On July 10, 2013, the same day it announced the adoption of rules permitting general solicitation under certain conditions and disqualifying “bad actors,” the Securities and Exchange Commission issued proposed new rules entitled “Amendments to Regulation D, Form D and Rule 156 under the Securities Act.” The proposal dramatically increases the Form D filing requirements for Rule 506 offerings and increases the consequences for failing to file Form D or filing Form D late.
In a previous post, I discussed the fact that the consequences for failing to file Form D are usually not significant and usually can be cured. If this proposed rule is enacted, this will change.
The proposed amendments to Regulation D would institute the following:
- In Rule 506(c) offerings (i.e., offerings in which general solicitation is permitted), the issuer would be required to file an “Advance Form D,” covering certain of the items required in a regular Form D, at least 15 days before the issuer commences any general solicitation;
- In any Rule 506 offering, the issuer would be required to file a closing amendment to Form D within 30 days after the termination of the offering;
- Issuers that failed to file any required Form Ds within the last five years would be disqualified from relying on Rule 506 in any further offerings (however, failures to file before the effective date of the rule would be grandfathered). If the issuer then files all delinquent Form D filings, the disqualification would expire one year after the delinquent filings had been completed. Issuers would get a one-time (per offering) 30-day cure period, so for instance, if one Form D filing is 10 days late, no disqualification would occur, but if the issuer was then late on a second filing, the issuer would be disqualified from using Rule 506 for another year;
- Under a new Rule 509, issuers would be required to include certain legends (i.e., disclaimers) in any written general solicitation materials used in a Rule 506(c) offering and additional disclosures for private funds if such materials include performance data;
- Under a new Rule 510T, for a temporary period of two years, issuers would be required to submit online to the SEC, on a nonpublic basis, any written general solicitation materials used in Rule 506(c) offerings no later than the date of first use;
- Private funds’ offering documents would be subject to the anti-fraud guidelines contained in the current Rule 156 (which currently applies only to mutual funds). This would apply regardless of whether the private fund uses general solicitation; and
- Form D would be revised to require more detailed information.
Some of the proposed rule changes are perfectly appropriate and reasonable. For instance, creating guidelines for private fund offering documents, in my view, will not be particularly burdensome and may be helpful for the fund’s legal counsel in giving guidance on what is appropriate to disclose. Nor do I have any real issue with adding some additional questions to Form D. However, I do have many significant issues with these proposed rules, namely:
- Automatically disqualifying issuers from using Rule 506 simply for failing to file what is, in the end, mere paperwork seems like an overly harsh penalty. Form D is not an investor protection requirement; it is there to help the government keep current on trends in the private securities market. Since the disqualification is automatic, it is possible that companies will be disqualified from Rule 506 without even being aware of the fact and that a determination would be made that the issuer was disqualified after the completion of an offering, subjecting the issuer and its owners, officers, directors, and other personnel and advisers to significant civil and criminal liability. This is especially true given that after the effectiveness of this rule, issuers would be subject to many Form D filing requirements: (1) 15 days prior to general solicitation (if used), (2) 15 days after the first sale, (3) “as soon as practicable” after there are certain material changes to the offering or it is discovered that there was a mistake in the original filing, (4) annually for offerings that last over one year, and (5) within 30 days after the end of the offering. With some of these, it can be difficult to discern when the deadline actually occurred. For instance, when does an offering actually end? Sometimes that is clear. Many times, if the full amount of the offering is not sold, it is not clear. What constitutes “as soon as practicable?” Often times the deadline for filing some Form Ds or amendments is not clear-cut — which seems at odds with the purpose behind Rule 506 of providing a safe harbor, i.e., a method of complying with the rules that gives a certain level of comfort and certainty to the person attempting such compliance.
- The harsh penalty of being unable to raise money in a Rule 506 offering can potentially be a death sentence. If a company is in an early growth stage, it is often dependent on raising capital. If it can’t do it, the company may fail completely. The penalty for failing to file paperwork should not be a corporate death sentence! (For an example of a company that was unable to raise further funds because of securities violations, see the example of Neogenix Oncology, in the following posts: Part 1, Part 2, and Part 3).
- I am also somewhat uncomfortable with increasing the number of Form D filings that are required. For larger institutions or private funds this may not be much of an issue, but for startups, more required paperwork just gives the startup more opportunities to run afoul of the law, without providing investors any additional protections.
- Another issue I have with the proposed rule is that Form D must be filed at least 15 days prior to the commencement of a general solicitation. If the frequently held “investor pitch days” were ever deemed to be a general solicitation (and there are at least some good arguments on why they could be, as discussed in this great post by William Carleton), the fact that the pitching companies did not file Form D at least 15 days in advance could already disqualify them from raising funds.
- All written general solicitation materials must be submitted to the SEC prior to their use. Sounds reasonable, right? What happens the next time a startup founder tweets about his capital raise? That could be a violation if the SEC doesn’t get a copy of the tweet first (which of course, is never going to happen).
I could go on. These rules, I suspect, will not be as harsh on the private fund industry, which is already accustomed to a fairly significant regulatory compliance burden. But for startups, if enacted, they would be a massive obstacle to growth. These rules are not yet in effect. I’m hoping that the startup community makes itself heard and gives feedback to the SEC, so that the final rules do not end up making us rue the day the SEC lifted the ban on general solicitation.
© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.