FINLAW: Steps to Navigate FINRA for a Title III Crowdfunding Platform Approval
See recent blog post appearing at https://www.katipult.com/education-center/news/tips-to-registering-your-securities-crowdfunding-portal
Crowdfunding Portals continue to disrupt traditional ways of raising capital by leveraging the historic reforms under the JumpStart Our Business Startups (JOBS) Act, financial technology and growing demand by self-directed and nonaccredited investors who seek to invest in potentially innovative ventures.
With 38 funding portals registered with the Securities and Exchange Commission (SEC) and members of the Financial Industry Regulatory Authority (FINRA) raising over $100 million of capital since adoption, crowdfunding is providing private companies much needed access to capital and investors new investment opportunities. Crowdfunding Portal registration has expanded beyond just US based portal operators with two non-resident portals registering with the SEC from Hong Kong and Canada.
Prospective crowdfunding portals (non-broker dealer) are required to register with the SEC by filing an application on Form Funding Portal (FP) through the SEC’s EDGAR system and become members of FINRA by submitting a New Membership Application (NMA). The FINRA NMA process is a combination of submitting a series of corporate, compliance and other documents regarding your proposed crowdfunding portal for regulatory review and an interview with various FINRA departments. Here are some best practices and tips to consider when preparing to register your portal.
Written Compliance Procedures & Supervisory System
Crowdfunding Portals are regarded as “gate-keepers” and the first line of defense against fraudulent or non-compliant offerings reaching the public. Each crowdfunding portal must develop and implement supervisory procedures and internal processes that are reasonably designed to achieve compliance with Regulation Crowdfunding and applicable FINRA rules. FINRA will conduct a detailed review of your Compliance Manual and Written Supervisory Procedures (WSPs) for regulatory compliance. For those new to the securities industry, WSPs are the rules governing the day-to-day operations and provide an internal process for meeting your various compliance obligations, identifying persons responsible for execution and the timing for each process (i.e. daily, quarterly, annually or as required).
FINRA rules require your supervisory system to provide, at a minimum:
- procedures to supervise the activities of your firm and member,
- the designation of a person with authority to carry out the supervisory responsibilities of the funding portal member, and
- the frequency when these supervisory and compliance steps will occur.
WSPs must go beyond just Regulation Crowdfunding but also consider other regulatory obligations such as Regulations S-P (Privacy of Consumer Financial Information and Safeguarding Personal Information), S-ID (Identity Theft Red Flags) and S-AM (Limitations on Affiliate Marketing) just to identify a few. A compliant and effective compliance program is one that has developed WSPs tailored to the portal’s specific business and includes periodic internal audits to both ensure timely execution of the procedures as well as to evaluate effectiveness. Any deficiencies or suggestions for potential improvement should immediately be addressed.
Crowdfunding portals are required to maintain their books and records in an original, non-alterable format in which they were created or as required by Section 17a-4 of the Securities Exchange Act of 1934, as amended. This is often referred to as “WORM” format or ‘write once, ready many.’
Record retention should be comprehensive and include communications such as emails and portal posts, as well as other documents reflecting investments occurring on the portal. Popular service providers in the securities industry who provide WORM format services include Egnyte, Smarsh and Global Relay.
Applicants are not required to have engaged such service providers at the time the NMA is submitted but are required to include draft service agreements as attachments to FINRA Staff for their review. FINRA will also review the investment process for compliance. There are a number of white label providers like Katipult that have experience and expertise in ensuring the platform works in the manner required by the rules.
Portal Design & Marketing Material
FINRA will conduct a comprehensive review of your technology platform ranging from its content to its functionality. During the interview process, you will be asked to do a live demo of the platform. Before submitting your NMA, it is important to thoroughly review all content on your portal to ensure compliance with FINRA Advertising rules and guidance.
Crowdfunding portal communications may NOT:
- include any false, exaggerated, unwarranted, promissory or misleading statement or claim,
- omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communication to be misleading,
- state or imply that FINRA, or any other corporate name or facility owned by FINRA, or any other regulatory organization endorses, indemnifies, or guarantees the funding portal member’s business practices; or
- predict or project performance, imply that past performance will reoccur or make any exaggerated or unwarranted claim, opinion or forecast.
All communication must be “fair and balanced” and not promissory in nature. For example, any discussion of the benefits of investing in crowdfund offerings or startups more generally (i.e. like representing that an offering will perform like Facebook or Uber) will be problematic. You must always include a clear statement of the potential risks of investing, including high failure rate and the possibility an investor may lose his or her entire investment. This type of disclosure goes to the heart of your responsibilities and a funding portal – to educate your users and not to provide investment advice or make recommendations.
If you have posted or intend to post third-party articles about crowdfunding or industry specific developments, you will be deemed to have adopted such material, so it is important that you consider the information provided in its totality to be fair and balanced.
All crowdfunding portals must provide a forum that allows registered users to raise concerns about an offering, ask management questions about the company as well as communicate with other registered users.
There are a few key elements you must make sure not to miss such as:
- only registered users can post questions, comments and interact with other registered users,
- issuer can respond to questions or comments posted but you must ensure that the portal identifies that the response is from the company or a company insider, and
- comply with record keeping obligations with respect to such communications.
Each crowdfunding portal must provide its users with educational materials reasonably tailored to the types of offerings that will be conducted on the portal. Although Regulation Crowdfunding provides a detailed list of items that you are recommended to cover in your educational materials, it is important to ensure that the educational materials are tailor made to the type of transactions that you will be posting on your portal (i.e. debt or equity securities, risks of real estate investing, SAFEs, SAFTs, etc.).
However, education is only one element of the user onboarding process. The portal onboarding process should be designed so that each investor:
- reviews investor education materials;
- positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss;
- understands the investment process and their rights under Regulation Crowdfunding; and
- must answer questions designed to demonstrate that the investor understands the level of risk applicable to investments in offerings posted on the portal, the offering process and their rights as a crowdfund investor.
Understand Your Limitations
Unlike registered broker-dealers, crowdfunding portals are prohibited from providing investment advice or any investment recommendation. A common mistake by crowdfunding portals is failing to appreciate what can be deemed a recommendation or investment advice.
You must pay careful attention to disclosure on the portal, how offerings are presented as well as other communications with the public. The portal design and your WSPs should address these issues and how you intend to monitor compliance with these restrictions.
Crowdfunding Portals continue to disrupt traditional ways of raising capital. Meeting the requirements of both Regulation Crowdfunding and applicable FINRA rules is necessary to be compliant and meet your obligation to protect investors. While becoming a crowdfunding portal in some ways is complicated, it offers an excellent avenue for small issuers to raise capital from nonaccredited investors in the United States.
About the Authors
Scott Andersen is principal at finLawyer.com. He has also been Deputy Regional Chief Counsel at FINRA, Enforcement Director at FINRA and the NYSE, Co-Chief of the Securities Prosecutions Unit of the NY Attorney General’s office, and Asst. Attorney General for the State of NY. In these roles, he has investigated, prosecuted and supervised criminal, civil and regulatory enforcement actions for over nineteen years. He concentrates his practice on SEC, FINRA and state regulatory defense and securities regulatory counseling, as well as working with crowdfunding portals, funding platforms, broker-dealers and fintech providers on regulatory compliance matters.
George S. Georgiades, of counsel to Ellenoff Grossman & Schole LLP, focuses his practice on capital formation transactions and providing regulatory compliance advice to broker-dealers, investment advisors, exchanges and crowdfunding portals. He has extensive experience in structuring, negotiating and consummating initial and other public and private securities offerings with a particular focus on technology driven finance, including Crowdfunding, Regulation A+ and Initial Coin Offerings. He has been meaningfully involved in crowdfunding since its inception working cooperatively with regulators, industry associations, funding portals and other interested parties to fashion the crowdfunding regulations and develop fundraising strategies. He routinely speaks at national conference on topics ranging from crowdfunding, broker-dealer compliance, blockchain technology, cryptocurrencies to securities reforms. He can be reached at firstname.lastname@example.org
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