Crowdfunding Industry Insider Criticizes SEC Proposal on Special Purpose Vehicles for Reg CF

Special Purpose Vehicles or “SPVs” have long been requested by FINRA regulated platforms participating in the Reg CF sector of crowdfunding. Under current rules, SPVs are not allowed to be utilized. This may soon change as the Securities and Exchange Commission (SEC) has proposed enabling SPVs for issuers using Reg CF in amendments that are currently out for comment.

So you ask why are SPVs beneficial? If structured correctly, SPVs can help both issuers and investors accomplish their goals.

Smaller firms that have many investors may struggle to communicate with all shareholders. Having a single entity as a point of contact reduces overall cost. Additionally, an SPV can be shown as a single shareholder on a firm’s investor ledger.

For investors, an SPV can be worded to assure shareholder rights – like anti-dilution requirements – thus providing an element of investor protection. One criticism of investment crowdfunding is not the issuer quality it is the deal quality offered to retail investors.

One criticism of investment #crowdfunding is not the issuer quality it is the deal quality offered to retail investors Click to Tweet

As with many issues, the devil is in the details but as the SPV proposal is structured now the viability is being questioned.

Crowdfund Insider has recently received some feedback regarding the current wording of the SPV proposal that is critical of the specific amendment. We spoke to an industry expert and posed several questions regarding the SEC’s proposed SPV structure for  Reg CF.

SPVs have long been requested by the CF industry. The SEC has included it in its proposal but there are some pitfalls. In your opinion, what are these shortcomings?

Private Equity investments are traditionally made by aggregating investors’ capital into a fund (itself an SPV) and deploying such capital into a portfolio company, to which each investor has a pro-rated interest in such investment. The SPV charges these investors a management fee to account for the operational burdens of managing the investors, including the disposition of tax documents every year and the costs of liquidating the SPV at specific times. Generally, the organization of the SPV takes a carried interest in the SPV to incentivize and align their interest with the underlying investors and seek a return on investment.

This manner of financing has become familiar to many and familiarity leads to comfort.

SPVs have been requested since Reg. CF’s inception as they are a way to make the “crowd’s” investment appear on an issuer’s cap-table as one true line item, rather than thousands.

SPVs also potentially provide relief from Section 12(g) of the Exchange Act’s requirement to register as a public reporting company if an issuer has a more than 500 unaccredited holders of record and more than $10M (or $25M if certain another post-Reg. CF conditions are met) at the end of any fiscal year. However, as proposed, the shortcomings of the current SPV proposal will make their use difficult for portals and issuers to justify, when the advantages they provide can be achieved through other means, further the Concept Proposal does not guarantee these SPVs will actually shield underlying investors from being counted as holders of record due to the unique provisions of the proposed rule.

This is particularly poignant when seeing the Commission’s language:

“We are therefore proposing to require a crowdfunding vehicle to provide to each investor the right to direct the crowdfunding vehicle to assert the rights under state and federal law that the investor would have if he or she had invested directly in the crowdfunding issuer.” (See Concept Proposal at page 150)

The specific shortcomings are as follows:

As proposed SPVs or “crowdfunding vehicle”:

  • Must be organized and operated for the sole purpose of acquiring, holding, and disposing of securities issued by a single crowdfunding issuer and raising capital in one or more offerings made in compliance with Regulation Crowdfunding;
  • Would not be permitted to borrow money and would be required to use the proceeds of the securities it sells solely to purchase a single class of securities of a single crowdfunding issuer;
    • This will prevent the SPV from being re-used to avoid dilution.
  • Would be permitted to issue only one class of securities in one or more offerings under Regulation Crowdfunding in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers under the Securities Act;
    • This will prevent issuers from selling securities at different terms during different stages of an offering and may require multiple SPVs due to the “one class” requirement, despite the fact that a multi-series SPV could solve this issue.
  • Would be required to obtain a written undertaking from the crowdfunding issuer to fund or reimburse the expenses associated with the crowdfunding vehicle’s formation, operation, or winding up, and the crowdfunding vehicle would not be permitted to receive other compensation
    • This will add substantial upfront costs to the issuers for entities that may not be needed if the offering is not successful.
  • The crowdfunding vehicle would be required to vote the crowdfunding issuer securities, and participate in tender or exchange offers or similar transactions, only in accordance with instructions from the investors in the crowdfunding
    vehicle.

    • Even with a proxy in place, this will cost time and money for a party to aggregate, if this is to be the portals they will need to charge higher fees to account for this.
  • The crowdfunding vehicle would receive all of the disclosures and other information required under Regulation Crowdfunding from the crowdfunding issuer and would then be required promptly to provide such disclosures and information to the investors and potential investors in the crowdfunding vehicle’s securities and to the relevant intermediary.
    • Previously, issuers just had to post on their website, but now there is a delivery requirement which will add cost.

Further, the provisions provide no guidance on who should manage the SPV, how the distribution of K-1s each year will be paid for or handled, how the person directing the SPV can make decisions without providing impermissible investment advice.

SPVs can protect investor rights – correct? And what about follow on rounds? Dilution rights?

Due to the Commission’s proposed constraints, the answer appears to be a resolute no unless the SPV was able to find another exemption from registration to take money from all pre-existing investors and deploy those funds to purchase new securities, which is highly speculative.

For an issuer, investing in a single entity can lower the cost and make communication easier. Is that accurate?

An issuer receiving an investment from a single entity could certainly lower costs, however, due to the unique requirements outlined above, there will be substantial costs and it is likely the issuer will bear them.

As they are structured now, who is the lead (or nominee) of the SPV? Can the platform be a part of it?

This is not clear, as the Issuer is the one who has “to fund or reimburse the expenses associated with the crowdfunding vehicle’s formation, operation, or winding up, and the crowdfunding vehicle would not be permitted to receive other compensation” they are likely the organizer. The Platform could potential by part of it, but this would require further rules to make such activity permissible, as currently, the management of an SPV would likely be an impermissible business activity.

What about carry?

To take carried interest either a registered investment adviser (RIA) needs to have qualified clients (a standard higher than accredited investor) or an exempt reporting adviser (ERA) needs to advise the SPV. I can’t see an RIA being involved with these SPVs due to the need to audit all funds under management, which there is no budget to do here.

ERA’s could potentially be well-positioned to advise these SPVs, however, the cost and risk of advising a large group of unaccredited investors who can’t deploy more than $5M may not be economically appealing.

Hypothetically if these SPVs were only used for equity or right-to-equity investments an ERA could advise an unlimited amount without needing to register as an RIA after having more than $150M under management, however, crowdfunding is diverse in nature and this may be hard to achieve. The questions the Commission posed in the Concept Release makes it clear this issue is unresolved.

Internationally, in the UK for example, creating a structure is commonplace. Correct?

Yes, the UK has a unique option called the “nominee structure”. Basically a nominee arrangement is a structure whereby the nominee (the crowdfunding platform) holds legal title to the securities for the benefit of the crowd person.

This means that the portal would be the legal security-holder but we hold those shares on behalf of the various individuals who had invested in the company. The full economic interest in the securities – including the benefits- are passed through to the underlying investors.

This arrangement is very similar to a trustee relationship, as well as to the structures used by stockbrokers (think Cede and Co.) However, unlike the public markets, where investors can either make their own disposition decisions or assign an adviser or broker to make the decision, in this case, the platform which has an interest in the issuer would make the decision, attempting to optimize profits and aligning interests.

This would make the private markets much more similar to the public markets and we are more strongly in favor of this type of arrangement but would require a paradigm shift in the current U.S. private market set up.

Luckily, there are solutions that don’t require an SPV that can be achieved to get to a similar outcome, already.

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