Portals & Broker-Dealers
Published on March 30, 2016
By David M. Freedman and Matthew R. Nutting
Two kinds of intermediaries may conduct Title III equity crowdfunding offerings and transactions: (1) funding portals that are not registered broker-dealers, and (2) offering platforms that are registered broker-dealers. Both kinds must be registered with the Securities and Exchange Commission (SEC).
There are important distinctions between funding portals and broker-dealer platforms that feature Title III offerings. Funding portals are a new type of intermediary created by Title III of the JOBS Act, while broker-dealers have been established market makers for many decades. A broker-dealer can be an individual or a company.
Being a broker permits the platform to trade securities on behalf of its customers, and being a dealer allows the platform to trade on its own account.
Broker-dealer platforms are authorized to do, while funding portals (which are not owned or operated by broker-dealers) are prohibited from doing, the following:
- Offer investment advice or recommendations to investors.
- Solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal.
- Compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal
- Hold, manage, possess, or otherwise handle investor funds or securities.
Broker-dealers are subject to strict standards of due diligence, with respect to how they select issuers and equity offerings to be listed on their platforms. Funding portals are not legally subject to any such standards, although they do have incentives to select high-quality issuers, which usually requires a respectable level of due diligence. When you visit a broker-dealer platform, though, you know exactly what its due diligence standards are because they have been published by the SEC and the Financial Regulatory Authority (FINRA).
Acting as an intermediary, a broker-dealer must take reasonable steps to ensure that the information and disclosures that issuers post on its platform are materially accurate and complete. If the broker-dealer fails to take those steps it will face disciplinary action, including fines and civil enforcement action, by the SEC and FINRA. (See the SEC’s “Guide to Broker-Dealer Registration,” published in 2008.) That means the platform’s staff has to examine carefully and in depth an applicant’s financial disclosures, perform criminal background checks on its executives, and so on. The broker-dealer is obligated to take reasonable steps to screen out dishonest issuers and fraudulent offerings.
Registered broker-dealers are subject not only to the general antifraud and anti-manipulation provisions of federal securities laws and regulations, but to additional due diligence and anti-money-laundering rules, and other requirements specific to broker-dealers.
Two fairly new requirements are the Know Your Customer Rule (FINRA 2090) and the Suitability Rule (FINRA 2111). Together, they require broker-dealers to collect sufficient information about each investor to determine that investor’s risk profile and whether particular investments are suitable. To accomplish that, the broker-dealer operating an offering platform should review applicant companies’ business plans in order to screen out offerings that it believes are generally unsuitable for its registered investors.
All intermediaries—funding portals and broker-dealer platforms alike—must conduct background checks on officers, directors, and 20 percent equity holders of each issuer, to reduce the risk of fraud. Intermediaries must disqualify an issuer if one of its officers, directors, or “participants” (such as promoters) in the offering is a “bad actor,” as defined by the SEC (a convicted felon, person subject to a finance-related injunction or restraining order, person subject to SEC disciplinary action, etc.). Likewise, all funding portals and broker-dealer platforms are subject to antifraud and anti-manipulation provisions of federal securities laws and regulations.
How can you tell funding portals and B-D platforms apart? They may be very similar in appearance, because they use the same kind of website architecture and navigation structure. You may not be able to distinguish between them readily, unless you read the “About Us” page and/or the fine print in the footer on the home page. If you are unable to determine whether a site is operating as a broker-dealer, you can (1) contact the platform’s staff and ask about their broker-dealer status or (2) visit FINRA’s BrokerCheck page (http://www.finra.org/Investors/ToolsCalculators/BrokerCheck/) and conduct a search to see if the platform is registered as a broker-dealer or merely as a portal.
If you consider registering as an investor on a non-broker-dealer funding portal, ask the principals exactly what kind of screening and selection process they use before they approve an issuer’s application and list an offering. Some portals use third-party services such as CrowdCheck, a Virginia-based compliance and due diligence service provider, to perform due diligence and/or conduct background checks on the owners and officers of issuers. If the platform claims to conduct its own due diligence in-house, make sure the principals have relevant experience in the securities or investment banking industry so that their due diligence is effective. Keep in mind that you (along with the crowd) may still need to conduct your own due diligence before you invest, even if the platform is a broker-dealer. Do not presume that due diligence performed by the intermediary supports your personal objectives and risk tolerance.
About the authors
David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).
Regulatory Notice 10-22: Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings, published in 2010 by Financial Industry Regulatory Authority https://www.finra.org/industry/notices/10-22
“FINRA Actions and the Due Diligence Obligations of Broker-Dealers in Private Placements,” by Ze’ev D. Eiger, Morrison & Foerster, August 2013 http://media.mofo.com/files/Uploads/Images/130805-FINRA-Actions.pdf