William Carleton, Counselor @ Law

Hey Crowdfunding Fans: Get Congress to Democratize the Existing Laws!

Note from Bill: This is a guest post from Joe Wallin. I really appreciate Joe sharing his views here because he's bringing ideas to the debate that I think crowdfunding advocates should hear, think through, debate, and fold into their advocacy.

Dear Crowdfunding Advocates & Enthusiasts:

It is great that you are excited about the crowdfunding proposals being kicked around Congress. I too am excited about the prospect of crowdfunding becoming legal in the new year.

Making Crowdfunding Legal Is A Great Idea

Crowdfunding is a great idea. It would be great for companies to be able to easily raise small amounts of money from hundreds or even thousands of small investors over the Internet or through other public means, legally, and without having to spend fortunes in legal and accounting fees complying with legal and regulatory mandates at both the federal and state level.

Today, companies don't need to raise huge sums of money to build what could be the next great mobile game or software or other product, resulting in a company that could employ many people. Our laws should be changed to allow entrepreneurs to democratize the funding of these enterprises.

The Trouble With Current Crowdfunding Proposals

The trouble with the current crowdfunding proposals? I don’t think Congress is going about making crowdfunding legal in the right way. And I think that it is wasting precious time fuddling with various and competing proposals that ultimately won’t work when it could easily and should be able to quickly change existing law to achieve the goals we all share.

What Existing Laws Could Easily Be Slightly Changed To Achieve Our Goals?

What existing laws could be changed to achieve our goals? All we need to do is amend Rule 506 of Regulation D to do the following:

• allow general solicitation;
• allow non-accredited investors to investors in Rule 506 offerings without triggering Rule 506’s onerous information sharing provisions even if non-accredited investors are involved--so long as the non-accredited investors invest less than $1,000 (or pick your number) a piece and the total raised from non-accredited investors is less than $1M (or pick your number).

Why is this better than what is currently being proposed? Because it is simpler. Simpler is not always but is frequently better. Let's look at what is currently happening with crowdfunding proposals in Congress. There are multiple, competing crowdfunding legislative proposals proposed. Each is complex. It is unclear which one will emerge as the consensus appraoch. And even if one of them passes, it will likely be years before the regulations are adopted and everything is in place to allow them to be used readily. The likely outcome of all this effort is that nothing will get passed (or that that what will pass will be unusable), and us crowdfunding advoicates will have nothing to celebrate.

What Could Congress Do Instead?

Instead of trying to pass a new, complex law, Congress should just improve upon what is already on the books. I am referring to Rule 506 of Regulation D, the securities law exemption most widely used by startups.

Rule 506 works. And one of the reasons it is so widely used is because of federal preemption. It is unclear how new crowd funding rules and regulations will work with state law. They very well may give state regulators significant authority over crowd funding financings. This may make crowd funding just impractical--look at how well Rule 504 doesn’t work (and how rarely it is used because of the lack of federal premption). In other words, the new proposals may not work as well with state law as Rule 506 does--which could render them not nearly as usable as we all hope them to be.

What Should Congress Do?

Congress should just fix the laws currently has in place. That would actually work. And it could work immediately. Specifically, Congress should make Rule 506 usable in the crowd funding context. How?

1. Remove the ban on general solicitation--period; for all offerings. Allow companies to advertise for funds on their web sites. On the Internet. Everywhere.
2. Reduce the financial threshholds to qualify as an accredited investor. Consider reducing them to really, really low threshold amounts.
3. Allow non-accredited investors to invest in Rule 506 offerings as long as non-accredited investors don’t invest more than $1,000 per offering or $1M in the aggregate.
4. Repeal the ridiculous and onerous new bad actors rules and regulations.
5. Allow “sophisticated” investors to qualify as “accredited investors.” What do I mean by this? Perhaps a test administered by the SEC, or NASAA, that once investors pass allows them to check the box that they are accredited. This “test” would essentially educate potential investors about the risks and the likelihood that they are going to lose money.

I hope that in the new year Congress will see fit to pass laws which actually make life easier for entrpreneurs and startup companies. I have a long list of suggestions I have made in this regard, that you can read about on Quora here. 

Photo by S.S.K.

Joe Wallin is a startup and emerging company attorney who practises law at the Davis Wright firm. He blogs at Startuplawblog.com and is Bill's fellow Seattle Dude behind the Startup Trivia app.

SEC 2011 Forum on Small Business Capital Formation

The following is a (more or less) speaker-by-speaker summary of the two morning session panels at the SEC's 2011 "Government-Business Forum on Small Business Capital Formation." Great stuff here. Crowdfunding, general solicitation, reforms to Reg A - all that. It got feisty over the question of whether the lack of a robust IPO market is all that bad. Is continued expansion of private capital formation the future? (If so, if the focus of reform today is on making exemptions broader to facilitate more private capital formation, no doubt more attention on secondary trading will follow.)

10AM Pacific/1PM Eastern
The forum is breaking for lunch.

The afternoon activities are breakout sessions, not webcast, so I will sign off for now.

950AM Pacific/1250PM Eastern
SEC Commissioner Troy A. Paredes is speaking now. He seems to support the private capital formation reforms (repeal prohibition on general solicitation, expand Reg A, promulgate a crowdfunding exemption) discussed this morning and also sounds themes on easing the path to going public.

940AM Pacific/1240PM Eastern
There is some back and forth now on "preparing the market" and relaxing restrictions on pre-offering communication.

Hogoboom has a contrarian view on eliminating the general solicitation prohibition. Again, this is stream-of-paraphrase:

"I heard what the person from Silicon Valley said. There's a lot of things that happen on the West Coast that wouldn't play well in New York and elsewhere. If people are allowed to make general solicitations, then I don't know who is saying what to who and how many. All those others [solicited but not allowed to invest] told how great an investment it was, they are going to be seeking that stock in the secondary market" about companies for which there is little public information available.

I would presume that Hogoboom likes the paradigm of keeping information close, then disseminating it, making it open to everyone at once, through 8-Ks.

910AM Pacific/1210PM Eastern
Stream-of-paraphrase/quotation here, of John D. Hogoboom, a securities lawyer in New Jersey:

"I think Professor Coffee nailed it. I've spent 25 years as a securities lawyer. There is not some enormous pent up demand for people to do IPOs that have not been able to do them. It's a shame that the dot com bubble burst like it did. But there are a lot of investors running scared who do not want to put money into an IPO situation."

His theme is challenges faced by smaller public, not private, companies. His materials here.

910AM Pacific/1210PM Eastern
Kathleen Weiss Hanley of the SEC now speaking. More data on IPOs. Reg D is beginning to overtake public debt as means of financing.

9AM Pacific/Noon Eastern
ThinkEquity CEO just spoke. I apologize but I was distracted. His materials will be posted later, I think I heard? Here is a link to the page where I am getting links to the various presenter materials.

845AM Pacific/1145AM Eastern
Professor John Coffee starts by rebutting David Weild. He says the goal should not be to bring back the smaller IPO. The goal should be for the SEC to help the entrepreneur raise money in an efficient manner, while also maintaining appropriate investor protection. The future will remain with Reg D, private placements, and smaller capital raising mechanisms.

""Build it and they will come." May be true for baseball, not necessarily so for capital markets. Coffee thinks entrepreneurs are making a rational choice to forego going public. Part of it is that relaxation of 144 and other restrictions make liquidity, which before had been the more exclusive province of being public, more available to private companies.

"IPOs didn't decline slowly, they want off a cliff . . . A drop that sharp can't just be slow erosion."

Amounts NOT raised in IPOs are offset by the explosion in amounts raised under Reg D. 37,000 offerings, median size around $1 million. 37 Reg D filings a day - and that doesn't show everything that is happening because of the reliance on 4(2). (Sorry, I missed the period of time covered by these stats. Should be in his paper that is provided online?)

In brief, Coffee's views on other points discussed today:

On the general solicitation prohibition: "A vistigial appendix . . . I don't think it has any significant function."

On moving Reg A from $5 million to $50 million: good move; does not remove SEC oversight.

On crowdfunding: "A catchy, fashionable idea, tweeting for investors." As drafted now, should it pass, then we will see, every night in every bar in America, a Danny DeVito-figure hawking securities. "It would add some stigma to the securities marketing process."

Bottom line: Coffee thinks exemptions are the present and are the future; thinks they can even be improved to make things easier for entrepreneurs. But don't create overbroad exemptions, he urges.

Coffee was speaking from prepared remarks, too, but they were obviously his and he delivered them with personality, gusto and good humor.

830AM Pacific/1130AM Eastern
Stunting the IPO market puts the entire public market into systemic decline, says David Weild of Grant Thornton. His diction and syntax are at once aggressive and impersonal. He seems to be speaking from materials which he acknowledges were prepared by others. (What was cool about the last panel was that people were speaking their own thoughts.)

Here is a link to Weild's slide deck.

The loss of the IPO market has cost the country 10 million jobs, Weild says.

From the Grant Thornton-branded deck: "IPO success rates have been in sustained decline for nearly two decades, despite deals that are increasing in average size and maturity."

820AM Pacific/1120AM Eastern
The earlier panel, blogged about below, was on "exempt offerings," sales of stock by startups and private companies that are not required to go through the registration rules. A new panel up now that is about IPOs and regulation of smaller public companies.

810AM Pacific/1110AM Eastern
A rally was planned, I think to promote the crowdfunding exemption, to occur in DC this morning. Representative McHenry, the sponsor of the crowdfunding bill that passed the House, is on the agenda to speak. If I can find a picture of the rally, I'll post it.

740AM Pacific/1040AM Eastern
First panel now over. I may take a brief break.

730AM Pacific/1030AM Eastern
Gregory C. Yadley, a lawyer in Tampa, now speaking. Talking about the 500 shareholder limit. Is it a true reflection of what is a public market, he asks. For small companies that do not have their stock held in the manner big companies do, it can add up.

710AM Pacific/1010AM Eastern
Yokum Taku of the Palo Alto office of WSG&R now speaking. He quickly gives a smattering of details on what his startup law practice is like:

• Has completed 100 private company financings in the last year or so.
• The typical financing involves a two person startup raising between $500,000 to $1.5M.
• These entrepreneurs do very little disclosure; they do not do a Reg D private placement memo.
• His clients expect him to get convertible debt financings done for "five to ten K."

He is in the thick of it. From his home, he sees Mark Zuckerberg walking to work every morning.

Taku turns to the general solicitation prohibition. Many startups find funding through public pitch events, incubator programs, etc. "Does it make sense that three name brand angel investors later have a rescission right, just because the issuer solicited over the internet?"

"Would be better if there were bright line rules," Taku says, on resales of private securities. The Section 4(1)1/2 exemption is too vague. The lack of information is troubling, too; buyers in secondary markets sometimes don't even know the fully diluted capitalization of the company they are buying into.

7AM Pacific/10AM Eastern
A. Heath Abshure, Arkansas Securities Commissioner, says that state regulators are the better and more proper regulators of a crowdfunding exemption. "The focus needs to be reasonable regulation," and not, as Prof. Bradford had said, "as little regulation as possible." Abshure thinks the states have not been given a chance to coordinate and come up with a crowdfunding exemption that would work and would leave authority with them to regulate crowdfunded offerings. "They [the states] can provide a uniform way of dealing with this. . . I think we are the more appropriate regulator here."

Bradford rejoins that the federal exemption should be passed, with preemption, and that preemption can later be removed when the states get around to coming up with their uniform exemption. Abshure says it ain't easy to get authority back, once taken away.

655AM Pacific/955AM Eastern
Bradford now talking about how sensitive crowdfunding will be to regulation. Too many filing, disclosure or other requirements, you make it necessary to involve lawyers, you "destroy the exemption's utility." Regulate the platforms, he says. They are visible, they can afford the lawyers, they can be the gatekeepers. Require the crowdfunding sites to enforce the rules for issuers, such as they are (e.g., the bad actor rule?).

"That's the problem I have with the House bill . . . you don't have that gatekeeper."

State brokerage laws should be preempted too, Bradford says, in a federal crowdfunding exemption, not just an issuer registration preemption.

Further thoughts from me on keeping lawyers out of crowdfunding, at this prior post.

645AM Pacific/945AM Eastern
Steven Bradford, the professor with the slidedeck on crowdfunding (link below), says crowdfunding could do for capital formation what Google did for search. Interesting analogy!

Bradford now talking about whether crowdfunding sites (a/k/a platforms or, in the verbiage of proposed legislation, "intermediaries") might be treated as brokers or investment advisers. Bradford thinks they should not be and should not be regulated as either.

He wouldn't have believed a year ago that a crowdfunding exemption would become law, but today it looks like it probably will happen.

"There will be more fraud if we allow crowdfunding, but that is a trivial point," Bradford says. No question there is an outsized risk of fraud in crowdfunding, as well as increased self-dealing by the entrepreneur. But, "the real question is whether the capital formation benefits of crowdfunding outweigh" the costs of fraud. Bradford says they do, and that the trick is to get the limits right. Limitations on size of offering and size of individual investment.

645AM Pacific/945AM Eastern
Graham just finished by talking about how state preemption should extend to Rules 504 and 505. Those are other Reg D exemptions that no one uses because states overlay regulations that make reliance on those rules impractical. "Nearly everyone uses 506, even for offerings under one million dollars." That's because 506 is the only one of the three that preempts state registration requirements. He also mentions that many are now simply relying on a 4(2) exemption and skipping Reg D filings altogether. (That reduces transparency.)

640AM Pacific/940AM Eastern
Stephen M. Graham, a Seattle attorney, is speaking now about how the prohibition on general solicitation really doesn't serve entrepreneurs well and doesn't seem to add anything to investor protection if the offering is otherwise conducted under Rule 506 of Regulation D and investors are restricted to those who are accredited.

630AM Pacific/930AM Eastern
A speaker on the first panel will be a professor, C. Steven Bradford, who will speak about crowdfunding. Here's a link to a slidedeck, "Crowdfunding and Federal Securities Law," that looks like it covers Prof. Bradford's recommendations for an ideal crowdfunding exemption (aggregate and individual investment caps).

6AM Pacific/9AM Eastern
The SEC is holding its annual "Forum on Small Business Capital Formation" today. I am going to try to live blog through a couple of the morning panels. I'm not there in Washington DC, I'm watching the webcast. See this agenda for the forum.

How to Improve the House "General Solicitation" Bill

Not only did the House of Representatives pass a crowdfunding bill this week. It also approved a bill overriding the regulatory ban on "general solicitation" in Rule 506 offerings, "provided that all purchasers of the securities are accredited investors."

Let's compare and contrast the two.

The crowdfunding bill is about going to the masses. It would create an exemption from securities registration requirements for public offerings within certain parameters (cap on how much money can be raised, cap on how much any one person can invest, criteria for crowdfunding platforms to follow, etc.). The essential direction here is to say, everyone can be solicited and everyone can participate. You don't need to be a millionaire or part of the 1%. You don't need to be "accredited."

The general solicitation bill is different. It is not about democracy. It is about the internet and arguably about transparency. But the reform here is taking place within the confines of an otherwise traditional exemption, private offerings open only to well-heeled angels, "accredited investors."

The general solicitation bill, should it become law, would make it okay for startups can solicit accredited investors - for deals still limited to accredited investors- over the internet. AngelList would rest easier.

To my mind, the general solicitation bill is about having the courage of a conviction that the basic framework of Rule 506 of Reg D makes sense. (In fact, you might almost get rid of 506's permissiveness in allowing up to 35 non-accredited investors.) The 1% can fend for themselves. It shouldn't matter how an angel first learns of a deal she later decides to back. Her "investor protection" is the wealth surrounding her.

But the House bill should be improved upon in the Senate.

The House bill, as written, would not end the "general solicitation" ban right away. Rather, it requires the SEC to engage in rulemaking to do so:

"Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. 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."

Here's what a Senate version of a general solicitation bill should do: rather than call upon the SEC to engage in rulemaking, as the House bill does, a Senate bill could simply re-write the underlying regulation, Rule 502(c), and make the change effective once the legislation is signed into law.

Congress effectively bypassed rulemaking in this manner last year, when the accredited investor definition itself was reformed effective with signing of the Dodd-Frank Act.

Photo, National Library of Scotland, Lieutenant Generals talking on the British Western Front.

General Solicitation: An Update

Four months ago, a post on this blog, and attendant comments from Joe Wallin and Asher Bearman, discussed the question of whether this might be the year in which the prohibition on general solicitation might be lifted. We're talking about securities offerings that otherwise meet the requirements of Regulation D and are limited to "accredited investors."

This is important to the startup ecosystem because (a) all startups rely on Rule 506 to conduct seed, angel and other early private financings, and (b) AngelList, Twitter, incubator and angel group competitions, and other now common practices call into question whether the prohibition on general solicitation is strictly observed by anyone, anyway.

Well, earlier this month a subcommittee of the House Financial Services Committee approved (by a voice vote, which I think means it was not controversial and had bipartisan support) a bill that would eliminate the prohibition, where all purchasers are indeed accredited investors.

This bill is not as crazy or as radical as the crowdfunding bill, which was marked up and approved by the same subcommittee on the same day, but on a split of 18-14. I wrote about the crowdfunding bill earlier this week, and the comments there from Jeremy Freeland and Joe Skocilich tease out the spectrum of issues implicated by crowdfunding in general and the dollar caps chosen in this bill in particular.

The bill okaying general solicitation - for 506 offerings limited to accredited investors, we should keep emphasizing - is not controversial. It's something long overdue.

The original bill sponsored by Rep. McCarthy of California saw two amendments, both noncontroversial, during the markup. I couldn't find a copy of the amended and restated bill, as approved by the subcommittee, so I constructed one myself. Here you go:

Photo, National Library of Scotland: "General Henry Rawlinson with a French war correspondent. Three men stand in a half-circle, chatting. They appear relaxed and smiling. They are well dressed with heavy coats but also mud bespattered. The town square, buildings and troops are visible in the background."

#Occupy Securities Exemptions

For some time, startupers have been out ahead of the SEC, in terms of interpreting pre-internet regulations around "general solicitation" in private financings.

That gap is increasing.

Consider this appeal for funding from TechStars-sponsored Romotive (great company name, by the way) on the Kickstarter crowedfunding site.

The pitch is incredibly well done. Could hardly be more professional.

Style it an executive summary and circulate it to accredited investors, you've got more than you need for a good seed financing pitch. Coming out of the context of an offering to accredited investors, there could be no recrimination were the company to fail to deliver because of a technical impediment or another unforseen obstacle.

But, as I understand it, and reading the guidelines of the Kickstarter site, Romotive is not raising financing by selling equity in the company. ("The Kickstarter economy is based on the offering of rewards – copies of the work, limited editions, fun experiences. Offering financial incentives, such as ownership, financial returns (for example, a share of profits), or repayment (loans) is prohibited.")

Instead, they're selling units of their initial product (or prototype), a kit to make a robot out of your smartphone. That kit is yet to be built (that's what the fundraising is for).

 

I want to be very clear about this: I think what Romotive appears to be doing is very cool. Moreover, most angel investors and startup lawyers I know think crowdfunding makes sense, and many support an express exemption that would even allow equity to be sold in this manner. Even the SEC has acknowledged that some kind of crowdfunding exemption should be established.

But how nerve racking this is, the gap between modern practice and the antiquated letter of the regulations. Clearly Rotomotive is in "fundraising mode," as the chatter on Twitter seems to confirm. If they are observing the ban on "general solicitation," it must be on the basis that securities are not being offered via the Kickstarter site.

Companies - and I'll stop picking on Rotomotive and instead say, not Rotomotive, but other companies like it - that raise funds on crowdfunding sites, by selling prototypes that are yet to be built, arguably sit in a regulatory twilight zone, between an FTC-regime charged with consumer protection, on the one hand, and a securities compliance regime charged with protecting investors who can't fend for themselves, on the other.

It's getting pretty fucking annoying that everything about our federal government appears to be slow, out of synch, non-responsive, broken.

Policing Reg D for "Bad Actors"

Startup founders and angels alike do not want felons and other "bad actors" participating in the startup ecosystem.

So SEC rulemaking on this point - specifically, by disqualifying a private offering from the federal exemption under Rule 506 of Regulation D if the offering involves bad actors - is something you'd hope entreprenuers and angel investors could cheer.

But the details are bedeviling.

The SEC's proposed rules - and these are the rules as proposed, not final rules - seem to place on even the youngest of companies a burden of inquiry that is more stringent than that required to meet any other condition of the Rule 506 exemption.

Disqualification does not apply, the proposed rule states, "If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed . . ."

It's the negative epistemological imperative, "could not have known," that is troubling.

What if it turns out after the fact that a bad actor had, unknown to anyone in the deal but the bad actor himself, been involved?

What if the accredited investor standard were subject to such a test? Could an issuer "have known" that a given investor's accredited investor reps were false, had it merely verified the investor's brokerage and bank accounts, checked his tax returns, and hired a private detective to ensure he wasn't living in his winter cabin as his principal residence?

On the other hand, footnote 85 in the SEC release announcing the proposed rules seems to suggest that checking for bad actors might be no more onerous then screening potential investors for accreditation by use of a questionnaire:

". . . using questionnaires similar to the current practices for establishing a reasonable basis for determining accredited investor status would seem to be appropriate . . ."

So which is it going to be? The language in the proposed rule, or the guidance of the footnote?

There shouldn't be this much uncertainty about such a practical issue.

Thankfully the Angel Capital Association has keyed on this point, in a letter from ACA Executive Director Marianne Hudson that supplements her prior letter to the SEC on the bad actor rules:

"Perhaps the Commission’s intentions would be better served by rewording the proposed safe harbor as follows: 'If the issuer establishes, after inquiry that is reasonable in the particular circumstances, that it did not know that a disqualification existed.' This regulatory language should be supplemented with an instruction that, where an issuer engages no compensated solicitor but instead sells securities directly in conformance with the exemption, the use of questionnaires (as proposed in our letter dated July 14, 2011) will ordinarily satisfy the standard."

I think that's exactly right.

Pictured: René Descartes reviews investor questionnaires with Queen Christina of Sweden.

Joe's New Blog Design (And a Note on "Bad Actors")

Joe Wallin has revamped the design of his blog and it looks great.

It's easier to read, and the design now pulls you into Joe's opinionated writing, which is what you're there for.

Not that he's always right! His post this week about the SEC's proposed "bad actor" disqualifications raises a perfectly valid concern - one I share - that the new rules could do to Rule 506 to Reg D, what, well, 409A did to startups wanting to issue options to early employees. That is to say, in an effort to chill bad behavior in other, later stage, better capitalized sectors of the economy, regulators could write rules that, as applied to startups, are sheer overkill.

Keeping "bad actors" out of 506 offerings is a good idea. It's one of the mandates of Dodd-Frank and, as Joe knows, it's one of the reforms that were part of the Angel Investor Amendment that saved 506 from (then Senate Banking Committee Chair, now MPAA lobbyist) Christopher Dodd's initial, indiscriminate attack on startups and angel financing.

So I support the bad actor exclusion. Even as I applaud Joe for bring up the concern that the proposed rules are trending to overkill as applied to startups.

The "bad actor" disqualifications should be as easy to comply with as startups today comply with the accredited investor standard. Ideally, a questionnaire filled out by the appropriate persons should do it. And if it takes everyone some time for everyone to learn what the "bad actor" definitions are, I think that's okay. The integrity of Rule 506 is really important! If we're fortunate to get reform (elimination) the general solicitation prohibition, then it's probably even more important to keep scamming middlepersons out of the financing process.

Pictured: detail from Joe's new blog design. I like the buttons that navigate by making different use of the right hand column, without switching the page.

Angel Capital Association Weighs in on Proposed "Bad Actor" Rule for Reg D

The Angel Capital Association (ACA) has weighed in on the SEC's proposed rules to implement a "bad actor" disqualification to Rule 506 of Regulation D, as contemplated by the Dodd-Frank Act.

As you may recall, early drafts of financial regulatory reform bills in the Senate during the prior Congress would have gutted Rule 506 of Reg D, the primary securities regulatory exemption that most tech entrepreneurs and angel investors rely on to get startups launched and funded.

Were it not for the Angel Investor Amendment that passed one evening as the Senate prepared to finish up its bill to ship it off to a conference committee to be reconciled with the House version of Wall Street reform (the House bill never directly attacked Reg D), Rule 506 might have been ruined and as many as two-thirds of active angel investors would have no longer qualified as "accredited investors."

The ACA was a huge driver of the Angel Investor Amendment, and among other things helped reconcile the need to save startup seed investing with the concerns of state securities regulators, who were (and remain) concerned with fraudsters who abuse Reg D to push illegitimate, brokered "private placements" to retirees and other people far outside the genuine startup ecosystem.

That reconciliation took the form of two material compromises: (1) the value of a person's principal residence would be excluded from the $1 million net worth (alternative) test for accredited investor status; and (2) the participation of felons and other "bad actors" in an offering would mean the issuer could not rely on the Rule 506 exemption.

Well, compromise (1) was self-executing (sort of; it's actually pretty complicated) in that Dodd-Frank changed the accredited investor definition as a feature of the Dodd-Frank Act itself and that change became effective when the President signed the law as Congress passed it.

Compromise (2) was not self-executing: instead, Dodd-Frank stated that Rule 506 should have a "bad actor" and other disqualifications and instructed the SEC to write rules to implement the same.

In May the SEC issued its proposed bad actor rules and now ACA Executive Director Marianne Hudson's letter to SEC Chair Mary Shapiro has been posted to the SEC page for comments.

Discussion of this issue gets technical pretty quickly, but the upshot of the ACA's position is this: the bad actor disqualification is a good thing, but don't make it so hard for startups to comply with the rule that you essentially swamp the Reg D boat and make it no good for getting anywhere.

There's a central, common sense insight expressed in the ACA's position that the SEC should remember when it (hopefully) scales back the complexity of its first cut at the bad actor rules: make the standards of inquiry for the bad actor rule mirror the standards used when figuring out whether or not someone is accredited.

Today when startups raise money and need to be sure that only accredited investors are participating in an offering, they don't hire private investigators to do background checks, they don't request years of tax returns from investors, and they don't deploy reporters from News of the World to go dig up dirt. No; they just ask the investor if she or he meets the standard.

If you actually know an investor is really not accredited, or if you otherwise have reason to doubt an investor's rep will be accurate, that's a different story: proceed conservatively, lest you cause yourself a private lawsuit and lose yourself a critically necessary securities exemption.

We need the bad actor rule to situate itself in the essentially self-policing system that has worked for startups and Rule 506 offerings for a couple decades plus.

The Senate almost blew it, but in the final hour, they got it, and the Angel Investor Amendment (embodying the statute the SEC is now working to implement) saved the day. Don't let the implementing rule defeat the purpose of the originating law!

Photo by Flip Schulke, US National Archives.

Felons and Other Bad Actors, Ruining the Party for Everyone Else

Screening felons and "bad actors" from participation in Rule 506 offerings is a good idea, and in fact is one of the reforms to Regulation D hammered out in the Angel Investor Amendment that last year prevented Dodd-Frank from laying waste to angel investing in America.

Earlier this year, the SEC proposed changes to Rule 501's definition of "accredited investor," to conform the rule to changes already wrought by Section 412 of Dodd-Frank. To be sure, there is some minor controversy over whether or not the SEC's proposal here simply implements Dodd-Frank, or whether the SEC is taking the opportunity to make the accredited investor definition more restrictive than the statute had. The other way to look at it is that the SEC is necessarily confronting an ambiguity in the statutory language as applied to the problem of underwater mortgages. But whatever your perspective on this point, the fundamental change wrought by Dodd-Frank to the accredited investor definition (exclusion of one's principal residence from the $1,000,000 net worth test) was not dependent on subsequent SEC rulemaking; that change has been effective since last summer when Dodd-Frank passed and the President signed it.

Now the SEC has gotten around to proposing changes called for by Section 926 of Dodd-Frank, changes to Rule 506 to disqualify offerings tainted by the participation of felons and "bad actors." The "bad actor" story is different from the accredited investor story. In this case, final rules are actually necessary to change the status quo. Section 926 mandated that the change should happen, but told the SEC to accomplish the change through rulemaking. And that process has begun.

All this background by way of getting to a letter from Seattle attorney Mike Liles, commenting on the proposed "bad actor" rules, that I just read via the comments page on the SEC's site. If you're interested in this subject, Liles's letter is short and worth reading, but here's a part of his letter that hit me over the head:

" . . . [T]he proposal has so much detail and requests comments on so many different nuances of that detail, that it risks creating a final version that is too complicated for ordinary small businesses to use with an acceptable degree of reliability. If the final version is too cumbersome, many small businesses may elect to use the private offering exemption of Section 4(2) of the Securities Act of 1933 without reliance upon the safe harbor provided by Rule 506. . . . It is my view that any trend towards the making of private offerings outside of Rule 506 would be unfortunate for a variety of reasons, including the difficulty of a regulator's or citizen's being able to know of the existence of a given private offering, as well as in estimating the magnitude of private offerings in the United States, without the issuer's having filed a Form D, which accompanies a private offering made in reliance upon the safe harbor of Rule 506."

This is well said and identifies a grave threat to the viability of Rule 506.

The "bad actor" disqualification remains a good and necessary reform, but the SEC's rules on the point should be as simple for issuers to observe as the accredited investor definition is.

Photo of Al Jennings, "a train robber and a silent-film star," from the Library of Congress via Flickr.

General Solicitation

Will this be the year that the prohibition on "general solictation" will be scrapped from private offerings that are restricted to accredited investors?

Most startups raising seed and subsequent rounds of private financing rely on a federal securities exemption, a condition of which states that "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."

One may dip casually into any startuper-oriented tweet stream to find suggestions that the rule is fraying against the pressure of the new value society places on transparency of information. Here's one example.

But the argument for repealing the rule isn't just that it is honored only in the breach. The better argument is that the rule isn't necessary.

The SEC conducts an annual, public forum on small business capital formation, and a report on the forum held November 2010 was released this month. The report lists recommendations from forum participants (excluding SEC staff), and the following recommendation ranks near the top, at number 2:

"The Commission should adopt a new private offering exemption from the registration requirements of the Securities Act that does not prohibit general solicitation and advertising for transactions with purchasers who do not need all the protections of the Securities Act’s registration requirements."

This proposal is echoed by the Business Law Section of the American Bar Association:

"Permit general solicitation for private placements, so long as the people who end up actually purchasing securities are accredited investors."

The best quote I've seen on this topic, though, is one from Joe Wallin that I've posted before. Tieing an originating rationale for the rule to the present-day problems state securities regulators have with brokers who abuse Reg D to shop private placements to retirees, Joe said:

"I think re-working or scrapping the general solicitation restrictions is a really good idea. This prohibition on general solicitation is what drives startups into the hands of brokers, who create the mischief that it appears the NASAA [an organization of state and provincial securities regulators] is really concerned about."

Photo, National Library of Scotland: "General Beltier (?) and the Adjutant General await the arrival of Commander-in-Chief of the American Expeditionary Force, General Pershing. . . . [M]ost likely taken by the British official photographer, John Warwick Brooke. It is a good example of the type of candid shot he was famous for, particularly of visiting dignitaries and royalty."