The SEC’s New Quasi-IPO … Bad Boys Excluded

This piece was initially posted on Tumblr on August 15, 2013; it is reposted here. ©David Jargiello 2012-2016 All Rights Reserved.

On July 10, 2013 and with much ado the Securities and Exchange Commission issued two sets of final rules that will greatly alter the startup funding landscape:  Release No. 33-9415 (“Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings”) and Release No. 33-9414 (“Disqualification of Felons and Other Bad Actors from Rule 506 Offerings”).  As Upstart notes, the new rules “have the operators of crowdfunding sites giddy.”  Upstart Business Journal, July 11, 2013.  For what I think is the best overall review see TechCrunch, July 10, 2013.

Thoughts follow.

A – Primer

Section 4(a)(2) (the old “Section 4(2)”) of the Securities Act of 1933 (the “33 Act”) exempts transactions by an issuer “not involving any public offering” from the burdensome registration requirements of Section 5 thereof.  Any startup raising money by selling stock (or something that looks like stock) must therefore do one of two things … (1) file a registration statement (aka “go public”), or (2) find an exemption from the legal requirement to do so.  Venture capital securities law practice is thus in large part an exercise in finding the correct “exemption from registration” and structuring a venture capital fundraising transaction accordingly.

As a technical legal matter, “Regulation D” is a set of rules created by the SEC to effect such “private placements” and creates three basic exemptions from registration … Rule 504 (summary here and rule here), Rule 505 (summary here and rule here) and Rule 506 (summary here and rule here).  For rules geeks, the Regulation D issuing release (“Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers and Sales”) is at SEC Release 33-6389, or 47 Federal Register 11, 251 (March 8, 1982), or 1982 WL 35662.

B – Practicalities

Of those three exemptions, Rule 506 dominates the capital raising landscape.

The SEC estimates that Rule 506 accounts for 90 to 95% of all Regulation D offerings by number of deals (Release No. 33-9414, at 4-5) and approximately 99% of the absolute dollars raised in private placements generally.  Release No. 33-9415, at 64.  To the latter point, the SEC further reports from issuer filings that operating companies raised approximately $71 billion and $173 billion in “Rule 506 deals” in 2011 and 2012, respectively.  Release No. 33-9415, at 64-65.  Likewise, venture capital funds and private equity funds – which also rely on Rule 506 in their fundraising – raised approximately $778 billion and $725 billion in “Rule 506 deals” in 2011 and 2012, respectively.  Release No. 33-9415, at 64–65.

Rule 506 is therefore both the workhorse of venture capital financings and the “Big Boy” exemption, i.e., companies can, in a Rule 506 deal, (1) raise a theoretically infinite amount of money, from (2) a theoretically infinite number of “accredited investors.”  As the SEC notes

Under existing Rule 506, an issuer may sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors” … and to no more than 35 non-accredited investors who meet certain ‘sophistication’ requirements.  Release No. 33-9415, at 6-7.

The two basic mechanical limitations on Rule 506 fundraising are the rules regarding disclosure of information (required) and solicitation of investors (prohibited).

Regarding disclosure, if all of the investors in a Rule 506 deal are “accredited investors,” then there are no specific disclosure requirements … the company must simply provide such information as may be required by the (always applicable) antifraud rules.  On the other hand, if any of the investors a Rule 506 deal are not “accredited investors” (i.e., if any of them are what the rule calls merely “sophisticated”) then there is a detailed matrix of business and financial information that must be provided to all investors.  Think “private placement memo with exhibits.”  From a disclosure standpoint, the practical result is that most venture capital Rule 506 deals are “accredited investor”-only affairs.

Conversely, the public advertisement of any Rule 506 deal – whether it is of the “accredited-only” sort or not – has been expressly forbidden for decades …

“The availability of Rule 506 is subject to a number of requirements and is currently conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of ‘general solicitation or general advertising.’  … [E]xamples of ‘general solicitation and general advertising,’ including advertisements published in newspapers and magazines, communications broadcast over television and radio, … [advertised] seminars … [as well as any] other uses of publicly available media.”  Release No. 33-9415, at 6-7.

C – The New “With or Without” Regime

One of the things the Jumpstart Our Business Startups Act (the “JOBS Act”) did was require the SEC to eliminate this prohibition against ‘general solicitation’ for offers and sales of securities made to “accredited investors” under Rule 506.  To implement the JOBS Act mandate, the new SEC rules do three basic things:

**First, the SEC has kept the current Rule 506 exactly as is and re-numbered it “Rule 506(b).“ Thus, venture capital financings can still be done the “old way,” i.e., a company can (1) raise a theoretically infinite amount of money, from (2) up to 35 “sophisticated” investors and a theoretically infinite number of “accredited investors,“ provided that (3) there is no ‘general solicitation,’ and provided further that (4) the disclosure requirements described above are met.

**Second, the SEC has created a new Rule 506(c) that eliminates the ban on ‘general solicitation.’  Thus, venture capital financings can now be conducted in a “new way,” i.e., a company can (1) raise a theoretically infinite amount of money, from (2) a theoretically infinite number of “accredited investors,” who have been (3) contacted via any available means of ‘general solicitation,’ provided that (4) the company “takes reasonable steps to verify that [the investors] are ‘accredited investors.’”  Although the Staff gives guidance on the nature of such “reasonable steps,” presumably best practices will evolve over time.

**Finally, the SEC has created a tracking mechanism for “old” vs. “new” style deals. Thus, whether a company chooses the “old way” (without ‘general solicitation’) or the “new way” (with ‘general solicitation’) must be indicated in a “check the box” manner on the SEC’s customary form for Regulation D deals (“Form D”).

D – Observations

(1)  Why Keep The “Old” Rule? 

According the SEC, the “old rule” was kept for several reasons:

(a) – Some companies may not want to advertise their financing to the public for business reasons (e.g., the existence of an already established investor base, or operation in stealth mode);

(b) – Some companies may not want to advertise their financing to the public in order to avoid the ambiguous new requirement to take “reasonable steps to verify” the “accredited investor” status of purchasers; or

(c) – Some companies may want to issue shares to non-accredited investors who meet the Rule 506 “sophistication requirements,” i.e., do a non-accredited deal.

Makes sense.  Good rulemaking IMO.

(2)  No Bad Boys.

In what the SEC calls an effort to “preserv[e] the integrity of the Rule 506© market and minimize[e] the incidence of fraud,” at the same time it adopted the new Rule 506© it extended the “bad actor disqualification” to cover such transactions.  In the SEC’s words

“Bad actor” disqualification requirements, sometimes called “bad boy” provisions, disqualify securities offerings from reliance on exemptions if the issuer or other relevant persons (such as underwriters, placement agents and the directors, officers and significant shareholders of the issuer) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.  Rule 506 in its current form does not impose any bad actor disqualification requirements.”  Release No. 33-9414, at 7-8.

Acting under authority granted by the Dodd-Frank Wall Street Reform and Consumer Protection Act (summary here and statute here), the SEC has barred any company from using either the “old” Rule 506 (without ‘general solicitation’) or the “new” Rule 506 (with ‘general solicitation’) if (1) any director of the company, (2) any executive officer of the company, (3) any other officer of the company participating in the financing, (4) any 20% stockholder of the company, (5) any promoter, broker, dealer or “finder” associated with the financing, or (6) certain others, are “Bad Boys” (i.e., have been convicted of any one of a long list of  enumerated crimes or disciplined for violating a host of different rules related to the sale of securities).

Good rule, IMO overdue.

(3)  Cottage Industry

Although I would quibble with the use of the term “whale” in any securities law context, TechCrunch correctly notes that the ability to openly solicit startup investors “will fuel a new cottage industry of investor matching-making sites that aim to broaden the investment pool to financial whales …”  Casino lexicon aside, point taken.  Matching capital seeking advertisers with accredited ‘advertisees’ will no doubt be big business.  Likewise, stand by for a host of practice pointers on the business and legal side for what constitutes a “reasonable” set of steps to “verify accredited investor” status.

Net:  Overall, “Wait and See.”  The mechanics of a “solicited Rule 506(c) deal” will evolve in two respects … (1) the logistics of matching investors with companies and confirming accredited status to the satisfaction of the rule, and (2) the nature of third party legal opinion practice (if any) in the context of these quasi-public offerings.

(4)  Rolling The Dice

On the subject of “financial whales,” I continue to marvel at the use of gambling analogies to support the “democratization” of venture capital investing, be it through equity crowdfunding or solicited Rule 506(c) deals.

For example, regarding the JOBS Act generally …

“Americans are allowed to gamble unlimited amounts at casinos … [y]et are legally prevented from making even modest investments in job-creating small businesses.”  Sen. Scott Brown (R-MA), in Wired, November 30, 2011.

“[G]ambling is legal in parts of the United States and has seen expansion recently thanks to promises of increased tax revenue for participating states.  [In Ohio we] also have a robust lottery that allocates millions of dollars to schools and public projects.  My chances of winning the lottery jackpot in Ohio?  1 in 13,983,816.  The house always wins.  The argument that equity crowdfunding is too risky for the average investor is a bogus narrative.” Crowdfunder Charles Luzar, in VentureBeat, October 6, 2012.

And today regarding the new ability to solicit private investors …

“People go to the casinos every year and spend over $49 billion without any limitations.” Crowdfunder Alejandro Cremades, in support of the new Rule 506(c), in Upstart Business Journal, July 11, 2013.

For my part, I think such gambling analogies are deeply misplaced.  “Car Czar” Steven Rattner is closer to the mark …

“Its enticing acronym notwithstanding, the JOBS Act has little to do with employment; it is a hodgepodge of provisions that together constitute the greatest loosening of securities regulation in modern history.  …  For the first time, private equity [funds,] hedge funds [and startups] will be able to advertise — and thereby separate inexpert individuals from their savings.  … I’ll wager that most of this new advertising will come from firms that sophisticated institutional investors wouldn’t consider investing in … The largest number of jobs likely to be created by the JOBS Act will [therefore] be for lawyers needed to clean up the mess that it will create.”  A Sneaky Way to Deregulate, NYTimes Opinionator, March 3, 2013 (emphasis added).

In a word, yep.  See “Lawyering Up For The JOBS Act.

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