Category Archives: JOBS Act

Improving Legal Documents in Crowdfunding: Get Rid of the State Legends!

I see lots of offering documents like this, with pages of state “legends.” The good news is that in Crowdfunding offerings – Title II (Rule 506(c)), Title III (Regulation Crowdfunding), and Title IV (Regulation A) – you can and should get rid of them.

The legal case is pretty simple:

  • Before 1996, states were allowed to regulate private offerings. Every state allowed exemptions, but these exemptions often required legends, differing from state to state.
  • The National Securities Market Improvement Act of 1996 added section 18 to the Securities Act of 1933. Section 18 provides that no state shall “impose any conditions upon the use of. . . .any offering document that is prepared by or on behalf of the issuer. . . .” in connection with the sale of “covered securities.”
  • The securities sold under Title II, Title III, and Title IV are all “covered securities.”
  • Hence, section 18 prohibits states from imposing any conditions regarding the issuer’s offering documents, including a condition that requires the use of a state legend.

If the capitalized legends just take up space, why not include them anyway just to be safe? Take Pennsylvania’s legend as an example:

These securities have not been registered under the Pennsylvania Securities Act of 1972 in reliance upon an exemption therefrom. any sale made pursuant to such exemption is voidable by a Pennsylvania purchaser within two business days from the date of receipt by the issuer of his or her written binding contract of purchase or, in the case of a transaction in which there is not a written binding contract of purchase, within two business days after he or she makes the initial payment for the shares being offered.

If you include the Pennsylvania legend “just to be safe,” you’ve given Pennsylvania investors a right of rescission they wouldn’t have had otherwise!

Two qualifications.

First, the North American Securities Administrators Association –the trade group of state securities regulators – suggests including uniform legend on offering documents. I include this or something similar as a matter of course:

IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN EXAMINATION OF THE COMPANY AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND RISKS INVOLVED. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT, AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS SHOULD BE AWARE THAT THEY WILL BE REQUIRED TO BEAR THE FINANCIAL RISKS OF THIS INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.

Second, some states, including Florida, require a legend to appear on the face of the offering document to avoid broker-dealer registration. Because Section 18 of the Securities Act doesn’t prohibit states from regulating broker-dealers, some lawyers recommend including those legends, while others believe those requirements are an improper “back door” way for states to avoid the Federal rule. I come out in the latter camp, but opinions differ.

Questions? Let me know.

Crowdfunding Speaking Engagements – Fall 2015

Map of Mark Roderick

September 24th – Chicago, IL

RealCap Chicago

Real Estate Crowdfunding Conference Real Cap Chi

RealCap Chicago will provide real estate entrepreneurs the opportunity to hear from the country’s leading real estate crowdfunding platforms. Attendees will learn how to raise debt and equity online for projects including “fix and flip” single family homes, multifamily complexes, commercial buildings, and ground up development projects.

Meet The Future of Real Estate Capital

“The rapid growth of real estate crowdfunding platforms can be attributed to both the low minimum investments of $100 – $10,000 as well as the transparency which both developers and investors now benefit from as they compare terms and opportunities on platforms, and even across platforms, ” Jorge Newbery said. “The ease and speed of investing on the platforms is seductive. Online capital raising is the future of real estate finance.” There are over 75 real estate crowdfunding platforms active in the United States, which several additional platforms planning to launch soon.

Click here for the full conference agenda.

MY SESSION: The Evolution of Online Capital Raising

Moderator: Mark Roderick, Flaster Greenebrg PC @CrowdfundAttny 

Panel Members:

  • AdaPia d’Errico, Patch of Land @Adapia
  • Jordan Fishfeld, Peer Realty @PeerRealty
  • Eve Picker, Small Change
  • Scott Jordan,HealthiosXchange @HealthiosX
  • Bhavik Dani, EquityRoots @EquityRoots

Click here for more information or to register. Stay connected #RealCapChi

October 13th – October 15th – Fairmont Royal York Hotel – Toronto, ON Canada

NAIOP Commercial Real Estate Conference 2015

NAIOP is taking its fall meeting north of the border for the first time since 1996 and you won’t want to naiopmiss the energy and enthusiasm in one of Canada’s fastest growing cities.

Toronto is home to NAIOP’s second largest chapter and is excited to host commercial real estate professionals from across North America at this leading industry event.

  • DEALS: Nearly 1,000 industry and association leaders who’ve come together to share strategies, make contacts and learn new ideas.
  • CONNECTIONS: Broaden your network in unlimited networking and business-building opportunities, including special events and receptions. Meet partners showcasing the latest innovative tools that can advance your business.
  • TRENDS: 15+ education sessions, featuring nationally recognized speakers, trainers, and industry experts, who discuss timely topics and critical issues to your business.

Click here for the full conference agenda.

MY SESSION: Crowdfunding and New Ways of Raising Capital (October 14th)

Moderator: Mark Roderick, Flaster Greenberg PC @CrowdfundAttny

Panel Members:

Click here for more information or to register. Stay connected #Crecon15

October 22nd – Builders League of South Jersey – Cherry Hill, NJ

Crowdfunding for Real Estate – News Ways of Raising Capital

8:30 – 10:30 A.M.

blsjEvent Details:

The internet has arrived in the capital formation business! In case you haven’t heard, Crowdfunding is a way to fund a project or venture by raising many small amounts of money from a large number of people, typically via the Internet. Explore its growth from small investments to large, how the process is managed, the risk and reward factors, and what the future holds. Learn about the potential for builders/developers and how New Jersey compares to other states.

*Free to all BLSJ Members/$25 Non-Members

To register, email Marlene Spencer at marlene@blsj.com

October 26th – Trump International Hotel Las Vegas – Las Vegas, NV

4th Annual GCCB Conference – REGULATION A PLUS MASTER CLASS

gccbThis very special event will sell out quickly and space is limited. Join us for the country’s first REG A PLUS Master Class training for professionals under the JOBS Act. We will kick off this event on Sunday night with a special Dinner for our sponsors and VIP attendees.

This is your opportunity to learn from the best and the brightest experts in the industry how you can integrate this new securities offerings directly into the professional services that you offer your clients . And this will help you stand out as one of the first experts in Title IV of the JOBS Act, REG A PLUS in your city or state.

This is a first mover advantage you don’t want to miss.

Speakers:

Click here for more information or to register. Stay connected #GCCB2015

You Can Use Subsidiaries Without Violating the 100 Investor Rule

crowdfunding_investorEveryone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.

The basics of the 100 investor rule:

  • A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
  • A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
  • There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.

Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.

In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?

Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?

Fortunately, the answer is No.

For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.

That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.

Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.

Questions? Let me know.

 

Why the Jobs Act Broker-Dealer Exception Doesn’t Matter (Much)

US CApitol Building Illuminated at Night

Under section 201(c) of the JOBS Act, an electronic platform is not required to register as a broker-dealer solely because the platform offers securities under Title II, co-invests in the securities, or provides due diligence services or standardized documents. That’s good.

What Congress giveth, however, Congress can taketh away. The exemption from broker-dealer registration is not available if:

  • The platform or anyone associated with the platform receives compensation in connection with the purchase or sale of securities; OR
  • The platform helps to negotiate deals; OR
  • The platform requires issuers to use its standardized documents; OR
  • The platform is separately compensated for giving investment advice; OR
  • The platform or anyone associated with the platform takes possession of investor funds or securities; OR
  • The platform or anyone associated with the platform is disqualified under the “bad actor” rules.

Theoretically, the JOBS Act broker-dealer exemption paved the way for Crowdfunding platforms to sell securities free from the constraints of Depression-era securities laws. In practice, however, platforms have found it very difficult, almost impossible, to build a profitable business around the exemption because of all the gaps in the exemption and the list of things you can’t do.

For example:

  • To claim the exemption, a platform may not receive any compensation in connection with the purchase or sale of securities. That doesn’t just mean “transaction-based compensation” like commissions, it means any compensation. If the platform receives a carried interest or promote, for example, the exemption disappears.
  • From a business perspective it makes sense for the platform to employ an investor-relations specialist, someone to reach out to prospective investors. But if that person receives any compensation, even a salary, the exemption disappears.
  • Suppose the platform organizes a special-purpose entity for its investors and negotiates the terms of the deal with the issuer. Buzz! The exemption disappears.
  • The exemption doesn’t even apply to employees of the platform. If they engage in activities that are not protected by SEC Rule 3a4-1, they themselves could be required to register as broker-dealers.
  • Even if you qualify for the Federal exemption, it doesn’t mean you’re exempt from state broker-dealer registration.

Here’s how the SEC answered a question about the scope of the exemption:

QUESTION

May an entity, such as a venture capital fund or its adviser, operate an Internet website where it lists offerings of securities by potential portfolio companies (in compliance with Rule 506), co-invest in those securities with other investors, and provide standardized documents for use by issuers and investors, rely on Securities Act Section 4(b) to not register as a broker-dealer?

ANSWER

Yes. These activities are permitted under Section 4(b), subject to the conditions set forth in Section 4(b)(2), including the prohibition on receiving compensation in connection with the purchase or sale of securities. As a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.

That’s pretty clear.

Now, the fact that a platform doesn’t qualify for the JOBS Act exemption doesn’t automatically mean the platform has to register as a broker-dealer. Whether the platform has to register as a broker-dealer would be tested under the body of laws stretching back 80 years. My point is that the JOBS Act exemption itself will be irrelevant for most platforms.

As someone once said, Crowdfunding is nothing more or less than the Internet come to the capital formation industry. Crowdfunding platforms sit astride the Internet pipeline directly connecting entrepreneurs with investors. Matching buyer to seller, they function as “brokers” in the most fundamental sense of the word.

In this sense, changing the business practices of a Crowdfunding platform to comply with the JOBS Act broker-dealer exemption is like pounding a round peg into a square hole. Pound long and hard enough and it’s possible. But it’s far better to run the platform business the way you want to run it, i.e., to make the most money. If you have to register as or affiliate with a broker-dealer, just do it.

Questions? Contact Mark Roderick.

Crowdfunding and Fiduciary Obligations

The term “fiduciary obligations” sends a chill down the spine of corporate lawyers – although some may object to using the word “spine” and “corporate lawyer” in the same sentence.

A person with a fiduciary obligation has a special legal duty. A trustee has a fiduciary obligation to the beneficiaries of the trust. The executor of an estate has a fiduciary obligation to the beneficiaries of the estate. The fiduciary obligation is not an obligation to always be successful, or always be right, but rather an obligation to try your best, or something close to that. A trustee who fails to anticipate the stock market crash of 2008 has not breached her fiduciary obligation. A trustee who fails to read published reports of a company’s impending bankruptcy before buying its stock probably has.

A person with a fiduciary obligation is required to be loyal, to look out for the interests of those under her care, to put their interests before her own.

By law and longstanding principle, the directors of a corporation have a fiduciary obligation to the corporation and its shareholders. In the classic case, a director of a corporation in the energy business took for his own benefit the opportunity to develop certain oil wells. Foul! cried the court. He has breached his fiduciary obligation by failing to pass the opportunity along to the corporation, to which he is a fiduciary.

Modern corporate statutes allow the fiduciary obligations of directors to be modified, but not eliminated, even if all the shareholders would sign off. If the corporation is publicly-traded, the exchange likely imposes obligations on the director (and the President, and the CEO, etc.) in addition to the fiduciary obligations imposed by state corporate law.

Which takes us to Crowdfunding. crowd funding word cloud

Most deals in the Crowdfunding space are done in a Delaware limited liability company. The Delaware Limited Liability Company Act allows a manager – the equivalent of a director in a corporation – to eliminate his fiduciary obligation altogether. If I’m representing the sponsor of the deal then of course I want to protect my client as fully as possible. And yet, I’m not sure that’s the best answer for the industry overall.

The U.S. public capital markets thrive mainly because investors trust them, just as the U.S. consumer products industry thrives because people feel safe shopping (that’s why securities laws and consumer-protection laws, as aggravating as they can be, actually help business). My client’s investors may or may not pay attention to the fiduciary duty sections of his LLC Agreement, but I wonder whether the Crowdfunding market as a whole can scale if those running the show regularly operate at a lower level of legal responsibility than the managers of public companies. Will it drive investors away?

Part of my brain says that it will, and yet, over the last 25 years or so, as corporate laws have become more indulgent toward management and executive pay has skyrocketed, lots of people have wondered when investors will say “Enough!” It hasn’t happened so far.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

Crowdfunding and the Trust Indenture Act of 1939

Handing over moneyThe Securities Act of 1933. The Exchange Act of 1934. The Investment Company Act of 1940. Those are the pillars of the U.S. securities laws, as relevant today as they were 80 years ago. And here’s one more old law relevant to Crowdfunding: the Trust Indenture Act of 1939.

Here’s the idea. A company issues its promissory notes (obligations) to a large group of investors. If the company defaults on one or two notes, it might not be financially feasible for those particular investors to take legal action. Even if the company defaults on all the notes it will be a mess sorting out the competing claims. Which investor goes first? If there is collateral, which investor has priority? At best it’s highly inefficient, economically.

The Trust Indenture Act of 1939 imposes order and economic efficiency. It provides that where a company issues debt securities, like promissory notes, it must do so pursuant to a legal document called an “indenture” and, most important, with a trustee, normally a bank, to represent the interests of all the investors together. The TIA goes farther:

  • It provides that the indenture document must be reviewed and approved by the SEC in advance.
  • It ensures that the trustee is independent of the issuer.
  • It requires certain information to be provided to investors.
  • It prohibits the trustee from limiting its own liability.

Why don’t Patch of Land and other Crowdfunding portals that issue debt securities comply with the TIA? Because offerings under Rule 506 are not generally covered by the law. Conversely, because Lending Club and Prosper sell publicly-registered securities (their “platform notes”), they are covered, and have filed lengthy indenture documents with the SEC.

The real surprise is with Regulation A+. If a Regulation A+ issuer uses an indenture instrument to protect the interests of investors then it will be subject to the TIA and its extensive investor-protection requirements. If the issuer does not use an indenture, on the other hand hand, it will not be subject to the TIA as long as it has outstanding less than $50 million of debt. That’s a strange result – giving issuers an incentive not to use an indenture even though indentures protect investors.

That’s what happens sometimes when you apply very old laws to very new forms of economic activity. Welcome to Crowdfunding.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

How Much of My Company Should I Give Away?

Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?

One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.

Suppose you’re raising $500,000. To calculate how much your investor should receive:

  • Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
  • Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
  • Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
  • Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
  • Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
  • Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).

Very elegant and simple.

But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.

money treeThat’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.

The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.

In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

%d bloggers like this: