The Renewed Attack on Reg D: An FAQ

What is Reg D? Reg D sets up a system of rules that all in the startup financing ecosystem -- entrepreneurs, angels, venture capitalists and lawyers -- know, rely on, and self-police. The process is amazingly efficient, protects investors, and supports innovation, economic growth and jobs. It is a success story, of which our nation should be proud. Reg D worked to help angels and venture capitalists support startups throughout the financial crisis and has not let us down.

What is the renewed attack on Reg D? The renewed attack on Reg D is contained at Section 926 and Section 412 of Sen. Christopher Dodd's "Restoring American Financial Stability Act of 2010." The renewed attack has three offensives: 

• one, to stop startups and other private companies from closing on financings until the SEC or a state regulatory authority has reviewed a regulatory filing; 
• two, to end federal preemption of state authority over smaller financings (exact size and scope to be determined by SEC rulemaking) exempt under Rule 506 of Reg D; and
• three, to change the existing thresholds for "accredited investors" so that most existing angel investors can no longer participate in the private financing of startups and other private businesses.

I thought Sen. Dodd's bill was about ending federal preemption over Reg D offerings. What is this about a 120 day waiting period? Through Section 926 of his bill, Senator Dodd would end the ability of startup companies and other private issuers to raise funds in reliance on their own self-policing of Rule 506. Instead, startups and other issuers would have to wait or escrow funds potentially for 120 days or more, pending SEC and possible subsequent state regulatory review. It is true that there was no such review period under the prior version of Sen. Dodd's proposed legislation; the prior version left the notice filing system intact.

So now the SEC would review Reg D filings, and the states would come in only if the SEC failed to review the filings in 120 days? That is one way the states would have jurisdiction over Reg D offerings under Sen. Dodd's bill. Another feature of Section 926 of Sen. Dodd's bill, however, would permit the SEC to determine, by rulemaking, that some offerings are too small in size or scope for Reg D exemption, and should be returned to the regulatory authority of the various states.

Senator Dodd is retiring. Doesn’t that mean that his attack on Reg D is dead? No. Sen. Dodd's bill was approved by the Senate Banking Committee on March 22, 2010, and now goes to the full Senate for consideration.

Is there something wrong with the current startup financing system, that requires this reform? No. As noted in a recent letter from the Angel Capital Association to Senator Dodd, there is virtually no fraud among angel financings for startups. The system works, and there are good reasons that it should. If you claim the exemption fraudulently, then anyone can come after you, personally: the SEC; the relevant states whose resident investors are hurt (federal preemption never stopped the states from pursuing fraud); and the investors themselves.

Why is Reg D so important?  Reg D does not slow down capital formation, and speed is essential to startups. While you do indeed need to make a Reg D filing in connection with each offering, you can do so concurrent with or shortly after closing a first sale. States need to be notified, too, but can't impose "merit review" or otherwise slow down the capital raising process.

Is there a way to stop this? Yes. Individual senators may offer amendments to the bill. The Angel Capital Association and private individuals are working hard to contact senators to tell them of their concerns and to offer alternative changes to the law that would not devastate startup seed financings and angel investment in the United States.

Who would want to kill Reg D? For all intents and purposes, state "blue sky" registration and review of seed financings for startup tech companies ended in 1996, when the National Securities Markets Improvement Act preempted state authority over offerings meeting the criteria for federal exemption under Rule 506 of Regulation D. State securities administrators, speaking through an organization called NASAA, have long sought to repeal this federal preemption to restore their former authority.

How does imposing a 120 wait period help restore state authority that existed prior to 1996? It doesn't. This is supposition, but it may be that the 120 waiting period feature of Sen. Dodd's bill is one of those misbegotten attempts at compromise that pleases no one and fundamentally misunderstands the very purpose of a registration exemption. It is not clear that NASAA even wants this. Dow Jones Newswires reported that the president of the organization, Denise Crawford, acknowledges that a 120 day waiting period is too long.

Would there be another way to address abuses that state regulators are worried about? "Get rich quick" scam artists and ponzi scheme promoters have used Reg D to attempt to shield themselves from state jurisdiction, and this problem might be fairly addressed by legislation. However, rather than gut Reg D, which facilitates the safe and efficient formation of startup capital for tech and other entrepreneurs in this country and is not abused by the participants in this industry, the rules could be reformed to match the practice that works. For instance, SEC and state regulators could be further empowered to regulate offerings that may pay lip service to Rule 506 under Reg D, but don't actually meet existing Reg D requirements. If Reg D were clarified to underscore that an issuer must have a pre-existing business relationship with its investors, or to not allow federal preemption when broker dealers participate in a private seed financing, the current, successful and prevalent practice of the tech startup community would be preserved.

Why is the National Venture Capital Association ambivalent on this? Early this month, together with the ACA, the NVCA did write a letter to Sen. Dodd, protesting the attack on Reg D. Since then, the ACA and other angels, entrepreneurs, lawyers and individual venture capitalists have taken the lead. It may be that the NVCA will become more active on the issue as Sen. Dodd's bill is considered by the full Senate. Some believe that many venture capitalists still may think that the attack on Reg D is primarily an "angel issue," and will not impact venture capital firm financing rounds that materially (costs and delays for VC-led rounds would be more manageable). Furthermore, with most angels eliminated from the startup ecosystem, some perceive that VC firms will have more 'leverage" over entrepreneurs with regard to financing terms.

How can I help? 

• Learn more about the issue, and find links to important news articles and blog posts on this issue, at the Save Reg D website.
• Contact your senators and representatives in Congress and tell them of your concerns. However you may feel about financial regulatory reform in the United States, the provisions in Sen. Dodd's bill that attack startups, entrepreneurs and angel investors are not necessary.
• If you like, sign the petition against the attack on Reg D (widget link below).
• If you are an angel investors, see the resources on the ACA site and get involved, either through the organization, a regional angel group, or on your own.
• If you are a member of the NVCA, lobby the leadership of that group and let them know the NVCA should follow the instinct it had earlier this month and work for entrepreneurs on this issue.