FinLaw: The Issuer Exemption and Investment Advisers Who Are Operating Funding Platforms
By Scott Andersen
Can advisers operate a funding platform for Rule 506 offerings without registering as a broker-dealer? This is a common question in the Rule 506 offering space. Funding platforms are websites that display offerings, and there is confusion about what rules come into play, asked by people in many diverse sectors, including technology and real estate. The short answer is yes, this can be done, has been done before, and is currently and regularly being done in the industry today. And we have guidance on this issue from the Securities and Exchange Commission (SEC).
In its no-action letters to AngelList LLC and FundersClub, Inc., the SEC Division of Trading & Markets staff states its agreement not to recommend enforcement actions. By doing so, the SEC alerts the legal and investing community of two instances where investment advisers operating funding platforms do not need to register as broker-dealers, even as serial issuers. This is a worthy area of discussion because regulation as a broker-dealer is onerous and expensive. It makes sense to consider whether functioning solely as an investment adviser is a better option for certain businesses. The AngelList and FundersClub letters set forth specific examples where federal broker-dealer registration by advisers is not required.
Investment Advisers Who Are Operating Funding Platforms
a) AngelList LLC
AngelList is a registered investment adviser that operates a website to connect companies seeking financing (Portfolio Company)  with accredited investors. AngelList forms numerous investment vehicles to invest in Portfolio Companies. These are funds known as “special purpose vehicles” or “SPVs.” After forming the SPVs, AngelList makes its investments available to (but does not solicit) accredited investors via AngelList’s website (“Platform”). Potential investors are able to view the fund’s private placement memorandum and disclosures on the platform.
AngelList’s business model is to provide investment advice and administrative services to the SPVs. AngelList does not receive transaction based compensation or even a management fee, but receives compensation solely by way of carried interest. This is generally defined as a portion of the increase in value of the fund calculated at termination or upon a liquidity event. Additionally, the business model also recoups expenses paid to create the SPVs.
The SEC no-action letter does not require AngelList to register as a broker-dealer. The SEC notes that AngelList is to operate as a registered investment adviser. As such, AngelList provides investment advice and administrative services to each fund. The SEC also notes facts pertinent to an analyses of the JOBS Act’s exemption from broker-dealer registration and whether AngelList’s business involves traditional broker-dealer activities.
b) FundersClub, Inc.
FundersClub operates a funding platform and is the parent company of FC Management, a manager for a series of investment funds (i.e. SPVs). Each SPV is formed to invest in the securities of one or more target companies. FundersClub posts information about various companies who are seeking capital on its platform, and the SPVs invest in the companies on behalf of the accredited investors. FC Management “engage[s] in the traditional activities of venture capital fund advisers, including negotiating and exercising management rights with the companies in which the funds invest, and providing assistance to the portfolio companies of the investment funds in terms of advice about issues such as possible customers, suppliers and employees.” FC Management receives carried interest compensation.
The SEC, in providing no-action relief, does not require that FundersClub or FC Management register as broker-dealers. The SEC notes that they are acting as advisers to venture capital funds. As such, FundersClub and FC Management already are under regulation of the Investment Advisers Act of 1940 (Advisers Act). FC Management’s services include, among other things, exercising any rights negotiated with the company the fund is investing in, providing the company with strategic advice, and ultimately liquidating the securities owned by the fund in the company. The SEC also notes facts pertinent to an analysis of the JOBS Act’s exemption from broker-dealer registration and whether the business model involves traditional broker-dealer activity.
c) Investment Adviser Funding Platform Model
The SEC no-action letters provide for the first time support for an investment adviser to operate a funding platform. While the SEC’s broad interpretation of the term “compensation” limits the scope of the JOBS Act’s broker-dealer exemption, the SEC no-action letters nonetheless do not require AngelList and FundersClub to register as broker-dealers. Although the no-action letters do not provide the SEC’s rationale, we do have a template for an investment adviser funding platform model. The investment adviser may: i) form investment funds (SPVs), ii) use a funding platform to provide information and disclosures to accredited investors, iii) use the funds (SPVs) to invest in businesses or other assets on behalf of accredited investors, and iv) earn traditional investment adviser-type compensation (specifically, a carried interest). By not requiring broker-dealer registration, the SEC no-action letters eliminate regulatory friction and provide the industry an opportunity to structure businesses that can actively engage in the capital formation process, receive compensation for doing so, and operate platforms without requiring a broker-dealer model. The SEC should continue to build on this positive development by providing the industry further formal and informal guidance to further clarify the requirements of a solely investment adviser funding platform.
The Issuer Exemption and the Investment Advisor Act
i) Issuers Do Not Have to Register as Broker-Dealers Under the Issuer Exemption
The term “issuer” is defined under both the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) as “the person who issues or proposes to issue any security… .” In the context described above concerning AngelList and FundersClub, the issuer is the fund (SPV) that has pooled investor money to purchase securities. The Investment Adviser’s employees who participate in the sale of the fund’s securities are “associated persons” of the issuer.
The issuer exemption, found in Exchange Act Rule 3a4–1, provides a nonexclusive safe harbor for persons associated with certain issuers to participate in the sale of an issuer’s securities and without registering as a broker-dealer. While the issuer exemption may provide relief for issuers of a single offering, the exemption may be called into question when an issuer’s associated persons seek to participate in multiple offerings in a single calendar year (i.e., functioning as a “serial issuer”). Indeed, to qualify for the issuer exemption, persons associated with an issuer generally may not participate in the selling of securities for any issuer more than once every twelve months.
Notably, AngelList conceded in its submission to the SEC that it does not qualify for the safe harbor. This was because of a likelihood that its employees may sell the securities of more than one issuer in a twelve-month period.
Regardless, despite not meeting the safe harbor and functioning as a “serial issuer,” AngelList is not required to register as a broker-dealer. The safe harbor under Exchange Act Rule 3a4–1 is not exclusive. In other words, even in instances where the safe harbor cannot be met, an issuer still may be able to articulate that it, as an issuer, should not be required to register as a broker-dealer. Moreover, the safe harbor itself provides another exemption (even when its employees are involved in more than one issuer sale in a twelve-month period) if its sales activities are limited or passive. As the SEC does not identify its rationale for issuing the no-action letter to AngelList, it is unclear whether the issuer exemption is the basis. What is clear is that AngelList – as a serial issuer – is not required to register as a broker-dealer.
ii) Investment Advisers Engaged Solely in Investment Adviser Activities Should be Regulated Only Under the Investment Advisers Act
Like AngelList, FundersClub is also not required to register as a broker-dealer. Notably, counsel for both AngelList and FundersClub argue to the SEC that registration as a broker-dealer is not appropriate. After all, each of these investment advisers are already regulated under the Investment Advisers Act. And as articulated by counsel, there is no policy rational that supports requiring an investment adviser to be regulated as both as an investment adviser and as a broker-dealer. As counsel representing AngelList explains: “[t]here is no policy rational that should require an investment adviser receiving typical investment adviser-style compensation to register as a broker-dealer. In these circumstances, it would frustrate the intent of Congress and the Commission, when they recognized the important role that venture capital fund advisers play in providing capital for start-up businesses, to require a venture capital fund adviser to register as a broker-dealer.”
AngelList and FundersClub both earn carried interest. Carried interest is one form of investment adviser compensation. Carried interest is not the same as transactional based compensation earned by broker-dealers. Rather, it is a return on an investment as a result of a manager’s efforts to increase a fund’s performance. The SEC has not passed publicly on management fees, which are typically standardized as 2% annually on the assets of the funds. Management fees are another type of investment adviser compensation, and traditionally are not interpreted to be transaction based compensation.
Many types of investment advisers (venture capitalists, hedge funds, etc.) may see opportunities in employing the models used by AngelList and FundersClub. Namely, using a funding platform (a website) to provide information and disclosures to accredited investors while forming funds (SPVs) to invest in businesses or other assets on behalf of accredited investors. While earning traditional investment adviser compensation for these efforts. These activities thus fall under the Investment Adviser Act regulatory umbrella.
Market participants and their counsel should carefully think through their business model. They should determine whether they can follow the template established by AngelList and FundersClub. Former SEC Chief Counsel for the Division of Trading and Markets, David Blass, in an April 5, 2013 speech before the American Bar Association Trading and Markets Subcommittee, identified several areas that should be considered in determining whether a business model is possible without broker-dealer registration. These areas include how the adviser solicits and retains investors; whether employees who solicit investors have other responsibilities and whether the primary functions of these employees is to solicit investors; how personnel who solicit investors are compensated; whether those individuals receive bonuses or other types of compensation that is linked to successful capital raises; and whether a transaction fee is charged by the issuer or the entity operatin g the funding platform in connection with a sale of securities.
While each of these questions and others need to be addressed in determining whether broker-dealer registration is required, David Blass added: “[t]here is a wide array of options available to private fund advisers to raise funds without triggering broker registration concerns.”
David Blass was subsequently interviewed on September 25, 2013 in a Practicing Law Institute webinar entitled, “Private Fund Sales and Marketing: A Conversation with Senior Staff from the SEC Division of Trading and Markets.” During this interview, Blass reportedly stated “that compensation paid to advisers from the funds they manage based on assets under management and/or investment performance, absent other factors, likely would not trigger a requirement to register as a broker-dealer. However, he did state that pure transaction-based compensation paid to an adviser’s employees is generally a ‘clear cut example’ where registration would be required.”  AngelList and FundersClub are instructional on this point as they show us that it is both possible and legal for an investment adviser to operate a funding platform without broker-dealer registration. While the SEC does not provide us their rationale in the no-action letters, they p rovide us with a useful template for what is permissible for investment advisers.
The history of securities regulation is replete with questions regarding whether broker-dealers need to register as investment advisers, and whether investment advisers need to register as broker-dealers. The answer largely has been no, primarily in recognition of the fact that there are two regulatory regimes under federal law, the first governing broker-dealers and the second investment advisers. Each regime has a different governing structure (principle based versus rules based), different standards (fiduciary duty versus suitability) and different primary regulators (the states or SEC versus FINRA).
Today, in the context of persons who have funding platforms that display securities being sold pursuant to the Rule 506 exemption, the question again is being asked whether an investment adviser pursuing a venture capital model must also be registered as a broker-dealer. There is nothing in the JOBS Act or Dodd-Frank Act or Investment Adviser Act that requires that this be the case, especially as Congress included in the JOBS Act an express exemption from broker-dealer registration. While the SEC has interpreted this exemption narrowly, the AngelList and FundersClub no-action letters provide us with useful templates to show that an investment adviser funding platform is possible and can be designed to meet legal standards. There is no regulatory purpose for double regulation, and requiring investment advisers to also be regulated as broker-dealers would fly in the face of the JOBS Act by making it harder for small businesses to grow and spur job creation. The best course for the industry is to allow people to determine the best business model for their participation in capital formation activities. And to regulate them under only one federal securities regulatory regime –either as an investment adviser or as a broker-dealer — but not as both.
And when weighing choices, there is no doubt that many people will conclude the investment adviser model is the superior one for their business, while others will opt to pursue the broker-dealer model. Yet, when considering the costs of acting as a broker-dealer and complying with FINRA rules and other related regulations, allowing people to proceed solely as an investment adviser is essential to enable a more affordable option that will allow people to pursue the opportunities intended by Congress in enacting the JOBS Act.
NASAA: what about serial issuers and state securities regulators? I’ll address this topic in my next article.
About Scott Andersen:
Scott is principal at finLawyer.com, General Counsel of FundAmerica and principal at ConsultDA. He was most recently the Deputy Regional Chief Counsel at FINRA, and prior to that was the Enforcement Director at FINRA and the NYSE, Co-Chief of the Securities Prosecutions Unit of the NY Attorney General’s office, and Asst. Attorney General for the State of NY. He concentrates his practice on securities and regulatory law.
The information and materials in this article are provided for general informational purposes only and are not intended to be legal advice. The issues discussed include complicated areas of law and legal advice should be obtained from a securities attorney about your specific circumstances.
 See FundersClub, Inc., SEC No-Action Letter (March 26, 2013), 2013 SEC No-Act. LEXIS 271; AngelList LLC and AngelList Advisors LLC, SEC No-Action Letter (March 28, 2013), 2013 SEC No-Act. LEXIS 294.
 My article today is limited to a discussion of federal regulation. Industry participants should be mindful that state blue sky laws also may be applicable and should be considered. I will address this in a future article.
 AngelList represents to the SEC in its request for no-action relief that it intends to register as an investment adviser.
 Each Portfolio Company has a traditional Angel investor who negotiates deal structure.
 Each SPV is exempt from registration under the Investment Company Act of 1940, as amended pursuant to Section 3(c)(1)(where issuer of securities are not beneficially owned more than 100 persons) or 3(c)(7)(where securities are owned exclusively by qualified purchasers).
 There is a process through the platform to determine whether an investor is accredited and thus a qualified participant, together with a 30-day cooling off period before closing any investment. This 30-day cooling off period is to meet SEC guidance set forth in the Lamp Technologies, Inc. no-action letter for conducting 506(b) offerings online. The Lamp Technologies no-action letter is available at http://www.sec.gov/divisions/investment/noaction/1997/lamptechnologies052997.pdf .
 These services include seeking and determining when to exit investments, and exercising voting rights.
 See Robert H. Rosenblum March 25, 2013 letter to David W. Blass, Chief Counsel of SEC Division of Markets and Trading, AngelList LLC and AngelList Advisors LLC, SEC No-Action Letter (March 28, 2013), 2013 SEC No-Act. LEXIS 294.
 The phrasing in the no-action letter is that the SEC “noted in particular… ” which is followed by a listing by the SEC of certain facts.
 The SEC website details its narrow interpretation of the JOBS Act’s exemption from broker-dealer registration. For example, the SEC interprets “compensation” in connection with the purchase or sale of such security” “broadly, to include any direct or indirect economic benefit to the person or any of its associated persons.” See Answer to question 5 at http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm . In fact, the SEC interpretation goes so far as to question whether anyone outside the “venture capital area” would be able to meet the JOBS Act exemption from broker-dealer registration. See Answer to question 6. Despite the narrow interpretation (and the seeming inapplica bility of the exemption), AngelList does not have to register as a broker-dealer.
Section 3(a)(4)(A) of the Act defines a “broker” as any person engaged in the business of effecting transactions in securities for the account of others. The SEC has elaborated further on when one is acting as a broker through the posting of staff guidance on its website. See, U.S. Securities and Exchange Commission Guide to Broker-Dealer Registration (2008), Section IIA (“The staff has posted questions you should consider in determining whether you are acting as a broker, including do you participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction; does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal; Do you receive trailing commissions or other 12b-1 fees or other transaction-related compensation? Are you otherwise engaged in the business of effecting or facilitating securities transactions? Do you handle the securities or funds of others in connection with securities transactions?” A “yes” answer to any one of the factors listed indicates that you may need to register as a broker), at http://www.sec.gov/divisions/marketreg/bdguide.htm . In AngelList, the SEC considered that AngelList was engaged in Rule 506 offerings to accredited investors, that there was no transaction based compensation, and that AngelList did not handle customer securities or funds, among other facts.
 FC Management identifies the target start-up company, performs due diligence services and enters into a non-binding agreement with each company.
 Only accredited investors are able to access this information.
 There is an indication of interest process for potential investors on the website.
 See W. Hardy Callcott March 22, 2013 letter to David W. Blass, Chief Counsel of SEC Division of Markets and Trading, at FundersClub, Inc., SEC No-Action Letter (March 26, 2013), quoting, Callott’s analysis, at 2013 SEC No-Act. LEXIS 271.
 The SEC included a footnote in the no-action letter where it took a broad interpretation of the term “compensation,” thus limiting the scope of the JOBS Act’s broker-dealer exemption. Despite its interpretation, the SEC nonetheless granted no-action relief to FundersClub and broker-dealer registration was not required.
 These facts include that the parties engaged in Rule 506 offerings to accredited investors, that the investment adviser receives carried interest compensation and not transaction-based compensation, and that the adviser does not handle customer securities or funds, among other facts.
 AngelList stated: “We acknowledge that AngelList Advisors will not be able to avail itself of the safe harbor from registration as a broker-dealer provided by Rule 3a4-1 under the Exchange Act … . In particular, while AngelList Advisors’ employees will be “associated persons” of the issuers … and will not receive Transaction-Based Compensation, such employees will likely be involved in selling the securities of more than one issuer in any twelve month period.” See Robert H. Rosenblum March 25, 2013 letter to David W. Blass, Chief Counsel of SEC Division of Markets and Trading, supra.
 See Robert H. Rosenblum March 25, 2013 letter to David W. Blass, supra; W. Hardy Callcott March 22, 2013 letter to David W. Blass, supra.
 See Robert H. Rosenblum March 25, 2013 letter, supra.
 A registered investment adviser may charge carried interest only if permitted by rule 205–3 under the Advisers Act. Any carried interest paid to a manager that is not registered under the Advisers Act is required to comply with section 205(b)(3) of the Advisers Act.
 See Article: Fending for Themselves: Why Securities Regulations Should Encourage Angel Groups, 13 U. Pa. J. Bus. L. 107, 166, citing, Thomas P. Lemke and Gerard T. Lins, Regulation of Investment Advisers, at 154 (describing a fee based on assets under management as a “typical advisory fee”). If management fees are reasonably related to the services provided to the fund (SPV) by the investment adviser, its payments should not be viewed as transaction based compensation. A 2% annual management fee based on the invested capital of a fund paid to an investment manager for the day-to-day managing of the investment should thus be permissible.
 For example, see Section 202(a)(11)(C) of the Advisers Act which exempts from registration as an adviser a broker or dealer “whose performance of [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.”
 See SEC Release No. 34-69013; IA-3558; File No. 4-606 Duties of Brokers, Dealers, and Investment Advisers (“While both investment advisers and broker-dealers are subject to regulation and oversight designed to protect retail and other customers, the two regulatory schemes do so through different approaches…”); Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (January 2011)(“The regulatory schemes for investment advisers and broker-dealers are designed to protect investors through different approaches”), at http://www.sec.gov/rules/other/2013/34-69013.pdf .