United States: FINRA Issues First Litigated Enforcement Action Against Crowdfunding Portal

On June 5, 2019, a Financial Industry Regulatory Authority (FINRA) panel handed down its first enforcement action against a funding portal. DreamFunded, a crowdfunding platform, was banned from FINRA membership, and Manny Fernandez, DreamFunded's CEO, was barred from association with any FINRA funding portal member. DreamFunded and Fernandez were further ordered to cover $15,900 in hearing costs.

Although FINRA previously settled with another crowdfunding website in 2016, the panel's 148-page DreamFunded decision marks the first litigated enforcement action taken by FINRA applying the crowdfunding regulations included in the Jumpstart Our Business Startups Act (JOBS Act) signed in to law by President Obama in April 2012, and represents important insight for industry participants in an area with, as yet, no regulatory guidance.

Regulatory Context

Under Title III of the JOBS Act, crowdfunding securities ("equity crowdfunding") must be offered through an intermediary portal that is registered as a broker-dealer or funding portal with the U.S. Securities and Exchange Commission (SEC). Although intermediary funding portals escape the rigorous requirements imposed on broker-dealers, they are still expected to take both information sharing and reasonable vetting measures to protect investors.

FINRA was able to pursue the action based on Rule 8210 which vests them with investigatory authority. This was the first time Rule 8210 has been applied to funding portals, with the decision emphasizing that the JOBS Act specifically provides that Rule 8210 applies.

Background & Decision

As a registered funding portal between July 2016 and October 2017, DreamFunded was an intermediary in fifteen crowdfunding offerings, two of which resulted in the distribution of investor funds to the issuers. In October 2017, FINRA issued a Rule 8210 investigation request to Fernandez, seeking documents and information about DreamFunded's operations. But despite multiple extensions, Fernandez never provided a complete response to the request.

On February 23, 2018, FINRA filed a complaint alleging that DreamFunded had (1) made false or misleading claims to investors about offerings promoted on the portal and about the portal itself, (2) continued to allow access to its platform even after it had reason to believe issuers presented the potential for fraud or investor protection concerns, (3) included issuer communications on its website that contained untrue or misleading facts, (4) lacked a reasonable basis for believing the issuers offering securities through its portal had complied with SEC regulations, (5) failed to provide required notice to investors regarding investment commitments, (6) failed to conduct required background checks, and (7) failed to reasonably supervise the activities of the portal.

Although the FINRA panel concluded that DreamFunded and Fernandez engaged in significant misconduct by misleading and misinforming investors, it sought to avoid imposing a duty on portals to validate the future financial projections of issuers, and therefore dismissed a charge that DreamFunded lacked a reasonable basis for believing issuers on its platform were in compliance with SEC requirements.

The FINRA panel also interpreted FINRA's Funding Portal Rule 200(c)(2), which prohibits funding portals from including false or misleading communications on the portal. The panel concluded that fraudulent intent is not an element of a violation of that rule. As such, for example, the panel concluded that misleading tombstones on the Portal's website signaling it had enabled real estate transactions through the portal, and that they were equivalent to bank deposits, were found to be misleading under Funding Portal Rule 200(c)(2) even though the panel could not conclude there was an intent to mislead. In contrast, the panel found intent is an element of violations of Funding Portal Rule 200(b), which prohibits the promotion or sale of securities using deception or other fraud.

Analysis

This is FINRA's first litigated enforcement action involving crowdfunding regulations, and neither FINRA nor the SEC has issued any official regulatory guidance on crowdfunding portals. As a result, this decision serves as important guidance for industry participants and their advisers. Although crowdfunding has not traditionally been a focus for FINRA, and the fundraising mechanism was not listed in its 2019 Annual Risk Monitoring and Examination Priorities Letter, FINRA has made clear that it will pursue matters presenting clear violation of FINRA rules. Innovators employing crowdfunding platforms, along with the platforms themselves, should not take for granted the lack of enforcement in this space.

A copy of the FINRA panel's decision may be found here.

This article is presented for informational purposes only and is not intended to constitute legal advice.