Breaking News: Congress Passes H.R. 3784 SEC Office of Small Business Advocate Bill

Most of us were probably sleeping last night when the U.S. Senate passed by unanimous consent S. 2867, the counterpart to H.R. 3784, a Bill to create an Office of Small Business Advocate at the SEC. Earlier this year H.R. 3784 passed the House, by voice vote.

This legislation is now on its way to the President, and is expected to be signed into law this year.

For those of you who want to dig into this more, you may want to read my most recent article on this topic.

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Unstacking the Deck Against SME’s in Washington: A Call for an SEC Small Business Advocate

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[As published inn Crowdfund Insider on November 16, 2016]

With a new administration set to take the reins of power in the White House in January 2017, not to mention a new, Republican appointed Chair of the SEC in the offing, when it comes to the interests of small business’s access to capital, many things are now possible – indeed likely.

Today I would like to focus on a particular piece of legislation, now pending in the Senate, one of a number of important pending or proposed legislative reforms, which I and others consider vital to advancing the interests of SME’s to access capital – both in the deliberative process at the SEC, and in Congress.  The Bill, H.R. 3784, introduced in the Senate as S. 2867, is a piece of “common sense” legislation which would establish a permanent, independent office at the SEC, whose exclusive charge would be to represent, and advocate for, the interests of SME’s, both internally, and as a spokesperson for SME’s on Capitol Hill.  The bill is largely patterned after a similar bill which was part of the Dodd-Frank Act of 2010, creating an independent office of Investor Advocate.

After being voted out of the House Financial Services Committee, and ultimately the full House of Representatives, by voice vote, it now sits in the Senate in the Banking Committee, awaiting action – or inaction – as the case may be.  The bill is likely to see action, sooner or later, in view of the changing of the guard at the White House – not to mention the Commission. In my view, the sooner the better. Hopefully, a majority in the Senate will share that view.

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So who could be opposed to such a bill, and why? It seems to fit in well with Mom and Apple Pie. Right? After all, who could object to having a dedicated, independent voice, and advocate, for small business at the SEC?

Well, it seems there are still some doubters on the Senate side. This article is intended to speak to those fence sitters, on both sides of the aisle – not to mention our President-Elect Donald J. Trump, who is on the hunt for meaningful reforms in Washington which will grow our economy – and fuel the creation of new jobs.

Oddly, it seems that I was the first person to publicly advocate for an independent voice for SME’s at the SEC. I do not take too much credit for this, as this is a common sense proposal – even more so following Dodd-Frank’s creation of an Office of Investor Advocate at the SEC back in 2010. Instead, and very sadly, what this reflects, in my opinion, is the absence of voices in Washington dedicated to interests of small business, and their need to access capital. Yes, there are some – but they are heavily outnumbered – and outspent. History alone tells us that this has not been a fair fight, when it comes to addressing the need of small business to access capital.

Small business needs a legislative fix to even the playing field – both at the SEC and in Congress.

Daniel Gallagher Dont Be Bullied 2Not only my view. Others, with a better vantage point than me at the SEC, have echoed this sentiment in no uncertain terms.  Former SEC Commissioner, Daniel M. Gallagher, who left his post as Commissioner after four years in October 2015, had this to say on the subject, in a major address delivered at The Heritage Foundation in September 2014, aptly titled: “What Ever Happened to Promoting Small Business Capital Formation”:

“But small business has a big collective action problem here in Washington, where it is regularly and systematically underrepresented in the legislative and regulatory process. Small business owners are focused on making ends meet and growing their businesses, not hiring high-priced lobbyists to influence policy. Big businesses and unions, by contrast, can afford to hire lobbyists to develop relationships with politicians and regulators—which is the way business in the U.S. increasingly gets done. As an SEC Commissioner, I believe that this issue warrants the agency’s highest level of priority. And, as the son of two long-time small business owners, I take this issue personally.”

No surprise that, in that same speech, Commissioner Gallagher was the first public official to publicly address the need for an independent office at the SEC devoted exclusively to advancing the interest of SME’s, being one of the most outspoken, and effective, advocates for small business at the SEC in my lifetime.

office-of-small-business-advocateAnd so, I believe the SEC needs to create an Office of the Small Business Advocate, reporting to the Commission. This office would be modeled on the Office of the Investor Advocate created by the Dodd-Frank Act. There’s a natural parallel here, in that our staff perennially faces difficulty in receiving views from certain segments of the market that find it difficult and expensive to participate in the normal notice and comment rulemaking process: retail investors and small businesses. Having a single point of contact for outreach to these underrepresented groups, who can then turn around and advocate their views to the staff, is critical. Finally, just as the Investor Advocate now runs the Investor Advisory Committee, the Small Business Advocate could take charge of the SEC’s Advisory Committee on Small and Emerging Companies and the Government-Business Forum, an incredibly important group that does not have the profile it deserves at the Commission.

My sources tell me that there are still some doubters on the Senate side. On this piece of legislation there ought to be no doubt.  Yes, there is the perennial opposition of everything which would empower small business at the SEC and in the capital markets. To name one – that powerful and well funded (and “state sponsored”) North American Securities Administrators Association (NASAA). Also, some inside the SEC are not sanguine, to say the least, about the prospects that this change in the status quo would bring.  Unfortunately, necessary change often disrupts the status quo.

Many industry organizations have already weighed in on the record in support, including the U.S. Chamber of Commerce, National Venture Capital Association, National Small Business Association, Small Business Investor Alliance, SBEC, and BIO, the largest organization representing the biotech industry.  Also in the mix was the Crowdfunding Professional Association (CfPA), under my leadership as Chair and President when the bill was originally introduced into the House of Representatives back in 2015.

So Why are there Still Doubters?

To be fair, there are, and have been, doubters on both sides of the aisle. Some question whether there is a need to “expand” any governmental agency. Others question how effective a Small Business Advocate would be.  The most potent and pointed response to these doubters might be in the form of data – a tactic which some folks (NASAA) recently used as a sword to dismember the most recent legislative effort to resuscitate federal investment crowdfunding, Congressman McHenry’s Fix Crowdfunding Act, H.R. 4855.

Patrick McHenryUnfortunately, it is difficult to quantify, or datify if you will, the need for a dedicated small business advocate. Much of the story is told in what has not happened – and thus cannot be easily quantified. Alas, not all stories must be told with numbers, even in this digital age. 

History alone will not convince all of the doubters, measured by the progress that small business capital formation reforms have made since 1980, when a bi-partisan Congress enacted a host of legislative initiatives intended to empower small business at the SEC.  So I turn this conversation to some concrete, recent qualitative examples of why an independent small business advocate is necessary at the SEC.

Sometimes it Takes Some Red Meat to Change Minds.

Though I was not called upon to testify in support of H.R. 3784, here is some of what I would have put in the record.

Example No. 1 – Intrastate Crowdfunding.

Back in April 2014 the Staff at the SEC’s Division of Corporation Finance issued an informal, non-binding ruling, opining that states could not allow for broad, unrestricted internet solicitation in state legislation relying upon the federal exemption from registration, Section 3(a)(11), which in simple terms leaves it up to the states as to how best regulate securities offerings within their state.

I personally was “inflamed,” not only because this ruling reflected an about face on earlier rulings allowing broad solicitation, in radio, TV and newspapers, even when it crossed state lines,” but because it took away a powerful and inexpensive tool for small businesses to reach outside of their inner circle when seeking much needed capital. So inflamed, I penned two articles on the subject, followed by a meeting with ranking members of the SEC’s CorpFin staff. I was told in no uncertain terms that there were some (unnamed) people inside the SEC’s headquarters who did not share my view that internet solicitation was a good thing, when it came to capital formation. Others, including a former president of the Crowdfunding Professional Association, were also shown the “hand” on this issue by the Staff.  To put a fine point on this, when I left my meeting at SEC headquarters, I was consoled by another Staff member, who aptly remarked in a sympathetic manner that I was “beating my head against the wall.” Yes, there was a wall. And my head was exploding.

And the salt on the wound – the Commission was still dragging its feet on adopting proposed crowdfunding rules under Title III of the JOBS Act.

Ultimately the Commission Saw the Light

In 2015, in what I believe was a response to state securities administrators outraged by the SEC’s position, the SEC made intrastate crowdfunding, and SEC Rule 147, a priority, ultimately proposing new rules in October 2015.  In what I described in my formal comment letter on the proposed rule, what the Commission had proposed was a Faustian bargain of sorts – it would allow state legislatures to enact provisions allowing broad internet solicitation – but at a price. The Feds sought to cap the amount raised in any year to $5 million.

As history would have it, rule commenters were almost universally opposed to this cap – hence it was removed when the final rules were enacted in October 2016.

So What Difference Would a Small Business Advocate Have Made?

Well, I believe that if small business had a strong, independent voice at the table back in 2014, that Staff ruling would never had seen the light of day, and instead we would have seen much needed rulemaking, ultimately implemented in October 2016.  The ruling went against the grain of prior SEC pronouncements and published views of noted SEC scholars, Rutheford B. Campbell, to be precise – an influential voice in the enactment of regulations implementing Title IV of the JOBS Act, Regulation A.

Given that the new, final rules do not go into effect until April 2017, many startups, and would be startups, lost the opportunity for three years to utilize the internet to reach out to accredited and non-accredited investors in their own community.

Moreover, this ruling directly impacted state legislatures contemplating intrastate crowdfunding legislation. In my home state of California, yet to enact a crowdfunding statute due to intense lobbying efforts of the payday lenders, the Committee text to one of the bills stated that California was essentially forced to craft this legislation under another federal rule, Rule 504, which carried with it at that time an SEC mandated limit of $1 million per year.

And well, those legislatures which had enacted intrastate crowdfunding legislation back in 2014, or earlier – their local entrepreneurs would have to pound sand – when it came to the use of the internet – for three years.

Example No. 2 – Making Sausage out of a Pure Beef “Fix Crowdfunding Act”

I like many others, like sausage. Undoubtedly, I would forever renounce it if I witnessed the process by which it were made.  So too, apparently, 86% of the American electorate, fed up with business as usual in Congress.  Those with “access” can get things done in D.C., be it through high paid lobbyists or well placed political partisans. As former SEC Commissioner Dan Gallagher pointed out, small businesses don’t stand a chance.

where is the beef meatWe saw the result of this (but not the cause) as Congressman McHenry’s pristine Fix Crowdfunding Act fell victim to Washington sausage making before it was voted out of Committee. Though it was ultimately voted out of the House Financial Services Committee, and subsequently the full house, the amended bill fell victim to partisan deal making, losing one of its most vital provisions, what would have allowed would be investment crowdfunders to “test the waters” – in other words to interact with the public, through social media and the internet, to gauge interest in their business and their financing plan – before filling out all of the paperwork necessary to commence the formal offering process.

Though universally supported by the crowdfunding industry and small business advocates alike, it was opposed, on the record, by NASAA. Not enough data for them yet, it seemed. At least that is what their spokesperson, William Beatty, stated on the Congressional record.

OK, no surprise there. NASAA can always be counted upon to oppose any reform which would widen the spigot of capital to early stage businesses – too risky for the investing public they say.

But Here is the Big Surprise!

fix-mechanic-car-repair-auto-tune-up-toolsMuch of the important deliberations in Washington occur behind closed doors, outside the eyesight and hearing of the public.  After all, sausage making is ugly.

Less known, and unsettling to say the least, is that according to a highly credible Capitol Hill source, at least one SEC official weighed in on the testing the waters provision of the Fix Crowdfunding Act, behind the closed doors of a Congressional member of the House Financial Services Committee. In that person’s view, the testing the waters provision did not belong in the Fix Crowdfunding Act.

Wouldn’t it have been nice if there were a designated point person at the SEC who could freely and openly advocate for the interests of small business, both behind closed doors – and openly in Congressional hearings?

That is exactly what the pending Small Business Advocate Bill would allow. A dedicated, independent voice, to weigh in not only in Congress, but with some “bully pulpit” authority, now lacking, in the internal rulemaking deliberations of the SEC.

Joe BorgAnd well, those NASAA folks, they seem to be cutting off their nose to spite their face on the battle against testing the waters provisions.  After all, public internet-based solicitation before an offering formally commences would provide an early warning system for state regulators, on the hunt for the next securities fraud du jour. As one of my favorite State Securities Administrators and former NASAA President has remarked, Joe Borg, at the helm in the State of Alabama, the challenge of state regulators is to catch bad actors before the forest is burned to the ground – leaving victims who may have lost their life savings to fraudsters with no effective recourse.

Also argued by opponents to testing the waters in investment crowdfunding: it will have the impact of conditioning investors’ minds before they are afforded full disclosure. Well, it seems that the Fix Crowdfunding Act squarely addressed this concern, by expressly providing that material departures from testing the waters material would need to be highlighted as such in the mandatory SEC disclosure accompanying the formal offer and sale process.

perry-mason-1And for those investor protectionists concerned for perhaps the largest vulnerable population, the elderly, more than half of that population suffers from some form of dementia by time they reach their 80’s.  Surely they need protection from bad actors. But let’s get real.  It is unlikely, indeed impossible, that anyone with an impaired short term memory will be mentally conditioned by anything for very long.

So for those who question whether an independent small business advocate is necessary. I say: it is both essential – and long overdue.  And for those concerned about cutting government spending: plenty left, unutilized, in the current SEC budget, according to this week’s Congressional record. And I would expect that with a dedicated focus at the SEC on the interests of SME’s, this would reap oversized financial dividends for years to come – in terms of more focused SEC rulemaking and federal legislation – and more capital in the hands of this Nation’s largest engine of job creation – small business.

I rest my case.


Sam Guzik National Press Club BSamuel S. Guzik, a Senior Contributor to Crowdfund Insider,  is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice.  Guzik is also former President and Board Chair of the Crowdfunding Professional Association (CfPA) and currently CfPA Legislative & Regulatory Special Counsel. A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium sized business, he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. In 2014, some of his speaking engagements have included leading a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy, a panelist at the MIT Sloan School of Business 2014 Crowdfunding Roundtable, and a panelist at a national bar association event which included private practitioners, investor advocates and officials of NASAA. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation.

Posted in Capital Raising, Crowdfunding, General, Regulation A+ Resource Center, SEC Developments | Comments Off on Unstacking the Deck Against SME’s in Washington: A Call for an SEC Small Business Advocate

On the SEC’s New Intrastate Crowdfunding Rules and the Nanny State

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On October 26, 2016, the SEC’s three Commissioners convened at their headquarters to adopt new rules intended to modernize what had historically been a little used path of raising capital for startups, early stage businesses and community-based enterprises: the so called intrastate exemption. It had its origins in our federal securities regulation legislation adopted back in 1933, which required the federal registration of the sale of securities in the U.S.  absent an exemption from registration.

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In 1933 Congress, in its wisdom, carved out from the registration requirement those offerings that were purely local in character, where offers and sales were made by local businesses within their state borders.  This area it left to regulation by the states – on a state by state basis – with each state left to decide for itself how best to balance the need to protect its investing public with the ability of local businesses to access capital.

And to facilitate the utilization of this exemption from registration the Commission enacted Rule 147, intended to be a non-exclusive safe harbor to facilitate compliance with the federal exemption.

Over the years it became more and more apparent that both the exemption itself and the Rule were flawed – hence its use languished – in favor of other more manageable exemptions from federal registration.   Its use was generally shunned by securities lawyers, as it was too easy to fall out of compliance with its requirements.

And time was not kind to the intrastate exemption. If your business was a corporation, the statutory exemption was limited to corporations incorporated in the state where the offering occurred, thus excluding local businesses who might elect to incorporate in out of state jurisdictions.   And with the onset of the Internet in the 1990’s the Commission struggled with how to address offers by a local business on the internet which by their very nature would cross state borders.  This struggle came to a head in 2014, when the SEC Staff issued an informal interpretation, a “CDI” (compliance and disclosure interpretation), opining that unrestricted Internet solicitation and advertising of an offering was taboo for an offering relying on the intrastate exemption.  This effectively put a damper on local investment crowdfunded offerings in the dozens of states that had adopted, or were to adopt, intrastate crowdfunding statutes relying on the intrastate exemption.

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The 2014 CDI was greeted with a growing chorus of mystified securities lawyers, state securities regulators and small business advocates.  At a time when the SEC was dragging its feet to adopt regulations to implement interstate (nationwide) investment crowdfunding,  it had in effect shut off many states from enacting local crowdfunding statutes which would enable SME’s to leverage the Internet in local investment crowdfunding campaigns.

Invest Today Billboard AdvertisementIn 2015 the Staff at the SEC’s Division of Corporation Finance took the bull by the horns, recommending that the Commission adopt new rules to modernize and expand the federal intrastate crowdfunding exemption. On October 30, 2015, the same day that the Commission adopted the long-awaited final rules implementing JOBS Act Title III crowdfunding, it came with its own October surprise: proposed rules to update and expand the intrastate exemption – notably, allowing unrestricted Internet advertising of an offering.

One year later, on October 26, 2016, the Commission adopted final intrastate crowdfunding rules, much improved from the proposed rules. Gone in the final rules, among other things, was a provision which would have prohibited state legislatures and state securities regulators from authorizing local investment crowdfunded offerings in excess of $5 million per year.  Though no state has yet to authorize crowdfunded offerings above this amount, virtually all of those who commented on the propose rules were unanimous: this was a matter best left to the discretion of each state – not the federal government.  And in the UK, where investment crowdfunding has flourished, the $5 million dollar ceiling has been broken and is expected to go higher.

Though the vote by the Commissioners on the final rules was unanimous, not so with the sentiment of the Commissioners.  In Commissioner Kara M. Stein’s public remarks on the final rules, she was not shy about expressing reservations about the ability of the individual states to protect their local residents from questionable offerings and bad actors, cautioning of the need for continuing federal oversight:kara-stein-sec-intrastate

“Today’s rules amend Rule 147, and create a new federal offering exemption known as Rule 147A.  Hopefully, the updated safe harbor and new exemption before us today will foster opportunities and create new paths forward for such smaller firms, while still safeguarding investors.”

 

“At least, this is the theory.  Like other experimental capital-raising rules, such as Regulation A+ and Regulation Crowdfunding, only time will tell how well the theory works in practice. Only time will tell whether we can relax capital-raising regulations, while also maintaining appropriate investor protections.  So, while today’s rules may provide smaller companies with additional funding opportunities, today’s rules also raise some investor protection concerns.”

And in closing her remarks, Commissioner Stein  again emphasized what she viewed as the “experimental” nature of these new rules:

“Today’s amendments to Rules 147 and 504 and the new exemption under Rule 147A are part of a suite of rules focused on providing options for smaller businesses seeking to raise capital.  On balance, I think they are worth the experiment.  However, by collecting, sharing, and examining data on how these new options are working in practice, we should be able to recalibrate these rules if the experiment is not working out as planned.”

Most respectfully, I must take exception to Commissioner Stein’s characterization of these rules. It is not a question of whether the glass is half full, or half empty. In my opinion, the glass, from Commissioner Stein’s perspective, is simply upside down.

Science Chemistry TechnologyThe real “experiment,” historically, dates back not only to 1933, when Congress first carved out this statutory reservation of power to the states. The “experiment” also dates back to 1776, when our Founders adopted a Constitution which gave specified powers to the federal government, with all other powers being reserved to the states.  The “experiments” our Founders had in mind were those which would take place under laws enacted by each of the states – as they, and not the federal government, saw fit.  States were to set up their own laboratories of experiment for matters uniquely concerning their residents, and occurring within their borders – free from interference by a federal bureaucracy.

Seems that Commissioner Stein never got that memo. In her view, it would be up to the SEC to “recalibrate” the new rules if the states get it wrong – in the judgment of the Commission, of course.

So Why Does Any of This Matter?

It would be easy to be dismissive of the recently adopted intrastate rules.  After all, historically the intrastate exemption has not been in favor –there have been much better options – with far fewer pitfalls. Even more so now, with new pathways of capital formation opened up by the JOBS Act of 2012.  And with the advent of federal investment crowdfunding, most would yawn when examining the seemingly unimpressive statistics for the use of intrastate crowdfunding during brief period in which intrastate crowdfunding has been allowed.

I submit that current statistics are not very meaningful – as they do not tell the whole story. There is a lag between the time that new capital raising paths are created and when they become “mainstream.”  And let us not forget – until these new rules go into effect (April 2017), as a general matter broad internet solicitation is not permitted in intrastate crowdfunded offerings relying on the current Rule 147 – covering most of the 35 states which have adopted their own intrastate crowdfunding statutes.  And crowdfunding without the Internet is more akin to a day without sunshine. Not much can grow in that environment.

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Size Does Not Always Matter

Statistics, however, do not tell the whole story. Most businesses start out as local businesses.  But when it comes to allocating investor capital in SME’s, most of it winds up in California, New York, and Massachusetts, leaving the vast majority of this country as “capital deserts.”

Patrick McHenry 2Those are not my words. They are the words of US Congressman and Deputy Whip Patrick McHenry, who hails from the Great State of North Carolina – the same gentlemen who has been unrelenting in his efforts to implement smart federal legislation intended to remove unnecessary federal regulatory barriers to SME capital formation: starting with the JOBS Act of 2012, and continuing to this day with a host of bills to further improve the access of SME’s to much needed capital – especially in capital-starved “flyover” states.

Make no mistake about it.  This is not a political issue, notwithstanding the heated rhetoric in 2016 which has saturated our media.  To put a fine point on this, I offer the views of our Democratic Vice President, Joe Biden, spoken in 2014 at the U.S. sponsored Global Economic Summit, on the other side of the world in Morocco to an assembly of thousands of entrepreneurs and government officials, including the head of the U.S. Small Business Administration, Maria Contreras – Sweet.

“The single most valuable resource on this planet I think we could all agree on in this room is not what’s in the ground, but what’s in the mind.  It’s the single least explored part of the world, the mind.  The things that are going to happen in the next two, five, 10, 15 years are breathtaking.  Investors, they have to be willing to expand the horizon and invest in early stage entrepreneurs — not only in Silicon Valley — but . . . everywhere, everywhere where there’s talent.”

maria-contreras“Governments have to unlock the marketplace of ideas by allowing people to express their views openly about what they’re thinking and what they’re trying.”

“They must unlock the commercial marketplace by eliminating barriers to access to capital; ensuring that rules are fair and predictable, removing excessive cumbersome regulations.”

“The government can’t grow the economy by itself.  As a matter of fact, it’s not the major reason.  It’s a catalyst for growth — no matter how big the megaproject.  To prosper in the 21st century, you also need to grow from the bottom up, allowing your people to unlock their talents through private enterprise and political and economic freedom and action.”

And there was some irony – not apparent from the remarks themselves.  They were spoken at a U.S. sponsored world conference intended to promote entrepreneurial activity in Muslim-majority countries – one of former Secretary of State Clinton’s initiatives started by her back in 2009.

Washington Monument DCSo let’s not be too “provincial” when pronouncing judgment on who knows best, when it comes deciding how investors should best be protected – or what is needed to enhance capital formation for SME’s –  or where those funds are needed most – especially when the boundaries of that “province” are marked by the Washington Beltway – and the matters at hand reside within the borders of a single state.

So let’s wake up – and give some deference to our local communities, big and small, U.S. entrepreneurs everywhere, including in the flyover states, and the state legislatures which regulate them.  Sometimes big ideas start in small, seemingly unlikely places.

“Bite-size” businesses, in the aggregate, are important to our economy and job creation. And in Finfair Panel with Amy Cortesethis day and age of readily accessible technology “Uber” sized businesses often have their genesis with relatively modest amounts of capital.

After all, it’s why one notable leader championing the importance of local investing, and New York Times contributor,Amy Cortese, calls it “Locavesting,” – not “Loco” – vesting.

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SEC Adopts Final Expanded Intrastate Crowdfunding Rules

Today the SEC unanimously adopted amendments to Rule 147 and Rule 504, and adopted a new Rule 147A, intended to modernize and facilitate local offerings by companies in their home state.  The final rules are much improved from the proposed rules issued in October 2015, in response to virtually unanimous views of rule commentors.

The only fly in the ointment is that most states will need to update their legislation in order to be able to take advantage on the new, relaxed rules allowing broad internet solicitation. However, sales are still limited to investors in the company’s state.

The new rules will generally take effect in April 2017.

Here is a link to the SEC’s Final Rules Release: https://www.sec.gov/rules/final/2016/33-10238.pdf

Following is the SEC Press Release announcing the adoption of the final rules and a brief summary of the key provisions:

 

SEC Adopts Final Rules to Facilitate Intrastate and Regional Securities Offerings

Rules Provide More Options for Companies to Raise Money While Maintaining Investor Protections

FOR IMMEDIATE RELEASE
2016-226

Washington D.C., Oct. 26, 2016 —The Securities and Exchange Commission today adopted final rules that modernize how companies can raise money to fund their businesses through intrastate and small offerings while maintaining investor protections.

“These final rules, while continuing to provide investor protections, update and expand the capital raising avenues for smaller companies, allowing them to more fully take advantage of changes in technology and business practices,” said SEC Chair Mary Jo White.

The final rules amend Securities Act Rule 147 to modernize the safe harbor under Section 3(a)(11) of the Securities Act, so issuers may continue to use state law exemptions that are conditioned upon compliance with both Section 3(a)(11) and Rule 147.  The final rules also establish a new intrastate offering exemption, Securities Act Rule 147A, that further accommodates offers accessible to out-of-state residents and companies that are incorporated or organized out-of-state.

To facilitate capital formation through regional offerings, the final rules amend Rule 504 of Regulation D under the Securities Act to increase the aggregate amount of securities that may be offered and sold from $1 million to $5 million.  The rules also apply bad actor disqualifications to Rule 504 offerings to provide additional investor protection, consistent with other rules in Regulation D.  In light of the changes to Rule 504, the final rules repeal Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A will be effective 150 days after publication in the Federal Register.  Amended Rule 504 will be effective 60 days after publication in the Federal Register.  The repeal of Rule 505 will be effective 180 days after publication in the Federal Register.

*   *   *

FACT SHEET

Exemptions to Facilitate Intrastate and Regional Securities Offerings

SEC Open Meeting
Oct. 26, 2016

Action

The Securities and Exchange Commission is considering whether to adopt new and amended rules that would update and modernize how companies can raise money from investors through intrastate and small offerings.  The rules are part of the Commission’s efforts to assist smaller companies with capital formation while maintaining investor protections.

Highlights of the Final Rules

New Rule 147A and Amendments to Rule 147

The adoption of new Rule 147A and the amendments to Securities Act Rule 147 would update and modernize the existing intrastate offering framework that permits companies to raise money from investors within their state without concurrently registering the offers and sales at the federal level.

Amended Rule 147 would remain a safe harbor under Section 3(a)(11) of the Securities Act, so that issuers may continue to use the rule for securities offerings relying on current state law exemptions.  New Rule 147A would be substantially identical to Rule 147 except that it would allow offers to be accessible to out-of-state residents and for companies to be incorporated or organized out-of-state.

Both new Rule 147A and amended Rule 147 would include the following provisions:

  • A requirement that the issuer has its “principal place of business” in-state and satisfies at least one “doing business” requirement that would demonstrate the in-state nature of the issuer’s business
  • A new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser at the time of the sale of securities
  • A requirement that issuers obtain a written representation from each purchaser as to residency
  • A limit on resales to persons residing within the state or territory of the offering for a period of six months from the date of the sale by the issuer to the purchaser
  • An integration safe harbor that would include any prior offers or sales of securities by the issuer made under another provision, as well as certain subsequent offers or sales of securities by the issuer occurring after the completion of the offering
  • Legend requirements to offerees and purchasers about the limits on resales

Amendments to Rule 504 and Repeal of Rule 505

Rule 504 of Regulation D is an exemption from registration under the Securities Act for offers and sales of up to $1 million of securities in a 12-month period, provided that the issuer is not an Exchange Act reporting company, investment company, or blank check company.  The rule also imposes certain conditions on the offers and sales, with limited exceptions made for offers and sales made in accordance with specified types of state registration provisions and exemptions.  The amendments to Rule 504 would retain the existing framework, while increasing the aggregate amount of securities that may be offered and sold under Rule 504 in any 12-month period from $1 million to $5 million and disqualifying certain bad actors from participation in Rule 504 offerings.  The final rules also would repeal Rule 505, which permits offerings of up to $5 million annually that must be sold solely to accredited investors or no more than 35 non-accredited investors.

Background

The Commission adopted Rule 147 in 1974 as a safe harbor to a statutory intrastate exemption, Section 3(a)(11), which was included in the Securities Act upon its adoption in 1933.  Commenters, market participants and state regulators have indicated that the combined effect of the statutory limitation on offers to persons residing in the same state or territory as the issuer and the prescriptive eligibility requirements of Rule 147 limit the availability of the exemption for companies that would otherwise conduct intrastate offerings.

The $1 million aggregate offering limit in Rule 504 has been in place since 1988.

Effective Date

Amended Rule 147 and new Rule 147A would become effective 150 days after publication in the Federal Register.  Amended Rule 504 would become effective 60 days after publication in the Federal Register.  The repeal of Rule 505 would become effective 180 days after publication in the Federal Register.

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SEC REGULATORY ALERT: COMMISSION POISED TO ADOPT EXPANDED INTRASTATE CROWDFUNDING RULES

The Securities and Exchange Commission has announced that it will be meeting on October 26, 2016 to consider and adopt amendments to Rule 147, the safe harbor for the issuance of securities pursuant to the so called intrastate exemption.  Rule 147 has been problematic for issuers in the past, as it restricts offers and sales of securities solely to residents within a state’s borders.

SEC informal written Staff interpretations issued in 2014 took the position that open internet solicitation by an issuer would preclude the use of this exemption for local businesses, even if sales were limited to residents of that business’s state. Many, including myself, have criticized this Staff position, simply because it was at odds with many prior, longstanding SEC rulings allowing general solicitation via radio and newspaper ads which crossed state borders.

In October 2015 the Commission issued a new proposed rule, Rule 147A, which would have broadened this exemption to allow internet solicitations, but at the same time limited the aggregate amount that could be sold in an offering to $5 million. The Commission also proposed to eliminate the existing Rule 147 in its entirety, something which many commentators pointed out would effectively nullify the majority of the existing state crowdfunding exemptions, now available in approximately 35 states.  Moreover, most securities practitioners agree that the statutory intrastate exemption, without a “safe harbor” rule, would render the exemption unusable, leaving issuers with a single option: relying on the new Rule 147A – with its $5 million cap.

Though most comments on the proposed rule welcomed the modernization of the intrastate exemption, most were opposed to limiting the offering amount and eliminating the existing Rule 147 safe harbor. It is therefore highly likely that the final rules will incorporate these comments and concerns.

Stay tuned for more developments on this upcoming Commission action at www.corporatesecuritieslawyerblog.com.

Posted in Capital Raising, Corporate Law, Crowdfunding, General | 1 Comment

On Investment Crowdfunding, Diversification & the Wisdom of the Crowd

eggs-in-one-basket-risk-diversification


Still Time to Fix the Fix Crowdfunding Act

One of the cardinal rules of investing is  diversification – a critical ingredient for long-term portfolio growth.  This rule applies with equal, if not greater, force when investing in “Title III Regulation CF Crowdfunding” securities – open for business since May 2016 – and an important part of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act).  For the foreseeable future, companies relying upon Regulation CF will mostly comprise startups and very early stage companies, the riskiest investment class, particularly in view of the annual dollar ceiling of $1 million and the availability of other, less complex securities law exemptions – principally private placements limited to accredited investors.

broken-eggsDiversification inarguably increases the odds of a successful portfolio, as opposed to putting all of your eggs into one basket – regardless of how attractive a single investment may appear.  This is particularly true for the riskiest of investments: startups and early stage companies – where there are more things which can – and ultimately will – go wrong – and a total loss is more likely than an investment in a later stage company.

A corollary rule is to invest in things one knows best. And if this is not always possible, especially in this complex and rapidly changing world we live in, relying upon experts can often increase an investor’s odds of success.

Unfortunately, when it comes to Title III investment crowdfunding, the ability to effectively combine both diversification and external expertise is made more difficult by our securities laws, which currently provide no exemption which would allow so-called “special purpose vehicles” – i.e. diversified funds – limited to crowdfunded securities purchased by both accredited and non-accredited investors. Under current law, even a fund which has no non-accredited investors, but more than 100 accredited investors must register, thus limiting the capital pool derived from accredited investors as well.

Money Dollars Art 100Though registering the fund is, in theory, a solution, a registered investment company is a highly regulated entity. And with regulation goes costs – which would, of course, increase the cost of doing business and eat into a fund’s returns. This is likely to be especially true in the area of Regulation CF investments, where there is an annual $1 million cap for crowdfunding issuers and, at least in the short term, there will be a shortage of investment-worthy companies sufficient to justify the costs of operating as a fully registered investment company.

Fix Crowdfunding Act (HR 4855)

Congressman McHenryThe Fix Crowdfunding Act, introduced by Congressman Patrick McHenry earlier this year and passed by the House in July 2016, takes a step in the right direction. Unfortunately, due what I perceive as the absence of bi-partisan support, it is a baby step at best toward making Regulation CF a smarter and safer place for investors.

Specifically, HR 4855 affords funds investing in crowdfunded securities an exemption from registering as an investment company, but with provisos. The proviso which is the principal show stopper, in my opinion, is the requirement that the fund hold only securities of a single security – precluding diversification.  The Bill also limits eligible securities to companies with a single class of security – in my opinion another unnecessary barrier.  Broadening this Bill to allow investment by an unregistered fund in more than one issuer would foster investor diversification – and thus hopefully will be added on in the Senate, where the Bill now resides.

The Role of the Investment Advisor

The Bill also requires that in order to be exempt from registration as an investment company, the fund must be advised by an investment advisor registered under the Investment Advisers Act of 1940. I support this requirement, for a number of reasons, especially in conjunction with a diversified fund.

The Thinker Rodin ArtThough much has been said as to the “wisdom of the crowd,” there are limits on the wisdom of a crowd comprising largely investors inexperienced with early stage, illiquid investments – and the risks peculiar to this investment class.  The reality is that most non-accredited investors have no experience whatsoever – their experience being limited mostly to exchange-traded securities, managed funds and ETF’s.

As some investors will learn the hard way, simply picking a successful company in its early stages is not enough to guarantee a profit, or even to see a return of any of the invested capital. Though Regulation CF allows a company to sell a broad range of debt and equity securities, many early stage crowdfunding companies will undoubtedly offer common stock in their initial raise under Regulation CF.  The successful ones will often launch multiple, successive rounds under other exemptions as they grow and scale their businesses.

In the real world of SME finance, these subsequent rounds often have preferences over the common stock, including a preferential return over the common stock upon a future “liquidity event” – such as being sold.  In addition, initial Regulation CF investors who purchase common stock will typically not receive what is called “anti-dilution” protection – a common provision in early stage investments.  Without this protection the early “common” investor is at greater risk of being diluted in value by subsequent financing rounds, without any adjustment to the original purchase price, number of shares or the right to participate in future, often more favorable, financing rounds.

A registered investment advisor, advising a group of Regulation CF investors, will generally understand these risks more readily than the crowd. Moreover, even if a would-be Reg CF investor recognizes this risk, it is unlikely that a single investor will have any ability whatsoever to renegotiate the terms of an investment – making the investment decision in Regulation CF a “take it or leave it” proposition. However, a fund which represents a group of investors, coming with more potential capital, would have more leverage to re-negotiate the terms of a Regulation CF raise to make it more investor-friendly.

The Fix Crowdfunding Act Needs to be (and Should be) Fixed

Reg CF Title IIIThe ability to form a non-registered fund to invest in Regulation CF securities would go a long way toward protecting investors in these early stage, high-risk investments – but there is one missing ingredient in the Fix Crowdfunding Act: the ability of the fund to diversify – to invest in more than a single crowdfunded company.  Also problematic is the Bill’s current limitation on issuers issuing more than one class of security.

Allowing professionally managed funds to diversify would be expected to have the added benefit of enhancing the ability of these funds to attract greater amounts of investor capital to the crowdfunding market.  With the ability of a fund represented by a professional adviser to attract more capital this is also a potential benefit to all issuers worthy of investment seeking to hit their target offering amount.

senate-quoram-call-us-capital-congressThis is not to suggest that all Regulation CF funds ought to be outside the purview of investment company registration entirely. However, this is an issue that can be addressed by limiting the total dollars which the fund could attract before it would be required to register.

Notwithstanding the current state of this Bill, hopefully these few important tweaks can and will be made as the Bill passes through the Senate.  The result would be expected to reduce investor risk, increase the odds of a successful investment, and provide a useful vehicle to attract more capital in the aggregate to this new financial market.

[Author’s Note – Though there are many improvements to Title III of the JOBS Act which can, and should, be made, this article only addresses those provisions which remain in the current Bill, HR 4855.]

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NASAA and Members of Congress Come Together on the Need for the SEC to Expand Intrastate Crowdfunding Rules

It is rare that I am able to find agreement with the publicly stated positions of the North American Securities Administrators Association (NASAA). Equally rare – members of Congress who are traditionally strong advocates for “smart” regulatory reform of capital formation by SME’s to find themselves on the same page as NASAA.  However, there appears to be a growing, even overwhelming, consensus that the SEC’s proposed rules to modify current federal restrictions on the intrastate sale of securities – are on the one hand a step in the right direction.  But on the other hand, the SEC’s rule, as proposed, does not go far enough, and places unnecessary restrictions on the ability of states to decide what is in the best interests of their constituents – free of interference from the SEC.

By way of background, on October 30, 2015, the same day that the Commission announced final investment crowdfunding rules in furtherance of Title III of the JOBS Act of 2012 to implement investment crowdfunding on a national level – it also issued for comment a proposed rule, primarily intended to facilitate investment crowdfunding at the state level – Rule 147A. Significantly, the proposed rule would allow companies to advertise their offering on the Internet, something which the SEC Staff has stated is prohibited under current Rule 147 – and much to the consternation of state regulators and securities lawyers  alike.  In doing so, the SEC proposed to limit the amount that a state could authorize under its laws to $5 million. And it also proposed to eliminate the existing rule, Rule 147, in its entirety.

On October 7, 2016, a bi-partisan group of 15 members of Congress, many members of the House Financial Services Committee, signed a letter addressed to the SEC, encouraging the Commission to finalize its rulemaking, but with some important modifications. In particular, as proposed by the Commission, the existing “safe harbor” rule, Rule 147, which would allow states to regulate offerings occurring entirely within their state, would be scrapped in its entirety, and replaced by a new rule, Rule 147A, under the Commission’s general rulemaking powers.  This approach, if adopted in the final rules, has at least two untoward effects, as regards the ability of states to fashion their own rules for intrastate offering, including intrastate investment crowdfunding.

First, of the 35 or so states which have enacted their own investment crowdfunding statutes, adoption of the Rule, as proposed, would in effect, terminate these exemptions in many of the states which enacted their exemptions based entirely upon the current rule – proposed to be eliminated – bringing intrastate crowdfunding to a halt.  Comment letters to date have almost universally requested the SEC to clarify and expand the existing Rule 147, but to retain the existing rule.  Though a technicality of sorts, failure to fix this glitch would require the large majority of states authorizing intrastate investment crowdfunding to go back to their state legislatures to incorporate any new rule which replaces the current Rule 147. And until then, intrastate crowdfunding would be shut down.

Second, though the SEC’s proposed rule makes necessary improvements, it comes with some conditions which many find unpalatable – and unnecessary. In particular, the SEC rule, as proposed, would limit the ceiling under this proposed exemption to $5 million.  Opposition to this condition has been strong, simply because this is a matter which ought to be determined by each state – on a state by state basis.

The latest missive by 15 members of the House Financial Services Committee includes Congressman and Deputy Whip Patrick McHenry, a leading proponent of the JOBS Act of 2012 and subsequent legislation, and Congressman John Carney, the original sponsor of a Bill which passed the House this year which if enacted would create a new, independent office at the SEC – Office of Small Business Advocate – and would report to the full Commission and to Congress.  Undoubtedly, their letter will signal to the SEC the need to approval final rules as expeditiously as possible nearly a year after originally proposed. So look for good things to come from the Commission in this area in the coming months.

For those who want to dig a little deeper, I am providing links to my Comment Letter to the SEC as well as the Comment Letter submitted by NASAA, both back in January 2016.

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Protected: Yes – There Actually Is Something Obscene About SEC Regulation A+ (Sort Of)

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An Upcoming Event for Private Companies to Explore Regulation A+ Financing Options

Though I regularly speak at national alternative finance events it has not been my custom or practice to independently publicize these events.  So today being Columbus Day, an historic event marking the voyage of Christopher Columbus toward new horizons, I thought this would be as good a day as any to break with tradition and call attention to my next speaking event – open to the public.

On November 10, 2016, I will be joined by more than a dozen of some of the most prominent professionals in the new Regulation A+ financing space, representing the critical areas of a Regulation A+ financing: legal, accounting and marketing.  The event, which is open to the public, is The Regulation A+ Bootcamp.  The venue, and ringleader of this event, is none other than OTC Markets at their headquarters in New York City. And it is specifically targeted toward both early stage and privately held mature companies who are considering their financing options. Co-sponsoring this event is Crowdfund Beat, a leading crowdfunding media publication and event organizer.  Additional details regarding this Event are available here.

OTC Markets has been a leader in supporting a strong secondary market for Regulation A+ securities. It has also been an outspoken advocate for expanding all avenues of capital formation for both mature companies and SME’s.  Its most recent, visible example is its Petition for Rulemaking filed with the SEC in June 2016 requesting the SEC to expand the use of Regulation A+ to fully reporting companies. Currently, the SEC’s regulations limit the use of Regulation A+ to non-reporting companies and companies reporting under the SEC’s new, streamlined reporting requirements under Regulation A+.  This limitation is nowhere found in the statute mandating Regulation A+, Title IV of the JOBS Act of 2012.

The Petition has already garnered public support from some of the leading industry participants.  Any of you wishing to weigh in on expanding the use of Regulation A+ can do so via the SEC’s website.  You are also free to contact me directly at sguzik@guziklaw.com for more information on the Petition.

And in the interest of full disclosure, as noted in the Petition, I had the privilege of working with OTC Markets in connection with the preparation of the Petition.

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Busted! SEC Targets Reg A+ Marijuana Company, Med-X, in Administrative Proceeding

The Regulation A+ industry was buzzing this week – not with excitement, but with a healthy dose of trepidation.  One of the first, high (no pun intended) profile Regulation A+ offerings, launched in November 2015, after a seemingly successful “Testing the Waters” campaign, was for a company called Med-X, a startup formed to participate in the newly burgeoning marijuana industry – the so called “Green Rush.”

But this month’s headline for Med-X was a bit more sanguine, enough to counteract even the most potent dosage of THC:  “REGULATION A EXEMPTION OF MED-X, INC. TEMPORARILY SUSPENDED.”  The story that followed was not the kind of publicity any company is looking for – especially when it is in the throes of raising money under Reg A+. Actually, it was not a story. Rather, it was an Administrative Order issued by the SEC on September 16, 2016, temporarily suspending the exemption of Med-X under Regulation A+.  Why?

Well, it seems that this company failed to notice, or at least heed, the requirement that Reg A+ issuers file periodic informational reports as a condition of maintaining their status as Reg A+ issuers. The basic requirement calls for a company, at the least, to file a semi-annual and annual report with the SEC following the “qualification” of the offering.  Seems that Med-X failed to file its annual report, which would include audited financial statements, when due back in the Spring of 2016.

Some have speculated that the SEC was targeting a disfavored industry – marijuana. I doubt it. The SEC  has approved the registered sale of other companies in this industry long before Regulation A+ was adopted.

Others have speculated that this action reflects an uneven hand towards Regulation A+ issuers. After all, this type of swift action is rare for fully reporting companies which are delinquent in their filings. One more time: I think not.

The Staff at the SEC has been remarkably supportive of the rollout of Regulation A+, as measured anecdotally in terms of the efficiency in which it has been processing the review of Regulation A+ offerings.

Rather, I think back to one of the more notable sound bytes I coined in a Webinar back in April 2015: “Regulation A+ is not your daughter’s Kickstarter campaign.”  Raising capital from outside investors is serious, heavily regulated business.  And as indicated by some of the early Regulation A+ participants, the level of sophistication of the management of some of these issuers has hardly met the bar required to file and prosecute a Regulation A+ offering.

Yes, Regulation A+ is a little more complex than the pipedream: filling out a form, waiting for SEC approval, and then crowdfunding your way to $50 million.  Apart from detailed disclosure rules, including audited financial statements, and the always difficult task of raising capital – especially for early stage companies – there is an ongoing SEC reporting requirement. Yes, the requirement is lighter than a fully reporting public company, to be sure, but enough to quickly overload an early stage company, with limited financial and human resources.

So if nothing else, this is one SEC enforcement action can be expected to inject a dose of reality into the Regulation A+ capital raising process.  As our President might say, “A Teachable Moment.”

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