It’s been almost a year since Congress passed the Jumpstart Our Business Startups Act (or JOBS Act). At the time, the passage of this bill was greeted with significant enthusiasm from the start-up community. Among other things, it provided for a crowdfunding exemption from securities registration requirements and a repeal of the prohibition on general solicitation of investors in connection with certain private offerings. A year later, how do things stand? In this first of a series of posts, I’ll explore how implementation of the JOBS Act has progressed and what we might expect in the future. [Read more...]
U.S. House Votes to Adopt Six Measures Loosening Securities Regulation for Smaller Companies; Provisions Include Crowdfunding and “IPO On Ramp”
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: [Read more...]
Recycling is generally considered a good thing when it comes to trash. It helps the environment and conserves resources. However, in the context of legal work, it is not such a good thing. Of course, when I use the word “recycle,” I don’t mean recycling the paper that the legal documents are on. I’m talking about recycling the actual words on the page. When a client “recycles” their lawyer’s work which was performed on a previous deal and uses it in a new deal, the client is asking for trouble. [Read more...]
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 had 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?
- 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.
 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.
 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.
Rep. McCarthy (R-CA) introduces legislation to eliminate ban on general solicitation for private placements.
Representative Kevin McCarthy (R-CA and House Majority Whip) recently introduced the Access to Capital for Job Creators Act (H.R. 2940), which would remove the ban on general solicitation for securities offering conducted under Rule 506 of Regulation D. Rule 506 is a safe harbor regulation which sets forth some conditions that if met, will assure an issuer that its securities offering is exempt from registration under Section 4(2) of the Securities Act of 1933. The rule permits the sale of securities to up to 35 non-accredited but sophisticated investors and an unlimited number of accredited investors. However, the issuer must also avoid engaging in a “general solicitation,” which prohibits the issuer from conducting any public advertising of the offering. Rep. McCarthy’s bill would remove this prohibition on any offering conducted exclusively to accredited investors.
Rep. McCarthy has advocated for the bill by arguing that it will increase access to capital for small businesses. This is certainly true. Under current law, issuers of securities may only offer their private placements to pre-existing contacts, which significantly limits a small business’s pool of potential investors. However, while it may be true that lifting the ban on general solicitation will help many small issuers get a wider audience for their investment pitches, regulators have concerns that removing this requirement will increase the likelihood of fraud. The North American Securities Administrators Association (NASAA) articulated these concerns in testimony before the House Capital Markets Subcommittee.
In the NASAA’s testimony, Heath Abshure, Chairman of the NASAA’s Corporation Finance Section Committee, expressed concern that Rule 506 offerings are often used to defraud investors. Since an offering conducted under Rule 506 is considered a “federally covered security,” states are preempted from regulating them in any meaningful way (apart from prohibiting outright fraud). As a result, state securities regulators have become increasingly alarmed at the widespead use of this exemption, which they believe has led to increased incidents of securities fraud. If this exemption permitted publicly advertised offerings, they argue that these instances of fraud would become even more prevalent.
The outlook on this legislation is mixed. The state regulators’ concerns are certainly valid, though the reality is that most perpetrators of securities fraud routinely violate the registration requirements anyway. Perhaps increased enforcement of anti-fraud provisions is the answer to dealing with fraud rather than retaining the general solicitation ban. That said, I don’t think Rep. McCarthy’s bill is particularly well thought-out. He simply eliminates the ban on general solicitation without considering the effects on other parts of Rule 506. With no ban on general solicitation, Rule 506 would allow a company to raise unlimited amounts of money from an unlimited amount of investors using public advertising. This would pretty much be a public offering and allowing it to qualify as an exempt unregistered offering would essentially negate the registration requirements of the Securities Act and of the securities laws of all of the states. As a result, the only real limit placed on a company that does not register its securities would be that all of the investors must be accredited. But even that would not be much of a limitation, since an investor’s status as an accredited investor is determined by a questionnaire. Investors can and frequently do misrepresent themselves on investor questionnaires, especially if they are convinced that they are being given access to a great “investment opportunity.”
I do agree that the ban on general solicitation is an outdated idea. However, simply removing it from Rule 506 without considering the impact on the rest of the Securities regulatory system is probably not the answer. In its testimony, the NASAA itself advocated for the adoption of a different exemption called the Model Accredited Investor Exemption (which I’ll explore in a future post), so the NASAA is not completely unsympathetic to business owners. Overall though, I’m pleased that legislators and regulators are now beginning to look to find ways to update securities laws for the 21st century.
© 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.