Strictly Business

This last week, the Senate passed the “JOBS Act,” leaving it one step away from final passage by Congress and Signature by President Obama.  The JOBS Act contains a number of provisions which are aimed at reducing the securities compliance burdens of small companies and startups.  One of the major provisions within the JOBS Act is the so-called “crowdfunding” provision.

Crowdfunding has an enthusiastic following online and within the entrepreneurial community.  Obviously, that following is very excited about the bill’s Senate passage.  Unfortunately, I don’t think they should be popping the champagne corks anytime soon.  Before passing the bill, the Senate passed an amendment to the bill substituting a new version of the crowdfunding law by Senators Merkley, Bennet, and Brown in place of the one written by Rep. Patrick McHenry.  All signs point to the Republican leadership in the House conceding to the Senate’s amendment this week in order to get the bill to the president’s desk for signature as soon as possible.

And I believe the Senate’s amendment kills crowdfunding.  The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers.  While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison.  Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use:

• In the new version, the exemption from registration only applies if the aggregate amount sold to any investor by an issuer (that is, ANY issuer) does not exceed certain caps, which vary depending on the investor’s income.  That’s right, if you use the crowdfunding exemption, it may not apply depending on whether your investors have invested in OTHER startups using the exemption — something you have no control over.  Hopefully, the SEC, in regulations, will provide a safe harbor for issuers to make this determination (both as to income and the amounts invested in other crowdfunding offerings), but you can never count on the SEC making anything simple. [Update 4/19/12: see comments below.  One commenter had pointed out that from first blush the limits may not apply in the aggregate.  However, a separate portion of the bill does confirm that the limits apply in the aggregate, but the funding portal will have the obligation to enforce this.  That said, there still may be significant consequences to the issuer if the funding portal fails fulfill their responsibilities.]
• In the new version, the offering can only be made through a registered broker-dealer or a new “funding portal” which also must be registered with the SEC and, apparently FINRA.  In the McHenry version, an issuer could use an unregistered “intermediary” but was not required to.  This additional requirement will greatly increase the costs of conducting a crowdfunding offering.
• The new version requires that the issuer of any crowdfunding offering of over $500,000 have audited financials, again significantly increasing the compliance costs on issuers.  It also prohibits any advertising to promote the offering.
• The Merkley amendment creates a new cause of action against a crowdfunding issuer, and its directors and officers.  Traditionally, in Federal securities fraud suits (at least those involving non-public securities), the plaintiff has to prove that the defendant acted knowingly or recklessly.  In any suit involving a crowdfunded company, the burden of proof will be on the defendants and they will need to prove they didn’t know about any misstatements nor in the exercise of reasonable care could not have known about the misstatements.  Good luck finding competent directors for your crowdfunded company.

In all, the statute that provides for the crowdfunding exemption expanded from 12 pages to 24 after the substitution of the Merkley version.  For a crowdfunding exemption to work, it must be simple.  Small companies cannot afford the significant compliance burdens placed upon them by the crowdfunding exemption that was passed.  Therefore, my prediction is that entrepreneurs will quickly find that the new exemption is too expensive to utilize and is more trouble than it is worth and that it will rarely be used.  As I’ve stated in the past, there are some significant practical obstacles to crowdfunding even with the McHenry bill.  The Senate’s solution certainly didn’t help.   Therefore, I believe the Senate may have just effectively killed crowdfunding.  I may be wrong; the SEC may implement the bill well through regulation and save crowdfunding.  Anyone want to take a bet that this happens?

———————————–

© 2012 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.

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure:

The Reopening American Capital Markets to Emerging Growth Companies Act (H.R. 3606; the rest of the bills were added to this one).  This bill is also known as the “IPO On Ramp” and it creates a new category of company called an “emerging growth company,” which is defined roughly as a public company with less than $1 Billion in revenue.  An issuer that is an emerging growth company as of the first day of a fiscal year will continue to be one until the earliest of (i) the last day of the fiscal year during which the issuer had $1 billion in annual gross revenues or more; (ii) the last day of the fiscal year following the fifth anniversary of the issuer’s IPO date; or (iii) the date in which the issuer is deemed to be a large accelerated filer, defined by the SEC as an issuer with more than $700 million in public float. In addition, a company would not be considered an emerging growth company if it has issued more than $1 billion in non-convertible debt over the prior three years.  An emerging growth company would enjoy more lax regulation by the SEC.  For instance, the bill would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company.  Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that carries high compliance costs. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to their IPO rather than three years. The bill also exempts emerging growth companies from new corporate governance requirements within the Dodd-Frank Act, namely the so-called “say on pay” requirement and the requirement that public companies calculate and disclose the median compensation of all employees compared to the CEO.  The bill would remove restrictions prohibiting investment banks that underwrite a company’s IPO from publishing research on emerging growth companies and would  expand the range of permissible pre-filing communications to “qualified institutional buyers” or “accredited investors.”

The Access to Capital for Job Creators Act (formerly H.R. 2940).  As discussed in a previous post, this bill essentially removes the general solicitation prohibition on offerings made under Rule 506 of Regulation D.

The Entrepreneur Access to Capital Act (formerly H. R. 2930).  This is the “crowdfunding” bill, which I’ve discussed at length in the following posts: Is action forthcoming on a crowdfunding exemption to Federal securities laws?; Bill Creating Crowdfunding Exemption from Securities Registration Passes U.S. House of Representatives; What does the future hold for crowdfunding legislation?; Implications of the Pending Startup Crowdfunding Bill.

The Small Company Formation Act (formerly H. R. 1070).  This bill would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. It would also preempt state blue sky laws with regards to such offerings if they are traded on a national exchange.   Regulation A is a little used exemption from registration that permits an exempt public offering using a type of “short form” registration.  It is rarely used for two reasons: (i) it has a limit of $5 million and (ii) there is no preemption and so the offerings are subject to blue sky laws.  This bill would eliminate both of these obstacles.

The Private Company Flexibility and Growth Act (formerly H.R. 2167).  This bill raises the number of shareholders a company can have before it is forced to go public from 500 to 1,000.  In addition, it also excludes employees from counting against this limit.  More details can be found on a previous post on this topic: Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer.

The Capital Expansion Act (formerly H.R. 4088).  This bill raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.  The issue here is that community banks are often forced to engage in expensive Exchange Act reporting because they have over 499 shareholders.  This bill would remove this expense for many of them.

The vote was lopsided and the White House has indicated that it is supportive, so the bill has a decent chance of become law.  That said, don’t let the lopsidedness of the vote fool you.  There is genuine opposition to these bills in the Senate that has been building for some time.  There are some significant concern that the legislation will increase the incidence of securities fraud, particularly for senior citizens.  Therefore, stay tuned.

———————————–

© 2012 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.

The U.S. House of Representatives recently passed the Entrepreneur Access to Capital Act (H.R. 2930), which creates an exemption from the registration requirements of the Securities Act of 1933, allowing startups to engage in crowdfunding (i.e. raising capital from a large number of investors over the Internet).  Action is still pending in the U.S. Senate.  While the actual usefulness of this new exemption will depend largely on how the SEC interprets it in implementing regulations, it’s worth thinking ahead about how such an exemption would actually work (assuming of course that the bill passes).  Here are some of my thoughts:

• The bill may (or may not) reduce the amount of legal fees a company would pay for its seed round.  It creates a new type of capital markets participant called an intermediary, which would typically handle the offering for a startup.  The intermediary itself would be subject to considerable regulatory oversight and would also carry a large amount of risk of lawsuits brought under the anti-fraud provisions of securities laws.  Therefore, the intermediary’s need for legal counsel will be considerable (as will the need for some form of E&O insurance).  These costs will be passed along to the startups who use the intermediaries.  Ultimately, it remains to be seen whether the intermediaries will be able to obtain economies of scale for these costs, or whether startups will be better off engaging in the offering themselves.  And of course, even when a startup does use an intermediary, not hiring legal counsel is a risky move, given that the intermediaries will likely try to shift as much of the legal risk to the startup companies as possible through contract.
• With numerous shareholders comes the potential for class action securities lawsuits, derivative claims, requests for books and records inspections, and other actions shareholders can take against management.  These actions are much rarer when a company is funded through a small number of sophisticated investors.
• Having numerous shareholders also increases administrative burdens on a company.  The company will need to administer shareholder voting, transfers of stock, and communications with investors.  For large companies with significant resources, this is not a problem, but for a small startup that raises $1 Million, the administrative costs associated with having many shareholders could start to hurt the company’s bottom line. One possibility is that the intermediaries themselves may step in and provide this service to crowdfunded startups on their electronic platform, permitting them to take advantage of economies of scale.
• We have no way of gauging how VCs will regard the attractiveness of investing in a company that previously used a crowdfunding offering.  Crowdfunding can be used for seed rounds, but eventually, many companies need to turn to VCs or other institutional or sophisticated investors for further funding.  Assessing a startup’s capital structure is an essential part of any sophisticated investor’s due diligence.  When they find that they’ll be investing in a company that has numerous unsophisticated investors as its existing shareholders, they may balk at going ahead with the transaction.
• Finally, we have no idea how undertaking a crowdfunding offering will affect the price of a company’s D&O policy.  A sophisticated investor will usually want some form of board representation, which means they will also want the company to purchase D&O insurance for their board members (if they haven’t already).  D&O insurance providers may regard a company that has used the crowdfunding exemption as a higher risk, and price the premium accordingly.

As you can see, there are some downsides to using crowdfunding as your source of seed capital (as opposed to an angel investor or some other form of accredited investor).  If this bill passes, it will be interesting to see how this plays out.

———————————–

© 2011 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.

Previous, I summarized the Entrepreneur Access to Capital Act (H.R. 2930), a bill which provides for a crowdfunding exemption to the registration requirements of federal and state securities laws.  The bill was recently passed by the U.S. House of Representatives, and now awaits U.S. Senate action.  In this post, I’ll provide some of my thoughts on what is to come.

Will it pass?

Predicting the future is usually a futile effort, but I do believe that this bill (or something like it) has a good chance of becoming law.  If you had asked me this same question a year ago, or even six months ago, I would have told you that it has no chance.  The political climate over the last few years has favored the tightening of securities laws, not their deregulation, due in no small part to the perceived excesses of the securities industry in the events leading up to the financial crash in 2008.  What I hadn’t counted on was the cumulative effect of three years of high unemployment on the political process.  Politicians are desperate for a solution to reduce unemployment and consequently legislation that promises to reinvigorate the entrepreneurial sector has found rare bipartisan support.  Of course, the Republican gains in the Congress in 2010 helped significantly as well, given that the need for business deregulation is an article of faith within the Republican party.  As a result of these factors, the House passed the bill overwhelmingly in a rare bipartisan vote.  The White House has also signaled that it supports the effort.  The only remaining piece to the puzzle is Senate passage.

The U.S. Senate could choose to take up H.R. 2930 itself, or proceed with its own version, the Democratizing Access to Capital Act of 2011 (S. 1791), which is sponsored by Sen. Scott Brown (R – MA).  S. 1791 is remarkably similar to the House bill.  Given the bipartisan support for the concept, I think it is highly likely that a crowdfunding bill will pass the Senate, though it will likely differ in small or major ways from the House legislation.  These differences will need to be reconciled in conference committee, and then the reconciled bill will need to be passed again by each house.  However, neither political party has drawn a line in the sand about any of the particular differences and most of them are rather technical.  Therefore, there currently aren’t any major impediments to a final bill being passed before the end of 2012.  My prediction, therefore, is that we will see a crowdfunding exemption passed into law by the end of next year.

How will its implementation affect its usefulness?

Assuming the bill passes, it must also be implemented by SEC regulations.  It is crucial to understand that the SEC has significant power to determine how useful a crowdfunding exemption could be.  If the SEC’s regulations make it difficult to use, then no one will use it and the effort will be for naught.  If the SEC issues regulations that are friendlier to issuers, then the exemption could be highly useful.  For instance, here are some open issues that will need to be addressed and could drastically affect the ability of companies to use the exemption effectively:

• How will income be measured?  The bill requires that investors invest no more than the lesser of $10,000 or 10% of their annual income.  It further provides that an issuer or intermediary may rely on a certification of annual income provided by an investor.  This leaves several unanswered questions: (1) How will income be measured?  By the previous calendar year?  By an average of several of the previous calendar years? (2) Will the investor’s spouse’s income be included? (3) Is the limit subject to each of the spouses separately or are the amounts invested by each spouse considered in aggregate towards the limit?  (4) Will the certification ask for any kind of documentation to establish the income of the investor or does the investor merely provide a number which the issuer or intermediary can accept without question?  If so, is it reasonable for an issuer to accept that someone in a low paying field claims he or she makes $150,000 a year?  All of these questions will need to be addressed by SEC regulations, and the more specifically it does so, the more beneficial it is for issuers and intermediaries because bright-line tests remove business uncertainty.
• What will be the permissible activity of intermediaries?  The bill establishes a new category of participant in the capital markets called an “intermediary.” No definition of an “intermediary” is provided in the legislation, but presumably an intermediary would operate a website which administers the crowdfunding offering.  The  bill specifically exempts intermediaries from the broker-dealer registration requirements under the Securities Exchange Act of 1934.  There are a number of unresolved questions: (1) What activities may an intermediary engage in?  Are they simply passive participants, or may they engage in active sales efforts?  (2) How may they be compensated?  Are their fees limited to flat fees to use their platform or can compensation be varied depending on the success of the offering (i.e. a success fee or a fee in proportion to the amount of securities actually sold)? (3) Finally, how will state broker-dealer registration requirements apply?  Will they be required to register as broker-dealers and their employees as broker-dealer agents with the states they operate within?[1]
• Will issuers also be permitted to conduct a simultaneous offering under Rule 506 of Regulation D to accredited investors?  The bill itself says that use of the crowdfunding exemption does not prevent an issuer from raising capital through other methods.  Therefore, a simultaneous Rule 506 offering will not preclude the use of a crowdfunding offering.  Unfortunately, the use of a crowdfunding offering may preclude the use of Rule 506.  Regulation D provides that other offerings conducted near in time to a Regulation D offering are considered part of the Regulation D offering (i.e. they are integrated).  Since a crowdfunding offering would not be in compliance with Rule 506 (because it was conducted via a general solicitation and the securities were offered to non-accredited investors), the Rule 506 exemption relied upon for the offering would be invalidated.  Unless the SEC alters the integration provisions of Regulation D, companies may be unable to conduct an angel financing round near the same time as a crowdfunding offering.
• The bill requires issuers or intermediaries to “take reasonable measures to reduce the risk of fraud.”  It will be up to the SEC to spell out what those reasonable measures are.  The SEC could leave it with a relatively subjective standard, or they could provide a safe harbor which contains a number of measures an issuer or intermediary can take that will assure it that it has complied with this requirement.  A safe harbor would be far more preferable to an open-ended standard, since certainty is required for any securities registration exemption to be truly useful.  The bill also requires that the issuer or intermediary require potential investors to answer questions demonstrating their understanding of the level of risk involved with investing in a startup.  It also requires an intermediary to conduct a background check on the issuer’s principals.  Both of these requirements could also jeopardize the usefulness of the exemption if the SEC does not provide a safe harbor or otherwise objective criteria for meeting these obligations.

As you can see, even if the crowdfunding exemption bill passes as is, there will still be any number of issues unresolved until the SEC fills in the gaps in the legislation through interpretive regulations.  These regulations could greatly facilitate the usefulness of this new exemption, or could eviscerate its usefulness, causing it to be used as often as Rules 504 and 505 of Regulation D.[2]

Footnotes

[1] This issue of whether state registration requirements apply to intermediaries is very complex and merits its own post.  This issue has been around for some time, because there is an analogous situation pertaining to Rule 506 offerings.  Some states require the officers who conduct a Reg. D offering to register as “issuer agents,” but such requirements may be preempted by federal law.

[2] Rules 504 and 505 are other exemptions contained within Regulation D.  They tend not to be used very often because, unlike Rule 506, there is no federal preemption of state registration requirements, subjecting offerings conducted under this rule to numerous state regulations.

On November 3, 2011, the U.S. House of Representatives voted overwhelmingly to pass the Entrepreneur Access to Capital Act (H.R. 2930). The bill creates an exemption from the registration requirements of the Securities Act of 1933, adding a new Section 4(6).[1]  This section provides that an offering of securities is exempt if it meets the following criteria:

• The aggregate amount sold within the previous 12-month period is $1,000,000 or less. This limit is increased to $2,000,000 if the issuer provides potential investors with audited financial statements. Both limits are indexed to inflation.
• The aggregate amount sold to any investor in reliance on the exemption in any 12-month period is the lesser of (a) $10,000 (indexed to inflation) or (b) 10% of the investor’s annual income. No definition is given for annual income, so presumably fleshing this out will be handled by SEC interpretive regulations.
• The offering must also meet the requirements of the new Section 4A, which I’ll discuss shortly.

The bill also creates a new category of participant in the capital markets called an “intermediary.” There is not much detail provided as to what role an intermediary can play in an offering, but the bill explicitly exempts them from the broker-dealer registration requirements of the Securities Exchange Act of 1934. So presumably, an intermediary could act as a compensated finder and be paid a fee to find investors, though none of this is spelled out, and much will turn on the SEC’s interpretive regulations.

The new Section 4A sets out an additional set of criteria that must be met in order for an offering to qualify under the new Section 4(6) exemption. Such criteria include: warning investors of the risks involved in an investment in a start-up, reporting certain information to the SEC, ensuring that potential investors demonstrate an understanding of the risks involved, stating a target offering amount and a deadline to reach such amount, carrying out background checks on the issuer’s principals, and refraining from offering investment advice. If the offering is carried out by an intermediary, then the burden of complying with Section 4A lies with the intermediary.

The bill also provides that:

• Much of the information collected by the SEC will be shared with the States’ securities divisions.
• The securities sold will be subject to a holding period of one year, unless the securities are sold back to the issuer or to an accredited investor.
• Use of Section 4(6) does not preclude an issuer from raising capital through other means, though in practice, the integration provisions of Regulation D would probably prevent a simultaneous Reg. D offering from taking place, unless the SEC provides otherwise in its regulations.

The bill instructs the SEC to issue interpretive regulations for Section 4A and to issue regulations precluding the use of the Section 4(6) exemption by issuers, intermediaries, or affiliated persons with a poor disciplinary history. Presumably these rules will mirror the new “bad actor” exclusions for Rule 506.

Investors who purchase securities under the crowdfunding exemption would not count towards the 499 investor limit under the Securities Exchange Act.[2] In addition, securities issued under Section 4(6) will qualify as federally covered securities, which means they will be exempt from state registration requirements.[3]

The new exemption is complex and will no doubt keep securities lawyers busy. In a future post, I’ll discuss some of the implications and unanswered questions revolving around the new crowdfunding exemption.

Footnotes

[1] For those of you who might ask “what happened to the old Section 4(6),” the Dodd Fank Act had already moved the old Section 4(6) to Section 4(5), and the old Section 4(5) was eliminated.

[2] Under the Securities Exchange Act of 1934, a company with more than 499 investors held of record and more than $10 million in assets must register their securities with the SEC and become a publicly reporting company.

[3] Via federal preemption of state law.

———————————–

© 2011 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.

Previously, I highlighted a proposed Startup Exemption to Federal securities laws, which would allow small companies to “crowdfund” (i.e. raise small amounts of money as startup capital from a large number of participants over the internet).  At the time, I thought that it was highly unlikely that anything significant would come of it.  In today’s climate, where investment losses from 2008 are still fresh in the minds of policymakers, I thought it was unlikely that there would be any significant support for the loosening of financial regulations.  I might have been wrong.

I saw the following statement on the White House’s web site: “As part of the President’s Startup America initiative, the Administration will work with the SEC to conduct a comprehensive review of securities regulations from the perspective of these small companies to reduce the regulatory burdens on small business capital formation in ways that are consistent with investor protection, including expanding “crowdfunding” opportunities and increasing mini-offerings.”

In addition, Republicans (unsurprisingly) are also getting on the bandwagon.  Perhaps we may have a genuine area of bipartisan agreement here?

———————————–

© 2011 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.

Recently, I came across an online petition proposing a new “Startup Exemption” to federal securities registration requirements.  You can find the petition at this website:  www.startupexemption.com.  Like many other similar proposals, its goal is to ease the regulatory burden on small businesses trying to raise capital.   Some of the highlights of the proposed exemption are:

• There would be a $1 million limit on the amount of capital raised.
• It would only be available to “small businesses,” defined as a business with average annual gross revenue of less than $5 million during each of the last three years or since incorporation if the business has existed for less than three years
• Unaccredited investors could invest a maximum of $10,000.  I like this idea, though it is certainly possible that $10,000 could wipe out the life savings of some lower-income investors.
• It’s somewhat unclear as to the suitability requirements.  It’s clear that unaccredited investors would be permitted to invest, but investment should be limited to investors who understand “the risks inherent in this type of investment.”  I’m not sure what that means.  In general, ambiguity in registration exemptions is a bad idea and leads to them not being used, because people want the safe harbor that a clear exemption provides.  Another part of the site mentions some kind of questionnaire that would be used to determine sophistication.  I’m somewhat skeptical about the effectiveness of something like that.
• The 500 investor limit in the Securities Exchange Act would be lifted.  It’s not clear whether this would be for all companies or just small businesses.  Nor is it clear what would happen when these small businesses are no longer “small.”
• Securities issued under this exemption would be a covered security similar to Rule 506 offerings, so it would preempt state registration requirements.
• General solicitation would be permitted on certain” registered platforms.”
• There would also be “standardized forms (generic term sheets & subscription agreements) based on industry best practices” used for the offerings and regular reporting on the registered platforms.  This sounds a lot like a simplified version of Exchange Act reporting.  The problem is, as soon as you attach anti-fraud liability to reporting, the stakes become too high to do the reporting without sophisticated legal help, which of course is the expense that the proponents of this proposal are trying to avoid.
• There would be some kind of exemption from the requirement to use a broker/dealer in facilitation of these transactions.  I’m not sure if they are proposing that finders fees could be paid to non-broker/dealers or if they mean something else.

So those are the highlights.  As you can see, many of the points described need some further thought.  I like the basic idea and even Mary Shapiro, Chair of the SEC has spoken of the need to relax the regulatory burden on startups.  Actually accomplishing that without increasing the likelihood for fraud is the hard part.

———————————–

© 2011 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.