Authored by: Ernest E. Badway and Polina Pittell (law clerk)

This practice note discusses the regulation of crowdfunding intermediaries. Section 4(a)(6) (15 U.S.C. § 77d) of the Securities Act of 1933, as amended (Securities Act), added by Title III of the JOBS Act (112 P.L. 106, 126 Stat. 306), provides an exemption from the registration requirements of the Securities Act for offerings of securities using a process called “crowdfunding,” and requires that crowdfunding offerings be made through an intermediary, such as a registered broker-dealer (B/D) or a funding portal. This practice note discusses crowdfunding and then an overview of the regulation of intermediaries under Regulation Crowdfunding, including their obligations to investors and the requirement that they register with a national securities association such as the Financial Industry Regulatory Authority, Inc. (FINRA).

For more content on FINRA generally, see FINRA Resource Kit.

Crowdfunding is the process of raising capital over the internet by collecting low-dollar investments from numerous individuals (i.e., a “crowd” of investors). Although certain forms of crowdfunding have gained increasing popularity in recent years, the JOBS Act and remains focused solely on the type of crowdfunding in which investors are offered some form of equity in return for their investment, which implicates the federal securities laws.

Section 4(a)(6) to the Securities Act required the United States Securities and Exchange Commission (SEC) to implement a regulatory framework to achieve its crowdfunding objectives. In response, the Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding (17 C.F.R. §§ 227.100–503), on October 30, 2015, See Crowdfunding [Release Nos. 33-9974; 34-76324] 2015 SEC LEXIS 5486 and 2015 SEC LEXIS 5487. Section 4(a)(6) and Regulation Crowdfunding are intended to assist small and medium-sized businesses, that historically have struggled to raise capital for a variety of reasons, including the high transaction costs associated with public and private offerings of securities and the desire of investment banking firms to conduct more profitable high-dollar amount offerings.

Regulation Crowdfunding enables smaller businesses to access the capital markets by eliminating many of the transaction costs associated with securities offerings but with safeguards to ensure investor protection. Regulation Crowdfunding represents the result of a balancing test, where the SEC sought to protect investors while minimizing the transaction costs associated with such measures.

Crowdfunding Basics

Regulation Crowdfunding limits the amount issuers may raise in crowdfunding offerings; excludes or disqualifies certain issuers and other persons from relying on the exemption; limits investments in crowdfunding offerings by nonaccredited investors; and requires issuers to disclose certain information to the SEC, the crowdfunding intermediary, and the investors in the offering.

For a detailed discussion of the scope of the crowdfunding exemption, see Crowdfunding Regulations. See also Regulation D, Regulation A+, and Regulation Crowdfunding Requirements Chart.

Offering Limits

Most notably, Rule 100(a) (17 C.F.R. § 227.100) of Regulation Crowdfunding provides that an issuer may not raise more than $5 million in crowdfunding offerings in any 12-month period. The amount will be aggregated with any crowdfunding activities undertaken by entities that share common control with the issuer, or any entity that was a predecessor of the issuer. However, the amount does not include offerings made pursuant to another exemption from registration, such as private placements made in reliance on Section 4(a)(2) of the Securities Act or Regulation D thereunder.

Ineligible Issuers

Certain companies are not eligible to participate in crowdfunding, including non-U.S. companies, investment companies, certain exempted investment companies, Exchange Act reporting companies, companies without a specific business plan or having a plan to merge with an unidentified company, and companies that failed to comply with annual reporting requirements under Regulation Crowdfunding. See Rule 100(b) of Regulation Crowdfunding (17 C.F.R. § 227.100).

Disqualification Provisions

Rule 503 of Regulation Crowdfunding (17 C.F.R. § 227.503) provides that none of the following persons, subject to a disqualification event listed in the rule, may participate in a crowdfunding offering: an issuer and any predecessor or affiliated issuer; any director, officer, general partner or managing member of the issuer; any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power; any promoter connected with the issuer in any capacity at the time of filing, any offer after filing, or such sale; any person that has been or will be paid, directly or indirectly, remuneration for solicitation of purchasers in connection with such sale of securities; and any general partner, director, officer or managing member of any such solicitor.

Investment Limits

Crowdfunding investors who are not accredited investors, as defined in Rule 501(a) of Regulation D (17 C.F.R. § 230.501), are limited in the amount they may invest in crowdfunded offerings in any 12-month period. An investor with either annual income or net worth less than $107,000is limited to the greater of (1) $2,200 or (2) 5% of the greater of their annual income or net worth. If both annual income and net worth are $107,000 or more, the investor is limited to 10% of the greater of the investor’s annual income or net worth, with a cap of $107,000. There are no limits on crowdfunding investments by accredited investors.

Securities purchased in a crowdfunded offering cannot be transferred for one year except to the issuer; an accredited investor; or a family member or trust controlled by the purchaser or created for the benefit of a family member, or in connection with death or divorce of the purchaser; of if registered under the Securities Act. Issuers, however, are not limited in the type of securities (e.g., common or preferred stock, debt securities) that they may offer and sell in crowdfunding offerings.

Disclosure Requirements of Issuers

Rule 201 of Regulation Crowdfunding (17 C.F.R. § 227.201) requires issuers to disclose certain information to the SEC, the intermediary facilitating the offering, and the investors. The information that must be disclosed includes, among other things, the price of the securities, the company’s financial condition, risk factors related to the offering, and a description of the business plan underlying the offering.

Regulation of Crowdfunding Intermediaries

Section 4(a)(6) requires that crowdfunding offerings be conducted through an intermediary. Notably, Regulation Crowdfunding creates a new intermediary called a “funding portal” to allow internet-based intermediaries to conduct securities offerings without having to register with the SEC as B/Ds. See Rule 300(c)(2)(17) of Regulation Crowdfunding (17 C.F.R. § 227.300). The main role of an intermediary in a crowdfunding offering is to provide the internet funding portal or platform for the offering and to provide educational materials and other disclosures about the offering.

Funding portals provide a less expensive alternative to B/Ds, who generally tend to work on high-dollar offerings, which allow them to shift some of their transaction and compliance costs to the wealthy investors who can afford to invest in such offerings. By operating through funding portals, crowdfunding issuers can access a larger swath of the investing population without incurring the higher costs of engaging a B/D. Further, since crowdfunding offerings can be made to nonaccredited investors, issuers are able to access smaller investors who historically have been precluded from participating in of the securities market.

To protect investors, Regulation Crowdfunding requires intermediaries to register with the SEC, although they do not have to register as B/Ds and thus are not subject to the onerous B/D regulatory scheme. Regulation Crowdfunding also requires intermediaries to become members of a registered national securities association, such as FINRA, a topic discussed in greater detail.

General Obligations of Intermediaries

Funding portals are prohibited from engaging in broker-dealer activities and cannot:

• Offer investment advice or recommendations
• Solicit purchases, sales, or offers to buy the securities offered or displayed on their platforms
• Compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on their platforms
• Hold, manage, possess, or otherwise handle investor funds or securities

Moreover, Rules 300–305 of Regulation Crowdfunding impose certain affirmative obligations on all intermediaries (whether funding portals or B/Ds) by requiring them to:

• Provide investors with the most current and up-to-date educational materials on, inter alia, the process for investing on the platform, the types of securities being offered, the risks inherent in each security, resale restrictions, investment limits, and cancellation rights
• Have a reasonable basis for believing that an issuer meets the requirements for a crowdfunding offering and Regulation Crowdfunding and has established means to keep accurate records of securities holders
• Make required disclosure available to the public on its platform for the duration of the offering period and at least 21 days before any security may be sold in the offering
• Provide communication channels on their platforms that will allow investors who have opened accounts with the intermediaries and representatives of the issuer to interact and discuss the issuer’s offering
• Require any person who posts a comment on communication channels to disclose with every posting if such person is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer or a compensated promoter
• Provide disclosures to investors regarding intermediary compensation
• Only accept investment commitments after the investor has opened an account and consented to electronic delivery
• Obtain representations that the investor has reviewed and understands educational materials, understands the risks of engaging in securities investments, and is in a financial position to deal with such risks
• Obtain from the investor a completed questionnaire indicating the investor’s understanding of the restrictions on investment cancellations, potential challenges for resales, and the inherent investment risks
• Reasonably believe that each investor complies with Regulation Crowdfunding
• Provide investors with certain notices and confirmations during the various steps of the investment process
• Comply with requirements for the maintenance and transmission of funds
• Follow completion, cancellation, and reconfirmation of offerings requirements

See the SEC’s Regulation Crowdfunding: A Small Entity Compliance Guide for Crowdfunding Intermediaries for additional information.

In addition to the above duties, Rules 403 (17 C.F.R. § 227.403) and 404 (17 C.F.R. § 227.404) of Regulation Crowdfunding impose the following duties and obligations on funding portals only:

• Implement written policies and procedures that are reasonably designed to achieve compliance with the federal securities laws and related rules and regulations pertaining to their businesses as funding portals
• Comply with privacy rules that are applicable to B/Ds, such as Regulation S-P (Privacy of Consumer Financial Information and Safeguarding Personal Information), Regulation S-ID (Identity Theft Red Flags), and Regulation S-AM (Limitations on Affiliate Marketing)
• Permit examinations and inspections by representatives of the SEC and the relevant registered national securities association
• Maintain and preserve certain books and records relating to their businesses for at least five years, of which the first two years must be in an easily accessible place

Registration With the SEC

As noted above, funding portals must register with the SEC. To do this, funding portals must file Form Funding Portal (Form FP) on the SEC’s EDGAR system.

Before registering with the SEC, a potential funding portal should request and reserve a proposed name from FINRA to ensure that its desired name is available by completing and submitting to FINRA a Firm Name Reservation Request Form.

A funding portal’s registration becomes effective on the later of (1) 30 calendar days after the date that the registration is received by the SEC or (2) the date the funding portal is approved for membership in a national securities association registered under Section 15A of the Exchange Act (15 U.S.C. § 78o-3). To ensure a smooth transition, funding portals should coordinate the filing of Form FP and their registration with FINRA, as discussed further below.

Form FP requires a substantial amount of information from a funding portal covering seven subject areas, referred to as items. The seven items and the corresponding type of information each item seeks are:

• Item 1—Identifying information. Name, principal business address, mailing address, and contact information of the funding portal
• Item 2—Form of organization. The legal organization of the funding portal (e.g., corporation, partnership, limited liability company, etc.)
• Item 3—Successions. Only applicable if the applicant is succeeding to the business of a currently registered funding portal
• Item 4—Control relationships. Every person that directly or indirectly controls the applicant or management or policies of the applicant, or that the applicant directly or indirectly controls
• Item 5—Disclosure information. Information about the applicant’s disciplinary history and the disciplinary history of all associated persons or control affiliates of the applicant (If disciplinary action exists, additional disclosure pages providing details of the underlying incident must be submitted)
• Item 6—Non-securities related business. Non-securities related business the applicant engages in
• Item 7—Qualified third-party arrangements; compensation arrangements. Any third-party arrangements for persons who will hold investor funds in escrow as well as any compensation arrangements the funding portal has with issuers

Additionally, Schedule A to Form FP requires an applicant to identify and provide information about its executive officers and, unless the applicant is a reporting company, any direct holder of 5% or more its voting securities, including beneficial owners. For each qualifying owner or executive, the applicant must identify that person’s status and indicate whether they occupy a control position, which is defined as the power, directly or indirectly, to direct the management or policies of the funding portal, whether through contract or otherwise. Item 6 of Schedule A states that most executive officers and all 25% owners, general partners, elected managers, and trustees are control persons.

Rule 400(b) of Regulation Crowdfunding (17 C.F.R. § 227.400(b) requires funding portals to keep the information provided in their initial Form FP accurate by filing an amendment within 30 days after any information becomes inaccurate.

Nonresident funding portals must also complete Schedule C to Form FP. A nonresident funding portal is one that is incorporated in or organized under the laws of a jurisdiction outside of the United States or its territories or having its principal place of business in any place not in the United States or its territories. See Rule 400(f) (17 C.F.R. § 227.400(f)(1)). Schedule C requires a nonresident funding portal to identify its U.S. agent for service of process and certify that it can and will:

• Provide the SEC and any registered national securities association where it obtains membership with prompt access to its books and records
• Submit to onsite inspection and examination by the SEC and any registered national securities association where it is a member

Further, the nonresident funding portal must attach an opinion of counsel stating that it can, as a matter of law, comply with these certifications.

Should a funding portal cease operating as such, it must file a withdrawal of registration on Form FP, effective on the later of: (1) 30 days after receipt by the SEC or (2) such longer period of time where the funding portal consents or the SEC deems necessary to protect investors and the public interest.

FINRA Membership

In addition to registration with the SEC, Regulation Crowdfunding requires funding portals to become members of a registered national securities association. FINRA is currently the only registered national securities association, although other organizations may qualify in the future. FINRA Funding Portal Rule 110 (Funding Portal Application) provides the process that a funding portal must undertake to become a FINRA member.

To start, a funding portal applicant must first submit Form FP-NMA, together with an application fee, to the FINRA Department of Member Regulation, and indicate whether the funding portal or any associated person is subject to a statutory disqualification described in Section 3(a)(39) of the Exchange Act (15 U.S.C. § 78c), would also disqualify the portal from serving as an intermediary. See Funding Portal Rule 110(a)(3). An applicant has a continuing obligation to update its application to reflect any changes in the information relating to compliance with Section 3(a)(39) of the Exchange Act within 10 days following any change in the information. See FINRA Funding Portal Rule 110 (a)(3)(B).

An applicant may withdraw its application and receive a refund of its application fee, less a processing fee, within 14 days of filing Form FP-NMA. Also within those 14 days, FINRA may make a written request for further information and/or documentation or reject the application as incomplete. If FINRA seeks further information, the applicant must respond within 14 days (to the first request) or seven days to any subsequent request.

Within 30 days after the filing of an application, or within 14 days after the responding to a request for additional information (whichever is later), the applicant’s representative must have a membership interview with FINRA before delivering a final decision on the application. See FINRA Funding Portal Rule 110(a)(9). The applicant will be notified of the date and time of the interview at least five days before the interview date.

In making its final decision, FINRA will consider several factors, including if the applicant:

• Is capable of complying with applicable federal securities laws and rules and regulations, and FINRA’s Funding Portal Rules; relevant considerations under this inquiry include whether the applicant is subject to a Section 3(a)(39) event or is (or was) subject to an SEC investigation
• Has established all contractual and business relationships necessary to initiate the operation described in its application, such as relationships with banks, B/Ds, clearing corporations, and any other necessary service providers
• Has a supervisory system that is reasonably designed to achieve compliance with applicable federal securities laws, rules, and regulations, and the Funding Portal Rules
• Has fully disclosed and documented all direct and indirect sources of funding
• Has a recordkeeping system that enables the applicant to comply with all relevant recordkeeping requirements

See FINRA Funding Portal Rule 110(a)(10).

Within 60 days of the application, or such later date as FINRA and the applicant agree to, FINRA will deliver its written decision to the applicant. An applicant has 14 days thereafter to file a written request for review with the National Adjudicatory Council (NAC). See FINRA Funding Portal Rule 110(a)(13). Thereafter, the NAC will appoint a subcommittee to conduct the review, which will include conducting a hearing if one is requested. The hearing must be held within 45 days of being requested, and the applicant may be represented by counsel at the hearing. The applicant and FINRA will exchange copies of their proposed hearing exhibits and witness lists five days before the hearing; however, formal rules of evidence do not apply to the hearing. The subcommittee may also direct the parties to provide additional information or briefs. The subcommittee must present a recommendation to the NAC within 60 days of the hearing date.

The NAC may affirm, modify, or reverse the decision or remand with additional instructions, and must provide a copy of its decision to the FINRA Board of Governors. If the Board does not call the decision for review under Rule 110 (a)(13)(I)(ii), the NAC must issue the written decision after the expiration of the Board call for review period, and the decision will constitute final FINRA action.  If a call for review is made, the Board will review the membership proceeding not later than the next meeting of the Board. The Board will issue a written decision affirming, modifying, or reversing the NAC’s decision and setting forth its findings and conclusions. Alternatively, the Board may remand the membership proceeding with instructions. The decision will constitute final FINRA action, unless the Board remands the membership proceeding.

After a final decision has been issued by FINRA, an applicant may seek SEC review of the decision pursuant to Section 19(d)(2) of the Exchange Act (15 U.S.C. § 78s); however, seeking a review does not stay the effectiveness of FINRA’s decision unless otherwise ordered by the SEC.

Officers, Directors, or Partners of an Intermediary

Rule 300 of Regulation Crowdfunding (17 C.F.R. § 227.300) prohibits any director, officer, or partner of an intermediary, or any person occupying a similar status or performing a similar function, from having a financial interest in an issuer that is offering or selling securities under Regulation Crowdfunding through the intermediary’s platform. Additionally, any director, officer, or partner may not receive a financial interest in an issuer as compensation for the services provided to, or for the benefit of, the issuer in connection with the offer or sale of such securities.

Note that an intermediary may have a financial interest in an issuer if (1) the intermediary receives the financial interest from the issuer as compensation for the services provided to the issuer in connection with the issuer’s offer or sale of securities through the intermediary’s platform and (2) the financial interest consists of securities of the same class and having the same terms, conditions, and rights as the securities being offered or sold through the funding portal.

Permissible Activities of Funding Portals

Given that funding portals cannot engage in B/D-type activities, there was some initial confusion about what activities they can engage in under Regulation Crowdfunding. To address this confusion, Rule 402 of Regulation Crowdfunding (17 C.F.R. § 227.402) provides a “conditional safe harbor” that permits a funding portal to engage in the following activities:

• Selecting issuers. A funding portal may select which entities may, and under what terms, make offerings on its platform. However, the funding portal must not advertise or otherwise provide investment advice or recommendations.
• Highlight offerings. A funding portal may apply objective criteria to highlight offerings on the funding portals platform provided that the criteria are reasonably designed to highlight a broad selection of issuers utilizing the platform, are applied consistently to all issuers and offerings, and are clearly displayed on the funding portal’s platform, but may not receive special or additional compensation for highlighting offerings. Rule 402 also provides examples of objective criteria, such as the type of securities being offered, the geographic location of the issuer, and the industry or business segment of the issuer.
• Advertising. A funding portal may advertise the existence of the funding portal and identify one or more issuers or offerings available on the portal based on objective criteria similar to that applicable to highlighting offerings.
• Search functions. A funding portal can provide search functions that allow users to search and categorize offerings according to objective criteria. However, search criteria may not include the advisability of investing in the issuer or its offering, or an assessment of any characteristic of the issuer, its business plan, its key management, or risks associated with an investment.
• Communication channels. Under certain conditions, a funding portal can provide communication channels by which investors can communicate with one another and with representatives of the issuer through the funding portals platform; however, a funding portal and its associated persons may not participate in these communications. Additionally, a funding portal must (1) permit public access to view any communications, (2) restrict posting of comments to those persons who have opened an account on the funding portal, and (3) require any person posting a comment to disclose with every posting whether they are a founder or an employee of an issuer promoting an issuer or otherwise being compensated for promoting an issuer.
• Advising the issuer. A funding portal may advise an issuer about the structure or content of the issuer’s offering, including assisting the issuer in preparing offering documentation.
• Referrals. A finding portal can compensate a third party for referring a person to the funding portal so long as (1) the party does not provide the funding portal with information on potential investors and (2) the compensation, other than to a registered B/D, is not based, directly or indirectly, on the purchase or sale of a security offered through the funding portal.
• Utilizing B/Ds. A funding portal may compensate a B/D for its services, including referring a person to the funding portal, pursuant to a written agreement and provided that the compensation is permitted under Regulation Crowdfunding and the rules of any registered national securities association of which the portal is a member. Likewise, a funding portal may provide services to a B/D for compensation pursuant to the same conditions.
• Denying access to the funding portal. A funding portal may deny access to or cancel an offering of an issuer if the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.
• Accepting investment commitments. A funding portal may accept an investment commitment on behalf of the issuer for securities offered by that issuer on the funding portal’s platform.
• Directing fund transmissions. A funding portal may direct investors where to transmit funds or remit payment in connection with the purchase of securities offered and sold. Similarly, a funding portal may direct a qualified third party, such as an escrow agent, to release funds to an issuer upon completion of the offering or, alternatively, to return funds to investors upon the cancellation of an offering. However, a funding portal may not actually handle customer funds.