Tag Archives: SEC

Amendments and Supplements in a Regulation A Offering

Pigeon Point lighthouse USA, California, Big Sur

Your Offering Statement has been qualified by the SEC. Now something changes. Do you have to file something with the SEC? If so, what and how?

Changes Reported on Form 1-U

Some changes must be reported using Form 1-U:

  • If the issuer has entered into or terminated a material definitive agreement that has resulted in or would reasonably be expected to result in a fundamental change to the nature of its business or plan of operation.
  • The bankruptcy of the issuer or its parent company.
  • A material modification of either (i) the securities that were issued under Regulation A, or (ii) the documents (g., a Certificate of Incorporation) defining the rights of the securities that were issued under Regulation A.
  • A change in the issuer’s auditing firm.
  • A determination that any previous financial statements cannot be relied on.
  • A change in control of the issuer.
  • The departure or termination of the issuer’s principal executive officer, principal financial officer, or principal accounting officer, or a person performing any of those functions even if he or she doesn’t have a title.
  • The sale of securities in an unregistered offering (g., Rule 506(c)).

Form 1-U may be used, at the issuer’s discretion, to disclose any other events or information that the issuer deems of importance to the holders of its securities.

NOTE:  If an event has already been reported on an annual or semi-annual report, the same event does not have to be reported again on Form 1-U.

NOTE:  A report on Form 1-U must be filed even if the Regulation A offering has ended.

Amendments

After the offering is qualified by the SEC, the issuer must file an amendment of its Offering Statement “to reflect any facts or events arising after the qualification date. . . .which, individually or in the aggregate, represent a fundamental change in the information set forth in the offering statement.”

Examples of fundamental changes:

  • A change in the offering price of the security.
  • A change in the focus of the issuer’s business, g., we were going to focus on cryptocurrencies, but now we’re pivoting to blockchain-based financial services.
  • The bankruptcy of the issuer.
  • A change in the type of security offered, g., from preferred stock to common stock or vice versa.

An amendment of an Offering Statement must be approved by the SEC before it becomes effective, which means waiting.

Even more important, depending on the nature of the change, the issuer might be required to stop selling securities or even stop offering securities (i.e., shut down its website and all marketing activities) while the amendment is pending.

Supplements

After the offering is qualified by the SEC, the issuer must file a supplement of its Offering Circular to reflect “information. . . .that constitutes a substantive change from or addition to the information set forth” in the original offering circular.

Examples of substantive changes or additions:

  • A new Chief Marketing Officer joined the management team.
  • The issuer’s patent application, disclosed in the original Offering Circular, was approved.
  • The issuer moved its principal office.

Unlike amendments, supplements do not require SEC approval and do not require that that the issuer stop selling or issuing securities. Instead, the supplement must be filed with the SEC within five days after it is first used.

Real Estate Supplements

While its offering is live, an issuer in the real estate business — a REIT, for example — must file a supplement “[w]here a reasonable probability that a property will be acquired arises.” Not when the property is purchased, but when there is a “reasonably probability” that it will be purchased.

The SEC doesn’t specify what information to include in these supplements, except to disclose “all compensation and fees received by the General Partner(s) and its affiliates in connection with any such acquisition.” Including a statement of any significant risks associated with the property is a good idea, too.

Having filed a separate supplement for each property, the real estate issuer must then file an amendment at least once every quarter that consolidates the supplements and includes financial statements for the properties. Notwithstanding the general rule for amendments, however, the issuer doesn’t have to stop offering or selling securities pending SEC approval.

Supplement vs. Amendment

An amendment is required for “fundamental changes,” while only a supplement is required for “substantive changes.” Where to draw the line?

There’s a lot at stake. If an issuer uses a supplement where it should have used an amendment, it will be using an Offering Statement that has not been qualified by the SEC. Meaning, the whole offering will be illegal.

The SEC won’t say whether it believes a given change requires a supplement or an amendment, leaving the decision to the issuer and its lawyer. The SEC will, however, allow an issuer to file an amendment even for non-fundament changes, i.e., where a supplement would have done the trick. Filing an amendment takes a little longer, costs a little more, but eliminates the risk of guessing wrong.

Often, however, an issuer wants to make a change but doesn’t want to go through the amendment process. In those cases, the rule of thumb should be as follows:

Would an investor of ordinary prudence want to re-think his investment decision based on the new information?

If the answer to that question is Yes, the new information should be provided via amendment. If the answer is No, it can be provided supplement.

For example, an investor who liked the cryptocurrency space might not be interested in the financial services space, while the addition of a new CMO might be interesting and useful, but unlikely to affect the investment decision.

Contrary to popular belief, the main risk of this or any other violation of the securities laws is not that the SEC will bring your offering to a screeching halt or fine you. Those things are possible, but the SEC has more important things on its plate. The main risk is that an investor will lose money and hire a clever lawyer, who will then seize on your mistake (or your alleged mistake) as grounds to get the investor’s money back.

Supplement vs. Form 1-U

If a change falls within any of the specified categories of Form 1-U, then it should be reported on Form 1-U rather than via supplement.

If the offering has ended, then supplements are no longer relevant and changes should be reported on Form 1-U.

If the offering is still live and the change does not fall within any of the specified categories of Form 1-U, then it can be reported on either Form 1-U or via supplement, take your pick. However, supplements may not be accompanied by exhibits. So if you need to change or add an exhibit (e.g., you’ve modified your Subscription Agreement or entered into a material contract that doesn’t constitute a fundamental change), you should use form 1-U.

Questions? Let me know.

Podcast: The Business Credit & Financing Show Focusing on How to Avoid Crowdfunding Legal Pitfalls with Mark Roderick

MSR Podcast OCt 2018

CLICK HERE TO LISTEN | Also available on iTunes & Spotify

During This Show We Discuss…

  • Your potential legal liability using crowdfunding platforms
  • When a potential investor can sue the project creator
  • The “3 flavors” of crowdfunding you should know about
  • Legal issues with flex versus fixed funding
  • How the new tax law affects crowdfunding
  • 20% tax deduction in crowdfunding transactions
  • Getting crowd funding for real estate investing
  • What you should know about peer-to-peer lending
  • Issues with bonuses you may offer to donors
  • What to know about the SEC’s role in crowdfunding
  • What an opportunity zone fund is and how they work
  • Why trusts invest in crowdfunding projects
  • Other big investors who are investing in crowdfunding campaigns
  • Potential legal pitfalls in peer-to-peer lending?
  • And much more

Mark Roderick is one of the leading Crowdfunding and Fintech lawyers in the United States. Expanding on his in-depth knowledge of capital-raising and securities law, Mark represents many portals and other players in the Crowdfunding field. He writes a widely read blog, crowdfundattny.com, which provides readers with a wealth of legal and practical information for portals, issuers and investors. He also speaks at Crowdfunding events across the country and represents industry participants across the country and around the world.

The Per-Investor Limits of Title III Require Concurrent Offerings

Since the JOBS Act was signed by President Obama in 2012, advocates have been urging Congress to increase the overall limit of $1 million (now $1.07 million, after adjustment for inflation) to $5 million. But for many issuers, the overall limit is less important than the per-investor limits.

The maximum an investor can invest in all Title III offerings during any period of 12 months is:

  • If the investor’s annual income or net worth is less than $107,000, she may invest the greater of:
    • $2,200; or
    • 5% of the lesser of her annual income or net worth.
  • If the investor’s annual income and net worth are both at least $107,000, she can invest the lesser of:
    • $107,000; or
    • 10% of the lesser of her annual income or net worth.

These limits apply to everyone, including “accredited investors.” They’re adjusted periodically by the SEC based on inflation.

These limits make Title III much less attractive than it should be relative to Title II. Consider the typical small issuer, NewCo, LLC, deciding whether to use Title II or Title III to raise $1 million or less. On one hand, the CEO of NewCo might like the idea of raising money from non-accredited investors, whether because investors might also become customers (e.g., a restaurant or brewery), because the CEO is ideologically committed to making a good investment available to ordinary people, or otherwise. Yet by using Title III, NewCo is hurting its chances of raising capital.

Suppose a typical accredited investor has income of $300,000 and a net worth of $750,000. During any 12-month period she can invest only $30,000 in all Title III offerings. How much of that will she invest in NewCo? Half? A third? A quarter? In a Title II offering she could invest any amount.

Because of the per-investor limits, a Title III issuer has to attract a lot more investors than a Title II issuer. That drives up investor-acquisition costs and makes Title III more expensive than Title II, even before you get to the disclosures.

The solution, of course, is that Congress should make the Title III rule the same as the Tier 2 rule in Regulation A:  namely, that non-accredited investors are limited, but accredited investors are not. I can’t see any policy argument against that rule.

In the meantime, almost every Title III issuer should conduct a concurrent Title II offering, and every Title III funding portal should build concurrent offerings into its functionality.

Questions? Let me know.

The Bad News About ICOs Is Good News

Every day brings more bad news about ICOs: another class action lawsuit, another subpoena by the SEC, another “request for information” by a state Attorney General, another country that outlawed ICOs altogether.

The bad news is probably hurting the industry’s reputation and driving away investors in the short term. But from my perspective the bad news is, on balance, actually good.

The ICO market was crazy in 2017. Lawyers were giving questionable advice, investors were buying anything called a token, and the billions of dollars sloshing around attracted bad actors and instant-millionaires. People convinced themselves this was normal and justified, as they did with tulip bulbs in 1636.

From my perspective, the bad news in today’s headlines shows that the fog is clearing. Among the lessons learned:

  • ICOs were not, after all, a law unto themselves.
  • It’s easier to describe a network than to build one.
  • Some smart contracts are dumb.
  • Honesty is still the best policy with investors.
  • An honest cop is good for the neighborhood.
  • The laws of economics have not been repealed.

Most important, it turns out that there really is value in blockchain, even without the hype, and that real entrepreneurs are building serious value and finding it easier to connect with investors as the fog clears. Your Uber driver is no longer offering tips on Bitcoin, but you can do a legal ICO, there really is such thing as a utility token, and there are a lot of really smart folks building real companies that are going to disrupt and transform a lot of industries.

We’re going through a much-needed adjustment right now. It’s all good, as we young people say.

Questions? Let me know.

“Secondary Sales” of Private Securities (And Tokens) in Crowdfunding

We use the term “secondary sales” to refer to sales of securities by anyone other than the issuer, and the term “secondary market” to refer to a marketplace where those sales take place.

Suppose NewCo, LLC, a private (non-public) company, raises money by issuing limited liability company interests under Rule 506(c). One investor, Amanda Sakaguri, later sells her limited liability company interest to a third party. The sale by Ms. Sakaguri is what we refer to as “secondary sale.” If Ms. Sakaguri sold her limited liability company interest on a marketplace – as opposed to a private sale – we call that a “secondary market.”

The Basic Legal Rules for Secondary Sales

All offers of securities must be fully registered with the SEC, under section 5 of the Securities Act of 1933. If there were no exceptions to section 5, Ms. Sakaguri would have to register with the the SEC before selling her limited liability company interest. But of course, this being the securities laws, there are lots of exceptions. For example:

  • If Ms. Sakaguri bought her limited liability company interest in a Regulation A offering, she could sell it to anyone right away.
  • If Ms. Sakaguri bought her limited liability company interest in a Regulation CF offering, she could sell it to some buyers right away, and to anyone after one year.

Ms. Sakaguri bought her limited liability company interest under Rule 506(c), so she isn’t eligible for either of those exceptions. For Ms. Sakaguri and other owners of private securities, the most likely potential exception is in section 4(a)(1) of the Securities Act, which exempts “[Sales] by any person other than an issuer, underwriter, or dealer.”

We know Ms. Sakaguri isn’t the issuer. How about a dealer or an underwriter?

A dealer is “[A]ny person engaged in the business of buying and selling securities . . . .for such person’s own account. . . .” but does not include “. . . .a person that buys or sells securities. . . . but not as a part of a regular business.” Provided she isn’t buying and selling securities as a business, Ms. Sakaguri isn’t a dealer.

Whether she’s an underwriter is a harder question, believe it or not. We think of underwriters as big Wall Street firms in gleaming towers, but the definition is much broader than that:  “[A]ny person who has purchased from an issuer with a view to. . . .the distribution of any security. . . .” If Ms. Sakaguri expected to sell her limited liability company interest from NewCo when she bought it, she might be an underwriter, ineligible for the exception.

Whether the seller of a security is an underwriter once caused so much confusion that the SEC adopted a long rule on that topic. 

Rule 144

Rule 144 provides a “safe harbor” for sellers. If a seller satisfies all the conditions of Rule 144, the seller will definitely not be treated as an underwriter for purposes of section 4(a)(1). If a seller doesn’t satisfy all the conditions, it doesn’t mean she will be treated as an underwriter. It just means she’s taking her chances.

Rule 144 imposes different requirements on sellers depending on whether:

  • The issuer is a private or a publicly-reporting company;
  • The seller is an “affiliate” of the issuer (generally meaning under common control); and
  • How the seller acquired the securities in the first place.

We’re going to focus only on private companies, like NewCo, and situations where the seller acquired her interest directly from the issuer.

If Ms. Sakaguri were an affiliate of NewCo, she would be subject to four requirements:

  • She would have to provide current information about the issuer, including its name, its business, its CEO and Directors, and two years’ of financial statements.
  • She would have to hold the securities for at least one year.
  • She would be limited in the volume of securities she could sell.
  • She would be limited in the manner in which she sells the securities.

On the other hand, because Ms. Sakaguri isn’t an affiliate of NewCo, but just an ordinary investor, she’s subject to only one requirement:  she has must hold her limited liability company in NewCo for at least one year. That means:

  • She’s not required to provide any information about NewCo to the buyer.
  • She can sell as much of her limited liability company interest as she wants.
  • She can sell it to anyone, accredited or non-accredited.
  • She can sell it in any manner she want, including on a website.

(Remember, Rule 144 is a safe harbor, not a legal rule. If Ms. Sakaguri is a minority investor in a private company and sells her limited liability company interest after four months because she lost her job and needs the cash, nobody thinks she’s an underwriter. At worst, she’d be sentenced to a week of Fox News.)

Where are the Secondary Markets?

There are lots of investors in the same shoes as Ms. Sakaguri:  everyone who owns an interest in a real estate limited partnership, or a tech startup, or even a family business. If it’s so easy legally for them to sell their interests, why aren’t there lots of places where they can sell them?

A place – a website, for example – where investors could sell their privately-owned securities would probably be treated as an “exchange” under the Securities Exchange Act of 1934 (“[A]ny organization. . . .which. . . .provides a market place. . . .for bringing together purchasers and sellers of securities. . . .”). Section 5 of the Exchange Act makes it illegal for any exchange to operate unless it is either a registered “national securities exchange” under section 6 of the Exchange Act (like NASDAQ or the NYSE) or exempt from registration under SEC rules. The typical private security couldn’t qualify for listing on a national exchange, so Ms. Sakaguri and others in her shoes would be looking for something else.

Fortunately, that something else exists in the form of an “alternative trading system,” or ATS, authorized by the SEC in 17 CFR 240.3a1-1(a)(2) and defined in 17 CFR 242.300 – 303. Today there are dozens of alternative trading systems operating in the United States for many different purposes, including several operated by OTC Markets, Inc. Any broker-dealer can create an ATS without much difficulty, and for that matter anyone can create a broker-dealer.

All the legal pieces of the puzzle are in place:  Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144; and it’s not hard to create an ATS where she can sell it. So why does everyone complain about the lack of liquidity in private securities?

The answer is that the legal pieces of the puzzle turn out not to be the most important. Ms. Sakaguri is allowed to sell her limited liability company interest, but finding someone who wants to buy it is another story. We can create all the legal mechanisms we want, but a secondary market needs lots of buyers and sellers, especially buyers.

Remember, Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144 without providing any information about NewCo. That’s great, except there aren’t a lot of people willing to buy that limited liability company interest without information about NewCo. Other characteristics of NewCo, if it’s a typical privately-owned company, also make it unattractive:

  • It probably has a very limited business, possibly only one product or even one asset.
  • It probably has limited access to capital.
  • It probably lacks professional management.
  • Sakaguri probably has limited or no voting rights.
  • There are probably no independent directors.
  • The insiders of NewCo are probably allowed to pay compensation to themselves more or less free of limits, and have probably protected themselves from just about every kind of legal claim that investors could bring.

When Franklin Roosevelt and Sam Rayburn created the American securities laws in the 1930s, what emerged from all the new regulation was the most efficient, most transparent, most vibrant public capital market in the world. Eighty-five years later, you might say Americans have become spoiled by the safety of buying publicly-traded companies on national exchanges. When Ms. Sakaguri asks them to buy her limited liability company interest in NewCo on an alternative trading system, she’s asking for a lot.

To create a more vibrant secondary market for private securities we need greater standardization, greater protections for investors, and greater transparency. Some of these things the industry can do by itself – for example, by using blockchain technology. Other things will probably require regulation.

To create a vibrant market in automobiles we didn’t adopt laws protecting auto manufacturers. We adopted laws protecting consumers, e.g., lemon laws. My guess is that to create a vibrant secondary market for private securities the law should focus on buyers, not sellers.

What About Tokens?

More companies than I can remember have said they want to convert their limited liability company interests or preferred stock to token form because “There’s a secondary market for tokens.”

From a legal point of view that’s not true. The laws governing secondary sales of securities apply equally to the most boring share of common stock, represented by a paper certificate stored in a battered aluminum filing cabinet, and the most interesting token treated as a security under the Howey test, residing only in the cloud on a public blockchain.

But it is true in two other senses:

  • The rules I’ve talked about above apply only to tokens that are securities under the Howey test. A token that is a currency and not a security is not subject to those rules. I would also say that a true utility token isn’t subject to the rules, either, except a token being traded is probably a security under the Howey test, i.e., it probably isn’t a true utility token.
  • The reason there isn’t a vibrant market in private securities isn’t the legal restrictions, but the risk inherent in private securities. The frenzy over anything called a token in the last 12 months has overridden investor fears of private securities. Whether that frenzy will continue is impossible to predict (it won’t).

The same people ask “What about all those crypto exchanges?” There are two answers to that question as well. One, many or all of them have become alternative trading systems controlled by broker-dealers, or are in the process of doing so. Two, many got in trouble. Some are being sued privately, some are being sanctioned by the SEC, and three of the really bad ones had to watch Fox News for a month.

Questions? Let me know.

Blockchain Is A Technology, Not A Philosophy

John Barlow died last Wednesday. Mr. Barlow wrote lyrics for the Grateful Dead, dabbled in Republican politics in Wyoming, and, more famously, had big dreams for the internet. He referred to the internet as “the new home of the mind” and demanded of governments, “I declare the global social space we are building to be naturally independent of the tyrannies you seek to impose on us.”

Good things have come from the internet, no question, but for the most part Mr. Barlow’s dreams have not materialized. Twenty five years later, the internet means mainly Facebook and Google for most people, along with a loss of privacy, e.g., Equifax. The internet has made it easier to work from home and collaborate and start social movements like #MeToo and #TeaParty, but also allows Russia to interfere with our elections. We’re connected all the time, yet somehow feel more lonely. And all the information circling the globe leaves us with a citizenry somehow less informed than when television came in three black and white channels.

Mixed results are not unique to the internet. Pick any technology – electricity, automobiles, television, nuclear power – and you’ll find the same story of idealistic dreams transformed or broken on the shoals of the real world. We imperfect human beings keep asking technology to save us from ourselves, and it never can.

Which brings us to blockchain.

Speaking at a crypto-conference in New York the day Mr. Barlow died, I heard a speaker predict that blockchain would replace the banking system, that cryptocurrency would eliminate national currencies, that we are about to witness a fundamental change (for the good) in the human condition. You can read articles in serious business publications about the “ethos” of blockchain, how the technology will replace our broken trust in private and government institutions.

In my opinion that thinking isn’t just wrong but dangerous. Blockchain is not going to replace the banking system, and shouldn’t. Cryptocurrencies will replace fiat currencies only in countries without a functioning currency of their own. If you see a country where Bitcoin is the currency of choice, it’s like seeing a guy on the subway with an IV in his arm:  you’re not sure what’s wrong, but you know he’s sick.

If you think blockchain has an ethos, you’ll sell tokens without bothering about securities laws. You’ll encourage wage-earners to invest their savings in a cryptocurrency whose price chart makes Pets.com look stable, having decided that it’s not so much a “currency” as a “store of value.” Most dangerous, you’ll convince yourself that technology is a substitute for morality.

Like every technology, starting with fire, blockchain can improve the human condition only if we tether it to our needs.

Fortunately, based on what I saw at the conference on Wednesday, there’s a lot of tethering along with the hype. Among other things, we heard from entrepreneurs using blockchain technology to:

  • Improve healthcare outcomes
  • Give consumers control over their financial records
  • Facilitate business and consumer payments
  • Reduce fraud in the financial markets
  • Make sense of our antiquated system of property ownership

With the grandiose predictions and the mystification and, frankly, some wishful thinking by lawyers, the blockchain industry has earned a black eye in the minds of many, including government regulators. Even so, light shines through. As an industry, let’s dedicate ourselves to using the technology wisely, making it work for ordinary people, being more transparent than the law requires, thinking long-term, and above all, remembering that how blockchain is viewed 25 years from now depends not on technology, but on imperfect human beings like us.

Questions? Let me know.

Using “Finders” To Sell Securities, Including Tokens

Selling securities is hard, and it makes perfect sense that an issuer or a portal would hire someone to help. And once you’ve hired someone, it also makes perfect sense business-wise to pay her a percentage of what she raises, aligning her interests with yours.

It’s perfect, but it might be illegal.

The Legal Issue

The Securities Exchange Act of 1934 generally makes it illegal for any “broker” to sell securities unless she’s registered with the SEC. The Exchange Act defines the term “broker” to mean “any person engaged in the business of effecting transactions in securities for the account of others.” That’s not a very helpful definition, but if you earn a commission from selling securities, like the helper above, you might be a broker.

So what? Well, if someone who’s a “broker” sells securities without registering with the SEC, lots of bad things can happen:

  • All the investors in the offering could have a right of to get their money back, and that right could be enforceable against the principals of the issuer.
  • The issuer could lose its exemption, g., its exemption under Regulation D.
  • By violating the securities laws, the issuer and its principals could become “bad actors,” ineligible to sell securities in the future.
  • The issuer could be liable for “aiding and abetting” a violation of the securities laws.
  • The issuer could be liable under state blue sky laws.
  • The person acting as the unregistered broker could also face serious consequences, including sanctions from the SEC and lawsuits from its customers.

What is a Broker?

Because the Exchange Act does not define what it means to be “engaged in the business of effecting transactions in securities,” the SEC and the courts have typically relied on a variety of factors, including whether the person:

  • Is employed by the issuer
  • Receives a commission rather than a salary
  • Sells securities for others
  • Participates in negotiations between the issuer and an investor, g., helps with sales presentations
  • Provides advice on the merits of the investment
  • Actively (rather than passively) finds investors

More recently, in court cases and in responses to requests for no-action letters, the SEC seems to be moving toward a more aggressive position:  that if a person receives a commission she’s a broker and must be registered as such, end of story.

So far, courts are rejecting the SEC’s hard-line approach. In a 2011 case called SEC v. Kramer, the court stated:

[T]he Commission’s proposed single-factor “transaction-based compensation” test for broker activity (i.e., a person ‘engaged in the business of effecting transactions in securities for the accounts of others’) is an inaccurate statement of the law. . . . . an array of factors determine the presence of broker activity. In the absence of a statutory definition enunciating otherwise, the test for broker activity must remain cogent, multi-faceted, and controlled by the Exchange Act.

As reassuring as that statement sounds, it was made by a District Court, not a Court of Appeals and certainly not the Supreme Court. A District Court in a different part of the country might take the SEC’s side instead.

But I Know Someone Who. . . .

Yes, I know. There are lots of people out there selling securities, including tokens that are securities, and receiving commissions, and nothing bad happens to them.

There are so many of these people we have a name for them:  Finders. The securities industry, at least at the level of private placements, is permeated by Finders. I had a conversation with a guy who offered to raise money for my issuer client in exchange for a commission, and when I mentioned the Exchange Act he said “What are you talking about? I’ve been doing this for 25 years!”

I’m sure he has. The SEC would never say so publicly, but the reality is that where broker-dealer laws are concerned there are two worlds:  one, the world of large or public deals, where the SEC demands strict compliance; and the world of small, private deals, where the SEC looks the other way.

In my opinion, Crowdfunding offerings and ICOs fall in the “large or public deals” category, even though it’s hard to tell a Crowdfunding client they can’t do something the guy down the street is doing.

So What Can I Do?

If you’re selling securities in a Crowdfunding offering or an ICO, don’t hire that person who promises to go out and find investors in exchange for a commission, unless she’s a registered broker.

On the other hand, in an isolated case, if you know someone with five wealthy friends, who promises to introduce you to those friends, without participating in any sales presentations, you might be willing to offer a commission, relying on current law, as long as (1) you understand that a court might hold against you, adopting the SEC’s hard-line approach; and (2) you hire a securities lawyer to draft the contract.

The Future

Several years ago the SEC created an exemption for Finders in the mergers & acquisitions area. I am far from alone in suggesting that we need a similar exemption for Finders in non-public offerings. The current situation, where a substantial part of the securities industry operates in a legal Twilight Zone, is not tenable as online capital raising becomes the norm rather than the exception.

Questions? Let me know.

Simultaneous Offerings Under Rule 506(c) And Regulation S

Co-Authored By: Bernard Devieux & Mark Roderick

If you ask one of my partners whether he wants beer or hard liquor, he says “Yes.” That’s the same answer most entrepreneurs give when asked whether they want to raise money from U.S. investors or investors who live somewhere else. Fortunately, if you’re reasonably careful, you can raise money from U.S. investors under Rule 506(c) – otherwise known as Title II Crowdfunding – while simultaneously raising money from non-U.S. investors under Regulation S.

You don’t have to use Regulation S to raise money from non-U.S. investors. You can use Rule 506(c) instead, as long as you take reasonable steps to verify that they’re accredited, just as with U.S. investors. But verification can be difficult with non-U.S. investors. You use Regulation S either because you want to include non-U.S. investors who are non-accredited or because you just don’t want the hassle of verification.

The concept behind Regulation S is simple:  the U.S. government doesn’t care about protecting non-U.S. people. That sounds harsh but think about it this way. If an American citizen is taken hostage in Albania, boom, the U.S. military comes to the rescue. But if a Russian citizen is taken hostage in Albania. . . .well, maybe that’s a bad example these days, but you get the picture.

To implement this concept, Regulation S provides that:

For purposes of section 5 of the Securities Act of 1933 [the law that usually requires the registration of securities offerings], the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed . . . not to include offers and sales that occur outside the United States.

An offer or sale by an issuer of securities will be treated as occurring “outside the United States” only if all of the following requirements are satisfied:

  • The buyer is a non-U.S. person.
  • The issuer follows designated guidelines with legends on the securities, restrictions on resales, etc.
  • The offer is not made to a person in the United States.
  • No “directed selling efforts” are made in the United States.

The first two are relatively easy:  you make sure the investor isn’t a U.S. resident and you put the right words on stock certificates, promissory notes, and other legal documents.

The second two become tricky in Crowdfunding, where everything is done on the Internet.

For example, suppose an issuer maintains a single website advertising its offering of common stock, equally accessible to prospective investors in Iowa and in Spain. The website undoubtedly constitutes an “offer” to investors in Iowa, and is undoubtedly part of a “directed selling effort” in Iowa, no less than if the offering had been advertised in the Des Moines Gazette. Does this ruin the Regulation S offering?

The SEC’s definition of “directed selling efforts,” written in the early 1990s, doesn’t address this situation. And other than confirming that issuers are legally permitted to conduct simultaneous offerings under Rule 506(c) (to U.S. investors) and Regulation S (to non-U.S. persons) so long as each offering complies with its applicable rules, the SEC has not provided specific guidance on how to avoid the “cross-contamination” issue involving websites.

Fortunately, the SEC addressed a very similar issue with intrastate Crowdfunding just last year. Technically, an intrastate offering is allowed only if “offers” are limited to the citizens of one state. Does posting an offering on a website violate that rule, given that the website is visible to everyone? The SEC chose the position more favorable to Crowdfunding (as it almost always does), announcing that an intrastate offering could be advertised on a website as long as the issuer accepts investments only from residents of the state in question.

The SEC’s position on intrastate offerings suggests that it would take a similar position on Regulation S, finding that the use of a single website would not violate either (1) the requirement that no “offers” be made in the U.S., and (2) the requirement that “no directed selling efforts” be made in the U.S. But we don’t know for sure.

To be on the safe(er) side, an issuer would create separate websites, one for the Rule 506(c) offering and the other for the Regulation S offering, and use IP addresses to ensure that the Regulation S website is not visible within the United States. On the Regulation S website, you would also:

  • Have each visitor (and potential investor) verify his, her, or its legal residence before being permitted to see the details of the offering; and
  • Feature prominent disclaimers that U.S. persons are not welcome.

Finally, bear in mind that Regulation S is an exemption from U.S. securities laws. If you’re offering and selling securities to the citizens of another country, you should think about the laws of that country, too.

Filing Financial Statements and Other Reports Under Regulation A

“I know I have to include financial statements when I file an Offering Statement under Regulation A. When should these statements be dated and what periods should they cover?”

“What ongoing reports do I have to file with the SEC after my Regulation A offering is qualified, and when do I have to file them?”

We hope to answer these questions below.

Types of Financial Statements in the Offering Statement

A Regulation A Offering Statement can require four kinds of financial statement:

  • A balance sheet as of the end of a fiscal year
  • An interim balance sheet
  • A statement of income, cash flows, and changes in stockholders’ equity
  • Interim statements of income, cash flows, and changes in stockholders’ equity

Requirements for Financial Statements

In general, the financial statements must be audited in a Tier 2 offering, but not in a Tier 1 offering. However, interim financial statements – balance sheets and statements of income and cash flows – never have to be audited, even in Tier 2.

Audits in Regulation A may be performed using U.S. Generally Accepted Audited Standards or the standards of the Public Company Accounting Oversight Board. The accounting firm that prepares the audit does not have to be registered with the PCAOB.

When Should the Financial Statements in the Offering Statement Be Dated?

This is tricky, because there are not one, but two important dates:  the date the Offering Statement is filed with the SEC, and the date it is qualified by the SEC. By definition, the date of qualification is always after the date of filing, by a month in the best of circumstances and often by many months. That means that a financial statement that was timely when the Offering Statement was filed might be “stale” by the time it’s qualified. In that case, you’ll need to submit updated financial statements before qualification.

Thus, read the term “Reference Date” in the chart below to mean the date of filing, when you’re preparing your Offering Statement. But bear in mind that eventually the “Reference Date” will mean the date of qualification. So if you’re close, you might as well use a later date.

Click here to view the printable chart.

Ongoing Reporting under Regulation A

Click here to view the printable chart.

 

Questions? Let me know.

What’s the Difference Between Rule 506(c) and Rule 506(b) in Crowdfunding?

Three and a half years into Title II Crowdfunding, I am asked this question a lot, sometimes by portals, sometimes by issuers.

A Chart, of Course

Three Important Differences

Verification

In a Rule 506(b) offering, the issuer may take the investor’s word that he, she, or it is accredited, unless the issuer has reason to believe the investor is lying.

In a Rule 506(c) offering, on the other hand, the issuer must take reasonable steps to verify that every investor is accredited. The SEC regulations allow an issuer to rely on primary documents from an investor like tax returns, brokerage statements, or W-2s, but they also allow the issuer to rely on a letter from the investor’s lawyer or accountant. In practice, that’s how verification is typically handled.

I strongly recommend that issuers do not verify investors themselves. Instead, they should use a third party like VerifyInvestor. If an issuer handles verification itself and makes a mistake, it’s possible that the entire offering could be disqualified. Conversely, once an issuer hands the task to VerifyInvestor, the issuer has, by definition, taken the “reasonable step” required by the SEC, and can sleep well at night.

Information

If all the investors are accredited, there is no difference between Rule 506(b) and Rule 506(c).

If there is even one non-accredited investor in a Rule 506(b) offering, on the other hand, the issuer must provide a lot more information, specifically most of the information that would be included in a Regulation A offering.

The technicalities are important to the lawyer, but to the issuer or the portal, the bottom line is that if non-accredited investors are included the offering will cost $5,000 – $7,500 more, and take a little longer to prepare.

Advertising

In a Rule 506(b) offering you can advertise only the brand. In a Rule 506(c) offering you can advertise the deal.

Ever watch the commercials for brokers and investment banks during a golf tournament? They feature an older guy and his very attractive wife, planning for a carefree and meaningful retirement. They message is:  we can help you achieve your dreams. But they don’t show any of the actual investments they recommend! They’re only advertising the brand.

That’s the model for a website offering investments under Rule 506(b). We can advertise the website – the brand – but we cannot show actual investments. The website attracts investors who sign up and go through a KYC (know your customer) process following SEC guidelines. We have the investor complete questionnaires, we speak with the investor on the phone a couple times, we learn about his or her experience and knowledge investing – we develop a relationship. Then, and only then, can we show the investor actual investments.

In contrast, a website offering investments under Rule 506(c) can show actual investments to everyone right away.

Which is Better?

If I own a jewelry store, I have two choices:

  • I can display jewelry in the front window where passersby can see it.
  • I can display a sign in the front window saying “Great jewelry inside. Must register to enter.”

That’s why I prefer Rule 506(c).

But I also acknowledge three benefits of Rule 506(b):

  • To include non-accredited investors, you must use Rule 506(b), or another kind of offering altogether.
  • If you use Rule 506(c), you might lose bona fide accredited investors who are unwilling to provide verification.
  • If you use Rule 506(b), which doesn’t require verification, you might get money from non-accredited investors who are willing to lie.

Switching Midstream

You can start an offering using Rule 506(b), then switch to Rule 506(c), as long as you haven’t accepted any non-accredited investors.

Conversely, once you’ve advertised a Rule 506(c) offering, you cannot go back and accept non-accredited investors, claiming you’re relying on Rule 506(b).

Questions? Let me know.

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