Related Liability With A Crowdfunded Offering

William A. PriceAttorney at LawGrowthlaw.com1-800-630-4780

What Does The Law Mean?

“A man who cares nothing for an ethical rule which is believed and practised by his neighbors is likely nevertheless to care a good deal to avoid being made to pay money, and will want to keep out of jail if he can.”

-- Oliver Wendell Holmes, Jr. “The Path of the Law”, 10 Harvard Law Review 457 (1897)

LIABILITY OF ISSUERS AND AFFILIATED PERSONS

17 CFR § 240.10b-5 Employment of manipulative and deceptive devices.

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or

of the mails or of any facility of any national securities exchange,(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were

made, not misleading, or(c) To engage in any act, practice, or course of business which

operates or would operate as a fraud or deceit upon any person,in connection with the purchase or sale of any security.

(Sec. 10; 48 Stat. 891; 15 U.S.C. 78j)

815 ILCS 5/12 Violation. It shall be a violation of the provisions of this Act for any person:

G. To obtain money or property through the sale of securities by means of any untrue statement of a material fact or any omission to

state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were

made, not misleading.H. To sign or circulate any statement, prospectus, or other paper or document required by any provision of this Act or pertaining to any

security knowing or having reasonable grounds to know any material representation therein contained to be false or untrue.

I. To employ any device, scheme or artifice to defraud in connection with the sale or purchase of any security, directly or indirectly.

“Plaintiffs' Counts VI, VII, VIII, and X are based on subsections (F), (G), (I), and (J), respectively of § 12 of the Illinois Securities Law. Subsections (F), (G), and (I) largely mirror the fraud provisions

of the federal Rule 10b-5, compare 815 Ill. Comp. Stat. § 5/12(F), (G), (I) and 17 C.F.R. § 240.10b-5”

-- Gandhi v. Sitara Capital Mgmt. LLC, 689 F. Supp.2d 1004, at 1013 (N.D. Ill., 2010)

What The SEC Must Prove In A 10b-5 Case

(i) Manipulation or Deception (through misrepresentation and/or omission);(ii) Materiality;(iii) "In Connection With" the purchase or sale of securities, and(iv) Scienter.

What Private Plaintiffs Must Also Prove In A 105-5 Case

(v) Standing - Purchaser/Seller Requirement;

(vi) Reliance (presumed if there was an omission of a material fact);

(vii) Loss Causation; and

(viii) Damages.

State Statute: Burden Of Proof On Defendant

“…Certain blue sky laws do not require the plaintiff to prove scienter. They place the burden upon the defendant to establish lack of knowledge as an affirmative defense…”

-- In re Nat'l Century Fin. Enters., Inc., Inv. Litig., 846 F.Supp.2d 828, at 888 (S.D. Ohio, 2012)

Control Persons: Section 20(a) provides as follows:“Every person who, directly or indirectly, controls any person

liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to

the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action. 15 U.S.C. § 78t(a) (1988). To establish control person

liability, a plaintiff must show that the defendant has "the practical ability to direct the actions of the people who issue or

sell the securities." Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 494 (7th Cir.1986).”

-- Donohoe v. Consolidated Operating & Production Corp., 982 F.2d 1130, at p. 1138 (C.A.7 (Ill.), 1992)

First SEC Crowdfunding Action

See http://Ascenergy LLC et al. (Release No. LR-23394; October 28, 2015):• Ascenergy raised $5 million from 90 investors

via crowdfunding.com, equitynet.com, fundable.com and angel.com

• Routine fraud: raised money for oil leases when none had been secured

• Portals were not named defendants

LIABILITY ISSUES FOR FUNDRAISING PORTALS AND AFFILIATED INDIVIDUALS

“Securities Act Section 4A(a)(1) requires that each intermediary in a

crowdfunding transaction be registered with the Commission

either as a broker-dealer or a funding portal.”

-https://www.sec.gov/divisions/marketreg/tmcompliance/fpregistration

guide.htm

A registered funding portal is prohibited from:

Offering investment advice or recommendations;Soliciting purchases, sales or offers to buy the securities

displayed on its platform;Compensating employees, agents, or other persons for

such solicitation or based on the sale of securities displayed or referenced on its platform; or

Holding, managing, possessing, or handling investor funds or securities.

-- https://www.sec.gov/divisions/marketreg/tmcomplianc

e/fpregistrationguide.htm

SEC Fundraising Portal Rules

• Official Release (Review in detail, if you have a client): https://www.sec.gov/rules/final/2015/33-9974.pdf

• Implements Title III of the Jumpstart Our Business Startup (“JOBS”) Act, which added Sections 4(a)(6) and 4A to the Securities Act and Sections 3(h) and 12(g)(6) to the Securities Exchange Act of 1934 (“Exchange Act”).

Investment Advisers Law (1940), 15 USC 80b-1 through 80b-21, generally applies to anyone who:

“[E]ngage[s] in the business of advising others. . . .as to the value of securities or as to the advisability of investing in securities. . ..”

or “[I]ssues or promulgates analyses or reports concerning securities.”

-- IAA 1940 Section 202(a)(11)-- No caselaw yet on portals as advisers

815 ILCS 5/12 (J) When acting as an investment adviser, investment adviser representative, or federal

covered investment adviser, by any means or instrumentality, directly or indirectly:

(1) To employ any device, scheme or artifice to defraud any client or prospective client;

(2) To engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any

client or prospective client; or (3) To engage in any act, practice, or course of

business which is fraudulent, deceptive or manipulative.

FINRA Rules

• SEC Approved new FINRA Rules for Fundraising Portals, https://www.sec.gov/rules/sro/finra/2016/34-76970.pdf

• FINRA has details on its website: http://www.finra.org/industry/about-funding-portals

• Rules text as proposed is at http://www.finra.org/sites/default/files/NoticeAttachment/p369763.pdf

BEST PRACTICES AND HOW TO AVOID LIABILITY

Broker-Dealer Status

• FINRA limited BD status as portal encouraged• Fraud Issues Are Similar: JOBS Act does not

provide different liability protection or standard for limited BD’s: Anti-Fraud Rules Apply

• FINRA Regulations text for portals is at http://www.finra.org/sites/default/files/NoticeAttachment/p369763.pdf

FINRA Rule 200: Portal Communications

• (2) Content Standards• (A) No funding portal communication may:• (i) include any false, exaggerated, unwarranted, promissory or misleading

statement or claim;• (ii) omit any material fact or qualification if the omission, in light of the context

of the material presented, would cause the communication to be misleading;• (iii) state or imply that FINRA, or any other corporate name or facility owned by

FINRA, or any other regulatory organization endorses, indemnifies, or guarantees the funding portal member’s business practices; or

• (iv) predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast. A hypothetical illustration of mathematical principles is permitted, provided that it does not predict or project the performance of an investment or investment strategy.

FINRA Rule 200: Portal Communications (II)

(B) All funding portal member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service.

(C) All funding portal member communications must prominently disclose the name of the funding portal member, or the name under which the funding portal member primarily conducts business as disclosed on the member’s Form FP-NMA.

FINRA Rule 200 : Issuer Communications

(3) Issuer Communications

The content standards of paragraphs (c)(2)(A) and (B) of this Rule shall not apply to any communication on the funding portal member’s website that is prepared solely by an issuer; provided, however, that no funding portal member may include on its website any issuer communication that the funding portal member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.

Due Diligence And Suitability Standards

• Broker-Dealers are obligated to conduct due diligence on Regulation D Private Placements Which They Recommend: https://www.finra.org/industry/notices/10-22

• The recommended security must also be suitable in type and quantity for the specific customer, and the BD must have a reasonable basis to believe it is suitable for at least some customers

FINRA BD Due Diligence Requires Reasonable Investigation Of:

• The issuer and its management.�• The business prospects of the issuer.�• The assets held by or to be acquired by the �

issuer �• The claims being made in the private placement

memorandum (PPM) or other offering document.• The intended use of the proceeds of the offering.�

Additional Due Diligence Under FINRA Notice 10-22 (I)

• Affiliation with the Issuer: If the Portal is affiliated, this must be disclosed, and insider/control person standards may apply

• Representations in the PPM: Check FINRA Rules 2010 and 2210, but cf Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (June 13, 2011) that only the "maker" of a statement, and not those who simply helped prepare and publish the statement, can be primarily liable

Additional Due Diligence Under FINRA Notice 10-22 (II)

• Red Flags: Additional investigation required if initial due diligence or client statements reveal any information that would alert a prudent person to conduct a further inquiry which is substantial adverse information about the issuer.

• Reliance on counsel or other experts: Check their qualifications and scope of work

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer and

Management (I) ➤ Examining the issuer’s governing documents, including any

charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determinewhether it has perpetual existence.

➤ Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.

➤ Looking for any trends indicated by the financial statements.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer and

Management (I) ➤ Inquiring about the business of affiliates of the issuer and the

extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.

➤ Inquiring about internal audit controls of the issuer. ➤ Contacting customers and suppliers regarding their dealing

with the issuer. ➤ Reviewing the issuer’s contracts, leases, mortgages, financing

arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer and

Management (III) ➤ Inquiring about past securities offerings by the issuer and the

degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuouslyraising new capital. This inquiry could be especially important for any blind pool or blank-check offering.

➤ Inquiring about pending litigation of the issuer or its affiliates. ➤ Inquiring about previous or potential regulatory or disciplinary

problems of the issuer. A BD might make a credit check of the issuer.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer and

Management (IV) ➤ Making reasonable inquiries concerning the issuer’s

management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or mightotherwise affect the issuer’s business.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer and

Management (V) ➤ Inquiring about the forms and amount of management

compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiriesconcerning the qualifications and integrity of any board of directors or similar body of the issuer.

➤ Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer’s

Business Prospects (I) ➤ Inquiring about the viability of any patent or other intellectual

property rights held by the issuer.

➤ Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer’s

Business Prospects (II) ➤ Requesting any business plan, business model or other

description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any businessforecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer’s

Business Prospects (III) ➤ Requesting financial models used to generate projections or

targeted returns.

➤ Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress test performed on the issuer’s assumptions and projections.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer’s Assets

(I)

➤ Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physicalplants and the adequacy of its equipment are accurate.

Industry Best Practices For Due Diligence Under FINRA Notice 10-22: Issuer’s Assets

(II) ➤ Carefully examining any geological, land use,

engineering or other reports by third-party experts that may raise red flags.

➤ Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.

DIFFERENCES BETWEEN SEC, FINRA, AND JUDICIAL RELIEF

SEC/State Securities Department Relief

• Agency does not have to prove standing and damages

• Agency (like state agency) has less time and resources for investigation than private parties: attention to big cases

• Agency may seek civil or criminal prosecution for securities fraud

• Agency, like private parties in federal suits, must prove fraud was intentional

FINRA Relief

• FINRA relief may be available against persons involved in selling private placements

• FINRA rules reference and elaborate on SEC rules and legal standards

• Restitution of customer funds invested a primary remedy

• FINRA rules for complaints and proceedings before FINRA apply

Judicial Relief

• New private securities litigation legal requirements for standing to sue in federal court

• Punitive damages possible for fraud• Contract actions possible counts• State counts may be easier to prove than

federal scienter

Illinois Securities Act Voidability

• 815 ILCS 5/13 makes fraudulent sale voidable, with 10% interest plus refund to purchaser

• Notice within 6 months of purchaser knowledge of voidability is required: this means 1) the date upon which the party bringing the action has actual knowledge of the alleged violation of this Act; or (2) the date upon which the party bringing the action has notice of facts which in the exercise of reasonable diligence would lead to actual knowledge of the alleged violation of this Act.

Any Questions?

William A. PriceAttorney at Lawwww.growthlaw.comTel/Fax 1-800-630-4780Email: wprice@growthlaw.com