 offerings. However, other references to Section 4(6) in other sections of the securities laws, including Section 18(b)(4) continue to refer to 4(6) while we assume the provision means 4(a)(6). This is important because we need clarity that Congress did not intend to pre-empt state law with respect to broker regulation under Section 4(b).

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No Integration: Ability to Do Simultaneous / “Close in Time” Offerings Under Other Exemptions

In Regulation CF, the SEC has explicitly stated that offerings complying with Regulation CF will not be integrated with offerings made by the same issuer under other established exemptions from the requirement to register securities offerings. This is true whether the offerings made under other exemptions are made close in time – either before or after the Reg CF offering – or simultaneously with it. An example often citied is one where an issuer may be doing a crowdfunding offering to demonstrate consumer interest in its product while obtaining venture funding through a simultaneous Rule 506 offering made to angel or venture investors.

However, the caveat is that an issuer must ensure that all of the requirements of the other exemption are met while it is conducting the Regulation CF offering. The most difficult requirement to meet will likely be the prohibition on general solicitation of investors under some types of Reg D offerings such as Rule 506(b) offerings while the issuer is soliciting crowdfunding investors via the internet. An issuer will be required to show that none of the investors in the Rule 506(b) offering heard about that offering or became interested in the issuer as a result of the information available about the Regulation CF offering, either online or through tombstone advertisements. It would seem that the most successful argument would be a provable long standing pre-existing relationship with the Rule 506(b) offering investor.

Non-Exclusive Method of Compliance

Regulation CF as a whole is a non-exclusive means of complying with the statutory equity crowdfunding exemption on the federal level. On a smaller scale, Reg CF, Rule 402(b) is a non-exclusive set of activities that will be deemed to be in compliance with the statutory definition of “Funding Portal”.

F. Practical Questions Raised

Intermediaries Preparing Offering Documentation

While the securities bar hasn’t seemed that interested in representing crowdfunding issuers in preparing information disclosure and ensuring compliance with offering exemptions, it is jarring to have an intermediary take over this function entirely for a securities issuer. This may be a slippery slope. If an intermediary can prepare offering documentation for a crowdfunding issuer, why can’t it prepare offering documentation in a Reg A or Reg D offering? Offering documentation will be filed with (if not reviewed by) the SEC in Reg CF offerings and will be filed with and reviewed by the SEC in Reg A and A+ offerings. Is that a good argument for letting intermediaries prepare offering documentation in those offerings? Or not?

Interstate and Intrastate Crowdfunding: Parallel Closed Systems

Securities sold under Regulation CF / ’33 Act §4(a)(6) are considered “covered securities” under ’33 Act §18. As such, state substantive law relating to the offering is pre-empted. From an issuer’s viewpoint, they are parallel but closed systems. An issuer uses one or the other – at least during the same time frame. However, both states and the federal government have jurisdiction over intermediaries and electronic platforms. Given the responsibility placed on intermediaries and their platforms in both interstate and intrastate equity crowdfunding, should we think of this

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issuer exemption as requiring compliance with both state and federal law rather than as state law being pre-empted?

Bottleneck: The Importance of Electronic Platforms and Intermediaries

The type of electronic platform specified in Regulation CF is not the type of website that you or your teenager could build yourself in WordPress. The significant amount of functionality required will require a not insignificant amount of money and will a erect a barrier to entry.

FINRA Regulation

Another wildcard is FINRA regulation of Funding Portals. FINRA clearly believes that it has crafted a less onerous but appropriate set of regulations. However, will FINRA be able to keep separate its regulation of Funding Portals from its regulation of broker dealers? Or, will the human nature of examiners and the inertia of a large organization mean that Funding Portal regulation will gradually become just like broker dealer regulation? It would be unfortunate if Funding Portals were regulated like brokers (at some amount of cost) while they are prohibited from engaging in the activities that make brokers money and taking transaction based fees.

Finally, it seems that given the rules for Funding Portals around the ability to give and take compensation, FINRA expects that registered broker dealers will be an integral part of Funding Portal success through contractual relationships or ownership of Funding Portals. At the same time it proposed the Funding Portal Rules for adoption, FINRA also proposed Rule 4518 for registered broker dealers requiring them to notify FINRA prior to engaging in crowdfunding transactions or within 30 days of entering into certain control relationships with a Funding Portal.

G. Summary

Interstate equity crowdfunding provides another tool in the toolbox when advising companies seeking to raise equity capital. A number of other new tools have come out of the JOBS Act, including, indirectly, intrastate equity crowdfunding; Rule 506(c) offerings with general solicitation and the ways in which non-issuer electronic platforms can be involved with those offerings; and Regulation A+/Tier 2 offerings of up to $50 million which may or may not use electronic platforms. If the sophistication of the platform requirements and FINRA regulation prove not to be an overwhelming burden for Funding Portals, this is a nice additional tool in small business capital formation and capital formation generally.

II. TEXAS INTRASTATE CROWDFUNDING RULES

As issuers and “Funding Portals” (as defined in the JOBS Act) waited for the SEC to act, certain state legislatures and regulators took action to create their own crowdfunding exemptions from the requirement to register securities offerings in their states if the transaction took place entirely within the state. The Texas State Securities Board enacted new rules in late 2014 to accomplish that in Texas.1

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A. Overall Requirements of the Exemption

The requirements for the issuer’s exemption from registration of the offering under Texas law are contained in Texas State Securities Board Rule 139.25 (7 T.A.C §139.25) (a part of the “Texas Intrastate Crowdfunding Rules”).

A Registered TCP or Registered Texas General Dealer Must Be Involved

This is required for the issuer to claim the exemption as well as a requirement for intermediaries. The “FAQs About the Texas Intrastate Crowdfunding Rules” on the Texas State Securities Board website suggest that a website may have both a TCP and general dealers associated with it. Both kinds of intermediaries may receive compensation in connection with sales under Texas crowdfunding offerings. However, that compensation cannot be in the form of a financial interest in the issuer. Nor can the intermediary be affiliated or under common control with an issuer or otherwise hold an interest in an issuer.2

All Offers and Sales are Made to Texas Residents3

The issuer can meet the requirement here through an affirmative representation by the potential purchaser and one of the following: a) a valid Texas drivers license; b) a valid Texas voter registration card; or c) property tax records showing the purchaser owns and occupies Texas property as his or her principal residence.4

That website must display certain disclaimers and have certain functionality, including: a) a disclaimer that access to offerings on the website is restricted to Texas residents and all offers and sales must be made to Texas residents; b) the means for a visitor to represent that he/she/it is a Texas resident before the visitor is allowed to view offering materials; and c) the means for verifying before a sale that a prospective purchaser is a Texas resident through an affirmation and the means set forth above.5

\All Offers and Sales are Made Completely on a Website Operated by a Registered Intermediary

The offering must be made exclusively through a website that is operated by a registered TCP or registered general dealer.6

Other than limited notices to the general public7, all communications between the issuer and potential investors must be made on the website. The website must have functionality to provide channels for issuers to communicate with potential investors and for potential investors to be able to communicate with each other. All investors must be able to see all communications. 8

The information provided by the issuer that can be displayed on the website is limited to: a) a summary of the offering; and b) a copy of the disclosure statement that the issuer is required to provide to potential investors.9 In addition, the issuer must provide specific disclosures about the liquidity risks of investments in exempt offerings.10 The information must be provided to potential investors and to the Texas State Securities Board at least 21 days before any sale under the offering. 11

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Information Disclosure Required by the Issuer

The rule requires the summary of the offering on the website to include: a) a description of the issuer, it form of entity, history, business plan, and intended use of proceeds, including any compensation to an owner, executive officer, member of a governing entity or manager of the issuer; b) the identity of executive officers and members of a governing entity and their titles or job descriptions and prior experience; c) the identity of persons holding more than 20% of any class of securities of the issuer; and d) a description of the securities offered, other securities of the issuer , and the percentage of the class that the offered securities represents.12

The disclosure statement must include all information material to the offering, including discussion of significant risk factors where appropriate. The rule provides a list of types of information that may be included. In addition, the issuer must disclose specific information about the nature of exempt offerings like: a) there is no ready market for the secondary sale of the securities; b) the investor may have to hold the investment indefinitely; c) the securities cannot be resold unless the secondary offering is registered or there is an exemption available; d) investors must rely on their own examination of the issuer and the terms of the offering, including the merits and risks of investment; and e) no regulatory authority has determined the accuracy or adequacy of the information provided13

Finally, the issuer must provide financial information about its business. All financial statements must be certified by the principal executive officer of the issuer. If the issuer has audited financials prepared within the last three years, it must provide them to potential investors.14

Aggregate Offering Limits within Twelve (12) Months

An issuer can raise no more than $1,000,000 within any twelve (12) months under this exemption. Any offering occurring less than six months before or less than six months after the current effort will be counted against the $1,000,000 limit. 15

Limits on Amount of Investment by Each Investor

Each purchaser can only invest $5,000 unless the investor meets the definition of Accredited Investor under the federal exemption, Reg D. There is no investment limit for purchasers who are Accredited Investors16. As with federal Rule 506 offerings, issuers must have a reasonable basis to believe that such a purchaser is an Accredited Investor. The requirement for reasonable basis will likely be the same as required under Rule 506(c ) offerings rather than under Rule 506(b)17.

Escrow of Offering Proceeds

The proceeds of the offering must be held by a bank or other depository institution as escrow agent until the aggregate amount raised from purchasers is equal to or greater than the minimum targeted offering amount specified in the disclosure statement as necessary to implement the business plan. If the minimum targeted offering amount is not raised by the time specified in the disclosure statement, the escrow agent will return the subscription funds to the investors. 18

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These requirements suggest specific requirements on the issuer itself. At least a minimum if not a maximum aggregate target offering proceeds is presumed and it must be tied to the issuer’s intended use of proceeds. A requirement to return subscription funds is also presumed.

B. Requirements for Companies Raising Capital or “Issuers” of Securities

In parallel with the federal Rule 147 requirements, §139.25 requires an intrastate crowdfunding issuer to: a) have its principal place of business in Texas; b) have eighty percent (80%) of its gross revenues in the last fiscal year coming from operations in Texas; c) have eighty percent (80%) of its assets at the end of the last semiannual period located in Texas; and d) use eighty (80%) of the net proceeds of the crowdfunding offering used in connection with its Texas operations. 19

It is not enough for an intrastate crowdfunding issuer to be formed in another jurisdiction but qualified to do business in Texas. It must be an entity formed in Texas.20

Companies that are investment funds, have registered a securities offering on the federal level or that have no operations or intend to merge into an as yet unspecified business entity cannot utilize the Texas Intrastate Crowdfunding Rules.21

C. Requirements for Texas Crowdfunding Portals

In order to register as a Texas Crowdfunding Portal (“TCP”), a person or entity must limit its activities solely to operating a website on which only offerings utilizing the exemption under §139.25 are offered and sold.22 It cannot facilitate a secondary market in the securities offered on the website.23 Like intrastate crowdfunding issuers, TCPs must be formed under Texas law. 24

TCPs have operational requirements that parallel the obligations of intrastate crowdfunding issuers including: a) the display and functional requirements of the website; b) the requirement to make certain disclosures regarding the liquidity risks of exempt offerings to potential investors and get affirmations from them regarding risks of exempt offerings25; and c) the requirement not to be affiliated with an issuer or take a financial interest in the issuer separately or as compensation for its services26

In addition, §115.19 limits the activity of the TCP even in connection with the website. A TCP cannot: a) give advice to investors or make investment recommendations; b) compensate employees or agents for soliciting purchases or sales of securities who are not registered as dealers or agents of registered dealers; or c) handle investor funds or securities.27 On the other hand, a TCP must: a) conduct background and regulatory history checks on intrastate crowdfunding issuers and their control persons;28 b) keep certain records of its business for a period of five years29; c) keep records of its registration as a TCP, associated Forms U-4 and organizational documents30; and d) provide access to the website and the ability to inspect it to the Texas State Securities Board.31

D. Comparison Between TCPs and Texas only Registered General Dealers.

Intermediaries that do not meet the TCP requirements must register as a Texas general dealer. General dealers can operate websites on which crowdfunding offerings are made. However, an

25

offering meeting the requirements of 139.25 on a website operated by a TCP is a “true “ equity crowdfunding offering.

E. Compliance with Federal Law – the Rule 147 Requirements

Rule 139.25(c) requires coordination with federal law and compliance with §3(a)(11) of the ’33 Act and SEC Rule 147. In fact, it substantially mirrors the federal rule as it currently reads. Rule 147 is a safe harbor rule. If issuers comply with all of the provisions of the rule, the offering will be deemed to be in compliance with §3(a)(11). However, it is possible to comply with §3(a)(11) by other means. Remember that an offering must have an exemption on both the federal and state level unless federal law pre-empts state law.

In conjunction with the adoption of Regulation CF for interstate crowdfunding offerings, the SEC proposed amendments to its Rule 147 to improve, update and streamline the regulatory requirements for intrastate offerings.32 The proposed amendments would: 1) do away with the requirement that all offers be made to in-state residents; 2) allow the use of general solicitation and advertising as long as all sales of securities take place in the state and the offering complies with a state exemption that allows no more than $5 million be sold in a single offering within 12 months and that also requires investors to hold the securities for a period of time; 3) require issuers to meet one of four thresholds in determining whether the issuer is primarily located and doing business in the state (as opposed to the current requirement to meet all of 3-4 tests); and 4) does away with the requirement that an issuer be organized in the state (as opposed to Delaware, for instance). The comment period for the proposals has passed, but one can continue to make comments to the SEC comment file and the comments from other practitioners, market participants and regulators are often well thought out and enlightening.33 There is no timetable for SEC action on the proposals. Beyond the proposed changes, SEC Rule 147 has been the subject of numerous SEC no-action letters and interpretations which any practitioner should review. 34

F. Disqualifications

Like federal Rule 506, the Texas intrastate crowdfunding exemption is not available to issuers where the issuer or persons affiliated with the issuer have experienced certain disqualifying events or conditions.35 Issuers must review whether it, any of its predecessors, any of its affiliates or control persons have experienced any disqualifying events or conditions. The issuer’s “control persons” include its officers, persons serving on its governing body, any person holding at least twenty percent (20%) of any class of securities of the issuer and any person having the power, directly or indirectly, to direct management of the issuer.36

The list of disqualifying events or conditions under the Texas Intrastate Crowdfunding Rule has a similar purpose to that of the set of disqualifying events under the federal Rule 506. However, the Texas list is much simpler and less multi-faceted than the list in Rule 506(d). Intrastate crowdfunding issuers and registered operators of crowdfunding websites need to be aware of the occurrence of disqualifying events or conditions in the last five years and whether they are still in effect at the time of the sale of securities in the crowdfunding offering. The persons or entities being reviewed for disqualification cannot:

1) have filed a registrations statement that is subject to a currently effective stop order issued by a state regulator or the SEC

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2) have been convicted of a criminal offense involving the offer, purchase or sale of a security or fraud or deceit;

3) be subject to a state or federal enforcement order or judgment finding fraud or deceit in connection with the purchase or sale of a security; or

4) be subject to any order, judgment or decree of a court of competent jurisdiction restraining or enjoining engaging in conduct involving fraud or deceit in connection with the purchase or sale of a security 37

G. Notice of Offering and Resales of Securities

Prior to using a crowdfunding website, the issuer has an obligation to provide the Texas State Securities Board with a notice of the offering on Form 133.17, the disclosure statement and summary of the offering.38 Executive officers and members of the governing entity of the issuer must make the disclosures required by federal Rule 147. Issuers must also place legends on the securities certificates providing notice that the securities cannot be resold unless certain requirements were met. 39

While they may not be resold without registering the secondary offering or compliance with an exemption from registration of the secondary offering, securities sold in an intrastate crowdfunding offering may not be sold for a period of nine (9) months after the last sale of the offering to anyone but Texas residents. 40

H. Summary

The Texas Intrastate Crowdfunding Rules were developed prior to the enactment of Regulation CF and with an eye to at least not contradict the federal statutory requirements for interstate crowdfunding offerings in the JOBS Act itself and Regulation CF, as proposed. Because securities issued in offerings done in compliance with Reg CF will be “covered securities” and state substantive law will be pre-empted with respect to securities offering registration and exemption, issuers in interstate and intrastate crowdfunding offerings can choose between two alternative but completely closed systems. What is unspoken is that intermediaries and platforms will be regulated on both the state and federal level. Whether that regulation is coordinated is important because intermediaries may want to operate in both systems and both state and federal regulation put a significant burden on the intermediaries for compliance.

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Exhibit “A”70

The Types of Events Under Rule 503Which Disqualify Issuers From Using §4(a)(6)

In order to use Regulation CF, issuers must ensure that all of those persons or entities falling in the above categories have not, have not been or are not:

1) convicted of any felony or misdemeanor (within the last five years if an issuer, a predecessor of an issuer or an affiliated issuer or within the last ten years if included in any other category of persons or entities set forth above):

a) in connection with the purchase or sale of a security, b) making of a false filing with the SEC or c) arising out of the conduct of the business of an underwriter, broker,

investment adviser or paid solicitor

2) the subject to an order, judgment or decree entered within the five years before any sale under the offering that, at the time of the sale, restrains or enjoins the person from engaging in conduct:

a) in connection with the purchase or sale of a security, b) making of a false filing with the SEC or c) arising out of the conduct of the business of an underwriter, broker,

investment adviser or paid solicitor

3) the subject of a final order of a state securities agency, state authority over banking or insurance, the CTFC or the NCUA that,

a) at the time of the sale, bars the person from (i) association with an entity regulated by any such agency or authority, (ii) engaging in the securities, banking or insurance business, or (iii) engaging in savings association or credit union activities

orb) was entered within ten years before the sale and constitutes a violation of

law/regulation that prohibits fraudulent, manipulative or deceptive conduct

4) the subject of an SEC order pursuant to the laws/regulations relating to registration of broker dealers and of investment advisers on the federal level that at the time of sales under the offering:

a) suspends or revokes the person’s registration as a broker, dealer, muni securities dealer or investment adviser,

b) places limitations on the activities, functions or operations of the person [as a registered person], or

c) bars the person from association with any entity or participation in a penny stock offering.

5) the subject of any SEC order entered within the five years before any sale under the offering which, at the time of the sale, orders the person to cease and desist from committing or causing a violation or future violation of:

70 17 CFR §227.503

28

a) any scienter-based anti-fraud provision of the federal securities laws, or b) Section 5 of the ’33 Act

6) suspended or expelled from membership (or barred from association with a member) of a registered national exchange or association for an act or omission that constitutes conduct inconsistent with just and equitable principles of trade.

7) filed a registration statement or Reg A offering statement with the SEC (or was named as an underwriter with respect to such)within the five years prior to any sale under the offering that was

a) the subject of a refusal order, stop order, or suspension order orb) at the time of the sale, the subject of an investigation to determine whether

such an order should be issued.

8) within five years before any sale under the offering, is subject to a) a USPS false representation order or b) an investigation to determine whether such an order should be issue

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1 7 T.A.C.139.25, 7 T.A.C. 115.19, Form 133.17 and amendments to 7 T.A.C. 115.1 and 115.3.2 7 T.A.C. 139.25(l)3 7 T.A.C 139.25(a)4 7 T.A.C. 139.25(h)(1)(B) and (C)5 7 T.A.C 139.25(h)(1)6 7 T.A.C. 139.25(d)7 7 T.A.C. 139.25(g)(2)8 7 T.A.C. 139.25(g)(1)9 7 T.A.C. 139.25 (h)(2)10 7 T.A.C. 139.25 (h)(1)11 7 T.A.C. 139.25 (h)(3)12 7 T.A.C. 139.25 (h)(2)(B)13 7 T.A.C. 139.25 (i)14 7 T.A.C. 139.25 (i)(3)15 7 T.A.C. 139.25 (d)16 7 T.A.C. 139.25 (e)17 Information for Issuers Using Intrastate Crowd Funding Exemption, Accredited Investors, http://www.ssb.state.tx.us/Important_Notice/Crowdfunding_Exemption.php18 7 T.A.C. 139.25(f)19 7 T.A,C 139.25(b)(1)20 Information Information for Issuers Using Intrastate Crowd Funding Exemption, Issuer Eligibility http://www.ssb.state.tx.us/Important_Notice/Crowdfunding_Exemption.php21 & T.A.C. 139.25 (b)(2)22 7 T.A.C §115.19 (a)(2)23 7 T.A.C. 115.19 (a)(3)24 7 T.A.C. 115.19 (a)(1) , Information for Crowdfunding Portals, http://www.ssb.state.tx.us/Important_Notice/Crowdfunding_Portals.php25 7 T.A.C. 115.19(b)(5)26 7 T.A.C. 115.19(c) (4) – (6)27 7 T.A.C. 115.19 (c )(1) – (3)28 7 T.A.C. 115.19(d)29 7 T.A.C. 115.19 (e)(1) – (2)30 7 T.A.C. 115.19 (e) (3)31 7 T.A.C. 115.19(e)(6)32 SEC Release 33-9973, “Proposed Rule Amendments to Facilitate Intrastate Crowdfunding and Regional Offerings”, 81 F.R. 69786-01(November 10, 2015)33 SEC File No S7-22-15. 34 17 C.F.R. 230.147 (2015) The Division of Corporation Finance publishes a series of Compliance and Disclosure Interpretations (“CD&I’s”), some of which relate to Rule 147 and Section 3(a)(11, including: Q 127.02, 141.01, 141.03 -05, and 227.01 - .06; In addition, the SEC has provided interpretation of the Rule 147 requirements through no action letters: Insurance Fin. Co., Oct. 18, 1974, 1974 WL 10053; Citizens Discount & Inv. Corp., Sept. 26, 1990, 1990 WL 286913; Master Financial, Inc., May 27, 1999, 1999 WL 343087; Film Festival ‘82, June 25, 1982, 1982 WL 29312; Fina Bancorp, Inc., June 15, 1987, 1987 WL 108275; Fidelity Credit Corp., June 23, 1988, 1988 WL 234463; Capitol Securities, Inc., Oct. 2, 1987, 1987 WL 108439; Diplomat, Ltd.,* Feb. 13, 1984, 1984 WL 47282.35 7 T.A.C. 139.25 (m)(2)

36 7 T.A.C. 139.25 (m)(1)37 7 T.A.C. 139.25 (m)(2) (A) – (D)38 7 T.A.C. 139.25 (j) 39 17 C.F.R. 230.147 (e) and (f)

40 7 T.A.C. 139.25(k)