On January 22, 2019, the Financial Industry Regulatory Authority (FINRA) released its examination priorities for 2019. At the top of the list was online funding platform compliance with the securities laws.
With an uptick in the offer and sale of securities offerings online with Rule 506(c) of Regulation D and Regulation A+, FINRA intends to focus there on its core mission of investor protection.
FINRA, the United States regulator of broker-dealers and their associated persons, is concerned that online funding platforms owned and operated by broker-dealers -or where the platform is not registered themselves and may utilize broker-dealer affiliates as selling agents, custodians or for financial technology (Fintech) services – are not meeting suitability, supervision, and anti-money laundering (AML) requirements.
FINRA’s examination priorities letter expresses the concern that broker-dealers engaged in online securities distribution have asserted the position that they are not selling or recommending securities.
FINRA believes the evidence is to the contrary, pointing specifically to broker-dealer online funding activities that include the handling of customer accounts and funds and where the broker-dealer is paid transaction-based compensation.
While the trigger point for the suitability obligation, for example, occurs only when a securities recommendation is made, and not when custodial or Fintech services are provided or a broker-dealer is compensated, FINRA is correct that these services may reflect a larger broker-dealer involvement in online capital raising. And, as we are aware, the Securities and Exchange Commission (SEC) and FINRA are most comfortable when a regulated entity like a broker-dealer is involved.
Examinations, registration, and FINRA regulation ensure that a broker-dealer is best equipped to protect investors. And suitability, supervision, and AML are all pillars of broker-dealer regulatory compliance.
FINRA will explore broker-dealer reasonable basis and customer specific suitability analyses, public communications, supervision, and compliance with AML requirements. FINRA will review offering statements to investors to evaluate whether there was full disclosure of all material facts, including compensation and whether compensation was reasonable, and whether there were misleading statements or promissory statements of a high return.
FINRA intends to probe the mechanisms of accredited investor verification in Rule 506(c) offerings and whether custodial or escrow arrangements meet the requirements of the Securities Exchange Act of 1934. While not specifically mentioned in its examination priority letter, broker-dealers also have due diligence obligations and will be held to that responsibility.
The SEC will take the lead on funding platforms that are not registered to determine whether the business activities they engage in require broker-dealer registration under Section 15 of the Exchange Act. The SEC has prioritized these cases by bringing enforcement actions in the EB-5, JOBS Act, and cryptocurrency/blockchain spaces.
The services offered by online funding platforms and their affiliated persons, including marketing services, must be carefully evaluated. This evaluation must analyze all services provided, the content of its communications with investors, and how the online platform is compensated.
The rules are pretty clear: if you look like, walk, and quack like a broker-dealer, you probably are one and need to be registered. And there are state blue sky law requirements you need to comply with in the states where you do business too.
We can anticipate that 2019 regulatory inquiries will also target online offerings made under Rule 506(b) of Regulation D. Rule 506(b), unlike its newer counterpart Rule 506(c), does not permit general solicitation.
General solicitation is the advertising of a securities offering, including any article, notice, or other published communication.
Scrutiny thus will focus on how online funding platforms and their affiliates raise capital under Rule 506(b) and whether their investment process can be reconciled with laws, regulations, and rules, including SEC no-action guidance.
Even inadvertent general solicitation eliminates Rule 506(b) as an available exemption to securities registration. Similar misunderstandings by online funding platforms and their affiliates may occur in evaluating whether there is a pre-existing, substantive relationship, a defense to general solicitation. Mistakes here too may remove Rule 506(b) as an available exemption and your securities offering may be illegal.
While all of this is a bit more complicated than the illustrative discussion above, online funding platforms and their affiliates must navigate compliance questions to protect the integrity of the securities offerings in which they participate.
Inadvertent errors may convert good faith fundraising into an illegal securities offering. Regulators are sticklers for compliance – good faith efforts alone that do not meet legal requirements are insufficient. And, in 2019, one consequential U.S. securities regulator has already publicly announced that it intends to take a very close look.
Scott Andersen is principal at finLawyer.com and concentrates his practice on SEC and FINRA regulatory defense and federal securities compliance counseling. Scott was previously Deputy Regional Chief Counsel at FINRA, Enforcement Director the NYSE, Co-Chief of the Securities Prosecutions Unit and Assistant Attorney General at the New York Attorney General’s office. He has investigated, prosecuted, and supervised criminal, civil and regulatory enforcement actions for over 19 years before entering private practice.