Proposed Rules Hard On Startups

Proposed Rules

Remember that old saying, “Be careful what you wish for, because you just might get it?”

Well, that’s sort of how I feel about the SEC’s new rules (see here: http://www.sec.gov/news/press/2013/2013-124.htm).

All the lobbying to change the law sort of backfired on us.

Sure, under fairly restrictive conditions we will now be able to advertise our 506 accredited-only securities offerings. But our “win” came at a price.

To compensate for the perceived additional risks to investors, the SEC has proposed a raft of new rules that are going to make all Rule 506 offerings (the most common type of private company securities offering) harder and the penalties harsher if you miss myriad filing deadlines, whether or not you advertise.

Can we make it easier on startups trying to raise money? Apparently not.

Bad Actor Due Diligence Now Required In All 506 Offerings

The first significant new wrinkle that now arises in every single Rule 506 offering, whether or not you advertise?

“Bad actor” disqualification due diligence.

Bad actor due diligence is now going to have to precede all 506 offerings, whether or not you are doing a generally solicited offering.

What are “bad actor” disqualification requirements, or “bad boy” provisions? In the words of the SEC:

“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.

http://www.sec.gov/rules/final/2013/33-9414.pdf

Prior to Dodd-Frank, bad actor disqualification wasn’t something startups had to worry about. Prior to Dodd-Frank, bad actor disqualification didn’t apply to Rule 506 offerings. Now it does.

What will this due diligence entail?

First you are going to have to identify all of your “covered persons.” Then you are going to have to undertake a factual inquiry as to whether they are “disqualified persons” or not.

The punch line of the new bad actor rules is that you are not going to be able to avoid doing due diligence on all of your “covered persons.” You are actively going to have to investigate those folks and make sure that none of them are “bad actors,” prohibiting you from using Rule 506.

The reason you are going to actively diligence all of these folks? Because if you find out later that someone was a bad actor, to preserve your securities law exemption you are going to have to be able to show that you did not know, and in the exercise of reasonable care, could not have known, that a disqualification existed. The SEC has this to say in the instructions

“An issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist.”

In other words, if you did not conduct a factual inquiry, you will not be able to establish that you exercised reasonable care, and your securities law exemption will be lost. This is not a position in which you want to find yourself.

Disclosure of Prior Bad Acts

Is there a silver lining to the new bad actor rules? Sort of, but not really.

The new bad actor rules won’t disqualify you from relying on Rule 506 if a triggering event occurred prior to the effective date of the new rules.

Disqualification will only apply for triggering events that occur after the effective date of the amendments.

However, pre-existing matters will be subject to mandatory disclosure to investors.

Timing of Bad Actor Due Diligence

For companies raising funds right now in 506 offerings that may not close in full in the next 60 days, now is the time to start your bad actor due diligence. There is no grandfather period. The rules will go into effect in approximately 60 days.

As the SEC said in the final rules:

“issuers and other offering participants will need to make reasonable factual inquiries during this 60-day period…”

Myriad New Filing Requirements and Penalties

Regardless whether you are doing a generally solicited 506 offering (now known as a 506(c)) or an old fashioned Rule 506 (now known as a 506(b)), under proposed rules you are going to have to be hyper-vigilant on the timeliness and completeness of Form D filings.

It used to be that if you filed a Form D late, it didn’t necessarily cost you anything. Under the new rules, it can cost you 506 eligibility for one year on your next financing–automatically! This is a harsh penalty. Companies are going to have to be hyper-vigilant, lest they suffer this potential death sentence.

Required Form D Filings

Under the proposed rules, there will be bunches of new filings required, and harsh consequences for failure to comply.

  1. Under proposed rules, an Advance Form D will be due no later than 15 calendar days in advance of the first use of general solicitation in a generally solicited offering. The Advance Form D filing will not have to include all of the information required by Form D, but only certain items. The reason for this is that some of the items may not be known at the time of the filing of the Advance Form D filing.
  2. After the filing of an Advance Form D, under proposed rules you will be required to file an amendment providing any remaining information required by Form D (that didn’t appear on the Advance Form D) within 15 calendar days after the date of the first sale of securities in the offering. For this purpose, the date of first sale is the date on which the first investor is irrevocably contractually committed to invest–which would normally be the date on which the issuer received the investor’s subscription or check.
  3. A Form D in a non-generally solicited offering must be filed no later than 15 calendar days after the first sale of securities in the offering.
  4. You will have file an amendment to a previously filed notice:
    • to provide the information required by Form D for each new generally solicited offering no later than 15 days after the first sale of securities in the offering (as indicated above);
    • to correct a material mistake of factor or error in the previously filed notice, as soon as practicable after discovery of the error or mistake;
    • to reflect a change in the information provided in the previously filed notice, except as provided below, as soon as practicable after the change;
    • annually, on or before the first anniversary of the most recent previously filed notice, if the offering is continuing at that time; and
    • no later than 30 calendar days after termination of the offering.

If I Miss, Can I Cure?

There is a 30 day cure opportunity if you miss a deadline. But you only get to use the cure once per offering!

Remember this–it is like a line out of a bad science fiction movie–”You only get to use the cure once per offering.”

Rules For Generally Solicited Offerings

If you want to conduct a generally solicited offering, here is a list of some of the things you will need to do:

  1. You will have to file the Form Ds and amendments as summarized above.
  2. You will have to include prescribed “legends” in any written communication that constitutes general solicitation (see below).
  3. You will have to submit any written general solicitation materials used in the offering to the SEC no later than the date of the first use of the materials.
  4. You will have to take additional steps to verify that your investors are accredited.
  5. You will have to undertake bad actor due diligence.
  6. You Form D will have to indicate additional information, including, for example:
    • That you are relying on Rule 506(c).
    • The signature block of the Form D will contain a certification where issuers will confirm that the offering is not disqualified due to a “bad actor.”
    • Methods used to verify accredited investor status.
    • Additional information summarized below.

The Legends

In “any written communication that constitutes a general solicitation or general advertising”, these “legends” have to be prominently displayed.

  1. The securities may be sold only to “accredited investors,” which for natural persons are investors who meet certain minimum annual income or net worth thresholds;
  2. The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;
  3. The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;
  4. The securities are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities; and
  5. Investing in securities involves risk, and investors should be able to bear the loss of their investment.

Given the length of these legends, there is not going to be any Tweeting for investors.

What If You Don’t Want To Generally Solicit?

What if you don’t want to do a generally solicited 506 offering? Instead, you want to do it the old fashioned way?

You’ve got to be religious about not blowing the prohibition on general solicitation–which still exists for non-generally solicited offerings.

You can’t, among other things:

  • Put on your web site that you are raising money.
  • Post in social networks that you are raising money.
  • Pitch at public events.
  • Let a reporter wrote a story about your fundraising efforts.

It is perhaps a perverse effect of the new rules that many startup are just going to file Advance Forms D and check the 506(c) box to avoid the risk of trying to do a non-solicited offering and blowing it.

Form D To Require More Info

But wait, it gets better. Form D is not going to be so easy to complete anymore. Instead, the forms are going to require a significant amount of time and effort to complete.

New information to be provided includes, among other things:

  • Information about each person who has functioned directly or indirectly as a promoter of the issuer within the last five years of the first sale of securities or the date on which the Form D was required to be made, whichever date is later.
  • For generally solicited offerings, information about each person who directly or indirectly controls the issuer.
  • The revenue range for the issuer. If you have not otherwise made this information publicly available (for example, in general solicitation materials for an offering conducted in reliance on Rule 506(c)) and if you otherwise use reasonable efforts to maintain the confidentiality of such information, you can enter “Not Available to Public.”)
  • The issuer’s aggregate net asset value. If you have not otherwise made this information publicly available (for example, in general solicitation materials for an offering conducted in reliance on Rule 506(c)) and otherwise use reasonable efforts to maintain the confidentiality of such information, you can enter “Not Available to Public.”
  • You now have to indicate whether your Form D filing is a:
    • new notice
    • an advance notice for an offering in reliance on Rule 506(c)
    • an amendment to a notice that was filed previously, or
    • a closing amendment for an offering in reliance on Rule 506
  • You will have to provide more detail on use of proceeds.
  • For generally solicited offerings, you will have to indicate each type of general solicitation and general advertising used or to be used in the offering.
  • For generally solicited offerings, you will have to indicate each method used or to be used to verify that the purchasers are accredited investors.

Consequences

You will be disqualified 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 all the Form D filing requirements in a Rule 506 offering.

Note the use of the word “affiliate” here. And the requirement of disclosing who controls the issuer. What does this mean? If you blow deadlines, you are not going to be able to escape by forming a new company.

You get one 30 day reprieve: Meaning, you can be late once, and if you fix it within 30 days, you will still be ok. But if you don’t catch it within 30 days, or if you catch it but blow another deadline–you will be automatically prohibited from using 506 on your next offering for a year after your current offering ends.

Conclusion

For now, we are discussing mostly proposed rules (e.g., the bad actor rules are final). There is still time to send comments to the SEC highlighting the burdens and traps built into the rule.

If the rule is adopted, then to make sure you don’t blow these deadlines, or fail to fill out forms correctly, you are going to have to spend a lot of time and money with your lawyers. This is truly unfortunate.

Congress and the SEC should either moderate the proposed rule to make if friendlier to all issuers, or consider a “startup-lite” version of these rules. For companies raising less than $1M, and not generally soliciting, how about not requiring any filings at all?

All of these new filing requirements are going to increase the cost of offerings to startups, creating an unfortunate consequence, despite the fact that one of the hoped-for results of Dodd-Frank was the easing of regulatory burdens on startups.

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  • Gary Jay Brooks

    An you tell me exactly “what” or “how” you would handle “bad actor due diligence”? Do you run a report with some company? What is the tools you would use, or can you minimize how much diligence you have to do with making up your own process?

    • Joe Wallin

      Gary, great question. In the SEC release the SEC talks about some different methods. In the end they conclude: “As a result, we do not believe it is appropriate to prescribe specific steps as being necessary or sufficient to establish reasonable care.”

      It is going to vary by company. I think something like a D&O questionnaire could be a good starting point.

      • Gary Jay Brooks

        Thanks Joe, sounds like I can run a background check and off to the races.

        • http://startuplawblog.com/joewallin Joe Wallin

          You could ask the person to fill out a questionnaire…

          • Gary Jay Brooks

            Wonderful :) Everyone loves the honor system.

          • Alexander Davie

            Do you think a questionnaire would suffice? It’s not just the SEC we need to worry about. I could see a plaintiff’s attorney litigating a private rights of action asking in a deposition “And you didn’t think to check the public records to verify his responses to the questionnaire?”

            In civil litigation, it is the burden of the issuer to prove that it has complied with all aspects of an exemption. Otherwise it’s strict liability for selling an unregistered security.

          • Joe Wallin

            I agree. I think a questionnaire is a good start.

  • http://LinkedIn.KentonHJohnson.com/ Kenton H Johnson

    The new SEC rules countering Adv “problems” seem to focus on 506 — are 505 and 504 affected at all?

    • http://startuplawblog.com/joewallin Joe Wallin

      Kenton, I have been focused on 506, because that’s what my practice revolves around. I haven’t yet looked at the 504 and 505 implications.

      • http://LinkedIn.KentonHJohnson.com/ Kenton H Johnson

        Looks like 505 has some of the Bad Actor provisions, and 504 doesn’t, but the rest of the reporting requirements and deadlines need to be researched, and hopefully become similar

  • http://LinkedIn.KentonHJohnson.com/ Kenton H Johnson

    In the document http://www.sec.gov/rules/final/2013/33-9414.pdf above, there seems to be some confusion on what can be affected during by comments, before the Effective Date: [insert date 60 days after publication in the Federal Register - 7/10/13].

    The following was just recently inserted into that document:
    Comment Date: Comments regarding the collection of information requirements within the meaning of the Paperwork Reduction Act of 1995 should be received on or before [insert date 30 days after publication in the Federal Register 7/10/13.], BUT according to the office listed in the document, this ONLY applies to the paperwork NOT the rules.

    So comments re the burdens and traps built into the rule may not have any affect, and we are stuck with the rules as written? (That’s US regulators trumping democracy for you.)

    • http://startuplawblog.com/joewallin Joe Wallin

      Yeah, the bad actor rules won’t technically go live until 60 days after they are published in the federal register.

      • http://LinkedIn.KentonHJohnson.com/ Kenton H Johnson

        You are very responsive, thank you. Let’s go a little deeper on this one, though:

        1) They just inserted the 30 comment restriction
        2) It only has to do with the paperwork burden, not the nature of the restriction, according to one senior person at the SEC office issuing this edict.
        3) So the conclusion is that not much will change

  • CLeyerle

    I suppose it is too much to expect that the SEC would maintain and publish a list of bad actors? One might think that, to the extent the SEC initiates enforcement, or provides documentation in an action, that they are perfectly poised to know who the bad actors are. If the JOBS Act is to be anything other than a boon for lawyers and Wall Street (and an impediment to entrepreneurs) then the SEC should add such a list to its collection of documents and records available to the public. As this stands, in the same way most of us will have to hire others to verify accreditation, we will also have to hire help for the bad actor due diligence. Such additional process and costs are exactly opposite to what is needed and to what all those big name entrepreneurs thought they were getting when they went lobbying in DC.

    I’m in the middle of a 506 offering now. Guess it’s time to trot out some convertible notes with hefty discounts so I can accelerate this thing to a close within the next 60 days before the circus starts.

    Thanks for keeping us apprised Joe, and congrats on the growing (and well-deserved) national recognition of your expertise.

    • Joe Wallin

      Chris, I am encouraging everyone to write comment letters to the SEC. Comment letters matter. In fact, the SEC says the reason it is proposing these ridiculous new rules is in part because of the comments it received!

  • Richard Rodman

    Although this may make a few more steps for issuers, it will ultimately make more opportunity for new solutions, new aids, and new startups. Although this could just be my overly optimistic attitude…

    • Joe

      That is optimistic and a good thought pattern for things that you can’t control But with that logic, we should lobby for more filing requirements and complications. It will be great because it will create jobs.

 
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