Dream On—FINRA Issues Its First Litigated Enforcement Action Against a Crowdfunding Portal

Introduction

On June 5, 2019, a Financial Industry Regulatory Authority (FINRA) hearing panel handed down a groundbreaking decision against a registered crowdfunding portal member.[1] The 148-page decision tackled multiple issues of first impression involving crowdfunding portals. Ultimately, the hearing panel expelled the portal member and barred its chief executive for violating the crowdfunding rules of both FINRA and the Securities and Exchange Commission (SEC),[2] but did not rule in favor of FINRA’s Department of Enforcement on all claims. The decision is a must-read for those seeking guidance on crowdfunding regulation, particularly for those seeking to operate as crowdfunding intermediaries under SEC and FINRA funding portal rules.

Crowdfunding Background

Crowdfunding originated as a means of raising capital for charities and small-business projects, where the public (i.e., the “crowd”) could evaluate the merits of a fundraiser’s proposal and decide whether to donate to the charitable cause or contribute small amounts of money to the business idea (usually in exchange for a token of value, such as early access to or discounted products, tickets to a performance, or other perks). Until relatively recently, crowdfunding did not involve the offer of a share in any profits that the fundraiser expected to generate from business activities financed through crowdfunding. This is because any crowdfunding offering involving the offer or sale of securities would trigger the application of costly registration requirements and regulatory obligations under the federal securities laws.

In an effort to give small-business owners and start-ups access to a broader base of capital, Congress in April 2012 enacted Title III of the JOBS Act, which established a regulatory framework for crowdfunding offerings of securities (also referred to as “equity crowdfunding”).[3] By adding Section 4(a)(6) to the Securities Act of 1933 (Securities Act), the JOBS Act created an exemption from registration for internet-based securities offerings by issuers that raise no more than $1 million in aggregate over a 12-month period.[4] This exemption is available only if a crowdfunding securities offering is conducted exclusively through an intermediary. Intermediaries are required under the JOBS Act to be registered with the SEC and FINRA as either a broker-dealer or a “funding portal.”

Section 3(a)(80) of the Securities Exchange Act of 1934 (Exchange Act) defines a funding portal as “any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to [the April 2012 exemption from registration for crowdfunding securities offerings].”[5] Section 3(a)(80) further provides that funding portals are not permitted to: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy the securities displayed on their platforms; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on their platforms; or (iv) hold, manage, possess, or otherwise handle investor funds or securities.[6]

Pursuant to the JOBS Act, the SEC promulgated Regulation Crowdfunding in October 2015,[7] and FINRA adopted its Funding Portal Rules shortly thereafter in January 2016.[8] FINRA oversees the crowdfunding industry’s adherence to both sets of rules, and, currently regulates nearly 50 funding portals.[9]

SEC and FINRA crowdfunding rules authorize issuers to conduct small offerings exclusively through websites operated by an intermediary funding portal. Through the portal, potential investors can review information about the issuer and the offering and can discuss the offering with other interested investors. If an investor makes an investment commitment, that money is held in escrow. There is a mandatory waiting period before the offering can close, during which investors retain the right to rescind their investment commitment. If the issuer’s target capital raise is reached by the specified target date, the offering is closed and investor funds are released to the issuer. If, however, the target amount is not reached by the target date, then the offering is canceled and all escrowed funds are returned to investors.

Any investor can participate in a crowdfunding offering, subject to two limitations: (1) if an investor’s annual income or net worth is less than $107,000, then, during any 12-month period, they can invest up to the greater of either $2,200 or five percent of the lesser of their annual income or net worth; and (2) if an investor’s annual income and net worth are equal to or more than $107,000, then, during any 12-month period, they can invest up to ten percent of their annual income or net worth, whichever is less, but not to exceed $107,000.[10]

Pursuant to crowdfunding rules and regulations—specifically SEC Crowdfunding Rule 201—issuers are required to publicly disclose on SEC Form C the following information to potential investors: (1) name, legal status, address, and website; (2) names of directors and officers (with business history); (3) names of persons holding 20 percent or more of the outstanding voting equity; (4) business plan; (5) headcount; (6) cap on number of investments; and (7) intended use of offering proceeds.[11] This disclosure must be filed before an offering can open to investors.[12] An issuer must also disclose the type of security offered, the target amount of the offering, and the deadline for reaching the target amount. SEC Form C also requires disclosure of an issuer’s basic financial information, total assets, cash, cash equivalents, accounts receivable, short-term and long-term debt, revenues and sales, costs of goods sold, taxes paid, and net income.

Pursuant to SEC Crowdfunding Rule 400(a), intermediaries must register with the SEC and FINRA as a broker or a funding portal. FINRA Funding Portal Rule 110(a)(10) promulgates five standards used to measure an applicant’s fitness to become a funding portal. These registration standards mandate that the applicant: (1) is neither subject to statutory disqualification under the Exchange Act or subject to pending regulatory action or investigation; (2) has established business relationships with banks, broker dealers, transfer agents, escrow agents, etc.; (3) has a supervisory system in place reasonably designed to achieve compliance with applicable federal securities laws and rules, including FINRA’s Funding Portal Rules; (4) has fully disclosed and provided support for all direct and indirect sources of funding; and (5) has a recordkeeping system that enables it to comply with federal, state, and FINRA recordkeeping requirements.[13]

An intermediary generally provides educational materials on its funding portal platform (i.e., website) that explain the process for investing via a crowdfunding platform, the types of securities being offered by the issuers on the platform, and the risks associated with investing in these types of securities. SEC Crowdfunding Rule 303(a) requires an intermediary to make an issuer’s required disclosures available to the SEC and investors. This includes posting an issuer’s Form C on its funding portal website.[14] Such information must be available on the website for at least 21 days before any securities can be sold.[15]

Although intermediaries involved in a crowdfunding offering are not required to conduct due diligence related to the offering, they do serve a critical gatekeeping function.[16] Under SEC Crowdfunding Rule 301(a), an intermediary must have a “reasonable basis” for believing that an issuer on its platform is in compliance with the various applicable statutory and regulatory requirements.[17] Critically, SEC Crowdfunding Rule 301(c) mandates that an intermediary deny an issuer access to its platform if the intermediary has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.”[18] Should an intermediary become aware of such concerns after granting access to its platform, it must promptly remove and cancel the offering, and return any invested funds.[19]

An intermediary is also responsible for notifying investors when their investment commitments have been received; when material changes are made to the terms of the offering; when changes are made in the company’s ownership; and when an offering closes early. Intermediaries are also subject to the recordkeeping requirements set forth in SEC Crowdfunding Rule 404, which include keeping records of issuers’ SEC filings and notices to investors, and other communications regarding offerings on its platform. All of these records must be available for SEC and FINRA inspection and examination.

FINRA’s Case Against Manuel Fernandez and DreamFunded Marketplace, LLC

Manuel Fernandez established DreamFunded Marketplace, LLC (DFM) in early 2016 and registered DFM with FINRA as a funding portal (the Portal) several months later. As CEO of DFM, Fernandez became an associated person of a funding portal member and was assigned a FINRA Central Registration Depository (CRD) number. Notably, “Fernandez had no experience working in the securities industry, but the applicable rules did not require him to take any classes or training, or to take any licensing or qualifying examination to qualify to operate a funding portal.” [20]

 Between July 2016 and October 2017, DFM served as an intermediary for 15 crowdfunding offerings, two of which closed and released investors’ funds to the issuers. The FINRA hearing panel’s decision in the Fernandez matter focused on three of these offerings:

  • Company A, a social networking company with no assets, revenue, or operating history sought initially to offer 100,000 securities with a $10,000 target capital raise and a September 27, 2016, closing date, but ultimately closed early on June 26, 2017 with a $4,000 target.[21]
  • Company B, a company hosting a library of short videos about health and well-being, targeted issuing 10,000 securities in an aggregate of $10,000 with a closing date of June 30, 2017, and ultimately closed early on April 14, 2017 after raising and distributing $10,500.[22]
  • Company C, which produced a special type of fire hose and harness, sought a $10,000 target capital raise with a target closing date of September 30, 2017, but did not reach its target amount before DFM removed it from the Portal on April 30, 2017.[23]

In October 2016, FINRA conducted ongoing surveillance of DFM and noticed a YouTube video clip showing Fernandez purporting to make an offer to invest $1 million into Company C. Suspecting that the video may have violated SEC Crowdfunding Rule 300(b), which prohibits officers of intermediaries from holding interests in issuers on their platforms, FINRA opened a “for cause” examination of DFM and Fernandez.[24] Thereafter, FINRA issued a series of Rule 8210 requests to Fernandez seeking documents and information relating to the 15 offerings on the the Portal’s website, DFM’s financial records, bank account statements, and investor agreements.[25] FINRA also took on-the-record testimony from Fernandez. As FINRA continued its investigation, it became concerned that Fernandez and DFM might have violated a number of SEC Crowdfunding and FINRA Portal Rules.

On February 23, 2018, Enforcement filed a complaint against Fernandez and DFM alleging ten causes of action.[26] Between September and November 2018, FINRA argued its case in an eight-day, two-session hearing. During the hearing, Fernandez essentially repudiated much of the on-the-record testimony he previously provided to FINRA. The hearing panel characterized Fernandez’s hearing testimony as “evasive, vague, and inconsistent,” contrasting it with the largely credible testimony of FINRA staff and investigators. The panel therefore discredited much of his testimony, noting that it appeared that “very little of Fernandez’s hearing testimony was candid or true.”[27]  

First Cause of ActionFailing to Provide Documents and Information (FINRA Funding Portal Rules 800(a) and 200(a) and FINRA Rule 8210): FINRA Funding Portal Rule 800(a) provides that funding portal members and their associated persons are subject to FINRA Rule 8210, which, among other things, requires compliance with FINRA requests for information and testimony. Throughout the litigation, Fernandez and DFM challenged FINRA’s jurisdiction to issue Rule 8210 requests and bring a disciplinary proceeding. The hearing panel rejected these jurisdictional challenges, determining that while the JOBS Act distinguishes between broker-dealers and funding portals, “it folds funding portals into the existing disciplinary system for broker-dealers,” and therefore grants jurisdiction to FINRA to discipline funding portals as it would broker-dealers.[28] The panel also determined that “[u]nder Funding Portal Rule 100(b)(1), all officers, owners, controlling persons, and employees of a funding portal are associated persons. As the CEO of the Portal, Fernandez was an associated person of a FINRA member who received a CRD number.”[29] Therefore, Fernandez was required to comply with FINRA Rule 8210 requests and was subject to FINRA’s broker-dealer disciplinary procedures.

The panel determined that Fernandez, in his capacity as CEO of the Portal, failed to respond fully and completely to FINRA’s Rule 8210 requests. His conduct violated FINRA Rule 8210, as made applicable to funding portals by Funding Portal Rule 800(a), which requires anyone subject to FINRA’s jurisdiction to provide information orally, in writing, or electronically, and to testify with respect to any matter involved in an investigation, complaint, examination, or proceeding. The panel also found that Fernandez violated FINRA Funding Portal Rule 200(a), the funding portal equivalent of FINRA Rule 2010, which requires industry members to conduct business pursuant to high standards of commercial honor and just and equitable principles of trade.

Under FINRA’s Sanction Guidelines, a bar is standard in situations where an individual fails to respond at all to a Rule 8210 request, as well as for a partial but incomplete response, unless the respondent demonstrates substantial compliance with the request. In determining the appropriate sanctions in this matter, the hearing panel heavily considered Fernandez’s “pattern of disclaiming responsibility,” his false and misleading statements to regulators, and his attempts to delay the investigation using “dubious” medical excuses.[30] These factors outweighed two key mitigating factors: Fernandez’s lack of experience and training (which led to ignorance of his responsibilities), and the minimal investor harm at issue. After concluding that Fernandez and DFM “were proven unfit to continue in the securities industry,”[31] the hearing panel expelled DFM from FINRA membership as a funding portal and barred Fernandez from association with any FINRA funding portal member.

Takeaway: FINRA has jurisdiction over all funding portal members and associated persons. Current and prospective intermediaries need to educate themselves about their obligations under FINRA funding portal rules and must comply with any requests for information and testimony from FINRA.

Second Cause of ActionFalse or Misleading Issuer Communications (FINRA Funding Portal Rules 200(c)(3) and 200(a) and SEC Regulation Crowdfunding Rule 301(c)(2)): As noted above, SEC Regulation Crowdfunding Rule 301(c)(2) requires an intermediary to deny an issuer access to its platform if it has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection,” or, if the intermediary already granted an issuer access to its platform, to rescind access and return investor funds after it becomes aware of such information.[32]

The panel determined that Fernandez violated SEC Regulation Crowdfunding Rule 301(c)(2) and FINRA Funding Portal Rule 200(a) based on the following facts that were known to him. First, Company A’s Form C filings contained numerous deficiencies, including inconsistencies in ownership information, changes in the number of securities to be sold to investors, and different offering deadline dates. Second, Fernandez was asked by the CEO of Company A to lower the target amount for its offering, close the offering early, and transfer investor funds to his personal bank account. The panel found that these were red flags that would have led a reasonable person to have serious investor protection concerns.[33] Furthermore, instead of terminating Company A’s access to the Portal, cancelling the offering, and returning investors’ money, Fernandez facilitated the transfer of funds to Company A’s CEO. For this misconduct, the panel determined that it would generally suspend the Portal for 30 days and suspend Fernandez for six months and fine him $10,000. However, due to the Portal’s expulsion and Fernandez’s bar for other violations, the panel did not impose these lesser sanctions.[34]

In contrast, the hearing panel dismissed the portion of the Second Cause of Action pertaining to FINRA Funding Portal Rule 200(c)(3). FINRA Funding Portal Rule 200(c)(3) establishes content standards for funding portal communications with investors. These standards include not only communications created by the funding portal, but also communications created by the issuer for the funding portal to provide to investors. A funding portal is not responsible for false or misleading issuer communications that have been prepared solely by the issuer unless the portal is aware of, or has reason to be aware of, the false or misleading statements. In its complaint, Enforcement alleged that Company A’s and Company B’s projections and forecasts were false and misleading, and that Respondents violated FINRA Funding Portal Rule 200(c)(3) by knowingly posting them. The hearing panel disagreed, determining that it was unclear whether the projections and forecasts were in fact misleading, and that Respondents did not have a duty to conduct due diligence on those projections and forecasts.

Takeaway: Although intermediaries are not required to conduct due diligence into issuer projections or forecasts, as gatekeepers they must evaluate information in their possession regarding issuers and offerings and deny issuer access if investor protection concerns are implicated.

Third Cause of ActionFalse or Misleading Funding Portal Communications (FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a)): FINRA Funding Portal Rule 200(b) prohibits a funding portal from “effect[ing] any transaction in, or induc[ing] the purchase or sale of any security by means of, or by aiding or abetting, any manipulative, deceptive or other fraudulent device or contrivance.”[35] FINRA Funding Portal Rule 200(c)(2)(A) prohibits a funding portal from distributing or making available communications to investors that are false, exaggerated, unwarranted, promissory or misleading; that omit any material fact that, in light of the context of the material presented, should be disclosed in order to prevent the communication from being misleading; that state or imply that FINRA or another self-regulatory organization endorses, indemnifies, or guarantees the portal’s business practices; that predict or project performance; or that make any exaggerated or unwarranted claim, opinion, or forecast.[36] As seen above, communications prepared solely by issuers are exempt from prosecution under Rule 200(c)(2)(A) unless the member portal knows or has reason to know the communications are false or misleading.

Enforcement alleged that Respondents made false and misleading statements, and induced the purchase of a security by engaging in deceptive practices, in violation of FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a) when Fernandez: (1) posted through social media and on the Portal’s website a video clip of himself striking a purported deal to make a $1 million investment in Company C; and (2) posted information on the Portal regarding (a) the Portal’s issuer due diligence and deal flow screening, and (b) real estate tombstones that created a misleading impression that the real estate deals offered a 10 percent return and were part of the Portal’s crowdfunding business when they were not.

The panel determined that the video clip contained two untrue statements: (1) that Fernandez had invested over $100 million in start-up businesses, and (2) that the $1 million offer by Fernandez to Company C’s CEO was accepted. The panel found that by posting the false and misleading video clip on the Portal’s platform and Fernandez’s social media accounts, the Respondents had intentionally or recklessly engaged in a “deceptive device” in violation of the Funding Portal rules.[37] The panel also determined that Respondents intentionally or recklessly made false statements on the Portal regarding their allegedly vigorous issuer due diligence and screening. Notably, the panel concluded there was “no screening team and Fernandez had no system for evaluating issuers or their offerings.”[38] The panel also determined that Respondents’ posting of real estate tombstones on the Portal was misleading in violation of Rule 200(c), and that all of these actions violated Rule 200(a). The panel concluded that the appropriate sanctions for Respondents’ Rule 200(a) violations were expulsion for DFM and a bar for Fernandez. Noting that the misleading statements about real estate transactions would generally have resulted in the lesser sanction of a Letter of Caution, the panel declined to impose this sanction in light of the myriad other violations.

Takeaway: Funding portal member communications regarding issuers and offerings have the potential to mislead investors and must be carefully vetted by intermediaries prior to publication on funding portal websites.

Fourth Cause of ActionNo Reasonable Basis for Believing Issuer Compliance (SEC Regulation Crowdfunding Section 301(a) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(a) provides that an intermediary must have a reasonable basis for believing that a crowdfunding issuer is in compliance with the applicable requirements.[39] An intermediary can rely on an issuer’s representations concerning compliance unless the intermediary has reason to question the veracity of those representations.[40] Enforcement alleged that Respondents violated Rule 301(a) because they had no reasonable basis for believing that either Company A or Company B had complied with their required disclosure obligations. The complaint alleged that (1) Company A falsely claimed in its SEC disclosure that it had provided investors with true and complete financial statements when, in reality, it did not submit financial statements, and (2) Company B both failed to provide a basis for its valuation of its video library—its main asset—and provided to DFM an SEC filing with inconsistencies regarding asset valuation and projections for revenue.

The panel dismissed the Fourth Cause of Action in its entirety and noted that when Company A filed its Form C, it had no operating history and no financial statements to disclose. According to the panel, the absence of a financial statement did not mean that the Respondents failed to comply with SEC Crowdfunding Rule 301(a) or any other rule. The panel also dismissed the claims relating to Company B because funding portals do not have a duty to analyze and evaluate issuers’ projections and forecasts.[41]

Takeaway: Although funding portals are not required to analyze issuers’ projections and forecasts, they must have a reasonable basis for believing that an issuer seeking to offer and sell securities through their platform complies with the requirements in Section 4A(b) of the Securities Act and the related requirements in Regulation Crowdfunding.

Fifth Cause of ActionFailure to Perform Meaningful Background Checks (SEC Regulation Crowdfunding Rule 301(c)(1) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(c)(1) requires an intermediary to conduct a background check and review securities enforcement regulatory history for: (1) each issuer whose securities are to be offered through the intermediary; (2) each officer or director (or persons occupying a similar status or performing a similar function); and (3) any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities.[42] Enforcement alleged that Respondents violated SEC Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a) by failing to perform any meaningful background checks or securities enforcement regulatory history searches on the issuers making offerings on the Portal.

The hearing panel determined that the evidence established that Fernandez failed to conduct the required background checks and failed to review securities enforcement regulatory histories for the Portal’s issuers and parties associated therewith in violation of Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a). For this misconduct, the panel would have suspended the Respondents for 30 days, but in light of the expulsion and bars for the other violations, did not impose these lesser sanctions.[43]

Takeaway: Funding portals must be diligent in conducting background and securities enforcement regulatory history checks on issuers. That diligence must be carefully reviewed by the intermediary before granting issuers funding portal access.

Sixth, Seventh, Eighth and Ninth Causes of ActionFailure to Provide Investors with Notice of Material Changes, Change of Offering Deadlines, Required Information and Completion of Transactions (SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d), 303(f) and FINRA Funding Portal Rule 200(a)): SEC Crowdfunding Rule 304(c)(1) provides that if there is a material change to the terms of an offering or the information provided by the issuer, then the intermediary must give notice of the material change to any investor who has made an investment commitment. The notice must inform the investor that the investment commitment will be canceled unless the investor reconfirms the commitment within five business days of receiving the notice. If an investor fails to do so, then within five business days after that the intermediary must provide notice that the commitment was canceled, the reason for the cancellation, and the amount of money the investor should expect to receive as a refund.[44]

Enforcement alleged in its Sixth Cause of Action that Respondents failed to provide any notices of material change to investors when Company A filed three Form C amendments that included material changes. The panel agreed that the Respondents violated Crowdfunding Rule 304(c)(1) when Company A’s Form C amendment was “marked as containing a material change in the terms of the offering” but Respondents did not notify any investors of such changes.[45] The panel also found that this conduct violated FINRA Funding Portal Rule 200(a).

Next, SEC Crowdfunding Rule 304(b)(2) provides that if an issuer reaches its target offering amount prior to the deadline specified in its offering materials, it may close the offering on an earlier date, as long as the offering is open for a minimum of 21 days. An intermediary is required to provide notice to any potential investors, and any investors who have made investment commitments, informing them of the new offering deadline and their right to cancel their investment commitments for any reason up to 48 hours prior to the new deadline. The new offering deadline must be at least five business days after the notice to investors is provided. The offering cannot close if, at the time of the new offering deadline, the issuer does not meet or exceed the target offering amount.[46]

In the Seventh Cause of Action, Enforcement alleged that Respondents failed to provide notice to investors of early closings for Company A and Company B and of the investors’ rights to cancel their investment commitments. The panel agreed, and determined that the Respondents violated SEC Regulation Crowdfunding Rule 304(b)(2) and FINRA Funding Portal Rule 200(a) by failing to give notice to investors when the offerings of Company A and Company B closed early. According to the panel, “Respondents deprived investors in both offerings of their right to cancel their investment commitments up until 48 hours of the closing.”[47]

SEC Regulation Crowdfunding Rule 303(d) provides that upon receiving an investment commitment, an intermediary must promptly give notice to an investor of the following: (i) the dollar amount of the commitment; (ii) the price of the securities, if known; (iii) the name of the issuer; and (iv) the date and time by which the investor may cancel the investment commitment.[48]

In the Eighth Cause of Action, Enforcement alleged that Respondents, in connection with offerings made by Company A and Company B, failed to provide required information to investors in the notices of investment, including the price of securities and the date and time by which investors could cancel their commitments. The panel determined that Respondents violated SEC Regulation Crowdfunding Rule 303(d) by sending notices to investors in the offerings of Company A and Company B that did not provide any information of the investors’ right to cancel their investment commitments up until a specific date and time, and in doing so, also violated FINRA Funding Portal Rule 200(a).[49]

SEC Regulation Crowdfunding Rule 303(f) requires an intermediary to provide a notification to each investor that contains certain information. The rule requires the following: (i) the date of the transaction; (ii) the type of security that the investor is purchasing; (iii) the identity, price, and number of securities purchased by the investor, along with the total number of securities sold by the issuer in the transaction and the price at which the securities were sold.

In the Ninth Cause of Action, Enforcement alleged that Respondents did not provide investor confirmations when the Company A and Company B offerings closed. The panel reviewed the record and determined that the Respondents violated SEC Crowdfunding Rule 303(f), and thereby FINRA Funding Portal Rule 200(a), by failing to provide investors with confirmation of the Company A and Company B offering closings.[50]

In its sanctions analysis for the sixth, seventh, eighth, and ninth causes of action, the panel aggregated the misconduct because, taken together, the violations of SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d) and 303(f) represented a “systemic failure to give investors the information to which they were entitled.”[51] For these violations, the panel would have imposed a 30-day suspension on both Fernandez and DFM, but in light of the expulsions and bars, it did not impose these sanctions.

Takeaway: Funding portals have a number of obligations to provide adequate notices to investors, including those regarding material changes to the terms of an offering, early closings, prices of securities, and the date and time by which investors can cancel their commitments. Funding portals must also maintain appropriate systems and procedures to track the occurrence of notice-related events and ensure that investors are provided with timely and proper notices.

Tenth Cause of ActionSupervision (FINRA Funding Portal Rules 300(a) and 200(a) and SEC Regulation Crowdfunding Rule 403(a)): SEC Regulation Crowdfunding Rule 403(a) requires a funding portal to implement written policies and procedures reasonably designed to achieve compliance with applicable laws, regulations, and rules. FINRA Funding Portal Rule 300(a) requires a funding portal member to establish and maintain a system for supervising associated persons that is “reasonably designed” to achieve compliance with securities laws and Funding Portal Rules.[52]

In the Tenth Cause of Action, Enforcement alleged that DFM’s written policies and procedures were not reasonably designed to achieve compliance with applicable rules, regulations and laws because they lacked substance, were not provided to the Portal’s employees, and were rarely referenced or used. The panel determined that Respondents violated SEC Crowdfunding Rule 403(a) and FINRA Funding Portal Rules 300(a) and 200(a) by failing to establish any concrete or practical system for supervising the Portal’s conduct of its business to ensure compliance with legal and regulatory requirements. For this failure, the panel noted that it would have suspended Respondents for 30 days and required them to submit a remediation plan to FINRA for approval and implementation. However, because of the expulsions and bars, the panel did not impose these sanctions.[53]

Takeaway: Funding portal members must maintain adequate written policies and procedures that are reasonably designed to achieve compliance with securities laws and FINRA Funding Portal Rules.

Upon reviewing all of the facts and circumstances in this matter, the panel suggested it had no other choice but to impose stringent sanctions: “Respondents committed numerous violations in a systemic, wholesale compliance breakdown. Fernandez failed to tell FINRA staff the truth prior to the hearing, and he failed to tell the Extended Hearing Panel the truth at the hearing. Fernandez also attempted to shift responsibility for all missteps to others. We have no confidence that in the future, if permitted to continue in the securities industry, Respondents would comply with regulatory requirements or fully and truthfully respond to regulatory inquiries.”[54]

In reaching its decision, the panel noted that it “might hesitate to impose stringent sanctions in other circumstances—as, for example, where a person operating a funding portal makes mistakes from a lack of understanding of the rules, but expresses a sincere desire to correct those mistakes, and develops and implements policies and procedures to avoid mistakes in the future.”[55] The panel also recognized that “[t]o some degree, Respondents’ violations may be partly attributable to the lack of a mechanism for educating and qualifying a person to run a funding portal. Fernandez may not have fully comprehended the applicable rules or the nature and degree of regulatory oversight exercised by the SEC and FINRA.”[56]

Conclusion

In the three years since the SEC’s Crowdfunding and FINRA’s Funding Portal Rules took effect, the use of equity crowdfunding to facilitate capital formation has been relatively modest. Recently, the SEC, in an effort to review and improve its general regulatory framework for securities offerings that are exempt from registration requirements, issued Concept Release on Harmonization of Securities Offering Exemptions.[57] The SEC published the release to solicit comments on possible ways to simplify and improve the exempt offering framework to promote capital formation and expand investment opportunities.

As part of the release, the SEC reported that from the inception of crowdfunding through the end of 2018, a total of 519 crowdfunding offerings have been completed, raising $108.2 million, or an average capital raise of $208,400 per offering.[58] The SEC’s data also indicate that the majority of crowdfunding issuers raised less than the maximum amounts targeted in the original offering documents, with only 29 issuers raising the full $1.07 million allowed by law over 12 months.[59]

The decision against DFM and Fernandez represents the first litigated FINRA enforcement action against a funding portal and serves as important guidance for current and future crowdfunding participants. Despite its seemingly slow start, equity crowdfunding is a powerful tool for small companies and entrepreneurs seeking access to start-up capital. As reflected by the lengthy hearing panel decision in the DFM/Fernandez case, however, SEC and FINRA crowdfunding rules are complex and can easily lead to compliance quandaries for issuers and intermediaries.


[1] Extended Hearing Panel Decision, Dep’t of Enforcement v. DreamFunded Marketplace LLC and Manuel Fernandez, Disciplinary Proceeding No. 2017053428201 Financial Industry Regulatory Auth., Office of Hearing Officers (June 5, 2019), available at https://bit.ly/2XwyeRr (“Extended Hearing Panel Decision”).  This matter has been appealed.  See Adjudication and Decisions, FINRA, https://www.finra.org/rules-guidance/oversight-enforcement/decisions (last visited August 29, 2019).

[2] Hearing Officer McConathy and the Extended Hearing Panel decided it was “necessary to write at length” on this matter because of issues of first impression and the numerous causes of action. Extended Hearing Panel Decision, at 7.

[3] 157 Cong. Rec. S8458 (daily ed. Dec. 8, 2011) (statement of Sen. Jeff Merkley) (“Low-dollar investments from ordinary Americans may help fill the void, providing a new avenue of funding to the small businesses that are the engine of job creation. The Crowdfund Act [Title III of the JOBS Act] would provide startup companies and other small businesses with a new way to raise capital from ordinary investors in a more transparent and regulated marketplace.”), available at https://www.congress.gov/112/crec/2011/12/08/CREC-2011-12-08.pdf; 157 Cong. Rec. H7295-01 (daily ed. Nov. 3, 2011) (statement of Rep. Patrick McHenry) (“[H]ighnet worth individuals can invest in businesses before the average family can. And that small business is limited on the amount of equity stakes they can provide investors and limited in the number of investors they can get. So, clearly, something has to be done to open these capital markets to the average investor[.]”), available at https://www.congress.gov/112/crec/2011/11/03/CREC-2011-11-03.pdf.

[4] Jumpstart Our Business Startups Act [JOBS Act], H.R. 3606, 112th Cong. (2012), Section 302(a) and (b), available at https://www.govinfo.gov/content/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Securities Act Section 4(a)(6) exempts offerings of up to $1 million in a 12-month period, subject to adjustment for inflation required by Section 4A(h) at least once every five years. Accordingly, issuers are currently permitted to raise a maximum aggregate amount of $1.07 million in a 12-month period. 17 C.F.R. § 227.100(a)(1) (2017).

[5] Extended Hearing Panel Decision, supra note 1, at 91; see also Section 3(a)(80) of Exchange Act of 1934, 17 C.F.R. § 227.300(c)(2) Intermediaries (2017), available at https://www.govinfo.gov/content/pkg/CFR-2017-title17-vol3/pdf/CFR-2017-title17-vol3-sec227-300.pdf.

[6] 17 C.F.R. § 227.300(c)(2)(i)-(iv) (2017).

[7] SEC Crowdfunding Rules, 17 C.F.R. § 227.100, et seq. (2015), available at https://www.govinfo.gov/content/pkg/FR-2015-11-16/pdf/2015-28220.pdf.

[8] Self-Regulatory Organizations; Financial Indus. Regulatory Auth., Inc.; Notice of Amendment No. 1 and Order Granting Accelerated Approval to a Proposed Rule Change, as Modified by Amendment No. 1, to Adopt the Funding Portal Rules and Related Forms and Rule 4518, SEC Release No. 34-76970, File No. SR-FINRA-2015, available at https://www.sec.gov/rules/sro/finra/2016/34-76970.pdf; Jumpstart Our Business Startups (JOBS) Act (SEC

Approval of FINRA Funding Portal Rules and Related Forms, FINRA Regulatory Notice 16-06, Effective Jan. 29, 2016), available at https://www.finra.org/sites/default/files/Regulatory-Notice-16-06.pdf.

[9] FINRA, Funding Portals We Regulate (last updated June 17, 2019), available at https://www.finra.org/about/funding-portals-we-regulate.

[10] SEC Crowdfunding Rules, supra note 7, at 100.

[11] Id. at 201.

[12] Id. at 203(a)(1).

[13] FINRA Funding Portal Rule Application, 110(a)(10) Standards for Granting or Denying Application (effective Jan. 29, 2016), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=12222.

[14] SEC Crowdfunding Rules supra note 7, at 303(a).

[15] Id. at 303(a)(2).

[16] See, e.g., Section 4A(a)(5) of the Securities Act, implemented through the JOBS Act, stating: “[An intermediary shall] take such measures to reduce the risk of fraud with respect to such transactions, as established by the [SEC] by rule,” available at https://legcounsel.house.gov/Comps/Securities%20Act%20Of%201933.pdf.

[17] SEC Crowdfunding Rules supra note 7, at 301(a).

[18] Id. at 301(c)(2).

[19] Id.

[20] Extended Hearing Panel Decision, supra note 1, at 5.

[21] Id. at 33-34, 42.

[22] Id. at 48, 50.

[23] Id. at 51.

[24] Id. at 6.

[25] Id. at 69.

[26] Id. at 73.

[27] Id. at 77.

[28] Id. at 19.

[29] Id. at 29.

[30] Id. at 140, 141.

[31] Id. at 139.

[32] Id. at 95.

[33] Id. at 109-11.

[34] Id. at 144.

[35] Id. at 114.

[36] Id.

[37] Id. at 116-17.

[38] Id. at 118.

[39] Id. at 120.

[40] SEC Crowdfunding Rules supra note 7, at 301(a).

[41] Extended Hearing Panel Decision, supra note 1, at 123.

[42] Id. at 124.

[43] Id. at 145.

[44] Id. at 128-29.

[45] Id. at 129.

[46] Id. at 129-30.

[47] Id. at 130.

[48] Id.

[49] Id.

[50] Id. at 131.

[51] Id. at 15.

[52] Id. at 132.

[53] Id. at 146.

[54] Id. at 8.

[55] Id.

[56] Id. at. 5.

[57] SEC Concept Release on Harmonization of Securities Offering, Release No. 33-10649 (June 18, 2019, available at https://www.sec.gov/rules/concept/2019/33-10649.pdf.).

[58] Id. at 147-48.

[59] SEC Report to the Commission Regulation Crowdfunding, at 4 (June 18, 2019), available at https://www.sec.gov/files/regulation-crowdfunding-2019_0.pdf.

ABOUT THE AUTHORS

Joseph L. Zales

Joseph L. Zales represents global financial institutions, public companies, and senior executives in high-risk government and internal investigations and complex litigation. …

Kathryn R. Barry

Katie Barry is an associate in the Special Matters and Government Investigations Practice Group in the New York office of King & Spalding.  Her practice focuses primarily…

Richard B. Margolies

Richard Margolies, a partner in King & Spalding’s Government Matters practice, has extensive experience in complex government and regulatory investigations, enforcement…

Mirella A. DeRose

As a partner in King and Spalding’s Securities Enforcement and Regulation practice, Mirella deRose leverages her extensive experience as a former prosecutor and regulator…

J.C. Boggs

A partner in King and Spalding’s Government Advocacy and Public Policy group, J.C. leads the firm’s FinTech and State Attorneys General practices.  He is recognized for…

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