Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

Colin O'Keefe at LXBN TV recently asked me a few questions about crowdfunding, the hype around it and what it might really look like.  At first glance, I look kind of pissed off - do I always scowl like that? - and more interested in something happening on the table.  But - despite appearances - I honestly enjoyed myself and appreciated the opportunity to discuss this exciting development. 

Looking at the interview again, I'm reminded of something my Dad likes to tell me:  "Jim, you have a face for radio." 

Again, the interview is here, and you can find my crowdfunding coverage here.  As the SEC starts to propose rules on crowdfunding, check back here for more detailed coverage on the latest developments.

Like many others, my interest in the JOBS Act really started with crowdfunding.  This is probably because securities law is an imposing tangle of archaic acts, byzantine regulations and repetitive rules.  (Securities lawyers commonly say things like “…Rule 506 under Regulation D, promulgated pursuant to Section 4(2) of the ’33 Act…” and expect you to understand/stay awake).  Crowdfunding, however, is the hip, internet-based, exciting new thing!  It’s like that Kickstarter thing your cousin, the “performance artist”, keeps posting about on Facebook!  Everyone is talking about crowdfunding, so it MUST be awesome, right?  Well, not so fast: a lot of media coverage and law blogs doesn't mean a law will live up to the hype (I admit my own guilt).   So, what impact will Crowdfunding really have once the SEC passes all its rules? 

I’m leaning towards not much.  First, they have 270 days to enact the rules, but as this guy explains quite well, you really shouldn’t bother writing that down in your calendar: the SEC will be late. More to the point, some think this will be the panacea to our economies ailments, while others expect it to pretty much license fraud.  Obama called this a “game changer” and I agree, but - to make a football analogy - this is more like a “two-point conversion” game changer than a “forward pass” game changer.  Most start ups will eschew crowdfunding for more traditional fund raising methods.

First, we need to ask: what kind of issuer will use crowdfunding?  Not the guys who are looking to ramp up an already humming business, they already have venture capitalist to turn to.  And remember that the JOBS Act also amended Reg A (allows a company to sell up to $50 Million in securities with minimal disclosures and no restrictions on advertising) and Sec. 12(g) of the ’34 Act (now companies can have up to 2000 investors without being forced to go public, and employees don’t count towards the limit).  One the SEC makes rules on these changes, a company can offer up to $50 Million in stock, advertising however it likes, using a Regulation A circular, provided that it keeps non-accredited investors under 500 and total number of investors under 2000.  $50 Million divided by 2000 investors is a mere $25,000 per investor – not an extravagant amount by any means, and this might deepen the venture capital markets.  For many more established or promising start ups, this will present a much more appealing opportunity.  The “start up” that already has a product and some employees probably won’t resort to crowdfunding.

Crowdfunding is limited to $1,000,000 dollars, gleaned from any number of investors.  Issuers (and the funding portals) are prohibited from advertising the offering, beyond director investors to the website (it will be interesting to see whether Facebook and Twitter links will be considered advertising or mere directing).  And if the issuer wants to raise over $500,000, it will need to release audited financial statements.  That means dropping a few grand on a CPA, on top of the whatever fees the funding portal will charge (and issuers would be remiss to do any of this without an attorney).  The transaction costs will be high.  If the issuer wants to raise somewhere between $100,000 and $500,000, then the financial statements need only be “reviewed”, which is slightly less pricey.  On top of those requirements (and the basics like names of officers and addresses), issuers will need to describe the purpose of the fundraising, a description of the ownership and capital structure of the issuer and file annual reports with the SEC, including financial statements.  And, do note, the SEC is empowered to make “any other requirements…for the protection of investors and in the public interest.”  That means that the SEC could make any of these requirements more onerous and costly.  Again, given that Mary Schapiro and Luis Aguilar have pooh-poohed the concept generally, expect the SEC to add some regulatory meat to the statutory bones.

Normally, a start up gets going using the founder’s own funds, and the money he can beg, borrow or steal from his friends and family, and sometimes they find an “angel investor” – some wealthy person willing to give them a shot in the form of a few thousand dollars.  Crowdfunding will be popular among the start ups that can’t find this kind of “seed money”.  Younger entrepreneurs, whose friends are all also broke, are more likely to turn to crowdfunding.  In addition, crowdfunding will be huge for entrepreneurs living outside of seed-money friendly areas.  It will also help individuals with really solid ideas of how to return 20% on the dollar, which isn’t the sort of return that excites many angel investors (think pizza shop in a small town without so much as a Dominos).  And, to be frank, it will help the socially awkward types who can’t sell their vision face-to-face. 

Crowdfunding isn’t the democratization of equity investment; it’s the democratization of angel investment.  Most of us will still be unable to invest in the next Facebook or Google, because they’ll skip crowdfunding altogether.  I suspect most crowdfunding offerings will end up being for less than $100,000 (meaning the issuer only needs to provide self-certified financial statements and last year’s tax return, plus the other rules).  It will be for just enough to make a prototype or launch a beta version.  In other words, just enough to attract a venture capitalist.

For investors, crowdfunding means a lot of chances to lose some money.  Some will get to support the next must-have app for your phone, but more will probably invest in a bar or restaurant (an industry famous for failures), or with tech-geeks without a lick of business acumen.  I’m okay with this, to be honest.  Some will invest for philosophical reasons (support only small/local businesses), others will gamble (better here than a casino), but I think most will do it almost for fun (another venue for those who “dabble” or “play” in the stock market).  And there are limits on how much someone can lose.  The Act uses “income or net worth” in setting limits, which will allow some retirees with over $100,000 saved to potentially risk the greater of 10% or $20,000.  Potential for fraud is restricted by investment limits, the fact that issuers need to use a broker or a funding portal*, and that said fraudsters need to give the SEC their name, address, etc. (generally not a good criminal plan, giving the Feds your personal info).  More importantly, the Act requires brokers/funding portals to ask and receive answers from the investors, making sure they understand the risks.  I’m pretty sure that no other group of investors have to pass a quiz before they can invest.  That’s a lot of work for something that should be understood as allowing the Average Joe to invest $100 in a company a few times a year.

Crowdfunding will be good for the little guy start up.  Investors who decide to go into crowdfunding should do so understanding the risks, and should model themselves after angel investors, who often invest in a dozen companies in the hopes that one strikes it big. 

Crowdfunding will be fun and exciting, don’t get me wrong, and I intend to invest this way myself.  For some, it really will be a game changer, but only if the game is already really, really close. 

* This is really an aside: Funding portals and brokers acting as crowdfunding intermediaries will need to register with the SEC and register with an applicable self-regulatory organization.  There are already a few nascent organizations coming together to create a funding portal SRO.  Thus, these guys will face the type of serious and undoubtedly complex regulations not unlike those that broker-dealers already face.  In addition, if a funding portal wants to skip registration as a broker-dealer, it will need to be a member of a national securities association, which means a battery of tests and not-insignificant fees.  Most importantly, they will be exposed to all sorts of liabilities, which will make prudent portals wary of shady start-ups.  The net effect will mean that a crowdfunding boiler room will have a similiar likelihood of getting caught as any other, only for a lot less potential payout.

The new SEC Rule 13h-1, the large trader reporting rule, became effective. 

Starting on April 30, 2012, broker dealers will be required to maintain records of large trader trading, similar to records maintained relating to the electronic blue sheet system.  Further, supplemental information will also be required.

This new large trader rule could implicate investment advisers, banks, broker dealers, insurance companies and foreign entities.  All may be required to self-identify by filing a Form 13H with the SEC, and provide unique information to the SEC.  Broker dealers will also be required to maintain information relating to these trading records supplemented with the time of order, execution and the trader’s ID number if the SEC so requests.  Broker dealers will also be required to file a Form 13H if they are large traders.

Although the definition of a large trader is enunciated in the rule, there is some factual assessment that goes into it.  That is, it relates to any person, who directly or indirectly, exercises investment discretion over one or more accounts through NMS securities and registered broker dealers in a certain activity level.  The large trader must file an initial Form 13H promptly after it crosses the trading thresholds, and it has been considered that promptly means within ten days.  There are also annual filings that must be done within 45 days after each calendar year.  Confidentiality was also critical in assessing this information, and the SEC expects firms to realize that it will maintain the confidentiality of said information.  However, it may have an obligation to disclose it to Congress, other federal agencies and pursuant to a federal court order. 

Accordingly, firms should be aware that these issues may arise, and should be ready to file and maintain the appropriate records.

FINRA recently announced that, in the first quarter, it will issue a risk control assessment survey to all member firms.  Although this is a voluntary program, member firms should strongly consider their participation.  Your efforts on the front-end may alleviate the work you would otherwise perform during an examination.

The purpose of the survey is for FINRA to better understand member firm business models, the risks attendant with those models and the controls intended to manage those risks.  According to FINRA, responses to this survey will afford it the ability to conduct more focused examinations.  In other words, the program will give examiners a better understanding of your firm before arriving on site and allow the examiners to streamline the examination.

According to FINRA, firms who do not participate will not suffer negative consequences.  However, those non-participating firms should expect FINRA to spend more time during an examination.  FINRA plans to conduct this survey on an annual basis; the content will change as new risks emerge and as priorities evolve.

Even though answering the survey will take time to complete, streamlining the examination process is a laudable goal.  If the time spent on completing the survey results in a more focused and shorter examination, it seems to me that the decision to participate in the survey should be a forgone conclusion.

BrokerCheck is a publicly available tool that FINRA offers for the public to learn about member-firms and their registered representatives.  Over the years, the information available to the public has expanded.  The fallout from the financial crisis has resulted in more and more information being made available to the public, with additional categories of information being made available by July 2012.  Now, FINRA is seeking public comment for the release of reasons for termination and scores from industry qualifying examinations, but there is a potential unappreciated downside to the release of this information.

 Making information available to the public about a registered representative’s reason for termination can be seen as another way to smoke out those individuals who should not be in the industry in the first place.  This disclosure will provide the public greater protection against rogue brokers fleeing one firm for another.

 One commentator has noted that there is a downside from the dissemination of all this information; namely, identity theft.  The more and more personal information that becomes available, the more likely for there to be identity theft.  In light of the SEC’s recent alert on investment scams through social media, FINRA may be inadvertently helping the promulgation of such scams.

 In the end, I suspect that the reasons for termination and test scores will become available through BrokerCheck.  As such, member-firms and registered representatives will have to be even more diligent to ensure that they are not subject to the improper use of this information.  One potential tool is the frequents internet searching of the names of registered representatives to test for improper use, but this will come at a cost in time and resources.  Similarly, FINRA will have to critically review instances of purported financial fraud to ensure that the perpetrator is who the public thinks she or he is.  Otherwise, BrokerCheck will become a tool for fraudsters as opposed to protecting the public.

The GAO has indicated to the SEC that it should consider the codification of the analyst conflict pact it entered into with other regulators in 2003.

As many recall, in 2003, a group of regulators, including the SEC, struck a deal with a number of Wall Street firms concerning their equity research analyst's conduct.  These firms agreed to pay $1.4 billion in penalties and disgorgement.  The GAO is now recommending that the SEC codify this pact (although at the time, the NASD and NYSE finalized rules relating to this pact), in the SEC’s rules and regulations. 

The SEC responded through its Director of Trading and Markets Division, who indicated that the SEC Staff believes this recommendation makes sense, and will plan accordingly. 

We wanted to make everyone aware of a great resource published by Fox Rothschild's Securities Industry and Labor & Employment practice groups.  It is called the National Survey on Restrictive Covenants.  You can access a copy by entering or clicking on the following link:  http://emarketing.foxrothschild.com/reaction/RSGenPage.asp?RSID=3H1FlS0GKN33lpQjC7nN5rf9QYXnH3iRCz_uLuiWHMc.  This survey is a quick reference for in-house counsel and human resource professionals.

For anyone reading this post, you appreciate the value of social media.  It looks as though FINRA is finally prepared to do so as well.

FINRA recently proposed changes to its rules governing communications with investors.  In doing so, FINRA has proposed easing its requirements of pre-approval for a broker-dealer's use of social media.  Chief among the proposed changes would be the authorization of registered representatives communicating with clients via social media without a supervisor's prior approval.  Without pre-approval, a registered representative could engage in interactive , real-time communications with customers via a social media site.

Assuming this proposal is adopted, this is a positive step for FINFRA.  Nevertheless, I think that broker-dealers and registered representatives still must be wary of using social media to communicate in real-time with their clients.  First, the member firm will surely still be required to maintain copies of these communications consistent with its record retention obligations.  Keeping track of the potential volume of such communications creates a record-keeping nightmare.  Second, broker-dealers should consider restricting their registered representatives from making investment recommendations through interactive social media because of suitability concerns.  The risk of an investment recommendation being disseminated via social media is that anyone accessing that source could argue that it was an investment recommendation made by the firm and pursue a claim against the firm in the event of a loss. 

In my experience defening member firms and registered representatives, the types of claims asserted are only limited by the creativity of the lawyers.   Do not be a victim.  If FINRA specifically endorses inter-active communciations via social media without pre-approval, be certain that you have meaningful policies, procedures and protocols to maintain proper records and avoid open-ended recommendations to the public.

Thought you might be interested in a recent podcast I did concerning my securities law practice.  http://web.me.com/cordpar/Client_Development_Tips/Law_Consulting_Coaching_Podcast/Entries/2011/10/28_Developing_a_Securities%2C_White_Collar_and_Complex_Litigation_Practice.html

In January 2001, the Securities and Exchange Commission (“SEC”) recommended the implementation of a uniform fiduciary duty standard for broker-dealers and registered investment advisors. Significant debate has followed regarding the potential parameters and scope of such a duty. Recently, the Securities Industry and Financial Markets Association (“SIFMA”), a lobbying group for large broker-dealers, proposed a framework for a uniform fiduciary duty.

Although SIFMA reiterated its support for such a standard, it also recommended against applying the fiduciary duty found in the Investment Adviser Act of 1940 to broker-dealers, stating that it would adversely impact “choice, product access and affordability of customer services”. Among other things, SIFMA proposed a new fiduciary duty for broker-dealers to accommodate broker-dealer conduct that would otherwise be in violation of the 40 Act.

In doing so, SIFMA recommended that, in its rulemaking, the SEC “provide the necessary rule-based guidance regarding when the fiduciary duty begins and ends and what disclosures and consents, if any, are necessary to satisfy the duty where a broker-dealer gives “advice involving principal trading, structured products, hybrid accounts, complex investment strategies, concentrated positions, and receipt of commissions and differential loads for different products.” To implement this standard, SIFMA proposed that it be articulated in the initial customer agreement. SIFMA also recommended that the fiduciary duty apply on an account-by-account basis.

By implementing a new fiduciary duty standard unique to broker-dealers, SIFMA believes that the SEC will properly take into account the distinctions in the law between registered investment advisers and broker-dealers while taking customer service into account. It remains to be seen if SEC heeds this call to action, or if the SEC simply rubbers stamps the 40 Act fiduciary duty standard to broker dealers.