FINRA Issues Crowdfunding Portal Proposals l Securities Lawyer 101

Securities Lawyer 101 Blog

On October 25, 2013, FINRA announced the release a set of proposed crowdfunding portal rules and forms for equity crowdfunding. Crowdfunding portals that engage in crowdfunding on behalf of issuers relying on the JOBS Act’s crowdfunding exemption must register with the SEC and become a member of a national securities association.

FINRA’s proposals consist of rules and related forms for crowdfunding portals. The proposals would implement in FINRA’s rules the provisions of the JOBS Act.  FINRA has streamlined the proposed rules to reflect the limited activity permitted by funding portals while maintaining investor protection.

FINRA’s proposal considers comments received in response to its initial comment request on the regulation of crowdfunding activities and submissions from its interim form for funding portals.  Comments on FINRA’s release are due by February 3, 2014.  FINRA’s proposals are summarized below.

General Standards l Funding Portal Rule 100

FINRA’s proposed Funding Portal Rule 100 provides that all funding portal members (both funding portals and their associated persons) shall be subject to the FINRA By-Laws,unless the context requires otherwise, and the Funding Portal Rules.  FINRA Funding Portal Rule 100 sets forth the basic definitions to apply to funding portal members.

Funding Portal Application l Funding Portal Rule 110, Form FP-NMA, Form FP-CMA and FP-SD Schedule

FINRA;s proposed Funding Portal Rule 110(a) sets out the membership application process (MAP) for crowdfunding funding portals.  During the membership application process FINRA will assess whether funding portals are capable of complying with applicable regulations.

Proposed Funding Portal Rule 110(a) tailors NASD Rule 1010 Series by:

● shortening the time frames for key events.  For instance, the time frame for the Department of Member Regulation (Department) to provide a decision on a funding portal MAP application is 60 days after the application is filed as opposed to 180 days in the broker-dealer MAP rules;

● streamlining and consolidating, from 14 to five, the NASD Rule 1010 Series standards for granting or denying an application.  These five consolidated standards address a funding portal’s: (1) ability to comply with applicable federal securities laws, rules and regulations and FINRA’s Funding Portal Rules; (2) contractual or other arrangements and business relationships necessary to initiate operations; (3) supervisory system; (4) direct and indirect funding sources; and (5) recordkeeping system;

● providing that the membership interview may be conducted by video conference (or such other means as FINRA may specify);

● streamlining the process for appealing the Department’s decision by reducing applicable filing and response time frames from 25 days for broker-dealers to 14 days and eliminating provisions providing for an appellate hearing; and

● narrowing the changes in ownership or control for which a funding portal member would be required to apply for approval.

Funding portals will apply for membership using proposed Form FP-NMA in ownership and control using Form FP-CMA.  Funding Portals will submit statutory disqualification information using the FP-SD Schedule.  The Form FP-NMA and Form FP-CMA require significantly less information for funding portals than the broker-dealer counterpart forms, consistent with the limited scope of business to be conducted by funding portals.

Proposed Funding Portal Rule 110(b) sets forth a streamlined version of FINRA Rule 4360 (Fidelity Bonds) and requires funding portal members to maintain fidelity bond coverage with minimum required coverage, deductible provision and notification of cancellation, termination or substantial modification of coverage.

Funding Portal Conduct (Funding Portal Rule 200)

Based partially on FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), proposed Funding Portal Rule 200(a) requires funding portal members to observe high standards of commercial honor and just and equitable principles of trade.

Proposed Funding Portal Rule 200(b), is based in large part on FINRA Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices), and prohibits a funding portal member from effecting any transaction in, or inducing the purchase or sale of, any security by means of, or by aiding or abetting, any manipulative, deceptive or other fraudulent device or contrivance.

Proposed Funding Portal Rule 200(c) is an abbreviated version of FINRA Rule 2210 (Communications with the Public), essentially prohibiting false and misleading statements.

Funding Portal Compliance (Funding Portal Rule 300)

A funding portal member is required under proposed Funding Portal Rule 300(a) to establish and maintain a system to supervise the activities of each associated person of the funding portal member that is reasonably designed to achieve compliance with applicable securities laws and regulations and with the Funding Portal Rules.  The rule is a streamlined version of current NASD Rule 3010 (Supervision) and is designed to permit funding portal members flexibility to tailor their supervisory systems to their business models.

Proposed Funding Portal Rule 300(b) requires each funding portal member to implement a written anti-money laundering (AML) program.  This is consistent with the SEC’s proposed requirements and Chapter X of Title 31 of the Code of Federal Regulations.

Accordingly, the proposed rule is similar to current FINRA Rule 3310 (Anti-Money Laundering Compliance Program); however, the proposed rule contemplates that all funding portals will be eligible to conduct the required independent testing for compliance every two years.

Proposed Funding Portal Rule 300(c) requires funding portal members to report to FINRA (and the obligations of such members’ associated persons to report to the member) regulatory proceedings, disciplinary and other events.  The rule is largely based on current FINRA Rule 4530 (Reporting Requirements).  Funding portal members would use the Funding Portal Rule 300(c) Form for their reporting requirements pursuant to the rule.

Based in large part on current NASD Rule 1160 (Contact Information Requirements), proposed Funding Portal Rule 300(d) requires funding portal members to report to FINRA all contact information required by FINRA through such means as FINRA may specify and to promptly update their required contact information.

Investigations and Sanctions (Funding Portal Rule 800)

Under proposed Funding Portal Rule 800(a), funding portal members will be subject to the FINRA Rule 8000 Series (Investigations and Sanctions), unless the context requires otherwise.  Paragraph (b) of the proposed rule includes a streamlined version of FINRA Rule 8312 (FINRA BrokerCheck Disclosure).  The rule provides that FINRA shall make available to the public information filed by a funding portal member that is currently or was previously registered with FINRA, and that, except as otherwise provided by the rule, FINRA shall make available any information reported on the funding portal’s most recently filed SEC registration forms.  Further, under the rule, FINRA shall make available information filed by a funding portal member indicating whether the funding portal member or any associated person of the funding portal member is subject to a statutory disqualification.

Code of Procedure (Funding Portal Rule 900)

Under proposed Funding Portal Rule 900(a), funding portal members will be subject to the FINRA Rule 9000 Series (Code of Procedure), unless the context requires otherwise. Paragraph (b) of the proposed rule includes a streamlined version of the current FINRA Rule 9520 Series (Eligibility Proceedings) and sets forth the procedures for a person to become or remain associated with a funding portal member notwithstanding the existence of a statutory disqualification, and for a funding portal member or person associated with a funding portal member to obtain relief from the eligibility or qualification requirements of the FINRA By-Laws or Funding Portal Rule 900(a).

Arbitration and Mediation (Funding Portal Rule 1200)

Under proposed Funding Portal Rule 1200(a), funding portal members will be subject to the FINRA Rule 12000 Series (Code of Arbitration Procedure for Customer Disputes), FINRA Rule 13000 Series (Code of Arbitration Procedure for Industry Disputes) and FINRA Rule 14000 Series (Code of Mediation Procedure), unless the context requires otherwise.  Paragraph (b) of the proposed rule addresses the use by funding portal members of predispute arbitration agreements for investor accounts.  The rule is a streamlined version of current FINRA Rule 2268 (Requirements When Using Predispute Arbitration Agreements for Customer Agreements).

Request for Comment

FINRA requests comment on all aspects of the proposed rules and related forms, including

● Do the proposed rules appropriately accommodate the scope of funding portal business as provided by the JOBS Act?  If not, what other accommodations are appropriate and why?

● Do the proposed rules provide sufficient protections to investors who might use funding portals?  If not, what additional protections are warranted and why?

● Is there any segment of the funding portal industry for which the rules will be more burdensome?  Are these additional burdens justified by the business engaged in by these funding portals?

● The proposed rules do not impose licensing requirements on associated persons of funding portal members, as they do not appear necessary in light of the limited activities of funding portals.  Should there be licensing requirements for associated persons of funding portals?  Why or why not?

● Funding Portal Rule 110(b)?  Are there financial responsibility or net capital requirements that FINRA should adopt in addition to or in lieu of a fidelity bond requirement?  Why or why not?

● As discussed earlier, proposed Funding Portal Rule 300(a) requires funding portal members to establish and maintain supervisory systems. Are there specific supervisory requirements that FINRA should adopt?  Why or why not?  What potential costs do prospective funding portal members expect in developing and implementing supervisory systems?  Similarly, what costs do prospective funding portal members expect would be imposed by compliance with the proposed requirements to develop and implement a written anti-money laundering program as specified under proposed Funding Portal Rule 300(b); and promptly report to FINRA the regulatory proceedings, disciplinary and other events as set forth under proposed Funding Portal Rule 300(c)?

Time will tell whether small companies seeking to raise capital will embrace equity crowdfunding in light of Rule 506(c)’s recent elimination of the prohibition against general solicitation and advertising.

Rule 506 of Regulation D provides an exemption from registration that permits companies to raise an unlimited amount of money from “accredited investors.”  As of September 23, 2013, issuers were able to engage in general solicitation and advertising so long a ssells are made only to accredited investors.  Accredited investors generally are investors with either (i) a $1M net worth excluding primary residence (but taking into account debt on such residence in excess of the fair market value), or (ii) $200,000 of income for the last two years with the expectation of the same in the current year, or $300,000 with spouse.)

One benefit of offerings made in reliance upon Rule 506 is that if a company sells securities under Rule 506 they are considered “federal covered securities,” meaning state securities regulators cannot impose additional requirements.  States are limited to requiring a filing fee and form D.

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit  www.securitieslawyer101.com.  This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship.  Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
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