SEC crowdfunding rules include anti-money laundering and financial crime requirements while Canadian regulators lag behind on issuing rules

 

After more than a year, the U.S. Securities and Exchange Commission has released draft crowdfunding equity rules (the “Rules“) for comment under the U.S. Jumpstart Our Business Startups Act (the “JOBS Act“).

The JOBS Act was brought into force in 2012 in an effort to facilitate the injection of capital in growing companies and start-ups. With respect to crowdfunding, its objective was to allow cost-effective access to capital provided over the Internet by removing unnecessary and burdensome regulations, while maintaining integrity of the financial markets and investor protection.

A. Overview of exemption requirements

Under the Rules, the Securities Act of 1933 would exempt certain crowdfunding transactions from registration provided certain conditions were met. Some of the key requirements for qualifying under the exemption are as follows:

    1. Limitations on aggregate salesthe aggregate amount sold to all investors by the issuer in reliance on the exemption in a 12-month period cannot exceed $1 million;
    2. Limitations on aggregate sales to individual investorsthe aggregate amount sold to any one investor by the issuer, including amounts sold in reliance on the exemption, in a 12-month period cannot exceed the greater of $2,000 or 5% of the annual income or net worth of the investor if the investor’s net worth is $100,000 or less;
    3. Limitation on crowding the funding – issuers could only use one intermediary to crowdfund an offering and the intermediary can only offer the investment opportunity over the Internet (equity cyberfinance);
    4. Exclusion of private and hedge funds and others – certain issuers may not use the exemption to crowdfund, such as those not registered as corporate entities in the U.S., reporting issuers, investment companies and others determined by the SEC as inadmissible. Hedge and private funds are de fact ineligible in any event by virtue of the fact that they rely on the exclusions for investment companies under the Investment Company Act of 1940;
    5.  Provide certain disclosures –  issuers would be required to file certain disclosure documents including their business plan, financial condition, intended use of proceeds of the offering and   ownership and capital structure of the issuers, and make the foregoing available to investors and annually file certain reports of the results of operations and financial statements; and
    6. Advertising restrictions – issuers would not be able to advertise the terms of offerings except for notices that direct investors to the crowdfund or broker.

B. Why crowdfunds are susceptible to money laundering & financial crime

The Rules are believed to be the first set of crowdfunding rules that introduce measures that would require crowdfunds to address financial crime (market manipulation, illicit financing and fraud), money laundering, economic sanctions and terrorist financing concerns.

Crowdfunding is particularly susceptible to money laundering and other financial crimes. There are many reasons why that is the case, including that they facilitate the offering of microcap or low-priced securities which by their nature are more susceptible to fraud and market manipulation. In the securities context, financial crimes occur most frequency (by volume not dollar value) with private placements and low-priced securities. Private placements pose a money laundering risk because they are often used to generate illicit assets through market manipulation, insider trading and fraud. In addition, unlawfully acquired assets can be used to purchase securities with proceeds of crime in order to resell them and create the appearance of legitimately sourced funds. The combined effect of crowdfunded securities being low-priced, placed in offerings that are exempt from registration and not subject to the filing review process of a registered offering, makes crowdfunding open to being used as a vehicle for money laundering and other financial crimes.

The objective in respect of the Rules is to preserve the integrity of the capital markets and ensure they are not used, however inadvertently, for money laundering or other financial crimes. The preservation of the integrity of the financial markets is as important for prospective investors, as it is for regulatory agencies and financial institutions, all of whom have a vested interest in ensuring that the markets remain free of financial crime.

C. Anti-money laundering and financial crime reporting applicable to crowdfunding

The Rules propose that crowdfunds be required to monitor transactions and report under the Bank Secrecy Act (the BSA“). Not all of the BSA requirements would apply to crowdfunding but certainly all of those applicable to “introducing brokers” under the category of registered “broker-dealers” would be applicable except to the extent that the transaction does not engage anti-money laundering (“AML“) obligations. The SEC’s position is that, for the purposes of AML, crowdfunds are a type of hybrid “introducing broker” and “broker-dealer”.

Under the BSA, among other things, the AML requirements most likely to be applicable to crowdfunding are as follows:

    1. Establishing and maintaining an AML program (“AML Program Requirement”);
    2. Establishing and maintaining a customer identification program (“ID Requirement”);
    3. Monitoring for and filing reports of suspicious activity (“SAR Requirement”); and
    4. Complying with requests for information from the Financial Crimes Enforcement Network (“FinCEN”).

AML Program Requirement

Pursuant to the Rules, the SEC is proposing that crowdfunds satisfy the AML Program Requirement by implementing and maintaining a written AML Program that includes, at a minimum: (1) policies, procedures and internal controls reasonably designed to achieve compliance with the BSA; (2) policies and procedures that can be reasonably expected to detect and cause the reporting of required transactions; (3) the designation of an AML compliance officer; (4) ongoing AML employee training; and (5) an independent test of the crowdfund’s AML Program.

ID Requirement

With respect to the ID Requirement, pursuant to the BSA regulations, crowdfunds will need to have a written ID program that includes procedures for: (1) obtaining customer identifying information from each person prior to an account opening; (2) verifying the identity of each customer to the extent reasonable and practicable, within a reasonable time before or after account opening; (3) making and maintaining a record of documents used for identity verification; (4) determining, within a reasonable time after account opening or earlier, whether a person or entity is a designated suspected terrorist or terrorist organization, or is subject to U.S. sanctions as designated by OFAC; and (5) providing customers with adequate notice, prior to opening an account, that requested information is being sought to verify identity without disclosing the filing of a SAR.

Crowdfunds may rely on financial institutions to fulfill some or all of the requirements of its ID Requirements if such reliance is reasonable and the entity relied upon is subject to AML compliance obligations and federally supervised in respect thereof. The crowdfund and the financial institution must  have entered into a contract which requires an annual certification by the financial institution to the crowdfund confirming its AML compliance.

Suspicious Activities

Under the SAR Requirement, crowdfunds will have to file a suspicious activity report if: (1) a transaction is conducted or attempted to be conducted by, at, or through a crowdfund; (2) the transaction involves or aggregates funds or other assets of at least $5,000; and (3) the crowdfund knows, suspects or has reason to suspect that the transaction: (i) involves funds or is intended to disguise funds derived from illegal activity, (ii) is designed to evade requirements of the BSA, (iii) has no business or apparent lawful purpose, and the crowdfund knows of no reasonable explanation for the transaction after examining the available facts, or (iv) involves the use of the crowdfund to facilitate criminal activity.

FinCEN Investigations

Crowdfunds will be required to respond to mandatory requests for information by FinCEN on behalf of federal law enforcement agencies. Agencies with criminal investigative authority can request that FinCEN solicit, on its behalf, certain information and FinCEN also may make similar requests on its own behalf or on behalf of the Treasury to the crowdfund.

The inclusion of AML Program requirements in the Rules by the SEC is not necessarily all that surprising – as the SEC noted in the Rules, if crowdfunds are viewed as broker-dealers they would, in any event, be subject to some AML requirements. How to categorize a crowdfund for the purposes of securities law is, of course, the issue.

D. Canadian crowdfunding rules – still a work in progress

In Canada, the key jurisdictions where crowdfunding will be significant – Ontario and British Columbia – are lagging behind in approving crowdfunding rules. In Ontario, the Ontario Securities Commission recently released a progress report setting out the scope of issues it is considering in its proposed draft rules but those rules are expected to be available only in about six to eight months from now. In British Columbia, the British Columbia Securities Commission has released for comment a proposed instrument that involves proposed prospectus and registration exemptions which would be similar to the offering memorandum exemption that currently exists in that province.

Neither Ontario nor British Columbia have addressed measures in respect of:

  • Fraud, AML and other financial crimes as a matter of market or investor protection;
  • Conflicts of interest involving the platforms and the disclosure and resolution thereof;
  • Platform failures and poor administration issues; or
  • Disclosure of salient risks such as lack of secondary market for shares, potential for equity dilution and no dividends, and likelihood of business start-up failures.

The lack of concern over money laundering and other financial crimes is particularly surprising since Canada has the dubious distinction of being the only known jurisdiction where crowdfunding (non-equity) was used to raise funds to benefit organized crime.

Canada’s “crackstarter” crowdfunding legacy

In May of this year, a crowdfunding website successfully raised $200,000 to pay organized crime in Toronto to acquire a video of the Mayor of Toronto allegedly taking crack cocaine. That fundraising exercise received worldwide attention, partly because it raised numerous ethical, criminal, investor protection, regulatory and money laundering issues for crowdfunding. The legacy of the so-called “crackstarter” crowdfunding campaign is that in Canada it became acceptable to raise capital for the purposes of funding the activities of a criminal gang, prompting American media to suggest that in Canada, it was crowdfunding that was on crack.

Taking a position, or implementing requirements, to curb the potential for money laundering, terrorist financing, economic sanctions violations and other financial crimes would go a long way to changing the unfortunate “crackstarter” legacy and help instill confidence in the emerging equity crowdfunding regime in Canada.

Comment period

The SEC is allowing a 90-day period to comment on the Rules. In respect of AML and financial crime, they are particularly interested in determining whether the proposed requirements go too far, or not far enough, in meeting the objectives of regulating the offering and sale of securities to support start-ups and combatting financial crime.

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