This post is the fourth in a series examining the impact of the Jumpstart Our Business Startups Act (or JOBS Act) one year after its passage and focuses on the provisions related to online angel investment platforms.
In the last post of this series, I discussed the progress of implementing the first half of Title II of the JOBS Act, which instructs the SEC to amend Rule 506 to allow for general solicitation in Rule 506 offerings if certain additional conditions are met. In this fourth post, I will look at the second part of Title II (namely Section 201(c)), which exempts some online angel investment platforms from the federal broker-dealer registration requirement.
First, I need to address the question: what exactly is an “online angel investment platform?” When I use that term, I refer to an interactive website which matches startups with potential investors who are “accredited investors” under federal securities laws (i.e. they are wealthy). Generally, federal securities law requires anyone in the business of “effecting” securities transactions on the account of others to register as a broker-dealer. Registering as a broker-dealer is an arduous and difficult process and carries an extremely high compliance burden. Thus, if online angel investment platforms were required to register, it would likely put most of them out of business.
These platforms existed prior to the passage of the JOBS Act in a legal gray area.[1] Section 201(c) of the JOBS Act is an attempt to provide clarity on their status. The provision exempts platforms that permit the offer, sale, purchase, or negotiation of securities transactions, including by general solicitation, as long certain conditions are met, namely: (a) neither the platform nor anyone associated with it takes any compensation in connection with the transactions on the platform, (b) the operator of the platform never takes custody of funds or securities, and (c) the platform and its associated persons have not been disqualified from the securities industry. The provision does allow the platform to offer ancillary services, such as due diligence services (but not investment advice) and the supplying of standardized documents.
Unlike the rest of Title II, Section 201(c) does not require SEC implementing regulations to be effective, and therefore is already in effect. In February 2013, the SEC issued some guidance on its interpretation of Section 201(c) in a set of online Frequently Asked Questions. In its guidance, the SEC confirmed that it views Section 201(c) as fully operational, though it did state that it believes that an online platform can’t permit a general solicitation to occur on its service until the SEC finalizes the regulations permitting Rule 506 offerings with a general solicitation (I will get to more on that below). Unfortunately, the SEC took two other positions that are, in my view, counter-productive. First, the SEC stated that it viewed any compensation paid to the platform or persons associated with it as disqualifying the platform from the exemption, even if the compensation is not “transaction-based” (i.e. based on the success of the capital raise or in proportion to the size of the offering). This extends even to compensation paid in the form of a flat fee. It is unclear from the guidance whether an online platform may receive compensation for ancillary services. The second interpretation is that, while Section 201(c) does exempt these platforms from broker-dealer registration, they are still broker-dealers and may have to comply with other regulations covering broker-dealers other than the registration requirement. It is important to keep in mind that this kind of interpretive guidance can influence court decisions, but carries no official force of law.
So can the exemption for angel investment platforms be used now? Yes, with one caveat. It could certainly be argued that most uses of such a platform constitute an impermissible general solicitation, and thus we still need to wait for the SEC to finalize it’s regulations related to easing the restrictions on general solicitation. Recently, in an August 30, 2012 letter (which was subsequently released publicly), the large international law firm K&L Gates LLP provided a legal opinion to AngelList LLC, the operator of an online angel investment platform, that it (a) is not required to register as a broker-dealer under federal securities laws and (b) companies posting information to accredited investors on the AngelList website are not engaged in a general solicitation in violation of Rule 506. K&L Gates took the view that AngelList need not register as a broker-dealer because of Section 201(c) of the JOBS Act, and that even absent this exemption, AngelList would not be required to register as a broker-dealer because it does not fall within the definition of a “broker” in the Securities Exchange Act of 1934 or perform any of the activities that the SEC and its staff have identified as causing an entity to be considered a broker. Most importantly, K&L Gates opined that companies posting information to accredited investors on the AngelList website are not engaged in a general solicitation in violation of Rule 506 because for 15 years SEC no-action letters have permitted similar websites that provided even more extensive services and information about offerings to accredited investors without raising general solicitation concerns. Key to K&L Gates’ reasoning is the analysis found in the 1997 and 1998 Lamp Technologies, Inc. SEC no-action letters (available here and here). In the Lamp letters, the SEC Division of Corporation Finance staff concluded that posting information about private funds to a password-protected website accessible only by persons who (i) completed a questionnaire that allowed Lamp to reasonably determine that they were accredited investors, (ii) waited for a 30-day “cooling off” period, and (iii) paid a subscription fee would not involve a general solicitation or advertising in violation of Regulation D. The Division’s analysis hinged particularly on the fact that access to the website is limited exclusively to accredited investors. As AngelList’s website is so limited, and its activities are more limited than those described in the Lamp letters, its activities also should not be deemed to constitute a general solicitation or advertising. Of course, K&L Gates’ opinion letter carries even less force of law than the SEC’s FAQ webpage, so no one can be 100% safe in relying on it.
Of further note, in two recent no-action letters issued by the SEC related to online angel investment platforms, the SEC’s Division of Trading and Markets issued no-action letters to FundersClub Inc. and AngelList LLC who were seeking confirmation that their online activities would not result in enforcement action by the SEC. The no-action letters did not address the issue of whether the solicitation of investors by an online platform would constitute general solicitation or advertising. The SEC did, however, permit the operators of such platforms the ability to take a “carried interest” (i.e. a portion of any gains from an investment) in exchange for monitoring the investments for the investors using the platform, on the basis that this was investment advisory activity rather than broker-dealer activity. While this form of compensation is fairly standard in the VC and hedge fund industries, some attorneys have previously (and I believe incorrectly) taken the position that when a carried interest is taken on a deal-by-deal basis (rather than as part of a pooled investment fund), it constitutes “transaction-based compensation” and thus activity requiring broker-dealer registration. Of course it does mean that while these platforms will not need to register as broker-dealers, they may have to register as investment advisers.[2]
Overall, there have been some fairly positive developments when it comes to online angel investment platforms. Some of these have been the result of the JOBS Act and some the result of further development of existing law. In either case, I think these are positive steps forward for the startup community and this area represents the most promising change brought about by the JOBS Act.
Next time, I’ll be discussing developments (or non-developments) in the area crowdfunding.
Footnotes
[1] No definitive determination has ever been made as to whether the activities of an online angel investment platform could be considered engaging in the business of effecting securities transactions on the account of others. Some platforms already began doing business without registering prior to the passage of the JOBS Act, risking federal or state enforcement action or a private lawsuit. To date, no enforcement action has been taken.
[2] This is still preferable for the angel investment platforms, since the compliance burden for investment advisers is generally lower than for broker-dealers.
© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
