You Can’t Tweet That

Can't tweet thatThere is a lot being written in the press and in the blogs right now about the SEC lifting the 80-year old ban on general solicitation of private companies’ securities offerings.

There is a lot of excitement about the possibilities.

We will soon be able to use Twitter, and Facebook, and Tumblr, etc., to seek investors for our startups, right?!

Well, not quite.

On the same day that the SEC issued the final rules lifting the ban on general solicitation, the SEC also issued proposed rules which are going to make the whole business of a private company securities offering much more complex and expensive.

You can read the PROPOSED RULES HERE

And you can comment on them HERE

One of the aspects of the proposed rules that hasn’t drawn a lot of attention in the blogs and press is the new legend requirement. What is a legend? A legend is a specifically required disclosure; frequently in all caps or bold, or called out in some other manner from other text in a document so that it is less likely to be missed.

For example, you might find on the top of your convertible note the following legend (this one from TechStars.com/docs):

    THIS CONVERTIBLE PROMISSORY NOTE HAS NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED. NO SALE OR DISPOSITION MAY BE EFFECTED EXCEPT IN COMPLIANCE WITH RULE 144 UNDER SAID ACT OR AN EFFECTIVE REGISTRATION STATEMENT RELATED THERETO OR AN OPINION OF COUNSEL FOR THE HOLDER SATISFACTORY TO COUNSEL TO THE COMPANY THAT SUCH REGISTRATION IS NOT REQUIRED UNDER THE ACT OR RECEIPT OF A NO-ACTION LETTER FROM THE SECURITIES AND EXCHANGE COMMISSION.

The SEC’s new rules on generally solicited offerings are going to require inclusion of lengthy legends in any written communication that constitutes a general solicitation or general advertising, “in a prominent manner.”.

These legends exceed 140 characters.

So, will you be able to use Twitter to seek out investors? It appears not, unless the SEC responds to comments of readers like you and revises its proposed rule.

Here is what the SEC’s proposed rules actually say:

An issuer shall include, in a prominent manner, the following legends in any written communication that constitutes a general solicitation or general advertising in any offering conducted in reliance on § 230.506(c):

  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.

Conclusion

What can you do if you don’t like this result? If you don’t want the SEC to come down in this way and prohibit the use of Twitter as a fundraising tool?

Submit a comment to the SEC. Don’t wait. The comment deadline will come sooner than you think (September 23rd, to be exact).

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Innovation Up In Flames

Your Idea (2)Thanks to the SEC, you may inadvertently blow up your next company.

Here is how it could happen.

You come up with an idea. You talk to some friends about it. They convince you to apply to pitch at an upcoming weekend pitch competition. A bunch of VCs, angel investors and other folks are going to be there.

You go and do your thing. Your pitch is well received, despite the fact that you didn’t know what you were doing. Some friends and other folks who are there helped you. It was great fun. A thrill.

A few weeks goes by. You have been receiving emails and some phone calls from folks who wanted to follow up with you. You knew you would need a lawyer, but not until you knew your idea could fly.

About two weeks later, one of the angels who attended the pitch event wants to invest, and you reach agreement with him on terms. The valuation is roughly what you suggested it would be in your pitch.

You call a lawyer. She asks you if you filed an Advance Form D before pitching at the public event. You wonder what the heck she is talking about. None of your friends in the startup community told you about any “Advance Form D” filing.

She tells you that since you didn’t file the form 15 days before you pitched, and didn’t cure your failure to file within 30 days after missing the 15 day advance filing deadline, you are screwed.

    “You are in the 1 year penalty box,” she says.
    “What do you mean,” you ask.
    “I mean,” she says, “that after this round you won’t be allowed to rely upon Rule 506, the most commonly used securities law exemption for startups, for a year after this round closes.”

You feel terrible. You wish someone had told you. You also wish the SEC hadn’t seen fit to put such a rule in place in the first place.

Epilogue

If you are new to the startup ecosystem, please be aware that it has always been illegal to generally solicit or advertise your private securities offerings. This has changed a little recently with the enactment of the JOBS Act and the SEC rules that have just come out in connection with the JOBS Act. However, as I wrote in a blog post recently published in the Wall Street Journal, generally soliciting or generally advertising your securities offering is fraught with difficulty. Always consult counsel before you proceed. Please don’t turn out like the character in this story. Do not assume the law in this context is easy. It is not, unfortunately.

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The Response: Astonishment

AstonishmentI was talking to a group over breakfast the other day about the JOBS Act and the new rules we hoped would soon be finalized regarding general solicitation (this was before the final rules came out). And I was summarizing the current rules. I got to the point in my presentation where I quote the current rule. The part that says companies relying on Rule 506 can’t “offer or sell” securities by any form of general solicitation or general advertising, including but not limited to:

    “Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

And I quoted the rule on my slide. The rule reads as follows (emphasis is mine):

    Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following
  1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
  2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

A person in my audience was surprised. “Wait a minute,” he said. “Doesn’t this happen all the time?”

My response was, “Well, it shouldn’t happen.”

But he was concerned. He was concerned that he had never heard this before. That maybe some of the angel groups he was participating in weren’t following this rule – that members of the general public were being invited to these meetings where companies were pitching. I suggested to him that it might be a good idea to remind any groups he was involved with about these rules.

Conclusion

The old rules are still the existing rules for companies trying to raise money in non-generally solicited offerings (which are known as 506(b) offerings). If you are a company trying to raise money in a Rule 506(b) (non-generally solicited offering) offering and you want to preserve your Rule 506(b) exemption, you cannot pitch your deal to angel groups if those angel groups invite attendees by any general solicitation or general advertising. I suspect this is one of the reasons companies are going to gravitate toward 506(c) offerings (i.e., generally solicited offerings), rather than 506(b), in the future.

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SEC Issues Proposed Rules Amending Reg D

Rules Amending Reg D

The SEC has issued proposed rules amending Regulation D and Form D.

The proposed rules are deeply flawed in that they will substantially increase the cost and complexity for startups trying to raise money.

How so? The proposed rules make it harder for companies to conduct both non-solicited and generally solicited offerings.

Congress, when it passed the JOBS Act, repealed the ban on general solicitation for all accredited investor offerings. But in doing so, it imposed one condition on companies—that they take additional steps to verify that purchasers of securities were accredited investors.

Originally, Section 201(a) of the JOBS Act simply instructed the SEC to repeal the ban on general solicitation for all accredited offerings, and did nothing more. In a hearing in the House, there was discussion, and a decision to add one sentence.

The one additional sentence was:

“Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

The SEC has now determined, in light of comments it received “and the magnitude of the change that the elimination of the prohibition against general solicitation represents to the Rule 506 market”, to re-legislate the deal.

I am pretty sure Congress understood the magnitude of what it was doing and it added one sentence and one sentence only.

Now, instead of just having to take “reasonable steps to verify that purchasers of the securities are accredited investors,” companies will have to do the following, under the proposed rules:

  1. Make myriad new Form D filings at different stages in an offering for all offerings.
  2. File in advance with the SEC all solicitation materials for generally solicited offerings.
  3. Prominently include lengthy legends in any written solicitation materials for generally solicited offerings (forget Tweeting, the legends are too long).
  4. Include substantially more information on Form D for all offerings.

You can find a description of these additional requirements in my last blog post.

Most unfortunate of all of these items, the proposed rules impose a 1 year prohibition on using Rule 506 in your next offering if you miss a 15 day filing deadline and don’t cure it within 30 days–or if you do cure the miss, you then miss another deadline in the same offering.

This 1-year penalty box provision will be a significant and scary trap for the unwary in the startup ecosystem.

Conclusion

The SEC seems to have forgotten the whole point: The JOBS Act was supposed to have made fundraising easier.

Instead, the rules, if adopted as proposed, will make it harder.

This is not what Congress intended. The SEC should re-visit its entire premise behind issuing these new proposed rules. The proposed rules do not reflect the deal Congress made when it passed the JOBS Act.

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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.

Posted in Financings, Startup Law | Tagged , , , , , | 17 Comments