Strictly Business

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.

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© 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.

Form D is a document that the SEC requires a company to file when it issues securities in a private placement under Regulation D.  It must be filed with the SEC within 15 days of the first sale of a security in a private placement.  In addition, for offerings made under Rule 506 (the most frequently used part of Regulation D), an issuer must also file a copy of Form D (along with a filing fee) with the securities administrator of each state in which purchasers of the securities reside within 15 days of the first sale within each state.  Overall, Form D is a relatively simple document to complete and file; however, it’s very easy for a small company to overlook filing one, especially if it doesn’t use qualified legal counsel for its securities offering.  I frequently get asked about what happens when an issuer fails to file Form D or if the issuer files it late.  This post describes what consequences can and cannot occur.

The first consequence an issuer might be concerned about is losing the federal private placement exemption and consequently be in violation of securities laws by improperly selling unregistered securities.  Thankfully, a failure to file a Form D does not result in the loss of the federal registration exemption.  The SEC has issued guidance on this in Question 257.07 of the Securities Act Rules Questions and Answers of General Applicability.  While filing Form D is a requirement for using a registration exemption under Regulation D, it is not a condition to qualifying for the exemption.  Instead, the only potential consequence on the federal level is that the SEC could take action against the issuer and seek to have the issuer enjoined from future use of Regulation D under Rule 507.  If the violation is willful, it could also constitute a felony.[1] Despite the fact that Form D is not a condition to being exempt under Regulation D, I would caution issuers to not take their responsibility to file Form D lightly.  Often when an issuer is sued in court, the plaintiff will accuse the issuer of violating the federal registration requirements of the Securities Act.  In such instance, the issuer will bear the burden of proof to prove that the securities offering met an exemption under Regulation D.  While courts have explicitly stated that failing to file Form D does not create a private right of action, an issuer may be assisted in meeting its burden of proof that the securities were issued pursuant to an exemption under Regulation D by producing a properly filed Form D.[2]  Therefore, while failing to file Form D may not result in the SEC seeking penalties against an issuer for selling unregistered securities, it could put an issuer at a disadvantage in civil litigation by eliminating one piece of evidence that an issuer can use to build their case that they substantially complied with Regulation D.  In addition, the SEC may seek substantial penalties against an issuer who has failed to properly file Form D.

The other question an issuer may be concerned about is what are the consequences for failing to file Form D at the state level.  Most Regulation D offerings are conducted through Rule 506.  When an issuer makes use of Rule 506 to issue securities, those securities are considered “covered securities,” and state registration requirements are preempted.  However, states are permitted to require that the issuer file a copy of the Form D (along with a filing fee) with the state securities administrator if the issuer has sold its securities to the state’s residents.  Is the preemption of state securities registration requirements in a Rule 506 offering lost if the issuer fails to file with a state?  The SEC’s position is that it is not.  Under Question 257.08 of the Securities Act Rules Questions and Answers of General Applicability, the preemption is not conditioned on properly making a notice Form D filing with a state.  One word of caution: some states take the opposite position.  The Wisconsin Department of Financial Institutions for instance takes the position that if a Form D is filed late in Wisconsin, the issuer must find another exemption or register the security.[2]  My personal opinion is that if the Wisconsin Department of Financial Institutions ever took the case to court and claimed that a Rule 506 offering needed to be registered because a Form D was late, Wisconsin would lose that case, as courts have repeatedly held that failure to make a notice filing does not strip the offering of the status of a “covered security.”[3]  But taking such a case to court would be expensive.  In addition, there can still be significant consequences on the state level beyond losing a registration exemption for an issuer who fails to make required notice filings.  States can issue fines or even stop orders, preventing further sales of securities by an issuer.  Arkansas, for example, is one state that has been particularly aggressive in issuing fines for late Form D filings.

The good news here is that if an issuer accidentally fails to file a required Form D when conducting an offering or files it late, that will not invalidate the private placement registration exemption, which would potentially be a catastrophic event for an issuer.  However, the SEC and state securities administrators can still issue fines and prevent an issuer from engaging in future private placements, so issuers still need to be diligent in making all required securities filings when conducting private placements.

Footnotes

[1] See Hamby v. Clearwater Consulting Concepts, Lllp, 428 F.Supp.2d 915, 920 (E.D. Ark., 2006).

[2] In a court trial, the issuer would have to produce additional evidence to show substantial compliance with Regulation D, such as subscription documents that evidenced an inquiry into whether the investors were accredited or sophisticated.

[2] See http://www.wdfi.org/fi/securities/regexemp/exemptions/23_19_506.htm

[3] See for example Chanana’s Corp. v. Gilmore, 539 F.Supp.2d 1299 (W.D. Wash., 2003) for an example of a case where a court concludes that a late filing does not cause a security to lose its status as a “covered security.”

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© 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.

One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties.  For instance, let’s say that two owners of a corporation decide that their corporation needs more funding.  However, they don’t want to invest more equity into the business.  They are willing to extend a loan to their company and expect to get paid back over the next few years with interest.  Here’s how that should work (assuming this company is a C Corporation):

The corporation would make payments of principal and interest back to the shareholders.  The corporation would be able to deduct the interest as an expense.  The owners would not need to pay taxes on the principal but would pay taxes on the interest.  There are no double taxation issues because the interest expense is deducible to the corporation.

Unfortunately, small business owners often don’t take the time to properly document transactions like this.  They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan.  After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared.  This can cause a couple of problems down the road.

First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction.  When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend.  As a consequence, the loan interest is no longer deductible.  Therefore the owners will pay double taxation on the interest.  In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).

Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders.  Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire.  The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)

A loan is just one example of the type of transaction that should be documented even when made between related parties.  Another example is leases.  Many business owners lease their own property to their business.  But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions.  Here’s a couple of other examples:  employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.

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© 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.

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© 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.

The so-called “friends and family” round is often the first capital raise a new startup will engage in.  Many entrepreneurs often go into it without any knowledge of securities laws and as a result, end up violating them, sometimes with real and significant consequences later.  However, plenty of entrepreneurs do take the time and effort to comply with securities laws and make use of an exemption from the registration requirements under the Securities Act of 1933.  Regulation D covers the most often used exemptions (at least by smaller companies).  The most common form of a Regulation D offering is one conducted under Rule 506, which essentially requires that the issuer offer the securities only to preexisting contacts (no advertising or widespread communication of the offering) who are accredited investors.  An accredited investor is someone who either: (i) has an individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeding $1,000,000, excluding the value of the primary residence of such person or (ii) had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.[1]  However, it is often the case that an entrepreneur’s friends and family are not accredited and so if he limits his capital raise to accredited investors, the capital raise will go nowhere.  Not everyone has a rich uncle.  So, if you are an entrepreneur in this situation, can you raise money from investors without those investors being accredited?  Yes, you can, but proceed with caution.

Regulation D offers a number of ways to accept investments from non-accredited investors.  Rule 506 itself allows a company to include up to 35 non-accredited investors in the offering.  However, this is impractical for two reasons.  First, any non-accredited investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”  This is a very subjective standard and unfortunately the only way to get a final determination if an investor meets this qualification is in the courtroom.  By relying on this subjective standard in the offering, the issuer is taking a huge risk of litigation later.  In addition, Rule 506 presents an even more significant obstacle to including non-accredited investors.  If a Rule 506 offering includes non-accredited investors, then it must provide investors with much of the same information as is provided in a registered offering, which largely defeats the purpose behind conducting an exempt offering and is likely to drive up costs of the offering to the point where it is not economical to conduct a small friends and family capital raise.  In contrast, when a Rule 506 offering is conducted without non-accredited investors, there is no information requirement, which means that there is no specific information that is mandated by securities regulations to be given to investors.[2]

So is there a way to include non-accredited investors in an exempt unregistered offering and still retain the “no information requirement?”  Yes, through Rule 504.  Rule 504 allows a company to raise up to $1 million over a 12 month period.  There is no requirement that the investors be accredited and, as in the case of a Rule 506 offering made exclusively to accredited investors, there is no information requirement.[3]  The one major limitation placed on a Rule 504 offering is that, like a Rule 506 offering, there must be no general solicitation.  All investors must be preexisting contacts of the issuer and its principals and no advertising or widespread promotion of the offering is permitted.

Rule 504 does have one major disadvantage as compared to a Rule 506 offering.  Rule 506 preempts state registration requirements whereas Rule 504 does not.  So, when conducting a Rule 506 offering, as long as the correct notice filings are made, issuers need not worry about finding an exemption from state securities registration requirements. However, if an issuer relies on Rule 504 in its capital raise, the issuer’s counsel will need to research the state law of every single state in which the company will be soliciting investors in order to find a separate exemption from registration in each state.  In some states there are exemptions allow for residents to take part in a Rule 504 offering.  For instance, in Tennessee, offering up to 15 investors in a 12 month period are exempt.  Other states may or may not have similar provisions and it may be possible that you might not be able to accept investments from residents in certain states.

The next question that needs to be asked is should you include non-accredited investors in your capital raise as a matters of morals and good business sense.  The law may permit it (subject to restrictions), but is it a good idea?  Recall the proverb: “Before borrowing money from a friend, decide which you need more.”  With any entrepreneurial venture there is a substantially high chance of failure.  You may think that you have the best idea in the world and it’s a sure thing, but chances are there are unforeseen forces that could derail your efforts.  Therefore, for both moral and legal reasons, it’s a good idea to only take investments from people who can bear the risk of loss of the investment.  Therefore, you should never accept investor money from a friend or family member when that money constitutes a significant portion of that person’s life savings or if losing that money could substantially harm them or those that depend on them.  In any event, before taking an investment from a friend or family member, ask yourself this: if he or she lost all of the money invested because the business failed after you did your very best to make it succeed, would this cause hard feelings?  If there answer is yes or maybe yes, then either don’t take the money from this person at all, or reduce the amount of the investment to something that this person would consider to be insignificant. If you don’t, the hard feelings you create can cause you to lose the relationship and may land you in court.

Conducting a first capital raise can be an exciting time for any company.  It can also be fraught with pitfalls.  You should consult an attorney who is familiar with securities laws to help you navigate this exciting but high stakes stage in the growth of your company.

Footnotes

[1] It is also possible for business entities to qualify as accredited investors if they meet certain net worth or other requirements.  In addition, directors and officers of the issuer also qualify.

[2] “No information requirement” does not mean that no information is given to investors; rather it means that the issuer is free to choose the overall format, degree, and composition of information given to investors, as long as that information does not violate the anti-fraud provisions of securities laws.  Frequently, the compiled information in a Rule 506 offering is called a “private placement memorandum.”

[3] Again, as a matter of clarification, “no information requirement” means no specific mandated information is required to be given to investors.  However, if the information that is given is misleading, the offering could violate the anti-fraud provisions.

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© 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.  In addition, the laws regulations discussed in this piece are complex.  In the interests of summarizing them, I have presented a simplified description some of the requirements of conducting a Regulation D offering.  Therefore, this post should not be viewed as comprehensive instructions on conducting such an offering.

Representative David Schweikert (R-AZ) recently introduced a bill called the “Private Company Flexibility and Growth Act,” which promises to allow private companies to remain private for a longer period of time.  Currently, if on the last day of a company’s fiscal year, any class of securities of the company is held of record by 500 or more shareholders and the company has total assets of more than $10 million, then it must register under the Securities Exchange Act of 1934.  This brings upon it a multitude of responsibilities and obligations including filing annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and meeting proxy regulation requirements.  With these added obligations, most companies will simply choose to go public (i.e. engage in an IPO), since they might as well gain the advantages of the public markets given that they will now be dealing with all of the compliance expenses that come along with them.  An example of a company that is likely dealing with this issue now is Facebook.  It has been widely reported that it is either past the 500 shareholder limit or soon will be, since its shares are held by many employees, some of which may have sold their shares to other parties.  Many people believe that Facebook has no desire to go public, but will likely be forced to do so early next year.  Is that fair?

Certainly Rep. Schweikert doesn’t think so.  His bill would make a couple of changes.  First, it would increase the shareholder limit to 999 from the existing 499.  Second, accredited investors and persons who received shares pursuant to an employee compensation plan would no longer count towards the limit.  The second change is the far more important one, since it will allow private companies to grow to almost a limitless size without ever being required to go public.  A vast majority of the shares of private companies are issued in one of two ways: (1) private offerings made only to accredited investors and (2) shares issued to employees as compensation.[1]  Since the two largest categories of shareholders in a private company would no longer be counted towards the limit, this bill would effectively do away with the requirement of companies to go public as they expand.

Since I also write a lot on private investment funds, I would also point out that this bill would be of significant benefit to some of the larger hedge funds and private equity funds.  Large private funds tend to be so-called “(3)(c)(7)” funds.  3(c)(7) funds are offered only to qualified purchasers, which general speaking are individual investors with investment assets over $5 million or companies with investment assets over $25 million.  Because of the Exchange Act’s 499 investor limit, these funds cannot have more than 499 investors under current law.  If this bill were passed, there would be no limit to the amount of investors that a 3(c)(7) fund could have, since any qualified purchaser would easily qualify as an accredited investor.  Many people often incorrectly believe that the 3(c)(7) exception itself contains the 499 investor limitation. It does not; the limitation is in the Exchange Act.  Thus this bill would allow the largest private hedge funds, private equity funds, and venture capital funds to get even larger.

I agree with the overall premise of this bill.  I do think that companies should have more control over when and if they go public.  I also think that the bill is unlikely to pass in its current form for a couple of reasons.  First, regulators are likely to lobby against it rather aggressively.  Since accredited investors and employee shareholders will no longer count towards the limit, the limit would be effectively eliminated.  For a lot of people in the securities regulation field, that would be a step too far, potentially undermining the investor protection policy goals of the Exchange Act.  Second, I’ve already pointed out that large hedge funds will be unintended significant beneficiaries of the bill, and it will be too easy to paint this bill as something favored by “Wall Street.” (And we would never want to do anything like that!)

That said, this bill is part of a conversation that is has begun over the last year.  Even Mary Shapiro, chair of the SEC has written about the possibility of loosening the 499 investor limit on private companies.  I think that if some of the concerns mentioned above are addressed, the introduction of this bill moves us closer to the possibility of reforming the Exchange Act’s limits on private companies.

Footnotes

[1] Some may point to Rule 12h-1(f), which exempts employee stock option holders from the 499 investor limit, if certain conditions are met.  But this rule does not exempt actual employee stock holders from counting towards the limit, so the exemption on employee shareholders in this bill is a significant loosening of restrictions.

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© 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.