FINRA Expels a Crowdfunding Portal

FINRA has expelled its first crowdfunding portal. The firm, UFP (uFundingPortal) of Herndon, Virginia has only been active since May 2016. In five months it apparently listed 16 offerings which FINRA found to be questionable. UFP signed a consent order agreeing to allow FINRA to expel it from membership. The settlement illustrates how FINRA expects crowdfunding portals to operate.

A central allegation in FINRA’s action against UFP was that the portal knew that none of the 16 issuers had made the filings with the SEC that the issuers were required to make. It is as straightforward as an enforcement action can get; either the required filings were made or they were not. If the portal had asked for copies of these filings it would have known that the filings had not been made and, presumably, declined to list the offerings which is clearly what it should have done.

This is the third regulatory action against crowdfunded offerings and the first against a portal.  The organized crowdfunding industry has greeted this action with a yawn as it did the first two.  The industry has its head buried in the sand because it is populated by a lot of people who have never worked in finance and who keep telling each other that they know what they are doing when they clearly do not.

The first regulatory action against a crowdfunded offering, filed by the SEC in October 2015, was against a company called Ascenergy which raised money from investors on four crowdfunding websites. Ascenergy claimed it was going to drill for oil on land where it had no rights to drill. The principals of the company essentially stole the investors’ money. The SEC did not name the websites in the action. If the websites had conducted appropriate due diligence on the offering investors would not have been defrauded.

I wrote, at the time, about the SEC action against Ascenergy and suggested that it was only a matter of time until the regulators would sanction one of the crowdfunding sites. The crowdfunding industry ignored it. Now it has happened and the industry still does not understand that it is a target for regulators and what to do about it.

In October 2016, the SEC filed its second action against a crowdfunding offering. It halted the Regulation A offering of a company called Med-X. The allegation was that Med-X had not made its required filings to the SEC about its financial condition. The Med-X case is ongoing and an action by FINRA or the SEC against the portal may still be filed. Again, if the portal had merely asked for a copy of the filing, it would have known that the filing had not been made.

The FINRA action against UFP paints a pretty clear picture of what FINRA expects from a funding portal.  FINRA said that it expects “a funding-portal intermediary such as UFP to, among other things, deny access to its platform if the intermediary has a reasonable basis for believing that the relevant issuer or offering presents the potential for fraud or otherwise raises concerns about investor protection.”

Thirteen of the 16 issuers listed by UFP did not have any assets or history of operations and each claimed an unrealistic and unwarranted $5 million equity valuation. FINRA was concerned because these companies had “an impracticable business model, oversimplified and overly-optimistic financial forecasts and other warning signs.”

Obviously, the portal cannot know if it should be concerned about fraud if it does not look.  Federal and state law is crystal clear that the portal or other intermediary is liable for a fraudulent securities offerings if they do not investigate the offering with “due diligence.” Most of the portals do not have a full time due diligence department and there seems to be a lack of understanding across the crowdfunding industry as to what is really required.

When FINRA highlights the fact that the issuers offered by UFP had no assets or history of operations, it is reminiscent of the actions that the SEC brought against so-called “penny stocks” back in the late 1970s.  I represented one of the brokerage firms offering penny stocks back then and the SEC was all over them for taking companies public that were not ready to go public. Nothing in the JOBS Act changed that.

The same is true for financial projections. FINRA requires that there be a reasonable basis for the projections given to investors. If the company has yet to make a sale, what basis is there to project the sale of 2 million units in the first two years?  It is usually wise to conduct a test marketing campaign or prepare a good marketing study before an offering is made. Those are few and far between for crowdfunded offerings.  But if you do not have a reasonable basis to make a projection, you should not make it.

There are fewer than two dozen Title III portals registered with FINRA and I have spoken or corresponded with management, compliance officers or lawyers for a few of them. Some are up to the task and some clearly are not.

The lawyer for one of the portals told me that he saw a gap in the regulators’ thinking. He said: “on one hand (the portal) was not supposed to ‘discriminate’, whatever that means, at the same time they were supposed to reject fraudulent offerings.”

I do not see a gap or a problem. If the offering is questionable or has an “impractical business plan” you do not put it on your website, period. The overriding regulation for the crowdfunding industry is not to allow fraudulent offerings to reach the public. No platform should believe that the SEC would sanction them if they refused to list an offering that they thought was going to be a fraud. Just the opposite is true.

The compliance director at another portal told me that their FINRA registration applied only to the Reg. CF (Title III) offerings it listed. “With respect to Regulation A offerings” she told me, we are “solely a technology platform established to host those offerings. Our FINRA membership has nothing to do with Reg. A offerings and imposes no diligence obligations result from such hosting.”

When I asked if she had a letter confirming that FINRA saw it the same way, she failed to respond.  It was a rhetorical question because FINRA was very unlikely to issue that opinion.

When a firm agrees to join FINRA as a Title III portal, it agrees to abide by all of the rules that are authorized by FINRA’s by-laws. Those rules include a requirement that the firm conduct all of its business in accordance with just and equitable principals of trade and not to commit or “aid and abet” securities fraud in regards to any aspect of its business. A registered representative can be expelled from FINRA for a DUI. The idea that FINRA is only concerned with a firm’s Reg. CF offerings is preposterous.

What, exactly does FINRA expect from crowdfunding portals? Three things. FINRA wants to know that each firm 1) has systems in place and written procedures to foster compliance; 2) has trained compliance personnel in place to carry out those procedures and 3) is vetting the offerings to make certain that what they tell investors is true, reasonable and represents a real business with at least a chance of success.

At the same time, there is no excuse for a Title II platform which is not a FINRA member not to adopt the same procedures and to take the same care that they do not list a fraudulent offering.  These procedures are expenses and few platforms want to pay what it takes implement them correctly.

There is some fraud and the potential for more throughout the crowdfunding industry on both Title II platforms and Title III portals.  I see it. Other people see it and the regulators see it. More than one “knowledgeable” person in the crowdfunding industry has told me that fraud is minimal because the regulators have brought only these three actions. That, too, is preposterous because fraud is fraud whether the regulators catch it or not.

The industry for the most part is in denial because it does not want to see fraud.  In many cases people in the industry would not know a fraudulent offering if they did see one. I am certain that the crowdfunding industry is not interested in eliminating offerings with “impractical business plans” because that describes a great many offerings that appear on both Title II and Title III sites.

Only about 30% of the equity offerings that list on crowdfunding sites actually achieve their funding goals. Issuers incur many costs to list these offerings. The crowdfunding sites are doing no one a favor by listing offerings that investors should not want to consider in the first place.

If crowdfunding platforms exercised some judgment and discouraged companies from raising funds until they were ready to do so, it would help the industry raise that percentage of funded offers. There would be fewer offers but each would stand a better chance of fulfilling the promise of crowdfunding for small businesses and the jobs and opportunities they create.

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