Loyola University Chicago School of Law, JD 2023
On September 20, the United States Securities and Exchange Commission charged three individuals with conducting fraudulent crowdfunding schemes while also bringing charges against the crowdfunding portal where the offerings were conducted in SEC v. Shumake. As the first case being pursued under Regulation Crowdfunding, a number of questions wait on the horizon regarding the responsibility of crowdfunding platforms to protect investors when orchestrating such offerings.
What is crowdfunding?
Crowdfunding is a source of raising equity that involves securing investment from the issuance of stock (generally, but not always) to everyday people rather than turning to venture capital firms or institutional investors. This generally involves turning to a large number of people investing small amounts of money over a period of a few months in the hope of getting a business or specific project off the ground. Crowdfunding figures in the U.S. grew by 33.7 percent last year and are projected to grow at a compounded annual growth rate of 14.7 percent for the next four years. Regulation Crowdfunding was initially introduced as part of the JOBS Act signed by President Obama in 2012 but did was not effectuated until May 16, 2016.
What do these regulations entail?
The regulations enacted by the SEC were significant given that anyone over eighteen years old can now buy securities in private companies. For the past eighty years, only accredited investors could buy equity in a startup, which required that they had made over $200,000 annually over the past two years or had over $1 million in net worth, excluding their primary residence. A key requirement in the SEC guidelines is that all crowdfunding security issuances go through an insurance[?] intermediary registered with the SEC, to ensure that all offerings are conducted within securities laws. One of the responsibilities that these registered intermediaries are accountable for is to check that the companies or “covered persons” of the company can pass what is known as the “bad actor” check pursuant to § 227.503. This check looks for criminal convictions as well as a number of different disciplinary orders from various government organizations to ensure that the company does not pose a risk to investors.
At the heart of the September 20 charge lies the funding portal, a new type of intermediary used for facilitating crowdfunding transactions, that carried out the “bad actor” check on the part of the companies involved and TruCrowd, Inc , their “covered persons.” At issue in particular is the SEC’s allegation that the portal’s CEO, Vincent Petrescu, had been told by a securities lawyer that there was a potential “red flag” concerning one of the participants’ prior conviction for mortgage fraud. During the multiple crowdfunding schemes presented by the charged individuals through the portal, investors had reached out to the portal regarding issues concerning lack of response from the issuers and not receiving any sort of certification for their investments. Despite the numerous concerns raised by both investors and attorneys who had warned him about the red flag, Petrescu continued to work with that individual and the companies.
What comes next?
The new regulation regarding what is required of these SEC-registered intermediaries goes no further than the statutory provisions themselves, as a case has never been tried under these regulations. Regulation Crowdfunding does little to define what is adequate in regards to denying access to an issuer, however it does provide that an intermediary may deny access to its platform to an issuer if the intermediary has a reasonable basis for believing that the issuer or any of its officers, directors, or beneficial owners is subject to disqualification under § 227.503. At a minimum, this involves a background check and a securities enforcement regulatory history check. In addition, the intermediary may deny access if it has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection. If the intermediary becomes aware of information after it has granted access, it must promptly remove the offering and return funds to the investors.
While Petrescu and TruCrowd carried out the minimum as required by law, it is not a leap to say that there was a reasonable basis for believing the offering in question presented the potential for fraud. If it did not exist upon an attorney’s warning of a potential red flag with a party involved with the offering, it surely must have after numerous complaints by investors following the issuance. While it may have taken five years and a glaring mistake regarding an intermediary’s duty to protect investors, the crowdfunding industry has been put on notice: protect investor’s interests as the SEC would, or charges may come your way.