Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

Yesterday, the SEC proposed rules to implement Section 201(a) of the JOBS Act, which mandates the elimination of the prohibition against general solicitation in Rule 506 and Rule 144A offerings.  The proposed rule answered the major questions securities professionals were asking about these reforms:  would the new Rule 506 replace the old (no), would “reasonable steps to verify” require issuers to comply with strict guidelines (no again), and would it take the SEC over 60 pages to answer those two questions (yes!). 

First, a quick review: Section 4(a)(2) of the Securities Act of 1933 exempts transactions “not involving any public offering” from the pricey and time-consuming registration requirements of Section 5 of the Securities Act.  Rule 506 was (and still is) a safe harbor under Regulation D under Section 4(a)(2) of the Securities Act, meaning that if an issuer met its requirements, it could safely assume that the offering was not public. 

Among other things, Rule 506 prohibited “general solicitation and general advertising” which is exactly what it sounds like.  In addition, an issuer relying on Rule 506 could sell to an unlimited number of accredited investors (basically: investment companies, funds, and wealthy people) and no more than 35 “sophisticated” non-accredited investors (basically: normal people who arguably have some idea of what an investment is).  A Bizarro Kanye might say, “the SEC doesn’t care about rich people” (that’s not exactly true, but remember: Bizarro isn’t that smart).  After those 35, an issuer had to “reasonably believe” that the investors were accredited.

That was the old Rule 506, hereby known as Rule 506(b).  The new Rule 506, or Rule 506(c), removes the ban on general solicitation, but issuers can only sell to accredited investors – no more 35 sophisticated non-accredited guys.  It also requires that issuers “take reasonable steps to verify” that the investors are accredited.  When the JOBS Act passed, some worried that its mandate to amend Rule 506 meant that the old version would be lost.  We can all rest easy: now issuers have a choice – stick with the stricter advertising rules if you want to offer securities to non-accredited investors, or advertise like crazy and take reasonable steps to verify that everyone you sell to is accredited. 

Rule 506(c) may be a huge benefit to a lot of start ups who have had trouble finding accredited investors to fund their ideas.  If so, this would come at the expense of the “finders” industry, although few entrepreneurs will cry over that side effect. 

The “reasonable steps to verify” also made some fear that Rule 506(c) would lead to mandatory tests or necessary documents to prove accredited-investor status.  There was a concern that issuers would need to undergo much more rigorous due diligence under this new rule.   (These securities professional types are real worry warts.)  Relax: “we [the SEC] anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c).”  The SEC is proposing an objective standard that weighs both the type of information and the amount of information an issuer has about a possible investor.  For example, if that investor claims to be a registered broker-dealer, you could just go to FINRA’s BrokerCheck website to check and be set.  Or if the minimum investment was $1 Million and an investor could provide that (unfinanced) in cash, you could safely assume a personal wealth of over $1 Million (and, also, that he’s a drug kingpin).  The SEC even suggested that a third party verification, such as an affidavit by an investment advisor, accountant or attorney attesting to the investor’s accredited status, would suffice.  That said, the SEC made it clear that simply asking “are you accredited?” ain’t gonna cut it – some due diligence will be required. 

Securities sold pursuant to Rule 506(c) offerings will remain restricted securities.  None of the changes to Rule 506 are meant to imply changes to Section 4(a)(2) or the other rules under Regulation D. 

The SEC is now requesting comments, and has a series of questions that it wants public feedback on.  The majority focus on the verification issue, but I don’t foresee many changes.  The SEC’s proposed approach offers flexibility.  More flexibility also means more uncertainty, but most of that uncertainty will only happen along the margins.  A company performing a decent level of due diligence should be safe.  And, as before, if an investor provides falsified documents and lies convincingly, the issuer will still have reasonable belief and will have taken reasonable steps.  

The SEC also proposed rules to allow general solicitation for Rule 144A re-sales of restricted securities.  This is less interesting, because Rule 144A restricts sales to Qualified Institutional Buyers (QIBS), which are generally investors with over $100 million in assets.  Rule 144A is usually used in initial offerings exempt from registration pursuant to Section 4(a)(2) or Regulation S (a safe harbor for the sale of securities made outside the US).  I’m not sure what this change to Rule 144A is supposed to accomplish, because there isn’t exactly a large target market of QIBS.  If you are planning on making a Rule 144A offering, and your investment banker says something like “well, I don’t know any QIBS, so why don’t we take out a subway ad?” you should fire him. As the SEC said, “Although Rule 144A doe not include an express prohibition against general solicitation, offers of securities under Rule 144A currently must be limited to QIBS, which has the same practical effect.”  That’s diplomatic bureaucrat speak for “we have no clue why Congress made us do this.”

These are just proposed rules, meaning the public has 30 days to comment. 

In its never ending quest to find suitable ways to address capital formation issues in the United States, the SEC’s Division of Corporation Finance is looking to see if foreign jurisdictions handle some of these issues better and if it could be applied in the United States. 

For example, the SEC is looking to see if other jurisdictions handle solicitations and advertising of private offerings differently.  Coupled with this item, Corporation Finance is also reviewing the regulation of private issuers as well.  In particular, Corporation Finance is looking at private placements and general solicitation bans in light of the new age of social media, and 24 hour news coverage.  One consideration is if the current regulatory scheme of a registered offering regime is relevant when one considers the way information is received in this type of market and the attempts to encourage investors through these communications.

The SEC is intrigued at the way foreign private issuers handle these matters overseas and if its current system should remain in place.  Historically, foreign private issuers in the United States ahd been the traditional large cap companies.  However, this model is changing, and it is unclear if the SEC’s current regulatory framework has adapted.

Finally, the SEC should be applauded for its efforts in realizing not all regulation needs to be addressed from an American standpoint, but that certain goals could be achieved by following an overseas model.

Recently, the SEC announced that it would take steps to bar felons and bad actors from any Regulation D offering. 

This rule was mandated by the Dodd-Frank Act, and the SEC issued the proposal last May 2011.  This new rule may be in place before the end of this year, but there is no certainty on timing at this point.  This new rule is part of an overall effort by the SEC to attempt to remove bad actors from early stage offerings since these offerings usually involve raising capital for small companies.

The Cayman Islands will amend a 2011 law to clarify that master funds will now have to register if they have even one Cayman regulated feeder fund.  This registration will have to take place with the Cayman Islands Monetary Authority. 

Previously, the Neutral Funds Law that was effective in December 2011, stated that, if there was only one feeder fund, no registration was required.  However, the Cayman Islands Government and its Monetary Authority determined that registration would be required.  As such, the legislation was to have been reviewed in March 2012, and likely approved shortly thereafter.

Recently, the SEC's Division of Corporation Finance Director indicated that the SEC was reviewing certain issues in an attempt to assist small businesses with capital formation. 

The SEC is assessing a number of initiatives, including, but not limited to, if the number of shareholders, currently 500, triggering reporting requirements could be increased.  Some have suggested that the Commission should increase the Securities Exchange Act of 1934 Section 12(g) level from 500 to 1,000.  Of course, as my colleague, Jim Saksa, has pointed out in his blogs on the JOBS Act that this number has already been raised to 2,000.

Nonetheless, the Senate majority leader has indicated that there is a potential for advancement of certain issues under consideration by the SEC, and is actively working on moving legislation through the Senate to accomplish these changes. The Senate majority leader sought to advance a legislative plan to ease the regulatory burden on small businesses.  Officially, the legislation would improve a small firm’s access to capital, as well as make it easier for these firms to sell their stock through IPO’s.  The Senate Leader was very cautious stating these changes would still protect investor rights. 

The legislation is scheduled for a hearing, and is expected to receive some support from the minority party.

In sum, clearly, given the economic uncertainties we still face, Congress and the SEC are attempting to find ways to improve access for small firms to raise capital and sell their stock into the public arena.

Like many others, my interest in the JOBS Act really started with crowdfunding.  This is probably because securities law is an imposing tangle of archaic acts, byzantine regulations and repetitive rules.  (Securities lawyers commonly say things like “…Rule 506 under Regulation D, promulgated pursuant to Section 4(2) of the ’33 Act…” and expect you to understand/stay awake).  Crowdfunding, however, is the hip, internet-based, exciting new thing!  It’s like that Kickstarter thing your cousin, the “performance artist”, keeps posting about on Facebook!  Everyone is talking about crowdfunding, so it MUST be awesome, right?  Well, not so fast: a lot of media coverage and law blogs doesn't mean a law will live up to the hype (I admit my own guilt).   So, what impact will Crowdfunding really have once the SEC passes all its rules? 

I’m leaning towards not much.  First, they have 270 days to enact the rules, but as this guy explains quite well, you really shouldn’t bother writing that down in your calendar: the SEC will be late. More to the point, some think this will be the panacea to our economies ailments, while others expect it to pretty much license fraud.  Obama called this a “game changer” and I agree, but - to make a football analogy - this is more like a “two-point conversion” game changer than a “forward pass” game changer.  Most start ups will eschew crowdfunding for more traditional fund raising methods.

First, we need to ask: what kind of issuer will use crowdfunding?  Not the guys who are looking to ramp up an already humming business, they already have venture capitalist to turn to.  And remember that the JOBS Act also amended Reg A (allows a company to sell up to $50 Million in securities with minimal disclosures and no restrictions on advertising) and Sec. 12(g) of the ’34 Act (now companies can have up to 2000 investors without being forced to go public, and employees don’t count towards the limit).  One the SEC makes rules on these changes, a company can offer up to $50 Million in stock, advertising however it likes, using a Regulation A circular, provided that it keeps non-accredited investors under 500 and total number of investors under 2000.  $50 Million divided by 2000 investors is a mere $25,000 per investor – not an extravagant amount by any means, and this might deepen the venture capital markets.  For many more established or promising start ups, this will present a much more appealing opportunity.  The “start up” that already has a product and some employees probably won’t resort to crowdfunding.

Crowdfunding is limited to $1,000,000 dollars, gleaned from any number of investors.  Issuers (and the funding portals) are prohibited from advertising the offering, beyond director investors to the website (it will be interesting to see whether Facebook and Twitter links will be considered advertising or mere directing).  And if the issuer wants to raise over $500,000, it will need to release audited financial statements.  That means dropping a few grand on a CPA, on top of the whatever fees the funding portal will charge (and issuers would be remiss to do any of this without an attorney).  The transaction costs will be high.  If the issuer wants to raise somewhere between $100,000 and $500,000, then the financial statements need only be “reviewed”, which is slightly less pricey.  On top of those requirements (and the basics like names of officers and addresses), issuers will need to describe the purpose of the fundraising, a description of the ownership and capital structure of the issuer and file annual reports with the SEC, including financial statements.  And, do note, the SEC is empowered to make “any other requirements…for the protection of investors and in the public interest.”  That means that the SEC could make any of these requirements more onerous and costly.  Again, given that Mary Schapiro and Luis Aguilar have pooh-poohed the concept generally, expect the SEC to add some regulatory meat to the statutory bones.

Normally, a start up gets going using the founder’s own funds, and the money he can beg, borrow or steal from his friends and family, and sometimes they find an “angel investor” – some wealthy person willing to give them a shot in the form of a few thousand dollars.  Crowdfunding will be popular among the start ups that can’t find this kind of “seed money”.  Younger entrepreneurs, whose friends are all also broke, are more likely to turn to crowdfunding.  In addition, crowdfunding will be huge for entrepreneurs living outside of seed-money friendly areas.  It will also help individuals with really solid ideas of how to return 20% on the dollar, which isn’t the sort of return that excites many angel investors (think pizza shop in a small town without so much as a Dominos).  And, to be frank, it will help the socially awkward types who can’t sell their vision face-to-face. 

Crowdfunding isn’t the democratization of equity investment; it’s the democratization of angel investment.  Most of us will still be unable to invest in the next Facebook or Google, because they’ll skip crowdfunding altogether.  I suspect most crowdfunding offerings will end up being for less than $100,000 (meaning the issuer only needs to provide self-certified financial statements and last year’s tax return, plus the other rules).  It will be for just enough to make a prototype or launch a beta version.  In other words, just enough to attract a venture capitalist.

For investors, crowdfunding means a lot of chances to lose some money.  Some will get to support the next must-have app for your phone, but more will probably invest in a bar or restaurant (an industry famous for failures), or with tech-geeks without a lick of business acumen.  I’m okay with this, to be honest.  Some will invest for philosophical reasons (support only small/local businesses), others will gamble (better here than a casino), but I think most will do it almost for fun (another venue for those who “dabble” or “play” in the stock market).  And there are limits on how much someone can lose.  The Act uses “income or net worth” in setting limits, which will allow some retirees with over $100,000 saved to potentially risk the greater of 10% or $20,000.  Potential for fraud is restricted by investment limits, the fact that issuers need to use a broker or a funding portal*, and that said fraudsters need to give the SEC their name, address, etc. (generally not a good criminal plan, giving the Feds your personal info).  More importantly, the Act requires brokers/funding portals to ask and receive answers from the investors, making sure they understand the risks.  I’m pretty sure that no other group of investors have to pass a quiz before they can invest.  That’s a lot of work for something that should be understood as allowing the Average Joe to invest $100 in a company a few times a year.

Crowdfunding will be good for the little guy start up.  Investors who decide to go into crowdfunding should do so understanding the risks, and should model themselves after angel investors, who often invest in a dozen companies in the hopes that one strikes it big. 

Crowdfunding will be fun and exciting, don’t get me wrong, and I intend to invest this way myself.  For some, it really will be a game changer, but only if the game is already really, really close. 

* This is really an aside: Funding portals and brokers acting as crowdfunding intermediaries will need to register with the SEC and register with an applicable self-regulatory organization.  There are already a few nascent organizations coming together to create a funding portal SRO.  Thus, these guys will face the type of serious and undoubtedly complex regulations not unlike those that broker-dealers already face.  In addition, if a funding portal wants to skip registration as a broker-dealer, it will need to be a member of a national securities association, which means a battery of tests and not-insignificant fees.  Most importantly, they will be exposed to all sorts of liabilities, which will make prudent portals wary of shady start-ups.  The net effect will mean that a crowdfunding boiler room will have a similiar likelihood of getting caught as any other, only for a lot less potential payout.

This post is a continuance of a series reviewing the JOBS Act.  For more on the registration requirement threshold shift from 500 to 2000 investors, click here.  For Jim's initial analysis of Crowdfunding, click here.  Check back later for a flushed-out analysis of Title I of the Jobs Act, which creates the "Emerging Growth Company" classification.   

Today’s the day! President Obama signed the JOBS Act in a Rose Garden signing ceremony today.  Most of the Act requires the SEC to weigh in, so there won’t be much immediate impact.  That said, effective today, “Emerging Growth Companies” - most companies with under $1 billion in annual revenues that have been public for less than 5 years - will be excluded from some of the SOX auditing requirements and Dodd-Frank corporate governance requirements that their older and bigger brethren are burdened by.  By one professor’s calculations, 94% of companies (excluding banks, savings and loans, and IPOs involving units) that went public between 1980 and 2011 had under $1 billion dollars in annual revenue.  I don’t know the exact legal threshold for “seismic regulatory landscape shift”, but I think something impacting 9 out of 10 IPOs probably does it.

That said, I promised to write about Titles II and IV of the JOBS Act today, and I’m a man who stands by his word. 

Title IV of the Act, Small Company Capital Formation, amends the curiosity that is Regulation A.  Unless you are Professor of securities law (my condolences if you are), you probably never heard of Reg A.  That’s because it was such a small exemption from the registration requirements under the Securities Act of ’33 that no one used it.  It was so unimportant that it doesn’t even have a Wikipedia page, making it less important than an individual episode of the Simpsons.  Regulation A is a safe harbor that lets small issuers avoid most registration requirements.  Before, the company was limited to raising $5 million in a year, so most companies relied on the limitless Rule 506 under Regulation D instead, even though Reg D came with a handful more restrictions on who you could sell securities to.  (Note that Reg D has its own wiki page.  Also note that its smaller than the Simpsons episode wiki.  I’ve already asserted that a topic’s importance can be gauged by it’s Wikipedia page so… QED: the Simpsons are more important than securities law?)  But now the limit is $50 million, which makes Reg A relevant for the first time.  But you start can’t handing out fliers about your $50 million dollar issuance under Reg A just yet, because the Act amends Section 3(b)(2) of the Securities Act of ’33, which states, “The [Securities and Exchange] Commission shall by rule or regulation….”  That means that you need to wait until the SEC gets around to revamping Regulation A. Sure, it seems as easy as just adding an extra zero to the current Reg A, but Congress didn’t give the SEC a deadline (not that they really matter: almost 70% of the Dodd-Frank deadlines were not met), so this could take a while.

A quick aside on the SEC’s take on the JOBS Act: they kind of seem to hate it.  Commission Aguilar and Chairwoman Shapiro both lambasted the Act when Congress was debating it.  Now that its law, they have been tasked with passing the necessary rules and regulations to enact the law.  First off, the SEC has been swamped with enacting Dodd-Frank, so the odds of them getting to the JOBS Act sometime soon are somewhat worse than the odds of the Pirates winning the pennant this year.  We are a long way off on seeing   Secondly, once they do make some rules, you can expect the SEC to only relent as much as the statute forces them. 

Title II of the Act will eliminate the prohibition on general solicitation on Rule 506 offerings under the Securities Act.  Before, companies using the Reg D exemption to do a private offering couldn’t use public advertising to sell their securities, or else they might be deemed a public offering.  Now they can, provided that they only sell shares to “accredited investors”.  The Act also amends Rule 144A under the Securities Act in a similar way, just replace “sell” with “resell” and “accredited investors” with “qualified institutional buyers.”   This provision is more of a stimulus package for the Wall Street Journal than anything else, coming out of the hides of some Wall Street law firms, who used to have plenty of work making sure that their clients weren’t engaged in “general solicitation.”  Now, an issuer relying on Rule 506 of Reg D can go shout it on the mountaintop that they are looking for one-percenters to buy their securities.  Congress gave the SEC a 90 day deadline to enact this change.  Title II should make it easier for companies using Rule 506 to stay in compliance, and "easier... to stay in compliance" means "cheaper, because of less lawyers fees."

Like I said yesterday, the JOBS Act isn't about jobs.  And it isn't about increasing the number of IPOs.  These two provisions, which make it easier for companies to raise money privately, makes that obvious.  Along with the changes to 12(g) of the Exchange Act, it'll be easier for small companies to stay private longer.  Notably, a bigger Reg A and easier-to-use Rule 506 means that angel investors will have an easier time cashing out of start ups.  

I joked a few weeks back about how no one could oppose something called the JOBS Act, but apparently I really was onto something.  The JOBS Act will reduce the fund-raising costs for many small- and mid-cap businesses.  That's not a bad thing, but its disheartening that it had to come under the guise of an IPO and employment booster.

Gail Collins weighed in on the JOBS Act today in a column glibly titled “The Senate Overachieves”.  Normally, I love her work – everything she does is glib, and I honestly feel there is a glib shortage in America – but this time I believe her winking nonchalance has descended into full-on flippancy.  Worse than that, I’m pretty disappointed that she couldn’t work into the column that Mitt Romney once drove to Canada with the dog strapped to the roof.  But I digress.

Securities regulation is a serious matter (and kind of my job).  That doesn’t mean we can’t have fun discussing it, but great zingers can only go so far.  Dismissing reforms because they let smaller businesses avoid excessively expensive auditing requirements makes sense, even if this means reducing (by a small amount) Sarbannes-Oxley’s reach.  Just because Sarbannes-Oxley and Dodd-Frank were passed to correct egregious regulatory gaps doesn’t mean that they cannot still overreach.  If anything, it makes just such overreaching more likely.

Crowdfunding does present a larger potential for hucksters to shill worthless stock.   But that is still fraud, and still illegal, regardless of the medium used to do it. 

For what it’s worth, I think a lot of securities regulation are misguided attempts to treat symptoms of the problems rather than the problems themselves.  So long as there are massive incentives to innovate new products and skirt regulatory requirements, firms will do so, and will pay their lawyers handsomely to make it happen within the confines of the law.

Rather, I believe that approaches towards fixing the fundamental flaws in the market must be addressed.  No recession or crisis will be caused by minimized auditing of mid-cap companies, or small start-ups raising a few hundred thousand over the internet.  As I noted in my last post, regulations that incentivize companies to stay small in order to avoid disproportionately larger regulatory burdens are counterproductive.

Instead, we need to work to realign the incentives of market participants with the incentives of the economy in general.  The Economist mentioned the interim Kay review last week, “it is easy to forget what the main economic functions of the equity markets are supposed to be.”  I agree with John Kay, the review’s author: the markets should promote long-term growth, not short-term profits.  And, for what it’s worth, Warren Buffet, Judge Richard Posner and Nassim Taleb, among others, also agree (oh my, am I clumsy! Just dropping those names all over the place!).

So, Gail’s barbed wit hit the wrong target this time, not unlike how some regulations aimed to prevent awful abuses end up frustrating legitimate businesses from growing.  The JOBS Act has its flaws too: the "emerging growth companies" that get to avoid some of the registration requirements of the '33 Act are defined to include companies with $1 Billion in revenue.  If you make $1 Billion, you aren't emerging anymore.  You've emerged.  But these call for sensible amendments, not lambasting the entire bill. 

Often, we are asked to consider assisting clients in obtaining funds for their start-up businesses.  Before asking for money, new businesses must have an understanding as to their business plan, need funding, and disposition of said funds. 

Accordingly, new businesses must develop an understandable business plan.  Further, these entrepreneurs must consider the amount of capital necessary for their goals before they seek money from those who may have an interest in their field.  Obtaining advice from a variety of persons is essential in formulating a plan to find capital.  Moreover, when approaching people, it is important to keep your presentation short, to the point and identify key team members.  Entrepreneurs should also be prepared to discuss what you are looking to do, the services or products offered, the competition, highlights of the business plan as well as possible investment terms.  This is not the complete package, but just the quick presentation.  Additionally, it should also be understood that the investor will, ultimately, want to exit the company, and contingency plans should be developed.

Finally, it should be expected that you will not get money right away.  It will undoubtedly take a long time to obtain funding, and you should be prepared for all eventualities.

Responding to numerous complaints, especially, regarding companies operating from the People’s Republic of China, the SEC has determined that it will tighten the listing requirements for companies involved in reverse mergers.  In particular, these new regulations will effect those companies listed on the Nasdaq, New York Stock Exchange, and the NYSE Amex. 

As many know, a reverse merger occurs when a shell company is acquired by a private company, and the two entities merge.  The SEC has estimated that since 2007, more than 600 of these “back door registrations” have occurred. 

The SEC had determined that obtaining reliable information from these types of entities, has not been easy.  In fact, the SEC was forced to suspend trading in many of these reverse merger companies since there was outdated or inaccurate financial information.  It is believed that, with these heightened requirements and the necessity to file the information prior to these companies becoming listed, the SEC will provide greater protections to investors. 

Now, with the new listing rules, these companies will have to endure a one year trading period in the over the counter market, or other U.S. or foreign regulated exchange after the reverse merger.  These companies will also have to provide additional financial and other records to the SEC prior to listing.  Further, the company will be required to keep a minimum share price for a period of time of at least 60 trading days before its application and listing are approved.  However, certain companies will be exempt from the new rules where the reverse merger companies are listing as part of a firm commitment underwriting, public offering or whose mergers occurred previously and where the company has already filed annual reports with audited financial information.

In sum, the SEC is cracking down on these reverse merger companies because it believes the companies are fraught with fraud.  Those wishing to conduct these types of transactions should be advised accordingly.

FINRA proposed a rule for SEC approval that would require FINRA’s membership, involved in a private stock offering, to provide detailed information on the transaction to investors prior to the sale, as well as to file such information with FINRA 15 days before the first sale.

This proposed Rule 5123 would require that offering materials used in these offerings, as well as the amount and type of compensation provided to a variety of people, be filed with FINRA.  Further, any amendments would have to be filed with FINRA within 15 calendar days after the date the document is provided to a current or prospective investor.  This new rule is also to be used in conjunction with Rule 5122, requiring certain disclosures in private placement offerings issued by the FINRA member or its affiliates.  Nonetheless, the proposed Rule 5123 would exempt certain types of private placements sold to certain purchasers, including, but not limited to, institutional accounts, qualified purchasers, qualified institutional buyers under the Securities Act of 1933, Rule 144(a), and investment companies.

In sum, FINRA is taking an aggressive approach on reviewing private placements, thus, this or some variation of this new rule is likely to be approved by the SEC.

We wanted to share with you a recently published article on broker-dealer registration enforcement.  Enjoy. 

http://apps.americanbar.org/litigation/committees/securities/email/fall2011/fall2011-tide-turning-against-sec-favor-finders.html