AML Costs of SEC Crowdfunding Proposal May Exceed $100,000 Per Business

On Wednesday, the U.S. Securities and Exchange Commission (SEC) proposed regulations that would define crowdfunding businesses as “brokers” under the Securities Exchange Act of 1934. The rules, which stem from the Jumpstart Our Business Startups Act, effectively bring the Internet portals under Bank Secrecy Act rules.

If finalized, the proposed rules would require the businesses to draft anti-money laundering (AML) policies, maintain a customer identification program (CIP) internally or with the aid of a financial institution, file suspicious activity reports and comply with data requests from law enforcement officials.

“While a funding portal is prohibited by statute from handling, managing or possessing customer funds or securities, which means it cannot accept cash from customers or maintain custody of customer securities… we believe that a funding portal… is in the best position to ‘know its customers,’ and to identify and monitor for suspicious and potentially illicit activity,” the agency said.

Once finalized, the AML requirements alone will likely cost crowdfunding businesses $100,000 or more, according to Thomas Lee Hazen, a professor in the University of North Carolina School of Law who studies securities regulations.

Some of the companies will likely find customer due diligence requirements under the proposal “difficult and expensive,” said Alma Angotti, a former senior counsel in the enforcement division of the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that would examine crowdfunding companies on behalf of the SEC.

The businesses that operate as a subsidiary of existing broker-dealers or that have relationships with other financial institutions familiar with the Bank Secrecy Act would likely have an easier transition, according to Angotti. Under Wednesday’s proposal, portals can contractually rely on the customer identification controls of other financial institutions.

The proposed rule comes as the industry is poised to further evolve beyond current models, in which individuals use crowdfunding portals to lend to other individuals or donate money to charitable causes, with the growth of the so-called equity model. The latter allows companies to raise money through portals rather than solely through angel investors and established venture capitalist (VC) firms.

The industry is expected to raise $3 billion in 2013, double what it raised in 2011, according to estimates published by Deloitte earlier this year. The smallest category of crowdfunding—the equity model—could raise more than $1 billion this year, depending on how the SEC intends to regulate it, according to the consultancy, which also said that many startups would continue to primarily rely on the expertise of VC firms.

The SEC expects the funding portals to “often facilitate offerings of microcap or low-priced securities, which may be more susceptible to fraud and market manipulation,” according to the proposal.

When monitoring for suspicious activity related to the securities, the portals should be wary of individuals who cancel their investments within the allotted 48-hour period, according to Bao Nguyen, a manager with Kaufman Rossin., and a former FINRA AML auditor. The quick transactional turnaround could be a sign of fraud, he said.

The publication of the SEC proposal coincided with the issuance of proposed rules by FINRA and, a day later, a consultation paper by the U.K.’s Financial Conduct Authority. The British regulator also asked that the businesses implement AML controls. The SEC’s comment period ends on Jan. 22. Companies and individuals have until Feb. 3 to respond to FINRA’s proposal.