WHO IS HOLDING YOUR MONEY AND CAN YOU TRUST THEM?

The Problems With Current Regulations
Regarding Crowdfunding Escrow Intermediaries

Escrow

If there is one thing that Title III of the J.O.B.S. Act and each of the currently enacted Intrastate crowdfunding exemptions have in common, it is that a third-party should be used to take and escrow investor funds in connection with an offering. But who should qualify as an appropriate third-party escrowee? This is where Title III and many of the Intrastate crowdfunding exemptions fall dangerously short.

The main concern of federal and state regulators regarding allowing an issuer, or even a crowdfunding internet portal, to collect and escrow investor funds is the potential for fraud and/or misappropriation. This is a very valid concern particularly given some of the horror stories recently popping up with respect to Kickstarter and Indiegogo campaignsFraud 2 and the like (for examples see HERE). However, by requiring that a third-party escrowee be used to handle such transactions but providing little to no guidance over who can qualify as such an escrowee, simply pushes the potential for fraud to another party and, in my opinion, only makes the potential for such fraud even greater.

Under the current iterations of Title III and many of the intrastate regulations, it would appear that anyone (subject to the satisfaction of certain minimal requirements such as an organization within a particular state) other than the issuer and the internet portal can serve as an escrowee. Putting this in context of a transaction, investors would be handing their money over to an escrowee company that has the least connection to the transaction, the least public exposure (being on the back end of the transaction), and little to no regulation over its operation. In my opinion, under these circumstances and with no real regulating body watching over them, it is the escrowee company that would be the most likely of the transaction parties to close its doors and walk away with investor funds. I don’t know about you but that doesn’t make me feel safe about handing over my hard earned money.

Fraud

Similar concerns regarding the misappropriation and/or fraud by an escrowee company have existed in the real estate world for decades. In a real estate sale, a title company is most often used to escrow the transfer of funds between the seller and the purchaser. As you can imagine, in any given real estate sale, the amount of escrowed funds held by a title company at a given time can range from a couple thousand dollars to tens of millions of dollars and above. With multiple deals happening at any one time the potential for misappropriation or fraud by an agent certainly exists. Many large and small title companies have gone belly up over the years and it is almost always due to mismanagement of its books; either as the result of outright theft or absolute negligence by its agents. So what happens to the escrow funds held by a title company that closes its doors? Luckily regulators have put some protections into place intended to prevent, or at the least mitigate, the loss of such escrow funds in the event of a title company’s bankruptcy, dissolution, etc.

In most states, title insurance companies (and their agents) are highly regulated. Such regulations can include, among other things, that each title insurance company: establish and maintain certain required reserves, minimum capitalization and/or paid-in surplus; deposit certain minimum amounts directly with the applicable state regulatory agency; and keep escrow funds separate from their operating, surplus and reserve funds (and keep accurate records of all such escrow funds). The purpose of these regulations is to help assure the availability of at least some amount of funds in the event a title company becomes insolvent. To further protect consumers, these regulations often include a specific plan for the liquidation of an insolvent title company’s assets and the distribution of proceeds to those owed money, which will typically be overseen by the applicable state regulatory agency.

Why should you care about regulations governing title companies if we are talking about crowdfunding? Because the concerns surrounding the misappropriation or fraud of escrow funds are the same, if not greater, in the crowdfunding context. By providing little to no regulation over who can act as an escrowee in crowdfunding transactions, and/or by forcing issuers and investors to use smaller “local” escrow intermediaries to facilitate intrastate transactions, the potential is very real that we will see cases in the near future of escrowing intermediaries closing their doors causing investors to lose their entire investment.

House Hearing on Improving Liquidity of Securities of Private Companies  If issuers are going to be required to use a third-party escrowee companies to facilitate the movement of investor funds, I believe the S.E.C. and the individual states should enact specific regulations regarding the operation of such intermediaries in order to better protect investors. While the draft legislation submitted by Congressman Patrick McHenry to repeal Title III of the JOBS Act (a copy of which is available HERE) comes closer than current efforts to regulate these intermediaries by requiring them to be “qualified third party custodian, such as a broker or dealer registered under section 15(b)(1) of the Securities 14 Exchange Act of 1934 or an insured depository institution,” I do not think it goes far enough. I believe these escrowee companies should be held to the same (or substantially similar) licensing, deposit and other requirements as those applicable to title companies which act as escrow agents.

Title 2I directly addressed the above concerns in my proposed bill for an Illinois Crowdfunding Exemption (a copy of which is available at www.illinoiscrowdfundingnow.com). Under my proposed bill, any third-party escrowee company being (or to be) used in a crowdfunding transaction would be granted the same powers, and be subject to the same certification and other requirements, as an “independent escrowee” under the Illinois Title Insurance Act (815 ILCS 5/1, et seq.). By taking this approach, I believe that the increased certification requirements regarding these escrowee companies will help to mitigate the potential losses to investors much in the same way that the regulations work to mitigate the potential losses to buyers and sellers currently using title company escrow services.

While my proposed bill (if passed) would go a long way to addressing the above concerns, it is clear that there is a gaping hole in the regulations of other states, and Title III itself, that needs to be addressed quickly. If not, my guess would be that the first cases of crowdfunding fraud are going to come not from an issuer or even an internet portal but from an escrowee company who was entrusted with holding the money.

About Anthony Zeoli

Anthony Zeoli is an experienced transactional attorney with a national practice. Specializing in the areas of securities, commercial finance, real estate and general corporate law, his clients range from individuals and small privately held businesses to multi-million dollar entities. Mr. Zeoli is also an industry-recognized crowdfunding, peer-to-peer (P2P) lending and JOBS Act expert and is currently an active board member and Secretary of the CfPA (Crowdfunding Professional Association) and an active member of CFIRA (Crowdfund Intermediary Regulatory Advocates). Most recently he drafted Illinois House Bill 3420, a bill which provides for an intrastate crowdfunding exemption in Illinois and which was unanimously approved by the Illinois’ house and Senate. Anthony is also currently actively involved with the entrepreneurship program at the University of Illinois at Chicago as both a mentor and a student advisor and is an active advisory board member of the New York Distance Learning Association (NYDLA).
This entry was posted in Crowdfunding Scams, Gen Crowdfunding, Intrastate Offerings, JOBS Act and tagged , , , , . Bookmark the permalink.

2 Responses to WHO IS HOLDING YOUR MONEY AND CAN YOU TRUST THEM?

  1. Layne Bodily says:

    Let’s hope it doesn’t take a major case of fraud to get the regulators moving on this! Thanks for the post, Tony.

  2. I think my frustration is the limited number of escrow banks approved by SEC for Title iii.

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