It [almost] goes without saying that issuers of private securities in any equity financing transaction must address each step of the transaction in detail. This is true whether the financing is crowdfunded or whether it is distributed using more traditional means. One such important detail is how investment proceeds are paid to the issuer. (If you want to read a FINRA release on this topic instead, click here!)
If I am selling $1 million of my LLC’s membership interests to 10 investors, the first investor sending me his $100,000 might wonder what happens if I don’t raise the other $900,000 I told everyone explicitly in my offering memorandum I needed for my financing. My offering memorandum provides that if I do not raise the entire $1 million, I will return any investor proceeds received without interest.
The investor may be concerned that if I can’t raise the entire $1 million, I might take his $100,000 and use it for some other purpose. Of course, that would be fraudulent on my part, but practically, the investor’s only recourse would be a lawsuit to recover his money. To ensure that I raise the entire $1 million in offering proceeds, some investors insist that the issuer establish an escrow where an independent third party evaluates whether the issuer has received minimum investment proceeds to close the financing round.
Historically, these escrow services could be and were performed by broker-dealers and banks (usually acting through their trust department). This is the case because the Securities Exchange Act of 1934 makes it illegal for anyone to accept compensation for facilitating a securities transaction (“effecting transactions in securities for the account of others”) unless you are registered with FINRA and the SEC as a broker-dealer, or you are a nationally or state-chartered bank. Interestingly, as noted in the FINRA release linked to above, in certain instances, state-chartered trust companies qualify as “banks” for purposes of Section 3(a)(6) of the Exchange Act. In that event, a trust company may perform escrow services in a private securities transaction without violating the Exchange Act.
Importantly, § 227.303 of Regulation CF (the SEC crowdfunding regulations applicable to Title III crowdfunding portals) requires that a funding portal direct investment proceeds to an escrow established by a broker-dealer or a bank. Unlike the language from the Exchange Act, Regulation CF also allows for credit unions to serve in this capacity. There is a question in the crowdfunding industry whether FINRA and the SEC will allow trust companies to serve in this manner. If they don’t, the new JOBS Act exemptions are worthless because as this article suggests, issuers inevitably must engage a broker-dealer (or a bank or credit union) to comply with this provision. Giving issuers the option of using a broker-dealer OR a funding portal was the original intent of this exemption.
Finding a bank to serve in this way has proved to be challenging. Banks themselves are skittish of engaging in these types of transactions because of the litigation risk. Because of their historically conservative nature, banks philosophically oppose the new.
Broker-dealers are not good options because of the expense. Operating a broker-dealer or a bank is an expensive proposition generally. A great deal of that expense is paid toward compliance costs and those costs must be paid by the issuers (and ultimately, investors). Because banks and broker-dealers engage in many types of transactions that are not crowdfunded sales of securities, their compliance programs must address many transactions that have no relevance for equity crowdfunding. A limited-purpose trust company formed for the specific purpose of Title III compliance and handling proceeds in Title II (i.e., Rule 506(c)) raises may be the most cost-effective option for issuers needing escrow services, because the compliance program of a trust company solely performing these functions could be vastly simplified relative to that of a bank or broker-dealer. Most important will be adopting procedural safeguards to make sure that the escrow agreement is read correctly and money is wired to the issuer only if the minimum offering conditions are satisfied. If not, the money is returned to the investors. These compliance functions theoretically could be built into software so that procedurally, the need for human intervention could be reduced.
For more information about escrow services for equity crowdfunding or private securities offerings generally, please contact me.