Category: Fundraising

Steps to Determine if an Investor is Accredited

Private funds will be able to advertise and solicit for investor, provided all of the investors are “accredited investors.” The will dramatically change the way capital raising for private funds operates.

The drawback is the loss of 35 non-accredited investors in the fund. That exception has been eliminated. Funds will need to wait until the Securities and Exchange Commission issues the rules under Section 201 of the JOBS Act.

Part of those rules may be a mandated approach to determine if someone is an accredited investor.

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

The SEC may take the opportunity to mandate an approach to validate an investor’s financial standing. As with most regulations, it could clear up uncertainty or create a paperwork headache (or both).

Will you need a copy of an investor’s W-2? A certified financial statement? Those are reasonable requests. However it would create much more personal information that would need to be safeguarded by the fund sponsor.

There is the possibility that the mandated approach would also address the requirements to determine if an investor is “qualified client” under the Investment Advisers Act or a “qualified purchaser” under the Investment Company Act.

We will have to wait and see what comes out of 100 F Street.

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Next Steps for the JOBS Act

The Jumpstart Our Business Startups Act, as amended by the Senate, was voted on by the House of Representatives yesterday and passed 380 to 41. That makes it a very bi-partisan bill, even though all 41 “Nays” were Democrats. If I remember my Schoolhouse Rocks song correctly, it’s up to the President to sign it or veto it.

The White House has already expressed support for the concept of crowdfunding. I expect President Obama will sign it into law very soon. He may actually have signed it by the time you are reading this.

As with the big Dodd-Frank law of 2010 that increased regulatory oversight, this law that decreases the regulatory burden tasks the Securities and Exchange Commission with many tasks. There are several studies and rulemakings thrown at the SEC. (I didn’t see any budget increase to go along with these tasks.)

The one I’m most focused on is in Title II-Access to Capital for Job Creators. Section 201(a) requires the SEC to

“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.”

The law gives the SEC 90 days to make the revision.  WWSECD? (What Will the SEC Do?)

The SEC could simply insert the new language into Rule 506. It’s exactly what Congress demanded. However, the SEC could provide some clarity and other restrictions around the advertising. There could be rules about record-keeping or submission of advertisements. The SEC still has its ant-fraud mandate so it could impose other requirements. Some of the SEC commissioners have already spoken out against the law. But given the short timeframe, I doubt the SEC will do anything except insert the new language.

However, the SEC does need to act before the late-night TV advertisements begin. There may be some regulatory limbo if the SEC does not enact the revision by the end of the 90 day period. Why would the SEC pick this fight with Congress? Get ready for a new wave of advertisements for unregistered securities starting this summer. But you can only buy them if you are an accredited investor.

The SEC will have to study the “tick rule” to determine if penny increments are too small for the new category of emerging companies under Title I of the JOBS Act: Reopening American Capital Markets to Emerging Growth Companies. Section106 tasks the SEC with this study. I guess Congress thinks the trading on public companies with less reporting on executive compensation, lesser financial reporting obligations, and less auditing would trade differently than companies that meet the more exacting standards of a public company. Of course this is just for small companies, with less than $1 billion in gross revenues. (When did a billion get to be so small?)  I’m sure the brokerage houses would love to see a bigger spread on the tick.

Title I also tasks the SEC with a review of Regulation S-K. Section 108 gives the SEC 180 days to study how to streamline the registration process.

Title IV-Small Company Formation expands the Regulation A exemption allowing a more streamlined approach for smaller issues. The limit is raised from $5 million to $50 million. (When did $50 million get to be so small?) The Comptroller General gets tasked with study of the state blue sky laws on Regulation A offerings.

Title V- Private Company Growth and Flexibility Act, or as I call it the let’s not make Facebook go public section. It raised the 12(g)(1)(A) standard from 500 shareholders to 2,000 or 500 who are not accredited.  Section 503 tasks the SEC with revising the definition of “held of record” and safe harbor provisions for employee compensation.  The SEC also look at its authority to enforce Rule 12g5-1 and report its recommendation back to Congress.

Title VI-Capital Expansion makes a shareholder increase for banks and bank holding companies and gives the SEC a year to issue final regulations to implement the changes.

Title VII makes the SEC tell people about the JOBS Act.

The Securities and Exchange Commission shall provide online information and conduct outreach to inform small and medium sized businesses, women owned businesses, veteran owned businesses, and minority owned businesses of the changes made by this Act.

I expect we will see a new web page or domain from the SEC on the JOBS Act.

Those are not very sexy changes and probably leave you scratching your head about why Congress would pass these changes and do so very quickly. It leaves me curious as well. Many of the SEC commissioners took that rare action of publicly stating their opposition to the law. The state regulatory association stated:

Election-year politics have blinded Congress and the White House to the unintended consequences of the JOBS Act, which while well intentioned, could do little more than open the floodgates to investment fraud.

I suppose it was election year politics. And good marketing. The bill sponsors were able to give it the acronym JOBS, even though the bill has little to do directly with jobs. The sponsors have draped small businesses with the flag of job creators and opening the floodgates of capital to them will allow them to grow and re-create the millions of jobs lost in 2008-2009.

There was also the sexy piece of the JOBS Act that I have not mentioned, Title III-CROWDFUND. It’s designed to enable aspiring entrepreneurs to access capital using the internet to gather small dollar investments from would-be investors across America. William Carleton has done a great job of covering the crowdfunding aspect of the law.

Don’t expect Kickstarter to start offering equity funding any time soon. The SEC has 270 days to enact the rules around crowfunding and regulation of funding portals.

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Lifting the Ban on General Solicitation and General Advertising

On Thursday afternoon, the US Senate passed the Jumpstart Our Business Startups Act, a bill designed to make it easier for small companies to raise capital. The centerpiece of the legislation is the crowdfunding provision. However, the Senate passed an amendment to that section of the legislation. That means the Senate version and the House version of the law are different. It’s up to the House to pass the Senate version, or meet in conference to find a compromise.

The Senate did not change Title II of the legislation. Those sections eviscerate the long-standing prohibition on general advertisement and general solicitation of investors. Amendments to Title II were proposed, but were shot down.

It seems like the House is willing pass the Senate version of the legislation and the President is willing to sign it. That means one of the biggest limitations to fundraising for private funds is likely to be erased. It will take a few months after the passage of the law for the SEC to change the regulations in Rule 506.

As early as this summer, the marketing opportunities for private funds will dramatically increase. Maybe that’s a fair trade for having to register as an investment adviser with the SEC.

Here is the text of the bill:

TITLE II—ACCESS TO CAPITAL FOR JOB CREATORS

SEC. 201. MODIFICATION OF EXEMPTION

(a) MODIFICATION OF RULES.— (1) 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. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).

(2) Not later than 90 days after the date of enactment of this Act, the Securities and Exchange Commission shall revise subsection (d)(1) of section 230.144A of title 17, Code of Federal Regulations, to provide that securities sold under such revised exemption may be offered to persons other than qualfied institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.

How Do State Regulators Really Feel About the JOBS Act?

The House of Representatives recently voted to pass The Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), a collection of several bills focused on barriers to capital formation. I’m focused on the bill because of mostly because of the Access to Capital for Job Creators section that would override the ban on general solicitation and advertising under Regulation D.

I welcome some sensible changes to Regulation D because I find the ban a bit vague as part of the fundraising process. Private fund managers could use guidance from the SEC on what is allowed and what is prohibited by the ban.

On the other hand, knowing the general ban exists makes it easy to dismiss scams and spam spinning tales of possible investment opportunities. That unsolicited message is either a straight-up scam or a naive entrepreneur who thinks they can operate without competent advice. Either way you can easily dismiss the opportunity.

Another provision of the JOBS Act that I found interesting is the Private Company Flexibility and Growth Act. The main purpose is to raise the thresholds under Section 12(g)(1)(A) of the Exchange Act. Currently under that provision, private companies with more than 500 shareholders and a big stream of revenue effectively have to become public companies. That shareholder limit forced Google into going public and most recently is forcing Facebook to go public.

The centerpiece of the JOBS Act is the new crowdfunding platform. Currently, platforms like Kickstarter are prohibited from offering equity. Project sponsors have to ask for donations, offer schwag, or pre-sell products. All of which seems to work very well.

Commentators like William Carleton think the concept of crowdfunding will be great for entrepreneurs. The Wall Street Journal has a point-counterpoint this morning on crowdfunding:

Like most stuff coming out of Congress, even if the concept is good I think Congress is likely to screw up the drafting of the law.

That is my view of the JOBS Act. Most of the concepts are good, but the execution is poor. I think Congress is missing the balance between investor protection and access to capital. That opinion is shared by the North American Securities Administrators Association. Here is a snippet from an editorial by Jack E. Herstein, president of NASAA:

The most jobs this cleverly named bill may create are jobs for fraudsters, like the Nigerian scammers, penny-stock pitchers and Ponzi schemers already lurking behind the Internet to cloak their schemes.

The Senate is mulling over their version of these bills where it seems to have bi-partisan support. President Obama has also thrown his support to some of the concepts in the JOBS Act. It seem likely that something will pass. According to Talking Points Memo it looks like Senate Majority Leader Harry Reid is willing to trade support for the JOBS Act for approval of some judicial nominees.

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Crowdsourcing the Crowdfunding Exemption

There is a growing movement to create a new crowdfunding regime for raising capital. The models seem to draw inspiration from Kickstarter, a platform to fund creative projects. I say that because each time I see a draft bill it talks about an internet-based intermediary as part of the exemption.

President Obama endorsed the idea of a crowdfunding exemption. That has lead to three bills in Congress, plus a proposal being generated by NASAA as a state-run alternative.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. The statement talks about the millions raised through Kickstarter in the form of donations. That’s not exactly right. The offering is sometimes a pure donation, but more often is linked to a product in development.

The Entrepreneur Access to Capital Act (H.R. 2930) permits “crowdfunding” to finance new businesses by allowing companies to accept and pool donations up to $5 million without registering with the SEC. It would limit individual investments to the lesser of $10,000 or 10% of an investor’s annual income. An amendment requiring a notice filing with the SEC was rejected as was an amendment that would have barred felons from being involved.

NASSA is putting together a model exemption for use at the state level. The various state level regulators are trying to craft this model.

The Democratizing Access to Captial Act (S.1791) was introduced by Senator Scott Brown. This bill is being supported by the Wefunders, who is in the business of being a platform for capital crowdfunding. Unlike Kickstarter, it’s only open to accredited investors.

Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (S. 1970) was  introduced by Senator Merkley. This bill has the right acronym.

What they all have in common is some cap on the total funds that can be raised and a cap on how much someone can invest.

I’m all for making it easier for entrepreneurs to have easier access to capital. The registration and legal limits on capital-raising deter lots of projects. However, they also vet projects. To some extent, excluding the unworthy. It also tends to deter lots of worthy projects.

I like the project crowdfunding at Kickstarter. There is no expectation of riches, other than whatever trinket or completed example of the project they promise to you in exchange for your funding. I have no concerns about the dilution of shares, executive compensation, ratchets, and follow-up rounds.

Capital crowdfunding should be an interesting experiment. I predict it will create lots of new jobs and fund lots of interesting projects.

I also expect that it will be suspect to fraud. I expect that there will be many disappointed small investors who expected to reap fortunes, instead being stuck with worthless shares in failed companies or companies that existed only to funnel cash to fraudsters.  The extent of that fraud will depend on how well Congress crafts a crowdfunding bill. I expect they will come up short.

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New York City “Pay-to-Play” Law is Upheld

The U.S. Court of Appeals for the Second Circuit upheld a New York City “pay-to-play” law against various constitutional challenges: Ognibene v. Parkes. The Pay to play law is in Local Law 34 and it:

  1. Lowers the caps applicable to campaign contributions from parties that have “business dealings” with New York City
    • to $400 (otherwise $4,950 applies to contributors not within the purview of the Law) for candidates for city-wide offices,
    • to $320 (otherwise $3,850) for candidates for borough offices, and
    • to $250 (otherwise $2,750) for candidates for city council,
  2. Prohibits public matching for contributions from the Affected Persons, and
  3. extends a ban on contributions from corporations to apply to partnerships, LLCs, and LLPs.

“Business dealings” include, among other things, “contracts for investment of pension funds” and transactions with “lobbyists”.

The plaintiffs in Ognibeneh include Republican Party members, the New York State Conservative Party, lobbyists, and other business interests. They challenged the Law as a violation of the First Amendment, the Fourteenth Amendment, and the Voting Rights Act. They lost in the district court and made this appeal. In affirming the district court’s decision, the Second Circuit considered whether the aforementioned provisions of the Law were “closely drawn to address a sufficiently important state interest” and found that each was sufficiently closely-drawn.

The Second Circuit agreed with the district court that the “doing business” contribution limits are “closely drawn” because combating corruption and the public perception of corruption is a sufficiently important justification for placing limits on donations to a candidate. The court draws a distinction from restrictions on independent corporate campaign expenditures which were struck down in Citizens United as overly burdensome limitations on speech.

The court was not persuaded that actual “evidence of recent scandals” was needed to justify the contribution limits. “[T]o require evidence of actual scandals for contribution limits would conflate the interest in preventing actual corruption with the separate interest in preventing apparent corruption.” Finding “no doubt that the threat of corruption or its appearance is heightened when contributors have business dealings with the City” and citing studies by the City Council on the issue, the court held that it is “reasonable and appropriate” to place additional limitations on contributions by Affected Persons.

The court drew another distinguish between the Green Party case in Connecticut and this law. The Connecticut law challenged in Green Party put in place a total ban on contributions, as opposed to mere limits.  However, “if the appearance of corruption is particularly strong due to recent scandals, therefore, a ban may be appropriate.”

Of course, pay-to-play laws are not unique to New York City. The SEC’s Rule 206(4)-5 enacted a similar limit on campaign contributions. Anyone challenging the SEC rule would have to look at this case and realize the SEC rule would like stand up to court scrutiny.

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Image is New York City celebrating the surrender of Japan. They threw anything and kissed anybody in Times Square., 08/14/1945 from the US National Archives

Amending the Ban on General Solicitation and Advertising

There seems to be some momentum for changes to the  Regulation D’s prohibition on advertising a private fund offering. The Managed Funds Association has asked the SEC to start a rulemaking and one of the SEC’s new advisory committees has also recommended a change.

The SEC’s new Advisory Committee on Small and Emerging Companies approved its first recommendation on January 6. It urged the Commission to “relax or modify” the restrictions under Reg D to permit general solicitation and advertising of private fund offerings, but only to accredited investors.

3. The Advisory Committee is of the view that the restrictions on general solicitation and general advertising prevent many privately held small businesses and smaller public companies from gaining sufficient access to sources of capital and thereby materially limit their ability to raise capital through private offerings of securities; and

4. The Advisory Committee is of the view that the investor protections afforded by the existing restrictions on general solicitation and general advertising are not necessary in private offerings of securities whereby the securities are sold solely to accredited investors.

In a petition filed with the SEC last week, the Managed Funds Association states eliminating the general and advertising solicitation ban would “promote investment and enhance economic growth,” add new transparency to hedge funds and free up resources the agency could reallocate.

The House has passed a bill that would eliminate the advertising. It still needs support and action from the Senate.

Personally, I find the current ban hard to deal with because of uncertainty about what you can and cannot do. On the other hand, a broad allowance of advertising would likely perpetrate fraud. Currently, if you see an ad to invest in a private company or unique investment opportunity, it’s a red flag that the offer could be a fraud.

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The New Accredited Investor Standard

After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.

Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.

Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.

Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.

One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.

The rule ends up amending:

  • Rule 144(a)(3)(viii),
  • Rule 155(a),
  • Rule 215, and
  • Rule 501(a)(5) and 501(e)(1)(i) of Regulation D
  • Rule 500(a)(1)
  • Form D under the Securities Act;
  • Rule 17j-1(a)(8) under the Investment Company Act of 1940and
  • Rule 204A-1(e)(7) under the Investment Advisers Act of 1940

The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if

  1. the right was held by a person on July 20, 2010 (the day before the enactment of  Dodd-Frank)
  2. the person qualified as an accredited investor on the basis of net worth at the time the right was acquired and
  3. the person held securities of the same issuer, other than the right, on July 20, 2010.

Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.

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Placement Agent Policies for Massachusetts Public Pension Systems

The local retirement boards in Massachusetts are subject to new regulations regarding placement agents. That means if you have one of the boards as investor in your fund or a client in your advisory business, you need to supply new information to your clients/investors.

Public Employee Retirement Administration Commission is the umbrella regulatory organization that oversees the dozens of local retirement boards in the Commonwealth. Last month they issued Memorandum #34 that implements the new PERAC Placement Agents Policy (.pdf).

As a manager you will need to provide:

(a) a statement whether you used a placement agent

(b)  a resume detailing education, professional designations, regulatory licenses and investment and work experience.  If he or she is a current or former member of a retirement board, employee or consultant or immediate family of such a person that fact should be specifically noted.

(c)  a description of any and all compensation of any kind provided or agreed to be provided to a placement agent, including the nature, timing and value thereof;

(d)  a description of the services to be performed by the placement agent

(e) a written copy of any and all agreements between the manager and the placement agent

 (f) in the event that any current or former Massachusetts public pension system board members, employees, consultants or other service providers have suggested the retention of the placement agent, the names of that person

 (g)  a statement that the placement agent has a minimum of three years experience in the investment field

 (h)  a statement that the placement agent is registered with the Securities and Exchange Commission or the Financial Industry Regulatory Authority, or, if appropriate, the Commodity Futures Trading Commission

The pension board will have to include a provision in the investment management agreement that in the case of a breach will allow the board to terminate the agreement and have two years of management fees returned.

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I’m an NFL Owner

Sort of.

The Green Bay Packers want to expand Lambeau Field by 6,700 seats, add new gates and new video boards. To finance the improvements, the team ownership decided to sell additional stock in the ownership corporation. Since the Kraft family is unlikely to be selling the Patriots anytime soon, I was willing to part with some football loyalty and some cash to get my own piece of the NFL pie.

Unlike the rest of the National Football League franchises, the Green Bay Packers franchise is owned by non-profit, community-based organization, Green Bay Packers, Inc. The corporation is required to be nonprofit sharing and that no shareholder may receive any dividend or pecuniary profit by virtue of being a shareholder in the corporation. Any increase in value or operating profits and any proceeds upon liquidation of the corporation will go to community programs, charitable causes or other similar causes. If you add in limitations in stock ownership and transfer restrictions, it’s virtually impossible for anyone to recoup the amount initially paid to acquire the stock. That makes it a completely non-economic investment.

Is it a security?

Here is what the offering document says:

Because the Corporation believes Common Stock is not considered “stock” for securities laws purposes, it believes offerees and purchasers of Common Stock will not receive the protection of federal, state or international securities laws with respect to the offering or sale of Common Stock. In particular, Common Stock will not be registered under the Securities Act of 1933, as amended, or any state or international securities laws. The Common Stock will not be approved by the Securities and Exchange Commission or any state or international regulatory authority nor will the
Securities and Exchange Commission or any state or international regulatory authority approve the Offering or the terms of the Offering.

Under the Howey definition of an investment contract, you need (1) a common enterprise and (2) to depend “solely” for its success on the efforts of others. Certainly, the Packers’ stock meets those two prongs. The third prong is an expectation of profits. That is not true. However the definition of “security” in the Securities Exchange Act of 1934 includes “any note, stock, treasury stock…” The interests in the Packers are clearly stock and seem to fall into the definition of security.

What do you get?

A certificate:

The certificate is designed in the timeless tradition of classic stock certificates. The 12 inch by 8 inch certificate is printed on exquisite paper using a classic engraved steel plate process. It features an artistic representation of heritage. The record of your ownership will be secure, and you will be able to display your ownership with pride.

Is this Crowdfunding?

This is the current state of crowdfunding. You can’t offer securities without going through the registration process or finding an exemption. But you can still raise funds from a large group of people. Just don’t offer a share of the profits or stock. That’s how the kickstarter crowdfunding platform works. You get an over-priced product or a t-shirt or some other token of appreciation. As a backer, you do not have visions of early retirement because you just bought a piece of ownership in a multi-million dollar idea.

A Packers’ alternative would be to have merely offered a certificate of appreciation or tufts of grass from Lambeau field. But they offered the ability to say “I’m an NFL owner.”

I’m supporting a multi-million dollar idea. On Any Given Sunday, any team in the NFL can beat another. A team from tiny Green Bay, Wisconsin can still generate the revenue to field a competitive team and win the Super-Bowl.

I still prefer that the Patriots win the Super Bowl.

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