First-year law students encounter what is called the “reasonable man” test. It is usually explained as what an average, reasonable person would do in a similar situation. It is applied as a standard of care in cases where the fact finder is trying to assess the conduct of one of the parties. You can find the “reasonable man” test in patterned jury instructions used every day all over the country.
There are often a lot of precedents that help judges and juries decide what is reasonable and not. Sometimes a jury will be asked to place themselves into the shoes of one of the parties and ask themselves “what would you do”. That is where things can get a little cloudy.
My law professor described it this way. If your spouse is having an affair with your neighbor, they likely feel that their conduct is reasonable at least as they view the surrounding circumstances. You are likely to view their conduct differently. So how you view the situation often depends on your perspective of the conduct at issue which is based upon your own experiences and beliefs.
There is also conduct that is judged against a higher standard of care. Professionals like doctors, because they are specifically trained and licensed, are expected to follow established medical protocols. Others, because of their training or title are expected to perform their tasks as other “reasonable” professionals would if faced with the same facts or situation.
In securities law, the conduct of those people who are in the business of selling securities to the public (intermediaries) is regulated. Laws passed by Congress and rules adopted and enforced by the SEC and FINRA define the conduct that is reasonable for both mainstream stockbrokers and Regulation CF funding portals.
What do regulators expect from Reg. CF funding portals?
I speak with portal operators and other lawyers working in the Reg. CF market. I get that question a lot, and I cringe whenever someone asks. The answer should be settled by now but it is not.
Many of the portal operators with whom I have spoken (and some of their lawyers) have very diverse views are regarding the portals’ obligations under the regulatory scheme in which they operate. Some seem to think that a funding portal’s role is primarily passive. They believe that the portals do not need to take steps to see if what investors are being told about the offerings they host is true.
More than one portal operator told me that they are most often satisfied with the initial representations made by most of the companies that list on their portals after a conversation or two because the managers at these companies sound “credible”. They do not see any “red flags” because they are not looking for them.
There have always been scam artists in the capital markets. Four decades before the federal securities laws in the 1930s, states were fighting fraud with “blue sky” laws so-named because people were selling stock in companies whose prospects were worth little more than the “blue sky” up into which the price of the stock would surely go.
Blue sky laws were not a response to a need to protect rich, money center investors. Rather, they were enacted to protect small, Main Street, rural, mom and pop investors. These were people who we now call the “crowd”.
If you have operated a funding portal for a year or two, a scam artist or two has likely come knocking on your door. Some portals turn away offerings because the companies cannot provide good answers to the questions the portal asks.
Other portals list any offering that comes along and allow these companies to make any number of false and misleading statements to sell the offering to investors. These portals ask few questions. They cite the SEC’s own statement to support their hands-off approach.
The SEC specifically states that it expects funding portals to take such measures to reduce the risk of fraud. Reg. CF specifically requires a portal to have a “reasonable basis” to believe that each issuer is complying with the law. That should include the laws that require an issuer to make all necessary factual disclosures to investors and to present the offerings in such a way that investors will not be misled.
Unfortunately, the SEC added the following sentence to the regulation:
“In satisfying this requirement, an intermediary (portal) may rely on the representations of the issuer concerning compliance with these requirements unless the intermediary has reason to question the reliability of those representations”.
Some portals rely upon that statement to support their idea that they can just pass on whatever information the issuers provide to the investors without questioning its content.
Taken in the context of the regulators’ desire to foster investor protection, the above statement should raise the question; how would an intermediary know if it had reason to question the reliability of the representations made by the issuer unless they dug a little deeper?
FINRA, which regulates both broker-dealers and the Reg. CF funding portals requires broker/dealers to conduct reasonable due diligence investigations of all offerings, especially when an issuer seeks to finance a new speculative venture. In that case, FINRA warns that broker/dealers “must be particularly careful in verifying the issuer’s obviously self-serving statements.”
New, speculative ventures are the meat and potatoes of the Regulation CF marketplace. Aren’t the younger, less sophisticated investors who are being solicited to fund these companies entitled to the same protections as the more sophisticated, accredited investors who might invest in a new venture through a broker/dealer? Are the accredited investors being lured to Reg. CF portals now that the portals have become less restrictive being told that the due diligence they get at the portal is much less than they would get at a BD?
For the record, the SEC originally included that statement about relying on the representations of issuers, in part, because the staff recognized that a true due diligence investigation can be expensive for a company raising only $1 million. As the limit has now been raised to $5 million the Reg. CF funding portals are earning 5x per offering and can certainly conduct a reasonable due diligence investigation of at least these larger offerings.
Given that 2000 fraudulent ICOS were funded and many just took the money, closed up shop, and crept away, it is easy to imagine a thief posting phony offerings on 4 or 5 portals at the same time raising $25 million and doing the same. Since the regulators cannot catch these offerings in real-time and the portals are not looking, I think that scenario is inevitable.
When is a funding portal compliance director being reasonable?
I trained in broker/dealer compliance while working at a large, national wirehouse. It took me a while to learn the rules and procedures that were already in place. It took longer for me to understand why each of those rules and procedures existed, and how and when they were being applied.
I have consulted with quite a few compliance professionals and departments over the years. The job requires them to make judgment calls and give advice that, if wrong, can be very costly to the firm. Many of these professionals are guided by their understanding of the rules and a healthy amount of common sense.
Lawsuits and problems with regulators are signs that compliance is sub-standard. Being ordered to pay investors back $5 million because of a fraudulent offering would hurt any funding portal’s bottom line. Good compliance, and not just trusting the issuers to make representations without verification, would reduce the costs of lawsuits and regulatory problems to zero.
A compliance director at a funding portal must also take into account that the portal must also answer to regulators other than the SEC and FINRA. Remember those pesky blue sky laws?
State securities laws apply in the state where the portal operates and also any state where any investor in an offering on the portal resides. The Uniform State Securities Act (adopted in more than 30 states) takes a completely different approach towards liability in cases involving a fraudulent offering.
Under federal law, the person who purchased the security has the burden of proving that they would not have made the purchase but for some important fact that was either omitted, false or presented in such a way that it caused the purchaser to be misled.
Under the state law, the seller must sustain the burden of proof that the seller did not know, and, in the exercise of reasonable care, could not have known of the untruth or omission. Given that the seller (intermediary) has done no investigation or asked any questions, it is difficult to demonstrate where the investigation would have led if it had been guided by the documents that could have been requested.
Sooner or later a portal owner will be sitting in front of a state securities administrator who is asking how some purely fraudulent offering got listed on the portal. The portal owner might take out a file of documents that record its investigation of the offering which, while not thoroughly comprehensive, is at least sufficient to sustain a conclusion that “having gotten responsive answers to the questions we asked, and seeing no red flags, we have a reasonable basis to believe the representations being made by the issuer are accurate.”
Other portal operators will pull out a letter from their lawyers advising them because of the SEC’s apparent green light, the portal can list any issuer relying only upon the issuer’s representations and presumed reliability. (Spoiler alert- state securities administrators really hate that response.)
I write a lot about scams in crowdfunding. A lot of people tell me that the problems I see are just growing pains for this new industry.
By next summer, if not sooner, thanks to new technology and techniques, 5-million-dollar offerings listed on Reg. CF funding portals will sell out in a matter of hours. Going forward, a lot of money is going to change hands very quickly with little scrutiny. That should attract more scam artists, not fewer.
The only way to reduce the presence of scam artists and scam offerings from the Reg. CF market is for the portal operators to push back against the idea that a portal can be passive when it comes to investor protection.
Portal operators need to ask a lot of questions about each offering that is presented to them. They need to be satisfied with the answers they get. It does not need to be an expensive due diligence investigation. A portal just needs to make a reasonable inquiry as judged from the perspective of a professional funding portal compliance officer.
The portals I advise are told to reject offerings when they are not comfortable with the answers they get. If something sounds too good or not quite right, a funding portal compliance officer should be expected to inquire further. The compliance officer should be expected to be satisfied with the veracity of the answers before passing the issuer on to the public.
You will not find words like “comfortable” and “satisfied” in the legal dictionary. Rather they are the result of a feeling of relief that compliance officers get when they have created a paper trail that supports their approval of a questionable offering.
“Comfortable” and “satisfied” are the result of a funding portal compliance officer having taken a practical, not legal approach. Quite often the most practical approach is also the most reasonable.
What will never be “reasonable”, “practical”, “satisfying” or “comfortable” is the idea that a funding portal could host an offering that did not tell investors the truth or which lure investors with fallacies and fabrications.
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