Staying the course with broker-dealer registration: the SEC's impending regulation of crowdfunding portals under the JOBS act.

AuthorShah, Raxit
PositionJumpstart Our Business Startups Act
  1. INTRODUCTION II. BACKGROUND A. Broker-Dealer Registration B. Crowdsourcing and the Advent of Crowdfunding C. The JOBS Act and a New Broker-Dealer Registration Exception D. Guidelines for Crowdfunding Intermediaries III. ANALYSIS A. Hallmark Broker-Dealer Activities B. Issuer Exception Elements C. Finder Exception Elements D. Investment Advisor Exception Elements E. New Crowdfunding Intermediary Exception Elements. 1. FundersClub No-Action Letter 2. Angel List No-Action Letter IV. RECOMMENDATION A. The Issuer Exception Compared B. The Finder Exception Compared C. Investment Advisor Exception Compared D. Rectifying Discrepancies V. CONCLUSION I. INTRODUCTION

    Collecting donations to run a political campaign, fundraising to support an artistic project, and contributing towards a charitable cause or foundation's funding goal; these examples illustrate diverse yet successful applications of crowdfunding. Investors' rewards for these commonplace transactions include sponsor recognition, a prototype or memorabilia from the launch of a product or project, and personal gratification. None of these circumstances, however, involve investor donations in exchange for ownership --otherwise known as securities--until now.

    In 2012, the Jumpstart Our Business Startups Act (JOBS Act) created a broker-dealer registration exemption for crowdfunding portals under Title III, allowing these security intermediaries to raise capital in exchange for securities. (1) The Securities Exchange Act of 1934 (Exchange Act) charges the Securities and Exchange Commission (SEC) to govern the securities market to protect investors. (2) Save for a few exceptions, the SEC requires those buying and selling securities, or doing so on behalf of others, to register as a brokerdealer. (3) The JOBS Act creates another exception to broker-dealer registration for crowdfunding portals and suggests guidelines for the SEC to adopt in order to regulate the intermediaries. (4)

    The guidelines the JOBS Act suggests, however, meaningfully stray and conflict with the SEC's history of broker-dealer regulation. (5) The SEC currently recognizes three exceptions: an issuer, (6) finder, (7) and investment advisor exception. (8) These exceptions, however, are narrow. None of the exceptions allow a person to exchange securities if he exhibits hallmark broker-dealer activity, including, but not limited to, receiving transaction-based compensation, possessing investor funds, participating in negotiations of the sale of securities, or even providing certain types of information about the securities. (9) Although the SEC has yet to issue formal guidelines for the JOBS Act's crowdfunding exception to broker-dealer registration, the public commenting period is underway and the SEC addressed the issue in two no-action letters. (10)

    This Note reviews the Exchange Act and its underlying policy objectives, focusing on the Act's regulation of the securities market and broker-dealer registration. This Note first explores the SEC's past regulation of broker-dealer registration and continues with a summary and analysis of two SEC no-action letters addressing the proposed crowdfunding exception. The analysis concludes by comparing and contrasting the existing exceptions with the proposed guidelines for the new crowdfunding exception from both the JOBS Act and SEC no-action letters.

    This Note contends that the JOBS Act's crowdfunding portal guidelines are too liberal and do not adhere to previous SEC precedent. As a result, this Note argues that crowdfunding portals would participate in hallmark broker-dealer activities if the SEC adopts Congress's JOBS Act guidelines. Moreover, recent SEC no-action letters regarding the regulation of crowdfunding portals do not align with past SEC rulings and exceptions. This Note argues that the SEC must take a more conservative approach in requiring crowdfunding portals to register as a broker-dealer when formally issuing guidelines than it took in its recent no-action letters or the guidelines under the JOBS Act. If it is impractical to create another exception without conflicting with the guidelines set forth for other exceptions, then the SEC should disallow a crowdfunding portal exception altogether, rather than straying from its course of 80 years.

  2. BACKGROUND

    In an effort to combat securities trading abuses in the American securities markets, the Exchange Act authorized a commission to adopt rules to "protect[] the public ... with respect to trading in securities, through ... the regulation of brokers and dealers and the securities markets." (11) Congress codified the Commission's rules into law two years later. (12) Therefore, the underlying policy for this regulatory framework is to protect and provide investor safeguards. (13) Although not mutually exclusive, a person may exchange securities by acting as a broker, dealer, or trader. (14) The Exchange Act defines a "broker" as "any person engaged in the business of effecting transactions in securities for the account of others." (15) A "dealer" is "any person engaged in the business of buying and selling securities ... for such person's own account through a broker or otherwise." (16) A "trader" does not fall into either of these classifications and is defined as "a person who buys and sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business." (17) This Note will generally refer to brokers and dealers collectively as "broker-dealers," because application of the rules of the Exchange Act does not differ between the two. (18)

    1. Broker-Dealer Registration

      Acting as a broker-dealer is expensive and complex. Broker-dealers must register with the SEC, join self-regulatory organizations (SROs) to satisfy competency and training standards under the Financial Industry Regulatory Authority (FINRA), satisfy rigorous net worth and capital requirements, (19) and comply with financial reporting guidelines, among other oversight requirements. (20) Once a person has registered with the SEC, the SEC then has the authority to conduct investigations to detect securities law violations. (21) If there are any infractions, or if a broker-dealer fails to register, the SEC may seek civil injunctions in federal court, (22) impose monetary penalties, (23) issue cease-and-desist orders, (24) or even refer the matter to the attorney general for prosecution. (25)

      Broker-dealers are subjected to this regulatory framework because they perform financially sensitive functions that necessitate investor protection. (26) The consequences of failing to register as a broker-dealer exist to (1) ensure broker-dealer competence, (2) provide information to the public regarding a broker-dealer's business and integrity, (3) promote broker-dealer financial solvency, and (4) subject broker-dealers to the jurisdiction, rules, and oversight of the National Association of Securities Dealers (NASD). (27) As such, registration is "prohibitively expensive." (28)

      Exemptions to broker-dealer registration exist, (29) but the policy considerations for allowing them do not trigger the same societal or regulatory concerns that an offering to the general public would. (30) The SEC recognizes an issuer exemption for self-selling issuers who only sell their own securities and do not both buy and sell securities. (31) A finder exemption for broker-dealer registration also exists where a person can identify purchasers or sellers of securities but may not participate in effecting transactions of others. (32) The SEC also recognizes an investment advisor exemption that applies to persons who only act as consultants and never possess customer funds or securities. (33) Ultimately, however, the Exchange Act requires regulation of virtually all instances of buying and selling securities. (34) These transactions typically occur either by traders not as a part of regular business, or by broker-dealers for the account of others as a part of ordinary business. (35)

    2. Crowdsourcing and the Advent of Crowdfunding

      Although Internet-based crowdfunding is relatively new, crowdsourcing, "which refers to mass collaboration efforts through large numbers of people," is vastly prevalent because any collective community contribution towards achieving a goal or adopting an idea constitutes crowdsourcing. (36) For instance, politicians have long collected public campaign donations, and crowdsourcing also funds scientific research projects and data collection. (37) The Internet and social media's progression, however, lowered the transaction costs associated with attempting to raise small amounts of money from a large group of investors. (38) This phenomenon of "lending very small amounts of money, typically to poorer borrowers" is known as microlending or microfinance. (39) Crowdfunding, then, is just a combination of microlending and crowdsourcing involving "small contributions from a large number of people to fund small entrepreneurial ventures." (40)

      Depending upon what investors obtain in return for their contributions, there are five different crowdfunding models: (1) the reward model, (2) the donation model, (3) the pre-purchase model, (4) the lending model, and (5) the equity model. (41) Besides the equity model, the other models only offer interest on any money invested while some models do not even return the money invested and consider it a donation. (42) In contrast, the equity model offers investors a portion of the company and thus a share of the profits. (43) By receiving a share of the profits from the businesses that investors are helping to fund, the equity model involves the sale of a security; (44) this raises regulatory issues, which is the main reason for the equity model's scarce popularity in the United States. (45)

    3. The JOBS Act and a New Broker-Dealer Registration Exception

      In 2012, Congress enacted the JOBS Act in an attempt "[t]o increase American job creation...

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