SEC Extends Comment Period for JOBS Act Rule 506 Proposed Rulemaking – Is the SEC About to Pivot?

Posted on September 28, 2013 by Samuel Guzik

September 23, 2013 kicked off an historic period in federal securities laws.  For the first time in 80 years companies would be allowed to publicly solicit investors in unregistered private placements so long as all of the investors were accredited.  The SEC did so under orders from Congress pursuant to what is known as Title II of the JOBS Act of 2012, by creating new Rule 506(c).  However, the week that started off with a bang ended with a wimper.

As I reported in The Corporate Securities Lawyer Blog on September 26, which was reprinted in Crowdfundinsider on September 27 (It’s the JOBS Act, Stupid! – Still Time to Comment on SEC’s Proposed Regulation D General Solicitation Rules?),  I expected the SEC to extend the 60 day comment period for the additional proposed rules relating to the use of SEC Rule 506(c), regarding the use of general solicitation and advertising in private placements. The original comment period for the proposed rules had expired on September 23.   The proposed rules, if ever enacted in final SEC rulemaking, would place additional limitations on SEC Rule 506(c) which are widely believed to undermine the utility of Rule 506(c).  These proposed rules require, among other things, advance Form D filing requirements, severe penalties for non-compliance with Form D filing requirements, and a requirement that soliciting materials be filed with the SEC no later than the day they are first used.  But on September 20, 2013 the SEC received two comment letters requesting that the comment period for the proposed rules be extended: one from the SEC Advisory Committee on Small and Emerging Companies and the other from none other than Congressman Patrick McHenry, the originator of the federal 2012 JOBS Act legislation.

In an SEC release published on September 27,  the SEC announced that it would be “re-opening” the comment period for the proposed rule, extending the comment period for an additional 30 days from the date notice of the extended comment period is published in the Federal Register – effectively extending the comment period by approximately 45 days (exact date to be determined).

According to the SEC’s September 27 Release:

“The proposed amendments have generated a large amount of public interest. The Commission believes that providing the public additional time to consider thoroughly the matters addressed by the release and comments submitted to date and to submit comprehensive responses would benefit the Commission in its consideration of final rules.”

One would have expected that after receiving over 300 comment letters, the SEC would have had sufficient input from the public to proceed with consideration of final rulemaking.  So the real question is what is behind the comment period extension, and what does this foreshadow for final SEC rulemaking?

And what is unusual is not the extension per se, but one of the reasons given:  to provide “the public additional time to consider thoroughly the matters addressed by the release and comments submitted to date .  .  ..”  In other words, the SEC is now soliciting comments not only on their rule proposal, but on the comments on the rule proposals.

Given the heated debate on these issues thus far, both among the SEC Commissioners themselves (the proposed rule issued on July 10 in a divided 3-2 vote) and among commentators, with state regulators and consumer protection groups in a pitched battle against Wall Street lobbyists, angel investors and the startup community, it seems the SEC is looking for a graceful exit from the proposed rules.  It appears the SEC is hoping to find a less intrusive solution to increasing the ability of state regulators and the SEC to monitor new Rule 506(c) – short of requiring measures that would make use of this new Rule impracticable for small issuers (e.g. advance Form D filing requirements, severe penalties for non-compliance with Form D filing requirements, and the requirement that soliciting materials be filed with the SEC no later than the day they are first used).

And then there is that minor detail of the SEC having one eye on satisfying reasonable expectations of Congress, the same body that must approve the SEC’s operating budget annually – at a time when there is political pressure to shrink the overall government spending pie.  Congressman McHenry has already presented the SEC with a tall order as to what he expects to come out of the proposed rulemaking – first on July 22 in a scathing six page letter, and then with a pointed two page letter on September 20 admonishing the SEC to consider the views of the SBA Office of Advocacy, as expressed in their September 12 comment letter – “given its expertise in small business capital formation”, concerns which were first raised with the SEC in my comment letter to the SEC on August 28 and provided to the Office of Advocacy at that time.

The proposed rules, though useful to monitor general solicitation in private placements, would in the opinion of Representative McHenry and others render Title II of the JOBS Act (and resulting SEC Rule 506(c)) useless as a tool for capital formation by small businesses  – an outcome which it appears the SEC now realizes will not withstand either Congressional oversight or judicial scrutiny.  Seems that the SEC failed to properly factor in the impact of its proposals on small businesses, or adequately consider alternative measures, as it is required to do under the federal Regulatory Flexibility Act of 1980.  The SEC already has a heightened sensitivity to limits on its rulemaking powers under the Administrative Procedure Act as a result of recent court challenges to its rulemaking powers.

Indeed, the inescapable conclusion is that the SEC realized that it had two choices:

  • leave the proposed rules substantially intact as final rules and provide an exemption for “small business” (defined under the Regulatory Flexibility Act as companies with total assets of $5 million or less who are seeking to raise no more than $5 million) –  an exemption which would effectively gut the effectiveness of the proposed rules in the eyes of consumer groups and state regulators – or
  • dramatically soften the proposed rules for all businesses, large or small.  Looks to me as if the SEC is taking the path of least resistance –  electing to go the latter route – one less likely to inflame key federal legislators or run afoul of federal rulemaking statutes.

In sum, look for the SEC down the road to re-propose kinder, gentler rules regarding the use of Rule 506(c) to extricate itself from the corner a sharply divided Commission painted itself into, rules which might possibly arrive on the heels of the long overdue Title III proposed equity crowdfunding rules.  It appears as if one last minute commentator, the Milken Institute Center for Financial Markets, has already tried to start the ball rolling in this direction in its September 20 comment letter – for example, by suggesting “a three strikes penalty system for issuers who fail to comply with Form D filing requirements,” rather than the proposed automatic one year mandatory penalty excluding the use of Rule 506.  The Milken approach is strikingly similar to the “two strikes” solution I proposed to the SEC in my August 28 comment letter – a solution whose elegance lies in both its simplicity and avoids the need for any new rulemaking by the SEC in this area (unlike the Milken proposal).  Milken’s letter does not spell out what the “three strikes” would be.

The Milken comment letter is certainly one letter that deserves a close look, both by the SEC and other commentators during the upcoming comment period – and many of its points may serve as a springboard for other persons seeking to submit comments during the renewed comment period –both because of certain points made in the letter and the visibility of the Milken Institute.   However, as with anything that is the product of a committee (including the JOBS Act), some good points will inevitably be overlooked or perhaps omitted entirely.  Look for a supplement to my August 28 SEC comment letter to plug at least one gaping hole in the Milken letter and add some real world context to at least one of its suggestions.

In the meantime, nearly 18 months after the JOBS Act became law, the cloud of uncertainty and confusion stemming from the proposed rules can be expected to dampen the utility of Rule 506(c).

Samuel S. Guzik is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience.  He is admitted to practice before the SEC and in New York and California. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  He also frequent blogger on securities and corporate law issues at The Corporate Securities Lawyer Blog.

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IT’S THE JOBS ACT, STUPID!

Posted on September 26, 2013 by Samuel Guzik

Still Time to Comment on SEC’s Proposed Regulation D General Solicitation Rules?

On July 10, 2013, the SEC issued its final rules allowing general solicitation and advertising in unregistered private placements, provided all of the investors were accredited, effective September 23, 2013.  However, on the same day the SEC took many observers by surprise when in a divided 3-2 vote it also issued proposed rules, primarily intended to monitor the use of general solicitation and to assist  regulators in ferreting out fraudsters using the media to separate unwitting investors from their hard earned money.  As is customary in the federal rulemaking process, the SEC invited comments from the public on the proposed rules, establishing a cutoff date for comments of September 23, 2013.

The comments received reflected sharp differences of opinion, as might be expected in view of the sometimes conflicting goals of promoting capital formation versus protecting investors.  http://www.sec.gov/comments/s7-06-13/s70613.shtml .  Most in the startup community argued that certain proposed conditions on the use of the new exemption allowing general solicitation would render the new rule impractical, conditions such as:

  • Filing of a notice with the SEC (Form D) 15 days before the use of any solicitation materials.
  • A one year disqualification from using the exemption, SEC Rule 506, as a penalty for failing to make a timely filing of the Form D notice.
  • A requirement that all solicitation materials be legended, and that they be furnished to the SEC electronically no later than the day they were first used.

Many argued that these requirements did not reflect the reality of fundraising practices in today’s world of startups and small businesses – often punctuated by “demo days” and “pitch events” – and the fluid manner in which financings were often cobbled together.

State regulators and consumer advocacy groups struck a different tone, vehemently arguing that these proposed measures were necessary to fulfill the SEC’s mission of protecting investors from unscrupulous actors engaging in phony investment schemes – and that relaxing traditional rules on fundraising would promote a culture of regulatory complacency in the entrepreneurial community.

Then the Comment Period Came and Went on September 23 – or DId It?

Seems that in a letter to the SEC dated September 20, 2013, the SEC Advisory Committee on Small Business and Emerging Companies asked for an additional 45 days to comment on the proposed rules

“ .  .  . to allow for additional thought and comment in an effort to ensure that the final amendments do not have a chilling effect on investor participation in Rule 506 offerings.” http://www.sec.gov/info/smallbus/acsec/acsec-recommendation-091713-proposed-amendments.pdf.

Then came the heavy artillery – a missive from none other than Congressman Patrick McHenry, the author and champion of the original JOBS Act legislation, in a letter to the SEC dated September 20, 2013 http://www.sec.gov/comments/s7-06-13/s70613-401.pdf:

“The Advisory Committee [on Small Business and Emerging Companies] states that the Commission’s current deadline of September 23, 2013 for public comment does not provide adequate time for interested parties to submit comments on this complex proposal.

The concerns described by the Advisory Committee are similar to the concerns that Chairman Garrett and I previously stated in our July 22, 2013 letter to you and consistent with the concerns displayed by many businesses and individuals that stand to suffer significant harm from the proposed rules. “

Then came the knockout punch:

“Consistent with the Advisory Committee’s recommendation, the Small Business Administration’s Office of Advocacy “believes that the [Initial Regulatory Flexibility Analysis (“IRFA”)] contained in the proposed rule is deficient, and for this reason, the SEC should republish a supplemental IRFA for additional public comment before proceeding with this rulemaking.”

I expect that the Commission will accept the unanimous recommendation of an Advisory Committee that it organized, particularly given that an extended comment period is a small request when compared to the potential economic harm of the proposed rules. I also expect the Commission to adopt the recommendations of the Small Business Administration’s Office of Advocacy, given its expertise in small business capital formation.

Accordingly, I request that you extend the comment period by forty-five (45) days and republish a supplemental IRFA as soon as possible. Your prompt consideration of this request is appreciated.”   [Emphasis added]

Congressman McHenry’s September 20 letter cited to a comment letter submitted to the SEC on September 12, 2013, by the Office of Advocacy, an independent regulatory watchdog under the umbrella of the Small Business Administration, http://www.sec.gov/comments/s7-06-13/s70613-339.pdf, charged with special powers and duties under the Regulatory Flexibility Act (RFA), which stated that the SEC’s proposed rules failed to properly evaluate their impact on small business – nor did the SEC properly consider less burdensome alternatives, such as exempting small businesses from these proposed regulations.

Seems that almost none of the hundreds of comments submitted to the SEC regarding the proposed rule noticed that the SEC, in its July 10, 2013 proposal, failed to fully and properly address the impact of the proposed regulations on small business and to consider alternatives to these proposals – in the manner required by a federal law overlooked by most commentators, the Regulatory Flexibility Act of 1980 – a point I repeatedly made in my 10 page comment letter to the SEC submitted on August 28.  http://www.sec.gov/comments/s7-06-13/s70613-312.pdf

What is the Regulatory Flexibility Act and Why Does it Matter?

The RFA requires federal rulemaking agencies to consider the impact on small business when they write new rules.  The RFA was enacted by Congress in 1980 to ensure a more level playing field for small business. Congress particularly wanted to avoid “one-size-fits-all” regulations whose costs fell disproportionately on small entities. The RFA requires agencies to assess the impact of their regulations on small entities and to consider less burdensome alternatives.  The RFA also allows the SBA’s Office of Advocacy to weigh in on any deficiencies in the rulemaking procedure which impact small business and to advance the interests of small business in the rulemaking process.

Seems that the SEC did not bother to adequately assess the impact of the proposed rules on small business, as required by the RFA.  This is not a minor omission.

After all:

  • Wasn’t the primary purpose of the JOBS Act to increase job creation by facilitating capital formation?  And
  •  Aren’t small businesses the engine of job creation in the U.S.?  And
  • Aren’t the new rules allowing general solicitation in unregistered private placements most beneficial to startups and small businesses?  And
  • Aren’t the proposed rules most burdensome on smaller businesses and startups, with limited resources generally?

Yes, it’s the JOBS Act, stupid! And it’s the startups and small businesses which are the principal drivers of economic growth in the U.S.

I furnished a copy of my August 28 comment letter to the Office of Advocacy at the Small Business Administration via email on August 28.  My concerns apparently did not fall on deaf ears.  Seems that the Office of Advocacy agreed with some of my concerns, as did Congressman McHenry.  Hopefully, so too,will the Commission.

Though I do not have a crystal ball, by all measures it appears that the SEC will heed the call of Congressman McHenry and the Committee on Small Business and Emerging Companies and extend the comment period for the proposed regulation, in part to allow commentators to address in greater detail the issues that the SEC apparently overlooked.

Perhaps a harbinger of the SEC’s intention to formally extend the comment period  is a comment letter dated September 25, 2013, belatedly submitted to the SEC on September 25, 2013, by the National Venture Capital Association (posted on the SEC’s website on September 26) – two days after the September 23 deadline to submit comments had passed. http://www.sec.gov/comments/s7-06-13/s70613-431.pdf.  Perhaps they know something the rest of the crowd has yet to hear.

Samuel S. Guzik is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience.  He is admitted to practice before the SEC and in New York and California. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. He is also a frequent blogger on securities and corporate law issues at www.corporatesecuriteslawyerblog.com.

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Preparing for (Regulation) D-Day – September 23, 2013

Posted on September 12, 2013 by Samuel Guzik

sec-seal

“The better part of valor is discretion, in the which better part I have sav’d my life.”

Henry the Fourth, William Shakespeare, Part I, Act 5, scene 4.

*          *          *          *          *

As featured in CrowdfundInsider on September 17, 2013:

(http://www.crowdfundinsider.com/2013/09/22880-preparing-for-regulation-d-day/)

September 23, 2013, represents an historic milestone for the U.S. securities industry. For the first time since the enactment of federal legislation in 1933, companies will be allowed to publicly solicit investors and advertise the sale of securities without registering the offering with either the SEC or any state if certain requirements are met – most notably, that the company have appropriate procedures in place to verify that all investors who purchase the securities are “accredited investors.”  The rule change was created by Title II of the Jumpstart Our Business Startups Act (the JOBS Act), which directred the SEC to promulgate a rule effecting this change by July 2012.  And so it did – Rule 506(c) – albeit more than a year behind schedule.

Behind the bipartisan cooperation that accompanied the enactment of the JOBS Act was bitter divisiveness over many provisions of the JOBS Act, including Title II, allowing general solicitation to accredited investors in private placements, and Title III, allowing investment crowdfunding to unaccredited  investors–subject to the SEC implementing the appropriate regulations.  Perhaps the most vocal critics were state securities regulators, concerned that general solicitation and crowdfunding would open the floodgates to a wave of securities fraud, while at the same time limiting the power of the states to regulate these areas.

Though the JOBS Act was praised by President Obama as “a potential game changer” when he signed the JOBS Act into law in the White House Rose Garden on April 5, 2012, the President of The North American Securities Administrators Association (NASAA) had a less sanguine view.  According to a formal statement released by NASAA on the day the JOBS Act was signed into law, Jack E. Herstein, the then NASAA President and Assistant Director of the Nebraska Department of Banking & Finance, Bureau of Securities, was quoted as saying:

The JOBS bill the President signed today is based on faulty premises and will seriously hurt all investors by either eliminating or reducing transparency and investor protections.  It will make securities law enforcement much more difficult.  Investors need to prepare themselves to be bombarded with all manner of offerings and sales pitches.  Congress has just released every huckster, scam artist, and small business owner and salesman onto the internet . . . .”

These sharp divisions of opinion – representing the sometimes conflicting objectives of job creation and capital formation versus  protection of the investing public– did not go away on April 5, 2012, and are not expected to go away any time soon.  Though a battle to loosen securities laws may have been won in 2012, given the seismic and potentially disruptive effects of equity crowdfunding and general solicitation and advertising, the war is far from over.  It is more critical than ever that crowdfunding participants not get caught up in the regulatory crossfire if equity crowdfunding and its participants are to survive.

How to Prepare For “D-Day”

September 23, 2013, may appropriately be called the “D-Day” for the U.S. securities industry, not only because of its historic significance, but because it also ought to signal an enhanced need by companies and intermediaries raising funds to exercise a high level of Diligence and Discretion in the conduct of private placements utilizing new Rule 506(c) – both for screening investors to ensure that they are “accredited,” and in the quality of statements made in offering materials.

There will undoubtedly be a strong temptation by many well intentioned issuers and intermediaries, vying for attention for their offerings, to aggressively market offerings to the public – increasing the likelihood of solicitation materials containing a “misrepresentation” or “material omission.”  The attention they attract may not necessarily be limited to potential investors.  Some publicly marketed offerings will almost certainly attract attention from the SEC and state regulators monitoring compliance and fraudulent practices – who have already made it clear to the public that they will be monitoring Rule 506(c) offerings for compliance with the new rule.  The consequences of this unwanted attention for ill-prepared companies or intermediaries could be catastrophic – both for the companies or intermediaries who get caught in regulatory crossfire – and the securities industry generally.  Clearly, if there are abuses, or even perceived abuses, of the new solicitation rules, this will give fuel to those who believe that these rules are ill advised and should be severely limited, if not eliminated entirely.

The Consequences of Not Getting it Right the First Time

There are potentially serious, life altering consequences that may beset a startup or an intermediary, such as an Internet platform, that does not conduct an offering in strict compliance with securities laws governing private placements – the first time and every time.  In the past, the most significant consequence of failing to comply with either an exemption from registration, such as Rule 506, or a material misrepresentation or omission, would likely be to create a right of the investor to the return of his investment from the fundraising company and certain participants in the offering.  This remains the law.  However, new rules recently promulgated by the SEC pursuant to the Dodd-Frank Act, effective September 23, 2013, and new rules yet to be promulgated by the SEC pursuant to Title III of the JOBS Act (the so called “bad actor” disqualification rules), significantly alter this landscape.

Case in point is SoMoLend, a peer-to-peer lending Internet crowdfunding platform founded by Candace S. Klein, an attorney, who was a co-founder of Crowdfund Intermediary Regulatory Advocates (CFIRA), a crowdfunding industry trade group, and who has been active in lobbying efforts giving rise to the JOBS Act and its implementation.  According to Ms. Klein’s website, she is co-author of the crowdfunding provisions included in the JOBS Act of 2012.  Until recently, SoMoLend by all accounts seemed to be the poster child for a successful startup:

  • Winning $75,000 in 2012 in a startup pitch completion.
  • Obtaining funding from its home town, the City of Cincinnati.
  • Raising over $2 million from Angel funding groups and others in private placements to fund SoMoLend’s operations.

However, it also seems that somewhere along the way SoMoLend attracted the unwanted attention of the Ohio Division of Securities.  In June 2013 SoMoLend and its President, Candace Klein, were issued a Notice of Intent to Issue Cease and Desist Order by the Ohio Division of Securities.  The Notice contains a number of yet unproven allegations of violations by SoMoLend and its President, Candace Klein of Ohio state securities laws based upon activities alleged to have occurred prior to June 2013 – including:

  • Unregistered sales by SoMoLend of its securities to raise capital for its business utilizing general solicitation.
  • Engaging in fraudulent acts and practices, including fraudulent financial projections, false statements regarding current and past performance, false and misleading statements regarding SoMoLend’s business relationships, and other material omissions.
  • Unregistered sales of securities of third parties utilizing the SoMoLend internet platform through general solicitation to the public.

Conspicuously absent from the Notice is any indication that:

  • any investor of SoMoLend filed a complaint with the State of Ohio.
  • any investor was in any way unsatisfied with any aspect of either SoMoLend or its management, including Ms. Klein.
  • any investor had lost any money.
  • any investor funds were used improperly.

Indeed, thus far I have been unable to locate any public reports of any SoMoLend investor expressing dissatisfaction with either SoMoLend or Ms. Klein.   Also noteworthy is that some of the allegations by the State of Ohio of unlawful activity, notably the general solicitation of investors, involve activity which will become lawful in Ohio and elsewhere if conducted after September 23, 2013 when new SEC Rule 506(c) goes into effect – assuming the requirements of SEC Rule 506 are otherwise met.

Pursuant to the Ohio Notice, these as of yet unproven allegations are set for an adjudicatory hearing in October, at which time both SoMoLend and Ms. Klein will have an opportunity to rebut the allegations.  However, the finding of even a technical violation could be catastrophic to SoMoLend and Ms. Klein.  Under the so-called “bad actor” disqualification provisions of Rule 506 enacted by the SEC effective September 23, 2013, being subject to an order of a state securities regulator based upon fraud would bar both SoMoLend and Ms. Klein from being involved in a Rule 506 offering for five years.  And perhaps even more significantly, under rules yet to be adopted under Title III of the JOBS Act, both SoMoLend and Ms. Klein could be similarly barred from engaging in crowdfunding activities under Title III crowdfunding for unaccredited investors when Title III crowdfunding is ultimately implemented.

According to published reports Ms. Klein resigned as President of SoMoLend in August 2013 shortly after the Ohio proceedings became public.  It is not clear if or when Ms. Klein will return to SoMoLend.  According to her personal website she practices law at the firm of Ellenoff Grossman and Schole LLP.  However, according to the website of Ellenoff Grossman and Schole LLP and the firm’s receptionist, she is not employed there.*

Lessons to be Learned

A moral of this story is that with greater regulatory freedom to market securities in the U.S. will come greater responsibilities, and a heightened risk to participants for failure to comply rigorously with both federal and state securities laws, especially as the new frontier of crowdfunding begins to take shape.  For securities industry participants and startups alike, the exuberance which often accompanies marketing a product or service to the public ought to be tempered by a healthy dose of caution and conservatism when the gates swing open to general solicitation on September 23, 2013.  This race will not be to the swiftest, but to those who exercise the proper discretion and diligence in the fundraising process – in vetting investors, investments and the manner of conduct of the offering.  A premium ought to be placed on utilizing experienced fundraising professionals and advisors, and well qualified intermediaries with a strong management team.  And if too many participants stumble at the starting gate on September 23, 2013, this will not bode well for the securities industry in general, and the nascent crowdfunding industry in particular.

As for SoMoLend and Ms. Klein, early pioneers in the investment crowdfunding arena, my hope is that if there are ultimately found to be any technical violations of Ohio Blue Sky laws, these will be viewed as an unintended by-product of entrepreneurial exuberance, and that the Ohio Division of Securities will utilize its discretion in a manner which will allow SoMoLend and Ms. Klein to continue, in a lawful manner, on the path they initially embarked – to facilitate funding for small businesses.

And for the sake of the crowdfunding industry, my hope is that SoMoLend’s fate will not parallel the fate visited on its home town baseball team, the Cincinnati Reds, in 1880 – who were suspended from the National League for 10 years after being found guilty of committing acts of moral turpitude in clear violation a now repealed, 50 year old Ohio state law – playing professional baseball and selling beer to the public on Sunday.

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*Postscript – Subsequent to the date of this Article, I was informed by Douglas Ellenoff, of Ellenoff Grossman and Schole, a major New York corporate and securities law firm, that Ms. Klein is “Of Counsel” to the firm.

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About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com

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SEC Regulation D and Rule 506 – Speak Now or Forever Hold Your Peace

Posted on September 12, 2013 by Samuel Guzik

On July 10, 2013, the SEC issued proposed rules to amend Regulation D.  The rules, if adopted, would place significant conditions on the use of new Rule 506(c) promulgated under the JOBS Act.

Rule 506(c), as will be in effect on September 23, 2013, will allow the use of general solicitation and general advertising in unregistered offerings so long as the investors are accredited and the issuer has adequate procedures in place to ensure that the investors are accredited.

The proposed amendments would require:

  • the filing of a Form D in a Rule 506(c) offering involving general solicitation and advertising before the issuer engages in general solicitation;
  • the filing of a closing amendment to Form D after the termination of any Rule 506 offering;
  • written general solicitation materials used in Rule 506(c) offerings to include certain legends and other disclosures;
  • the submission to the SEC, on a temporary basis, of written general solicitation materials used in Rule 506(c) offerings to the SEC.

The proposed rules would also disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with Form D filing requirements in a Rule 506 offering. The proposed amendments would also require an issuer to include additional information in Form D about offerings conducted in reliance on Regulation D.

It took a little bit of time to not only wade through the 186 page release, but to analyze and evaluate the impact of what on the surface appeared to be well intentioned rules – whose apparent necessity was buttressed by the need to monitor what by any measure are dramatic changes to federal securities laws – allowing general solicitation and advertising in private placements.  Having now done so, I concur with the views expressed by SEC Commissioner Troy Paredes insofar as it affects small businesses, which he placed on the record at the SEC’s July 10, 2013 meeting, in voting against the proposed rule:

“It seems undeniable that the proposal, if it ultimately were adopted, would thwart private offerings as an efficient means of raising capital.  This would be to our collective detriment.  The harm is real when entrepreneurs cannot raise the capital it takes to build an aspiration into a business and when small businesses are forced to scale back or abandon their plans for growth because they do not have the funds to move forward.”

As required by law, the SEC is soliciting comments from the public on the proposed rules.  The comment period expires on September 23, 2013.

On August 28, 2013, I submitted a comment letter to the SEC to formally voice my concerns regarding the impact of the proposed rules on small businesses.  The letter is available on the SEC’s website. https://www.sec.gov/comments/s7-06-13/s70613-312.pdf.  I also shared my concerns with others, including the Small Business Administration Office of Advocacy, which has statutory standing to comment on regulations under the Regulatory Flexibility Act of 1980.  On September 12, 2013, the Office of Advocacy issued its  comment letter to the SEC, supporting some of the concerns that I expressed to the SEC on August 28, most notably that the Commission’s evaluation of the impact on small businesses is deficient under the Regulatory Flexibility Act of 1980, and requesting that part of the SEC’s proposed rule be re-issued in conformity with the RFA.   https://www.sec.gov/comments/s7-06-13/s70613-339.pdf

The proposed rules, if adopted, would likely undermine the benefits that small businesses hoped to attain when the JOBS Act was adopted in April 2012.  Therefore, I strongly urge my colleagues, clients and readers to submit their views to the SEC before the comment period expires on September 23, 2013.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com

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Equity Crowdfunding in Wisconsin – The Bucks Start Here

Posted on August 13, 2013 by Samuel Guzik

Wisconsin today became the fifth state to introduce state legislation which, if enacted, would allow equity crowdfunding targeted at both accredited and unaccredited investors.  Two states, Kansas and Georgia, have already implemented laws and regulations which allow equity crowdfunding to unaccredited investors for offerings in their state, and two others have introduced bills – North Carolina and Washington State.

Federal legislation to enable equity crowdfunding, Title III of the JOBS Act, was signed into law in April 2012.  However, implementation at the federal level still awaits the adoption of rules by the SEC.  Though the federal JOBS Act mandated the SEC to promulgate rules by the end of 2012, this has yet to happen.  Proposed regulations are anticipated to be circulated sometime in the fall of 2013, with final regulations expected to be adopted sometime in 2014.  Much of the details of equity crowdfunding under the JOBS Act are left to SEC rulemaking, adding to the uncertainty surrounding the federal legislation.

The Wisconsin crowdfunding proposal creates two new crowdfunding exemptions from state registration – one which requires that the offering be conducted exclusively through a state-registered internet portal, which does not have to be a licensed broker-dealer, and a second exemption which does not require the use of an internet portal.  Portal-based crowdfunding, which harnesses the power of the internet, appears to be the principal focus of this proposed legislation.

Wisconsin Crowdfunding Portal Exemption

The Wisconsin crowdfunding portal-based exemption, as proposed, bears many similarities to its federal JOBS Act counterpart, including the requirement of solicitation through an internet portal, but with some key differences.

Offering Amount – JOBS Act limits equity crowdfunding to $1,000,000, in a 12 month period, and requires audited financial statements for offerings in excess of $500,000; Wisconsin’s portal exemption allows raises of up to $2,000,000 – with audited financial statements only required for offerings in excess of $1,000,000.  This appears to address a major criticism of the JOBS Act counterpart, which both caps the offering amount at $1,000,000 and requires audited financial statements to raise more than $500,000.

Individual Offering Cap –The JOBS Act limits investor participation in an offering to a maximum amount based upon income and net worth.  The state portal exemption allows an unlimited investment by an “accredited investor” and $5,000 for unaccredited investors, with the definition of accredited investor reduced substantially – $100,000 per year ($150,000 for joint income) or $750,000 in net worth, including the net equity in a primary residence.

Disclosure Document – The proposed state law mandates disclosure to investors of specific information regarding the issuer’s business, with substantial similarities to the categories of disclosure in the JOBS Act, pre-filed with the state securities administrator.  The state proposal also has a catchall proviso requiring disclosure of any other information “material to the offering,”

Limitation on Number of Purchasers  – As with the JOBS Act, there is no limit on the number of offerees or purchasers.  However, under the state exemption all investors must be Wisconsin residents.

Advertising – Both the JOBS Act and the Wisconsin exemption prohibit advertising by the internet portal.

Company Eligibility – Use of the state exemption is limited to Wisconsin chartered companies with their principal business operations in Wisconsin; SEC reporting companies are not eligible to use this exemption.

Wisconsin Crowdfunding Non-Portal Exemption

The proposed Wisconsin legislation creates a second exemption for non-portal offerings which permits unregistered, local offerings, to an unlimited number of persons.  Some key differences from the crowdfunding portal exemption are (i)  the absence of any specified form of disclosure document, and (ii) its availability for SEC reporting companies. Advertising is generally prohibited.

Some Observations From a Non-Wisconsin Securities Lawyer

The Wisconsin bill, as proposed, is intended to facilitate the use of the internet to raise equity without the necessity for an often cost prohibitive state registration and review process – something that in the past has blocked access by small businesses and startups to raising equity capital.  However, due to the mandated disclosure required by companies relying on the proposed crowdfunding portal exemption, undoubtedly companies will need to retain a lawyer to assist in the preparation of a disclosure document.  This is not a criticism of the bill, but simply an illustration of the tension between two competing goals: (1) ensuring that unaccredited investors are provided with detailed and necessary information regarding their investment, including its risks, without registering the offering with securities regulators, and (2) reducing the cost and complexity of the equity fundraising process.

The bill also appears to place a damper on the ability to conduct general advertising for the offering for those companies utilizing these exemptions, similar to the federal JOBS Act provisions for crowdfunded offerings to unaccredited investors .   Advertising is allowed under the Kansas and Georgia counterparts (the Invest Kansas Act and the Invest Georgia Act).

No equity crowdfunding bill will be perfect – any crowdfunding exemption will  have pros and cons.  However, the sponsors of this bill, State Representatives David Craig, Leah Vukmir and Chad Weininger, should be lauded for leading the charge to create new and necessary avenues to raise money for Wisconsin based businesses.

(Note – The Assembly Bill number assigned to this proposed legislation was not available at the time of publication of this article.)

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com

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Equity Crowdfunding and The Road Not Taken – What Congress Could Learn From Kansas

Posted on August 6, 2013 by Samuel Guzik

It’s pretty easy to make a case against equity crowdfunding:

  • Startups are risky investments – most will fail, and investors will lose their money.
  • Crowdfunding will be a magnet for fraud, drawing phony and exaggerated investment schemes.
  • The goal of crowdfunding, job creation, is illusory – money will be wasted on businesses which ultimately will fail – assuming they even get off the ground – thwarting long term job creation.
  • Investing in “bite-sized” businesses diverts human resources and capital from larger, more efficient economic ventures.

And then there is the time tested wisdom of many successful Wall Streeters:  The real money is made by getting in before the crowd or even after the crowd, but definitely not with the crowd.  Warren Buffet summed it up with this credo:  “Be fearful when others are greedy and greedy when others are fearful.”

Then there was that pillar of Wall Street – Joseph Kennedy, father of President John F. Kennedy and the first Chairman of the SEC, who reportedly rescued his fortune from annihilation by selling all of his investment holdings shortly before the 1929 stock market crash.  His reason for liquidating his entire portfolio: when the market is so popular that a shoe shine boy is giving you stock tips, it’s time to take your money off the table and run.

The JOBS Act debate rose to a new level of visibility on March 3, 2013, when President Obama’s 2009 “Car Czar,” Steven Rattner, weighed in by way of an article entitled “A Sneaky Way to Regulate” in The New York Times, http://opinionator.blogs.nytimes.com/2013/03/03/a-sneaky-way-to-deregulate/?_r=0, where he railed against the JOBS Act in general, but saving his harshest criticism for the legalization of crowdfunding:

Picking winners among the many young companies seeking money is a tough business,even for the most sophisticated investors. Indeed, most professionally run venture funds lose money. For individuals, it’s pure folly. Buy a lottery ticket instead. Your chance of winning is likely to be higher.

As one might expect, Rattner’s New York Times article generated a firestorm of criticism among those leading the equity crowdfunding movement.  According to some critics, Rattner simply didn’t get what crowdfunding was really about.

Mr. Rattner attempted to clarify some of his statements shortly thereafter.  Two days later, according to a CNN article, http://tech.fortune.cnn.com/2013/03/05/crowdfunding-boosters-are-not-happy-with-steve-rattner/, Mr. Rattner advised a reporter:

Rattner also clarified that his biggest concern with equity crowdfunding is not fraud, but rather “stupid business ideas.” In a phone call with Fortune yesterday, Rattner said that he believes there are far better ways to invest money –like in the mutual funds or proven corporate stocks –than to invest in unproven entrepreneurs through crowdfunding.

Seems that Rattner is saying that the average individual investor is ill-equipped to make intelligent investment decisions, and that Wall Street insiders are better able to screen out “stupid business ideas.”  The author of the CNN article could not help but comment on the respect Mr. Rattner’s views deserved:

Rattner’s opinion certainly merits attention considering his role as lead negotiator in President Obama’s bid to restructure the auto industry back in 2009. He also boasts a long career in investment banking, including experience with firms like Lehman Brothers, Morgan Stanley and the Quadrangle Group, a private equity firm he co-founded in 2000.

Clearly Mr. Rattner is an individual who by all accounts, is extremely accomplished in the financial world – and whose opinions and ideas in the financial arena command a great deal of respect.  However, ironically, what the CNN story left out (what a lawyer might call a “material omission”) were allegations by both the SEC and the New York State Attorney General dating back to 2010, which if true, could easily be characterized as “stupid business ideas.”

According to the SEC’s civil complaint filed against Rattner in November 2010, the Commission charged Rattner, a former managing principal of the private equity firm Quadrangle Group, with “entering into undisclosed quid pro quo arrangements .  .  .”  in order to secure up to $150 million of investment funds for Quadrangle from the New York State Retirement Fund (what the SEC described as “pay-to-play”).  http://www.sec.gov/litigation/litreleases/2010/lr21748.htm.  The SEC alleged that Quadrangle secured $150 million in investments after arranging for a Quadrangle affiliate to distribute the DVD of a low-budget film, and by agreeing to pay more than $1 million disguised as a “sham” “finders” fee, and without disclosing these transactions to the Retirement Fund’s investment community.

The SEC’s charges were ultimately settled without Rattner admitting or denying the allegations.  However, Rattner consented to the entry of a judgment that permanently enjoins him from violating Section 17(a)(2) of the Securities Act of 1933 and ordered him to pay approximately $3.2 million in disgorgement and a $3 million penalty – a status which would have barred him from taking advantage of some of the JOBS Act provisions under the“bad actor” exclusions, as they were then proposed by the SEC – proposals which would have barred him from utilizing the  new federal exemption allowing general solicitation of investors in Regulation D private placements.  Perhaps this explained the seemingly incongruous and dismissive criticism by Rattner of the JOBS Act  that “.  .  . the most successful private equity and hedge funds can already raise all the capital they can efficiently manage without advertising.”

The SEC’s allegations of impropriety against Rattner also attracted the attention of the New York State Attorney General.  This matter was put to rest in December 2010 in a settlement whereby Rattner agreed to pay $10 million to settle civil charges that he engaged in a kickback scheme involving New York state’s pension fund.  He did not admit any wrongdoing.

What a Difference One Hundred Years Makes

Okay, so what does Kansas have to do with federal crowdfunding.  After all, in 1911 Kansas earned the distinction of being the first state in the U.S. to enact stringent Blue Sky laws requiring the registration of sales of securities to the general public.  However, Kansas was the first to do an  about face 100 years later – enacting what can fairly be called the first equity crowdfunding law in the U.S.  It was done without an act of Congress, or even the Kansas State legislature, and without a great deal of fanfare and red tape.  It was done by the order of a man named Jack – Aaron Jack –  the now former Securities Commissioner of the State of Kansas.  Apparently the Commissioner had some firsthand experience raising capital and working with broker-dealers.  Seems that in a prior life he was West-Central Zone Director for New York Life, where he presided over 3,200 registered representatives and was the first director in the history of New York Life to raise $1 billion in new assets for its investment management subsidiary. http://www.fed-soc.org/doclib/20120813_JackEngage13.2.pdf.

On May 11, 2011, the then Securities Commissioner Jack formally submitted for public comment the proposed regulations known as the “Invest Kansas Exemption”, exempting from state registration sales of securities in Kansas to an unlimited number of unaccredited investors.  Commissioner Jack’s proposal came with a 60 day public comment period, with a public hearing set on July 19, 2011.   On August 12, 2011, the “Investment Kansas Exemption,” referred to officially as “IKE,” was the law of the State of Kansas, months before the earliest version of the JOBS Act was even introduced as a bill in Congress.

There has been a great deal of hype surrounding equity crowdfunding – both before and following the passage of the federal JOBS Act.  Seems that in Kansas some things are simpler – and quieter.  With the proposed regulations came a simple statement of purpose:

The proposed exemption will allow Kansas companies to raise capital without going through the registration process. A company could spend approximately $15,000 to $25,000 to properly register a $1 million securities offering. The costs would include a filing fee of $500, legal and accounting fees, due diligence costs, and other expenses associated with a securities offering. Most of these costs could be avoided if the company takes advantage of the new exemption, which has no filing fee and is designed to be used with minimal legal assistance. Because of the high expenses associated with registration, few companies actually use the registration process for small offerings.

Kansas Crowdfunding and the JOBS Act Exemption Compared

Here are some of the highlights of the Kansas crowdfunding exemption, compared to the JOBS Act provisions:

  • Limit on Amount Raised – The primary thing IKE has in common with Title III of the JOBS Act is the limit of $1 million raised in 12 months under this exemption – and there is an exclusion for money invested by controlling persons.
  • Limitation on Amount Invested – There are limitations on how much an investor can invest: unaccredited investors are limited to $5,000 per company; there are no limits on an investor who is “accredited” under SEC Regulation D.
  • Advertising – Unlike the JOBS Act, where general solicitation of unaccredited investors is prohibited, general solicitation is expressly permitted.
  • Manner of Sale – Unlike the JOBS Act, which requires an intermediary – either a broker-dealer or an SEC registered portal which becomes subject to FINRA rules governing broker-dealers, there is no requirement that a company use a registered portal to raise money.  Companies have the flexibility to raise money on their own website, or with a registered broker dealer.
  • Disclosure –  There is no particular form of disclosure required.  However, any information provided must be truthful and free of material omissions.
  • Disclosure Standards – Sales and advertising literature must be free of false or misleading statements:
  • Sales and advertising literature shall be deemed to be false and misleading if it contains any exaggerated statements, emphasizes positive information while minimizing negative information, or compares alternative investments without disclosing all material differences between the investments, including expenses, liquidity, safety, and tax features.

So What is IKE Missing?

Because Kansas’ IKE is an exemption from registration under Kansas Blue Sky laws, its scope by its terms is limited geographically to Kansas:

  • Offers and sales only to Kansas residents.
  • The issuer must be organized under Kansas law
  • All persons responsible for the management of the issuer’s operations or properties must be Kansas residents.

Apart from the limited geographic scope of IKE, its most striking feature is its simplicity.  IKE fits on one page – the JOBS Act crowdfunding provisions run nine pages – and that is before tacking on the unknown number of pages comprising the labyrinthian regulations yet to be adopted by the SEC .

IKE is also missing a crowdfunding exemption which mandates the use of an intermediary, such as a broker-dealer or an SEC/FINRA registered portal.  Unlike the JOBS Act, a company is free to set up its own crowdfunding campaign on its website – or to use a broker-dealer to assist it in the offering.

IKE is also missing the hype and the fanfare.

Statutes similar to IKE have been adopted in Georgia and are under consideration in North Carolina and Washington State.  And although IKE does not address all of the equity crowdfunding issues, and is itself not a perfect model for federal legislation, it is certainly a simpler starting point – and one more easily capable of implementation, even at the federal level.

What Congress Can Learn From Kansas and its Blue Sky Laws – They Don’t Know “Jack”

Our Congress could learn something from Kansas and its Securities Commissioner Jack.  The appropriate acronym is not a new one: “KISS” (keep it simple stupid), one that will never sell on Capitol Hill.  But when it comes to the equity crowdfunding debate, nothing is simple or straightforward. There are a great deal of competing ideas inexorably steeped in various conflicts of interest.  In this regard I agree with Mr. Rattner in at least one respect – when he says that the federal JOBS Act legislation in the form ultimately passed was more a function of Washington politics than sound economic or regulatory policy.

The JOBS Act equity crowdfunding provisions are a hodgepodge of ideas more representative of the special interests behind the legislation, primarily those who want to be in the business of equity crowdfunding, rather than sound economic or regulatory policy.  And while I am enthusiastic about equity crowdfunding on a conceptual basis – opening up more channels for businesses in need of capital to raise money – it is imperfect in its present form – and I believe it is likely that the multitude of SEC regulations which will put meat on the bones of the Title III of the JOBS Act will highlight and even accentuate some of these imperfections.

I suggest that while the crowdfunding community is intently focused on the long overdue SEC regulations – a community thus far comprised largely of those who have a vested interest in the business of crowdfunding – those who are interested in seeing equity crowdfunding succeed in raising capital for entrepreneurs ought to be looking ahead to the amendments to the JOBS Act which will inevitably follow, and/or consider other avenues of financing which are permissible under current laws and SEC regulations.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

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Equity Crowdfunding – The Road Ahead at the SEC and Beyond

Posted on July 25, 2013 by Samuel Guzik

Equity crowdfunding, hoped by many to be a promising new vehicle for capital formation for startups and other early stage companies, has yet to become operational under the JOBS Act – waiting on the SEC to promulgate proposed and final implementing regulations.   With the interest and hype generated by the JOBS Act crowdfunding provisions, one thing is certain – the viability and utility of equity crowdfunding has both its supporters and detractors – with strong opinions on both sides of the debate.

Among the supporters are the legions of companies and individuals hoping to cash in as service providers to this nascent market.  Among the many naysayers are some securities lawyers and regulators who see problems at every turn, and some VC’s, who have their own perspective on who should be raising capital and how it should be done.

The fact of the matter is this:  Title III of the JOBS Act, which provides a structure to legitimize equity crowdfunding, is by reason of its pedigree an imperfect product.  It suffered unduly from the machinations of the legislative process –being shaped by members of two houses of Congress and its myriad committees trying to reconcile a number of legitimate interests on a fast track, some of them in direct conflict.  The very name of Title III of the JOBS Act, which is the crowdfunding section of the JOBS Act, bears this out:  “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012”– The  title of the law is itself an oxymoron of immense proportions.  And to complicate matters further, there are a great deal of gaps and ambiguities in the law itself, many of which must be addressed through the SEC rulemaking process – expected to drag into 2014.

Size Matters

As in many areas of life, size matters.  Equity crowdfunding is no exception.  The dollar amounts that can be raised under the crowdfunding exemption are small, at least in relative terms, and the liability risk is disproportionately high.  Added to this are the compliance costs and relative complexity of the equity fundraising structure envisioned by the JOBS Act.

  • Limited Dollar Amounts –  The JOBS Act exemption limits amounts raised in a 12 month period to $1 million.  To get in the game and raise more than $100,000, a company seeking funds in this venue will need either “reviewed financial statements”  (up to $500,000), or audited financial statements for raises between $500,000 and $1 million.
  • Compliance Costs – The cost of a company engaging in equity crowdfunding will not be insignificant, in relation to the amount of funds sought.  Until the SEC promulgates regulations, these costs will be difficult to gauge, but at the very least there will be accounting costs and the costs and fees of the crowdfunding portal itself.  Also, each company will have another bridge to cross – do they rely on standardized documents generated by portals and ancillary service providers, such as CrowdCheck, or do they engage their own counsel to help them navigate through what some perceive as a potential legal minefield.
  • Liability – This is an area which will drive both the costs and risks of engaging in equity crowdfunding.  No doubt, equity crowdfunding has all the ingredients of an accident waiting to happen – historically high risk of failure for startups and early stage ventures; and hundreds or even thousands of investors in a venture who will likely see disappointment turn to anger as their investment capital evaporates.  Unlike social crowdfunding, the primary motive for the majority of equity crowdfunders will be a return on their investment.  And any way you slice it or dice it, when a company takes money from an investor, the regulatory deck is heavily stacked against the company and its control persons.  The very risk of investor lawsuits will have a chilling effect on companies seeking to engage in smaller offerings – an issue which private insurance is unlikely to dissipate, due both to cost, limitations on coverage imposed by insurers, and legal impediments to insuring against liabilities arising out of securities laws violations.
  • The Crowd – Unlike social crowdfunding, those seeking to raise equity from large numbers of investors in equity crowdfunding will undoubtedly discover that large numbers of investors are more likely to be a curse than a blessing, even if the venture is successful.  A capitalization table with a large number of investors (as in hundreds or thousands) could be an impediment to subsequent financings through more traditional venture capital channels.  However, with proper planning and documentation before the equity crowdfunding is launched there may be some legal workarounds for this issue.

The Road Ahead

To say equity crowdfunding is not perfect, perhaps even impractical, and fraught with peril to potential investors, should not be the end of the debate – but rather the beginning of undoubtedly what will be an ongoing process with a long and bumpy learning curve.  Hopefully, out of the confusion will come a practical tool for some startups, and a recognition that there can and will (eventually) be better solutions to raising capital in the Internet age, in addition to equity crowdfunding.  Undoubtedly there will be a need for further legislation and even more SEC rulemaking – both in the equity crowdfunding area and other capital raising avenues.  For better or for worse, we are starting from a federal regulatory scheme which is 80 years old as well as a patchwork of disparate state Blue Sky regulation, all of which serve as a barrier to capital formation.  This will be a slow and painful process, but the process has begun – and will serve as an impetus to break down outmoded and unnecessary barriers to capital formation in the Internet age, where information is more easily and economically transmitted, while at the same time providing a reasonable degree of protection to the investing public and the integrity of the capital markets.

By most estimates, equity crowdfunding under the JOBS Act is not expected to become a reality until sometime in 2014, when the SEC (hopefully) completes its rulemaking process, with proposed rules rumored to be published perhaps as early as September or October of 2013.  For those entrepreneurs and companies contemplating what equity crowdfunding holds for them, there is more than ample time to consider existing alternatives to equity crowdfunding, depending on the particular business model and stage of development.  The options do not depend on the enactment of crowdfunding regulations.

Companies with a viable business plan should consider other types of unregistered offerings, including private transactions with a small number of friends and family, or limiting the offering to “accredited investors” meeting the income and net worth tests of SEC Regulation D.  Those seeking “seed capital” for certain types of new startups should also explore interest in local “accelerators” and “incubators”.   And for some companies, social or donation crowdfunding, which is outside the purview of federal and state securities laws, may be a good option to explore.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and  California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

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Final and Proposed SEC Rules Allowing General Solicitation are Out – Crowdfunding Rules for Non-Accredited Investors to Follow-And So Too Should Caution

Posted on July 19, 2013 by Samuel Guzik

On July 10, 2013, the SEC released final SEC rules, effective in September 2013, which will allow general solicitation and advertising in unregistered debt and equity offerings so long as all of the purchasers are accredited investors and the issuer takes reasonable steps to assure itself that its investors are accredited.  As one might expect, this long awaited announcement brought with it a great deal of its own  publicity, much of it generated by service providers who hope to immediately and directly benefit from business opportunities created by the new rules.

One would certainly expect a great deal of hype to follow the new SEC rules and the opportunities created – particularly from those who hope to benefit financially from its implementation.  However, one would hope that those who intend to profit from riding the wave generated by the JOBS act, including the crowdfunding wave yet to be unleashed, would be more circumspect and deliberative in their communications.

Case in point:  SeedInvest, a company which holds itself out on its website as connecting accredited investors to high quality startups and small businesses seeking funding. https://www.seedinvest.com.  Notably, SeedInvest has been cited by Forbes as one of the top 10 crowdfunders of 2013.  http://www.forbes.com/sites/groupthink/2013/01/31/u-s-crowdfunders-the-top-contenders-in-2013/#

This morning I received an email from SeedInvest informing me of the recent SEC rule changes and how SeedInvest hopes to assist offering participants.   I reprint it below because I believe it represents a “teachable moment” about investing in the Internet age.  Here we go:

“Dear Sam,

In a historic and long awaited move, the SEC voted 4-1 to implement regulations under Title II of the JOBS  Act to lift the 80 year old ban on general solicitation for  securities offerings and bringing the securities industry into the internet    age.

This means that in about 60 days (around late September) companies will be able to generally advertise their securities offerings, so long as all the purchasers of these securities are Accredited Investors.

Companies will be required to take greater steps to verify the     accreditation of their investors, such as checking tax returns, W-2s or  getting certifications from a lawyer or CPA with personal knowledge.     Companies may also be required to make a filing with the SEC 15 days BEFORE  any advertising takes place and they also be required to file all of their     advertising material with the SEC. The penalties for violating these rules are severe, including being barred from raising additional funds using Rule 506 for a full year.

SeedInvest continues to be actively involved and at the forefront of these changes, and has developed a suite of tools to streamline all of these new processes and filing requirements. Companies will be able to use SeedInvest‘s social media tools to push information about their company and their offering to all of their Twitter, LinkedIn and  Facebook followers. Companies can also leverage our automated investor accreditation and verification tools to meet the heightened requirements with ease, comfort and minimal hassle.

We are extremely excited about these upcoming changes. However, it is important to note the following caveat:

You cannot advertise until late September and you will need to make     ADVANCE filing with the SEC 15 days BEFORE you advertise. 

For more details and up to date information on the new rules, check out our ongoing coverage on the SeedInvest blog.

Best,

The SeedInvest Team

SeedInvest, LLC

447 Broadway, Suite 2 | New York, NY 10013

(O) 646.291.2161

contactus@seedinvest.com     | www.seedinvest.com       *                    *                    *                    *                    *

Of course, something is very wrong with this picture, at least as presented by  SeedInvest:

 “You cannot advertise until late September and you  will      need to make ADVANCE filing with the SEC 15 days BEFORE you advertise.” 

Notwithstanding the representation on the SeedInvest website that; “We are laser focused on quality over quantity”, in its haste to get out what appears to be a widely distributed Internet mailing it failed to properly vet its own solicitation materials”:  it wrongly stated that an advance filing with the SEC will be required.

As the final SEC rules make clear, there will continue to be a Form D filing requirement for Regulation D offerings, including those that intend to utilize general solicitation.  However, the current SEC Form D filing requirement only provides for filings after the offering commences.

Importantly, the new SEC  rules proposed on July 10, 2013 do have a requirement that the issuer make an advance filing of Form D if it wishes to utilize general solicitation and rely on Rule 506(c).  But these are simply proposed rules, which may or may not be implemented by the SEC in the future, and which are not part of the recently announced final SEC rules which go into effect in September 2013.

A number of lessons may be drawn from this observation:

  • When it comes to investing, especially Internet investing where information can be disseminated and decisions can be made with the speed of a click of the mouse, do not believe everything you read – do your own due diligence.   Caveat Emptor is still the rule.
  • As the SEC notes on its website, “[I]nvesting is not a spectator sport. By far the best way for investors to protect the money they put into the securities markets is to do research and ask questions.” http://www.sec.gov/about/whatwedo.shtml
  • When it comes to something fundamentally new in a highly regulated area such as securities, whether it is Internet solicitation of investors or equity crowdfunding by non-accredited investors, mistakes will invariably be made at the outset, even by the most well intentioned.  So extra caution by all involved is in order – and the appropriate professional advice on securities law compliance should be sought before one acts– not after.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and  California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

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SEC Issues Final JOBS Act Regulations Allowing Public Solicitation of Investors in Private Placements Under Rule 506 of Regulation D; New Proposed Regulations Regulating Rule 506 Private Placements Also Issued for Public Comment on July 10, 2013

Posted on July 12, 2013 by Samuel Guzik

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), making sweeping changes to federal laws regulating capital formation.  One of the more significant changes to existing law was a directive to the SEC to promulgate rules expanding an existing exemption from SEC registration for private placements – Rule 506 under SEC Regulation D. Amended Rule 506 would allow companies conducting unregistered private placements to solicit investors using general solicitation and general advertising so long as all of the purchasers in the offering are “accredited investors.” The JOBS Act specifically required the SEC to adopt rules implementing these amendments to Rule 506, including a rule which would require that the issuer to take “reasonable steps” to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

On July 10, 2013, the SEC adopted final rules under the JOBS Act to lift the ban on general solicitation and advertising in private placements, a practice that, until the JOBS Act, had been generally prohibited since the federal securities laws were first adopted in 1933.  These new rules go into effect in mid-September 2013.

The impact of the final SEC rule allowing general solicitation and advertising in unregistered private placements cannot be ovcrstated.  It will certainly have a dramatic positive impact on the ability of issuers to both raise capital and to reduce costs associated with raising capital.  The rule change is expected to be particularly helpful for startup companies, emerging private companies and small public companies which generally have greater difficulty accessing capital markets.

In view of the dramatic and far reaching impact of this rule change (and the potential further rule changes announced in the companion SEC release discussed below) on expanded access of public and private companies to capital markets without engaging in an expensive and time consuming SEC registration, look for additional articles covering this topic in the coming weeks and months.  In the meantime, following is a brief summary of the new Rule and the related newly proposed rule.

Final SEC Rule Allowing Public Solicitation and Advertising in Private Placements

On August 29, 2012, in SEC Release No. 33-9354, the had SEC issued proposed JOBS Act regulations which, if adopted, would allow issuers to use general solicitation and advertising in private placements so long as all of the purchasers are accredited investors. Specifically, as proposed by the SEC, Rule 506(c) would permit the use of general solicitations to offer and sell securities under Rule 506, provided that the following conditions are satisfied:

  • the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors;
  • all purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities;  and
  • all other terms and conditions of Rule 506 are satisfied.

On July 10, 2013, the SEC the adopted a final rule allowing an issuer to engage in public solicitation and public advertising in private placements.  The final rule, as adopted, is substantially identical to the rule as proposed, with one notable exception: the SEC has added non-exclusive “safe harbor” provisions intended to provide some degree of certainty to an issuer that it has taken “reasonable steps” to verify that all purchasers are accredited investors, at least in the case of investors who are individuals (as opposed to entities such as corporations and LLC’s).

According to the SEC’s proposing Release, whether an issuer has taken “reasonable steps” to verify the accredited status of an investor would require an objective analysis, which in turn would depend on the particular facts and circumstances of each transaction.  In the view of the SEC, this approach would require an issuer to consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor. Some examples of factors cited as relevant by the SEC in determining whether an issuer has taken “reasonable steps” include:

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
  • the amount and type of information that the issuer has about the purchaser; and
  • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The Rule, as originally proposed, did not provide any “safe harbor” to allow an issuer protection in its belief that it took reasonable steps to verify that a purchaser is an accredited investor.  The result would have been that an issuer would not have the benefit of any certainty that it has complied with the Rule change allowing public solicitation in a private placement if it turns out that one or more of the investors was not in fact an accredited investor, even if the issuer has acted in good faith.  As pointed out by this author in The Corporate Securities Lawyer Blog article published on October 24, 2012, the absence of a safe harbor would likely force the issuer to either (i) take greater steps than it might otherwise take to verify “accredited investor status,” which would likely entail additional time and expense, or (ii) avoid the use of public solicitation in a private placement altogether.

In response to these concerns, expressed by a number of commentators, the final rule adopted on July 10, 2013, provides a safe harbor for specific, non-exclusive methods to measure the reasonableness of the steps taken to verify that individual investors are accredited investors:

  • Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year; and
  • Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.

The final rule is effective 60 days after being published in the Federal Register (effective on or about mid-September 2013).  Until the effective date issuers may not rely on the new rule provisions allowing public solicitation.  The adopting SEC release, Release No. 33-9415, which contains over 100 pages, is available to the public on the SEC’s website, www.sec.gov ( http://www.sec.gov/rules/final/2013/33-9415.pdf).

Proposed SEC Rules Governing Private Placements

In a companion release (SEC Release No. 33-9416)  (http://www.sec.gov/rules/proposed/2013/33-9416.pdf) issued on July 10, 2013, the SEC announced additional proposed amendments to Rule 506.  According to the SEC, the proposed amendments are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting issuers to engage in general solicitation and general advertising under the newly amended Rule 506. The proposed amendments would require:

  • the filing of a Form D in a Rule 506 offering involving public solicitation and advertising before the issuer engages in general solicitation;
  • the filing of a closing amendment to Form D after the termination of any Rule 506 offering;
  • written general solicitation materials used in Rule 506 offerings to include certain legends and other disclosures;
  • the submission to the SEC, on a temporary basis, of written general solicitation materials used in Rule 506 offerings to the SEC.

The proposed rule would also disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with Form D filing requirements in a Rule 506 offering. The proposed amendments would also require an issuer to include additional information in Form D about offerings conducted in reliance on Regulation D.

This author expects that many of the provisions in the proposed rule will ultimately be adopted by the SEC in final form.  Given that the proposed rules are intended primarily to facilitate oversight by the SEC of the newly expanded Rule 506 allowing public solicitation and advertising and to identify patterns of fraud or abuse, it is likely that the SEC will give a high priority to the promulgation of these rules in final form.  Given the breadth of the 186 page Release proposing the rule changes, specific details of the proposed rule will be addressed in subsequent articles.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and  California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

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Startup Business Lawyer or Legal Self-Help?

Posted on June 7, 2013 by Samuel Guzik

You finally have your management team and your business plan in hand.  You are ready to launch your startup business after months of analysis and planning.  Funds are limited, so you go onto the Internet to find the quickest and cheapest way to form the business entity.  With some advice you have gleaned from your Google search and free information from self-help websites, you are ready to form the business entity and launch your startup.  You pat yourself on the back for finding a legal self-help service which will actually form your business entity for free!  You need only pay the state filing fees.  Should it be an LLC or a corporation?  Should it be formed in Delaware, Nevada, New York, California or your home state? You have figured that out too, and have saved hundreds, perhaps thousands of dollars in unnecessary legal fees – or so you think.

For many entrepreneurs, one of their most costly mistakes is making a decision to avoid lawyers when starting their business, and go to a do-it-yourself site, such as LegalZoom or RocketLawyer.  In the long run, this may prove to be a very costly mistake – resulting in avoidable mistakes that require fixing down the road – at great expense – some mistakes may not be fixable at all.  If your startup business is worth all of the time and energy being put into it, it is best to have an experienced business lawyer on your team from the outset.

Case in point:  Forming a corporation can be done simply by anyone with access to a PC and a credit card, in many cases simply by visiting the website of the Secretary of State of the particular state.  However, one of the principal benefits of forming a corporation, avoiding personal liability, can easily and irretrievably be lost if proper steps are not taken after the corporation is formed.  As any law student can tell you, if the corporation does not follow proper formalities in the governance and operation of the entity, the limited liability status of the corporation could be lost when most needed – when a legal claim is made against the individuals operating the corporation.

Lack of foresight and proper planning can also get in the way of success, just as the business is starting to take off.  This is especially true when a startup business reaches the point where it is ready to seek outside investors – whether “angels”, or through investment bankers, placement agents, broker-dealers, or crowdfunding. Once outside investors have bought off on your startup’s story, they will look closely at areas that may have been overlooked by management entirely, or improperly structured or documented.  Two common areas are the capital structure and protection of intellectual property.

Often intellectual property is not adequately protected from the outset, such as by assuring that  all employees and consultants enter into confidentiality agreements.  Failure to take proper steps from the very beginning can jeopardize the ability of the venture to capitalize on its ideas or to convince third parties to make a favorable investment decision.

Other common mistakes include failing to properly structure or document initial investments by the founders.  These actions must be properly planned when the transactions are entered into: should the capital contribution be in the form of equity or debt, or some combination?  If equity, what type of equity should be issued: common stock or preferred stock?  Once these decisions are made and implemented, it can be hard, if not impossible, to “unring the bell” if there is not a proper capital structure in place from the outset.

Apart from these questions, in almost all cases, when the entity is formed, there ought to be an agreement among the founders as to matters such as what rights the founders will have over major business decisions or day-to-day operations;  and what options will the founders and the company have if there is a parting of the ways by the founders down the road.  These are matters which are best addressed by a “founders agreement” or “buy-sell agreement” when the business entity is formed.

So when getting ready to launch your next business venture, carefully weigh the risks involved in a decision to go it on your own at the startup phase without the benefit of experienced corporate legal counsel.  If money is tight, as it normally would be, seek out an experienced transactional lawyer who has the flexibility to provide competitive or fixed rate fee arrangements. In some cases it may make sense to consider a reduced fee in exchange for equity in your business – in order to conserve cash and align your legal advisor’s interests with the long term economic success of the venture.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

 

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