Monday, June 16, 2014

A Securities Law Puzzle on the Internet

The Internet is the Wild West of securities law. I often see things and wonder, “How can they get away with that?”

Sometimes, the answer is that they can’t. A couple of years ago, I stumbled across ProFounder, a crowdfunding platform offering equity interests in startups. I couldn’t understand how ProFounder could do what they were doing without running afoul of securities laws. Sure enough, a few months later, the California Department of Corporations issued a consent order barring ProFounder from selling securities on its web site unless it registered as a broker-dealer.

My latest securities law puzzle comes via the Wall Street Journal. A recent article reports that a new crowdfunding platform, CrowdFranchise, will allow investors to buy equity stakes in business franchises.

If those franchise interests were being sold only to accredited investors, the new Rule 506(c) exemption might apply. It allows public solicitations through a web site like this. But according to the Journal, “CrowdFranchise investors don’t need to be accredited, because the franchises themselves are offering the deals, and franchises are allowed to award multiple pieces of an outlet.” This doesn’t make a lot of sense to anyone familiar with securities law. Depending on how they’re structured, franchise interests can be securities, and there’s no exemption for selling “multiples pieces of an outlet,” whatever that means.

So how can these franchise offerings avoid registration? The new crowdfunding exemption in section 4(a)(6) of the Securities Act might work, but it’s not yet available. The SEC still has not adopted the required rules.

The argument appears to be that these franchise interests are not securities. A FAQ on CrowdFranchise’s web site says:

Until Title III of the JOBS Act is passed, each member will be required to sign a franchise agreement and be given the rights required as an active franchisee partner. To facilitate the management of the franchise with multiple partners, each franchise opened through CrowdFranchise will need to subscribe to mandatory electronic communication, management, and voting tools provided by CrowdFranchise to help with daily decisions for the company.

Title III has, of course, already passed; I assume they mean until the crowdfunding regulations under Title III are adopted. But, setting that aside, the requirements they impose don’t guarantee that these franchise investments won’t be treated as securities.

Business investments that do not involve corporate stock are generally evaluated under the investment contract analysis adopted by the Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946). Under Howey, a security is present if there is an investment of money in a common enterprise with an expectation of profits from the efforts of others. The franchise investors would clearly be investing money with an expectation of profits and, if there are multiple investors, there would be a common enterprise. The key is the final part of the test: whether those profits would come from the efforts of others or the investors’ own efforts.

Franchise investors would clearly have some control, and therefore, some involvement in determining the fortunes of the franchise. But the question is whether their efforts would be “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973).

To answer that question, most courts say you have to look beyond the rights granted in the agreement. You must consider whether, as a practical matter, the investors have the experience and knowledge to play an effective role in management. See, e.g., Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981). And the efforts of others test is more likely to be met where, as would presumably true of the CrowdFranchise investors, the investors are geographically dispersed, with no preexisting relationship. See, e.g., SEC v. Merchant Capital, LLC, 483 F.3d 747 (11th Cir. 2007). Significantly, the CrowdFranchise FAQ indicates the company may assign an operating manager "to help with the day to day operations of your franchise."

In brief, whether these franchises are securites would depend on the facts of the particular case, and there's certainly an argument that they would be. Perhaps CrowdFranchise has fully vetted this through an experienced securities lawyer and I’m just missing something. It certainly wouldn’t be the first time. But it puzzles me.

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So glad you're thinking about this, Steve. I am presenting a working paper idea related to this issue at the National Business Law Scholars conference later this week that follows up on my Tennessee Law Review article on this topic and some of my other work on crowdfunded securities offerings. I will try to keep you posted. Franchises have always raised these thorny what-is-a-security issues, yet crowdfunding makes them so much more visible . . . . Thanks for this post.

Posted by: joanheminway | Jun 17, 2014 12:55:45 PM

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