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.

The Managed Funds Association recently submitted a comment letter to the Securities and Exchange Commission dated January 6, 2012 requesting the SEC to amend Rule 502(c) of Regulation D to exempt private funds, such as hedge funds, private equity funds, and venture capital funds, from the ban on general solicitation and advertising under Regulation D.

Currently under existing law, private funds cannot engage in any “general solicitation” or “general advertising” in connection with offers and sales of interests in their funds.  This prohibits funds from engaging in any public advertising and communications about their securities offerings and requires a “substantial pre-existing relationship” between the issuer and any offeree.  In its letter, the MFA makes the case that changes in the securities markets and technology have rendered the general solicitation restrictions of Regulation D, enacted 30 years ago, outdated.  In addition, the MFA argues that the vagueness over what constitutes a general solicitation, combined with the severe penalties for even an inadvertent violation creates legal uncertainly for private funds, which inhibits capital formation.  It also makes the argument that allowing general solicitations for private fund offerings will increase transparency of funds, because they will be able to publicly publish their returns.

If the MFA proposal were to be adopted, private funds would be able to engage in public communications and offering activity while remaining in compliance with Regulation D and corresponding sections of the Investment Company Act that exempt private funds from investment company registration if they do not engage in a public offering.  This would certainly ease some of the compliance burdens on private funds.

One question that must be asked is why should this exemption from the general solicitation requirement apply only to private funds?  Why shouldn’t it apply to any Regulation D offering?  The MFA’s letter doesn’t really answer this point, though it does make a few arguments in favor of the change that would generally only apply to private funds.  For instance, it argues that the restriction creates an aura of secrecy that causes people not familiar with securities laws to make negative inferences about the hedge fund industry.  This is certainly true; though how much harm this actually causes the hedge fund industry is up for debate.   It seems to me that if we’ve decided that the ban on general solicitation is outdated, then it should be repealed outright, rather than just repealed for certain industries.[1]

Another thought I had while reviewing the letter is that the MFA makes a much better case for exempting so-called “3(c)(7)” funds rather than “3(c)(1) funds.”  3(c)(7) funds are limited to qualified purchasers who must have over $5 million in investment assets (if an individual) or $25 million in investment (if an institution).  Given that there are relatively few qualified purchasers, repealing the ban on general solicitation only for offerings targeted towards qualified purchasers would not likely cause the inundation of investment offers we are likely to see if this was opened up to all accredited investors.

Therefore, in my view, the best reform that could be instituted right now would be to allow general solicitation for any private offering that is offered solely to qualified purchasers (regardless of whether the offering is for a private fund or some other kind of entity).  I also propose that one additional condition on being exempt from the general solicitation ban would be that the issuer would be required to document proof of the qualified purchaser’s status by obtaining financial records (rather than now where the investor can simply represent that he or she is a qualified purchaser).  Such an approach, in my view, may be the best way to balance the needs of capital formation with investor protection.

Footnotes

[1] In fact there is a bill circulating through Congress right now that does repeal the ban on general solicitation for Regulation D private placements.  What comes of it remains to be seen.

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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.

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.

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 regulated 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 it’s 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.

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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.

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.

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.

Previously, I discussed the impact that the proposed “bad actor” rule will have on angel financings and offerings of interests in private investment funds.  By prohibiting the use of Rule 506 of Regulation D in connection with any offering which is associated with or promoted by a person which has committed certain enumerated bad acts, the rule will effectively impose a due diligence requirement on issuers requiring them to ensure that anyone associated with the issuer (i.e. directors, officers, greater than 10% shareholders) and any promoters of the offering have not engaged in prior misconduct.  In the event that the issuer later turns out to be associated with one of these bad actors, the issuer would lose its private placement exemption and could be liable for selling an unregistered security, unless it could establish that it did not know, and in the exercise of reasonable care could not have known, that the disqualification existed.  This requirement, I believe, will impose additional costs on startups and on private funds.  It seems that the Angel Capital Association (ACA), in a recent letter to the SEC, has taken the same view.

In the letter, the ACA makes some interesting arguments.  The ACA argues that the “bad actor” disqualification should be handled similarly to the way that qualification under the accredited investor standard is handled.  Private placements under Rule 506 are required to be offered exclusively to accredited investors[1], who are investors which meet certain net worth or annual income requirements.  Typically, an investor’s qualification under the accredited investor standard is verified by asking the investor directly.  Each investor in a Reg. D offerings is required to fill out a questionnaire which asks the investor to represent that he or she meets the qualifications of an accredited investor.  What happens if the investor lies and is later found out not to be accredited?  Rule 506 provides that as long as the issuer had a “reasonable belief” that the investor is accredited, then there is no violation.

Later in its letter, the ACA points out this is very different from the standard imposed on issuers in the bad actor rule, as currently proposed.  In the bad actor rule, if a person associated with the offering later turns out to be disqualified, the issuer must show that it did not know of and, in the exercise of reasonable care, it could not have known of the disqualification.  While showing a “reasonable belief” of a fact doesn’t sound all that different from showing that “in the exercise of reasonable care it could not have known” of a fact, there is nonetheless a huge difference: the new bad actor rule would require the issuer to prove a negative, which is notoriously difficult.  To show a “reasonable basis,” an issuer merely needs to produce the documents that they based their determination upon (in this case an investor questionnaire).  In contrast, it’s difficult to say exactly what an issuer would need to produce to show that “in the exercise of reasonable care it could not have known” that one of their affiliates had committed a bad act.  This is because it would always be possible in retrospect to second-guess the issuer and point out one more thing that the issuer could have done to discover a record of the bad act.  Therefore, as it is written now, the proposed bad actor rule is nebulous enough to compel issuers to perform extensive background checks to fulfill their due diligence duties.

The ACA has proposed that the issuer’s obligation under the bad actor rule be revised to ask one simple question: “does the issuer reasonably believe that no persons involved in the offering are ‘bad actors?’”  To establish this reasonable basis, the ACA has proposed that the issuer require that all persons involved in the offering be required to fill out a questionnaire which asks them if they have engaged in any of the specified bad acts.  The ACA provided an example of what such a questionnaire would look like with their letter .  The ACA’s proposal would, in effect, eliminate from the proposed rule any requirement of issuers to run background checks on persons affiliated with them.

Personally, I agree with the ACA’s proposal.  Most issuers I see that use Rule 506 tend to be small and have limited resources.  The bad actor rule, as it is written today, will only increase regulatory burdens on these small and often times struggling organizations.  Do I believe the SEC will accept the ACA’s recommendations and change the proposed rule before its final adoption?  Probably not.  I think even now, years after the Wall Street collapse of 2008, the trajectory in most regulators’ thinking still seems to be in the direction of adding more investor protections rather than easing the regulatory burdens of  small companies, despite the fact that Rule 506 offerings had absolutely no role in the events of 2008.  Perhaps a few more years of 9% unemployment will change this thinking, but for now, I think it’s here to stay.

Footnotes

[1] It is possible for a Rule 506 offering to include non-accredited investors.  However, in order to do this, the issuer would have to prepare offering documents that meet many of the same standards as those which are prepared in registered offerings, thus defeating the purpose of conducting an unregistered offering.

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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 recent rule-making, the SEC, at Congress’s behest, has proposed a rule that will increase due diligence requirements for Rule 506 offerings, which are is type of securities offerings most frequently used by startups for their seed and angel rounds of financing and by hedge funds and VCs.  The new rule is made pursuant to Section 926 of the Dodd-Frank Act, and prohibits securities issuers from relying on Rule 506 if anyone associated with the issuer or the offering has engaged in certain “bad acts” enumerated in the rule.  These bad acts include:

• Securities-related criminal convictions;
• Securities-related injunctions and court orders;
• Final orders from certain regulators, including federal banking agencies and state securities commissions, that bar the individual from association with a regulated entity, prohibit the individual from securities and banking-related business, or which are based on fraudulent conduct within the last 10 years;
• SEC disciplinary orders that revoke one’s registration as a broker-dealer or investment adviser, or otherwise limit one’s activities;
• Suspension or expulsion from a self-regulatory organization (for example a broker-dealer losing its affiliation with FINRA);
• SEC Stop Orders and Orders suspending exemptions of Regulation A offerings; and
• U.S. Postal Service false representation orders.

This prohibition on prior bad acts applies to (i) the issuer, its affiliates, predecessors, directors, officers, general partners, managing members, and beneficial owners of 10% or more of any class of the issuer’s equity securities, and to (ii) promoters and persons compensated for soliciting purchasers, such as placement agents, and their directors, officers, and managing members.

Rule 506, according to the SEC, is used in 90-95% of all private placements[1], so any change to Rule 506 will dramatically change the landscape of private securities offerings.  If a company is unable to rely on Rule 506 (or any other private placement exemption), then it risks violating Federal and state securities laws which prohibit the sale of securities that are not registered unless the issuer establishes that it is entitled to an exemption from registration.  A violation of this prohibition can carry significant civil or even potential criminal penalties.  In addition, the issuer, its officers, directors, and owners, along with anyone involved in selling the security, like internal salespeople and outside broker-dealers, are strictly liable to the purchasers of the securities in a civil suit.  Therefore, it’s important for an issuer to ensure that it is entitled to rely on Rule 506.

What happens if, unbeknownst to the issuer, one of the covered parties has engaged in one of the enumerated “bad acts?”  In order to avoid potential civil and criminal penalties, or to successfully defend a lawsuit from an investor, the issuer will have to establish that it did not know, and in the exercise of reasonable care could not have known that the disqualification existed.  To establish reasonable care, the issuer will have to show that it made a factual inquiry, most likely in the form of background check of parties covered by the rule.  However, the rule does not provide specifics as to what that inquiry must be.

What is the practical effect of all of this?  It will likely increase the legal costs associated with due diligence in connection with a private offering.  It is certainly true that even without this rule, an issuer and its legal counsel should still perform due diligence on the issuer’s principals and on any outside placement agents for the offering.  The anti-fraud provisions are often interpreted to require that an issuer disclose the prior bad acts of the issuer, its affiliates, and principals.  However, this new rule raises the stakes significantly.  To succeed on a securities fraud claim, a plaintiff generally must establish that the issuer acted recklessly or intentionally, which can be relatively difficult.  If and when this new rule is put into place, the issuer will bear the burden to show that it exercised reasonable care (itself, a higher standard of conduct compared merely avoiding recklessness), and if it fails to do so, it and its principals can be subject to strict liability claims associated with selling an unregistered security.  Even if an issuer is sure that no one who is affiliated with it has engaged in misconduct, its outside counsel will likely feel compelled to perform the requisite due diligence associated with compliance with this new rule, or risk a malpractice suit.  Placement agents will also need to be significantly screened prior to using them (which is a good idea anyway).  Finally, since the bad actor provisions, as they are currently proposed, will also include equity owners of the company, issuers will need to (i) use some kind of method of screening potential investors and (ii) restrict the transfer of their equity interests so as to ensure that bad actors do not acquire an interest in them.  Failure to do so risks unwittingly becoming associated with a bad actor and losing the ability to engage in further capital-raising.

The changes to Rule 506 have not yet been finalized and may be further revised significantly.  Final comments to the SEC are due July 14.  However, it is unlikely that the final rule will differ much, because the core principle that Rule 506 will not be available to issuers associated with “bad actors” is derived directly from the text of the Dodd-Frank Act itself.  Stay tuned.

Footnotes

[1] At least those that make use of Regulation D.

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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.