The rules, as adopted, are intended to implement the legislative intent as expressed in the statute and to make crowdfunding a feasible alternative to the normal methods of capital formation by small businesses in Colorado—a “friends and family” private placement or intrastate offering, venture capital financing, or a state- or federally-registered public offering. Because the CF Act is based on the federal intrastate exemption, it can only be used by Colorado businesses soliciting funds from Colorado residents, primarily for use in Colorado. The securities offered and sold pursuant to the CF Act must “come to rest” in Colorado—meaning that there have to be transfer restrictions imposed under Rule 147 to ensure that, for at least twelve months, they are not transferred to persons who are not Colorado residents.
The Issuer and Disclosure. The CF Act contemplates, and the rules provide for, the issuer giving a broad public notice to persons who may be interested in the offering. The notice may be in print format or in electronic format (through email, social media, or otherwise), but must be limited to Colorado residents. Following the guidance of SEC Compliance and Disclosure Interpretation 141.04, Colorado Rule 3.24.I provides that where an electronic-based notice “sent by or on behalf of the issuer” has appropriate legends and warnings, the public notification is permitted, even where it may be accessible to non-Colorado residents.
The CF Act and the rules (especially Rule 3.22.B) impose the obligation for full and fair disclosure on the issuer seeking to raise funds from the crowd. The rules include Form CF-2 which forms the basis for disclosure, although it is expected that many issuers will also use a memorandum format or a business plan for disclosure which they will incorporate by reference into the Form CF-2. It is likely that prospective investors will want to perform further due diligence and make inquiries of the issuer. Where the discussions with prospective investors lead the issuer to disclose material information not already contained in the Form CF-2 disclosure, the issuer must amend the Form CF-2 disclosure within five business days (Rule 3.22.D). Where material events have occurred after the filing of the initial Form CF-2 (or after the filing of any amendment), the issuer must appropriately amend the disclosure within five days.
The Investors. The investors must be Colorado residents. In fact, using language similar to SEC Rule 506(c), the CF Act requires that before making any sales, “the issuer shall obtain documentary evidence from each prospective purchaser that provides the seller with a reasonable basis to believe that the purchaser meets the [Colorado residency] requirements.” (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)) This arguably requires more than a simple investor affirmation as to residency since it requires “documentary evidence.” This language suggests that the issuer must review and maintain copies of the investor’s driver’s license, state voting registration, utility bills, or other documentary evidence to establish residency in addition to the investor’s affirmation.
No person may invest more than $5,000 in a crowdfunding offering unless that person is an “accredited investor” as that term is defined by the SEC. If a person is an accredited investor, there is no statutory limitation on the investment amount (subject to the maximum limits of the crowdfunding offering). In determining whether a person is an accredited investor, Rule 3.24.A.1 requires the issuer to have a “reasonable basis” for establishing the accredited investor status. This is language that is similar to Rule 506(c)(2)(ii) (which requires that the issuer “take reasonable steps to verify that purchasers” are accredited investors). It is not likely that an investor self-certification will be sufficient if challenged.
In any crowdfunding offering in Colorado, the prudent issuer will require the purchaser to sign (electronically or on paper) a subscription agreement or investment letter warranting residency and acknowledging the restrictions on ownership and further transferability of the security. The subscription agreement or investment letter will also likely follow the normal form for such documents and include warranties by the purchaser that:
- he/she has been fully informed about the transaction, the risks, and the issuer;
- the purchaser is acquiring the securities for investment purposes only and without a view toward further distribution;
- the purchaser is aware of the transferability restrictions to which the crowdfunding securities are subject; and
- the purchaser has consulted with legal counsel and other advisors as the purchaser has determined to be necessary or appropriate in the circumstances.
These investor representations and supporting documentation are information that the issuer and the on-line intermediary must maintain for at least five years. (Rules 3.23 and 3.25)
The On-Line Intermediaries. The CF Act contemplates, and the rules provide for, the crowdfunding offerings being accomplished through broker-dealers, sales representatives, or on-line intermediaries. Where broker-dealers or sales representatives are involved, the CF Act and the rules defer to FINRA which regulates broker-dealers and sales representatives. The Colorado Securities Act was amended to define “on-line intermediary” (C.R.S. § 11-51-201(11.5)) and to describe certain prohibited activities (C.R.S. § 11-51-308.5(3)(c)(III)). As set forth in the statute and the rules (and especially Rule 3.29.A):
- On-line intermediaries cannot handle or possess funds or securities in the offering process.
- On-line intermediaries cannot own a financial interest in any crowdfunding participant or receive compensation that is based on the amount raised.
- On-line intermediaries cannot be affiliated with or under common control with an issuer conducting a crowdfunding offering through that intermediary.
- On-line intermediaries cannot offer investment advice or recommendations or solicit purchases or sales of securities displayed on its website (but is merely a repository for the information displayed).
- On-line intermediaries must post the disclosure documents, and likely will have extensive terms and conditions, risk warnings, and investor acknowledgements that must be accepted as a condition precedent to the investor continuing to the funding site.
- On-line intermediaries have specific record-keeping obligations, and must take steps to ascertain that the persons viewing crowdfunding offerings through their website are in fact Colorado residents.
- On-line intermediaries may generally advertise their website but may not “identify, promote, or otherwise refer to a security offered by it.’ (C.R.S. § 11-51-308.5(3)(c)(V)).
The CF Act amended the Colorado Securities Act to exempt on-line intermediaries acting within the limitations of the CF Act from the registration requirements for broker-dealers and sales representatives. (C.R.S. § 11-51-402(1)(c)) Where an on-line intermediary reaches beyond the narrow scope of permissible actions described in the statute and the rules, the on-line intermediary may venture into broker-dealer territory. For example, an on-line intermediary who sends out an issuer-specific notification to its email list may be considered to be “engaged in a solicitation”; on the other hand, an affiliate of the on-line intermediary that is not an alter ego of the on-line intermediary may be able to provide these and other services in the nature of “marketing” or “crowd formation” to the issuer. Transaction-based compensation and direct solicitation and marketing is likely to result in broker-dealer classification, however. In this consideration, it is important to note that a number of on-line intermediaries doing business in other states are in fact licensed broker-dealers.
Subject to the requirements of Rules 3.27 and 3.28.C (discussed below), the role of an on-line intermediary may be passive—a bulletin-board like posting service. In some cases, the on-line intermediary may have a more active role. The rules contemplate that an issuer may contract with an on-line intermediary to collect residency information and preserve records for the benefit of the issuer, but this remains the issuer’s responsibility. (Rule 3.23.B) To help on-line intermediaries identify the boundaries of its role as compared to that of a broker-dealer, the rules also provide that an on-line intermediary that “does nothing more than collect information regarding the purchase of securities” and “provides a link to transmit funds to the escrow agent” is not conducting a prohibited act. (Rule 3.29.B)
Rules 3.27 and 3.28.C impose certain obligations on on-line intermediaries which require the on-line intermediary to be more involved than the typical bulletin-board posting.
- Rule 3.27 requires on-line intermediaries to establish “written supervisory procedures and a system for applying such procedures that is reasonably expected to prevent and detect violations of the Colorado Securities Act, given the limited role of the on-line intermediary under the CF Act.”
- More significantly, Rule 3.28.C requires that the on-line intermediary affirmatively “deny access” to an issuer where the on-line intermediary has a “reasonable basis for believing”:
- that the issuer is not in compliance with § 11-51-308.5;
- has not established a means to keep accurate records; or
- that the issuer or offering presents the potential for fraud or otherwise raises concerns regarding investor protection.
The use of the phrase “reasonable basis” in the context of Rule 3.28.C does not necessarily impose a due diligence obligation on the on-line intermediary; it does not permit the on-line intermediary to ignore facts that would come to its attention that might suggest the negatives set forth in the Rule. The wording of this rule creates an affirmative obligation to “deny access” only when the intermediary reasonably believes wrongdoing is occurring. This prohibits “willful blindness” on the part of the on-line intermediary; however, it does not require the same level of due diligence as (for example) the rule requiring the issuer to reasonably believe that the investor is a Colorado resident (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)), which requires documentary confirmation, or Rule 3.24.A.1, which requires an affirmative “reasonable basis” for determining that a purchaser is an “accredited investor” to take advantage of that provision.
With experience, the on-line intermediary may become the driving force behind crowdfunding in Colorado. Where the on-line intermediary has established a successful track record of relationships with escrow agents and investors, they may attract issuers. Where the on-line intermediary has offered record retention services and other permitted services at a reasonable cost, the on-line intermediaries will be instrumental in the success of the offering and compliance with the CF Act. Because an investor may use an on-line intermediary for more than one crowdfunding investment, the on-line intermediaries will likely look at the investors as their clients—not the issuers. Hopefully this will assist in the goal of investor protection which is the focus of the Colorado Securities Act.
By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association, August 2015