Tag: JOBS Act

Massachusetts Adopts Crowdfunding

Flag-map_of_Massachusetts.svg

Add Massachusetts to the growing list of states that are sidestepping the unusable federal crowdfunding alternative.

“The Crowdfunding Exemption is designed to foster job creation by helping small and early-stage Massachusetts companies find investors and gain greater access to capital with fewer restrictions. The exemption is also intended to provide necessary investor protections by requiring key disclosures, and by making the exemption unavailable to bad actors that have violated the securities laws or committed financial fraud.”

The federal crowdfunding provisions in the Jumpstart Our Business Startups Act of 2012 was supposed to be a panacea for crowdfunding. But the final language of the law was amended at the last minute. The Securities and Exchange Commission was vocally opposed to it, but issued proposed regulations in October 2013 to implement the exemption. The SEC received about 300 written comments to the proposed regulations, but there is no sign that the final regulations will come out any time soon. The Federal crowdfunding regime will not be effective until the SEC issues those regulations. Even then, the regime is likely to be unwieldy.

A May 1, 2014 Wall Street Journal article, entitled “Frustration Rises Over Crowdfunding Rules,” describes efforts in the U.S. Congress to amend the JOBS Act even before the federal regime takes effect. However, many states have decided that crowdfunding is worth trying and are not waiting for the SEC.

The new Massachusetts crowdfunding regime is limited to $1 million a year, which can be increased to $2 million with audited financial statements. The company must set a fundraising minimum and must keep funds in escrow at a Massachusetts bank until it reaches the target.

The investment amount limitations are a bit messy. For those with net worth and income of less than $100,000, an investment is limited to the greater of $2000 or 5% of annual income or net worth. For the wealthier, it can go up to 10% of income or net worth. The Massachusetts regulation looks to the SEC accredited investor standard for calculating those amounts (i.e. exclude the home).

There is a limitation on form. The business must be formed under Massachusetts law, have its principal place of business in Massachusetts and authorized to do business in Massachusetts. It’s too bad the regime excludes the Delaware formed organizations from crowdfunding. That limits future growth of the company. Bigger money investors will want a Delaware entity for the certainty under the Delaware corporate laws for protection of their shareholder rights.

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Congress Tries to Fix the JOBS Act

house financial services

I’m still surprised that the Jumpstart Our Business Startups Act flew through Congress two years ago. It’s surprising to see bi-partisan support for anything. Unfortunately, the law was flawed and has accomplished little that it set out to accomplish.

The Title III Crowdfunding law was wildly hailed as monumentally changing the way small businesses could raise capital. However, the law was deeply (fatally?) flawed. The law handed the Securities an impossible framework to craft regulatory control. The SEC has not produced the new regulations because of the deep flaws in the law. That fact is clearly acknowledged in a recent legislative cover memo. Plus there is a titanic clash between the consumer protection and capital formation goals of the the SEC.

Title II demanded a lifting of the ban on general solicitation. Congress added a caveat that the company raising the capital take reasonable steps to ascertain that the investor is an accredited investor. That’s a bad hurdle, but not insurmountable. However, the SEC’s consumer protection goal produced a nasty set of proposed regulations that has scared off many firms from taking advantage of the new possibilities for advertising and solicitation.

Congress is trying to fix the problem. There is a hearing today on three bills that offer technical fixes to the JOBS Act.

The first is rebuilding of the Crowdfunding platform. This bill repeals the old law and replaces it with a modified version of the original House bill proposed by Rep. McHenry.

The second is an improvement to the oft-forgotten Regulation A exempted offerings. The proposal would raise the offering amount to 10 million and makes a few other tweaks.

The third blows up the SEC’s proposed regulatory changes to Form D and otherwise makes advertising and solicitation more palatable for private offerings.

Hearing entitled “Legislative Proposals to Enhance Capital Formation for Small and Emerging Growth Companies, Part II”
Thursday, May 1, 2014 9:30 AM in 2128 Rayburn HOB

Witnesses:

  • Mr. Benjamin Miller, Co-Founder, Fundrise
  • Ms. Annemarie Tierney, Executive Vice President and General Counsel, SecondMarket
  • Mr. William Beatty, Director of Securities, Securities Division, Washington State Department of Financial Institutions
  • Mr. Jeff Lynn, Chief Executive Officer, Seedrs Limited

These are well-thought out changes that would improve capital formation. I fear that the House Financial Services Committee has become too partisan to effectively legislate.

Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

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The First Enforcement Action Under the JOBS Act

SEC Enforcement Logo

I believe the Securities and Exchange Commission has taken its first enforcement action under the JOBS Act. The SEC announced fraud charges against a Spokane Valley, Wash., company and its owner for misleading investors with claims to raise billions of investment capital under the Jumpstart Our Business Startups (JOBS) Act and invest it exclusively in American businesses.

Every critic has some concerns about investor protections in a post-JOBS Act securities world. There has been a whirlwind of entrepreneurs and wanta-preneuers who want to take advantage of the crowdfunding rules and the removal of the ban on general solicitation for private offerings.

“The JOBS Act is intended to help small businesses raise capital, not to legalize fraud or give unscrupulous entrepreneurs a right to make false claims to fleece investors.”
– Michael S. Dicke, Associate Director in the SEC’s San Francisco Regional Office.

According to the SEC complaint, Daniel Peterson sold his USA Real Estate Fund 1 securities, raising more than $400,000 based on false and misleading statements.  According to the business plan, the fund could invest in real estate, mortgage notes and technology companies. I consider all of these to be high risk investments. But the website touts that investors won’t lose their money.

Q: How do you assure the investor that they will not lose their investment?
A: Our protection works much the same as flood insurance or earthquake or tornado insurance. We buy Financial Instruments comprised of US Government treasuries, Top Rated US and World Insurance and Reinsurance Companies (GIC and Annuity) contracts. The fund reserves the right to invest up to 5% of its assets in other Debt securities, such as but not limited to, high yield securities, foreign bonds, and money market instruments, when to do so would be considered within the strategy of the fund and in the best interest of its investors. These are the financial instruments that will provide the money to insure against loss.

I’m not quite sure how to reconcile that answer with the investment strategy.

According to the SEC complaint, the firm claimed it would offer additional securities and raise more investment capital, made possible by the Jumpstart Our Business Startups Act. Again, its not clear to me how passage of the JOBS Act would create value for the fund investors. I suppose that’s one of the reasons the SEC is making a claim against the fund for false and misleading statements.

It is clear that this is not a case of legitimate fundraising trying to take advantage of the JOBS Act before the JOBS Act regulations are put in place. If you, like me, were looking for a juicy and sordid tale instead of mere fraud you will be disappointed with the headline.

Equity crowdfunding portals are not yet legal because the regulations have not been enacted. General solicitation for Rule 506 private placements is not yet legal, because the regulations have not been enacted. Of course there are legal ways to use exemptions in these situations, but they are all pre-JOBS Act.

Anyone currently touting ways to get rich using the JOBS Act should be viewed as suspect. They are merely speculating on what the SEC may do and how entrepreneurs would take advantage of the potential new regimes.

You need to draw the distinction between entrepreneurs and wanta-preneuers.

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Crowdfunding and the Ban on General Solicitation

18 Rabbits Bars

While entrepreneurs are looking to create crowdfunding portals under Title III of the JOBS Act, small business owners looking to raise capital should keep an eye on the regulatory changes under Title II of the JOBS Act. That may do a better job of opening the spigot for capital than the avalanche of crowdfunding portals likely to appear.

Look at the case of Alison Bailey Vercruysse, a maker of granola-based foods, and her company 18 Rabbits. According to a story in yesterday’s Washington Post, her products attracted a loyal following, but she could not tap those fans for capital as she tried to grow her firm.

“People would come up to me in different places and say: ‘I’m interested in investing in your company. How can I do that?’ ” Vercruysse said. “I couldn’t say we were trying to raise money. I’d end up saying things like; ‘Buy our granola. That would help us.’ ”

Without the ban on general solicitation, the company could put a message on its packaging or its website for accredited investors interested in investing.

Currently, the Securities and Exchange Commission has a ban on the use of general advertising and solicitation for raising private capital under the most popular exemption, Rule 506. Title II of the JOBS Act requires the SEC to remove that ban for offering where all investors are accredited. The agency tried to rush the rules last summer to meet the Congressional deadline, but investor advocates demanded that the SEC slow down. The SEC is gathering public comment before finalizing the rule.

Two SEC commissioners, Dan Gallagher and Troy Paredes, were in favor of immediately lifting the ban. SEC Commissioner Luis Aguilar did not like the rule, saying it lacked adequate investor protections. The fourth SEC Commissioner, Elise Walter voted for the proposal, but expressed concerns. She has stated the SEC must consider ways to mitigate potential harm to investors. The fifth and presumably deciding Commissioner’s seat is vacant with the departure of Mary Shapiro. Looking into my crystal ball, it would seem that the rule is not going to be finalized anytime soon. At least not until the vacancy is filled.

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Crowdfunded Companies Won’t Be Here Anytime Soon

Money

When the JOBS Act passed last spring, there was a huge surge on the future of crowdfunding. In pursuit of the riches of startup investing, many ignored the already successful world of Kickstarter, Indie Go Go, and others that already successfully fund projects. Those platforms don’t show the investor a pot of gold at the end of the rainbow. They show the investor the final project and maybe the chance to purchase one or participate.

By switching to equity fundraising, the focus would switch to the potential financial reward and perhaps less on the value of the project. Critics wailed about the onslaught of fraud. Proponents praised the unleashing of entrepreneurial capital. The lawyers and regulators worried about how to implement this new capital raising regime.

Congress didn’t make it easy. They chose do throw out the original crowdfunding law proposed for the JOBS Act and replaced it with a very cumbersome and difficult new piece of legislation. They gave the Securities and Exchange Commission 270 days to come out with the regulations. That’s on top of the huge pile of regulatory mandates passed 2 years ago with Dodd-Frank.

We have seen no inkling that the SEC has come close to proposed regulations. With the departure of Mary Shapiro, the SEC is down to four commissioners. Two of whom have publicly voiced their concerns about crowdfunding. Even if the SEC can gather three out of four of the commissioners to agree on proposed regulations, there will be a lengthy comment period and likely re-writing to get to the final regulations.

In addition to the SEC, FINRA will need to create a regulatory regime for the registration of crowdfunding portals. To get a taste of how difficult this going to be, you can take a look at the first baby steps of regulatory work that came from FINRA.

FINRA is inviting prospective crowdfunding portals to voluntarily file an interim funding portal form. The filing is meant to help FINRA develop rules that reflect the funding portal community and its business. It is not an application and does not get anyone any closer to having a working equity crowdfunding platform.

For a taste of the difficulties take a look at the last question:

Please describe how the [Funding Portal] addresses the requirements for funding portals under the JOBS Act. In particular, please describe how the [Funding Portal] would
(i) address investor education;
(ii) take measures to reduce the risk of fraud with respect to funding portal transactions;
(iii) ensure adherence to the aggregate selling limits; and
(iv) protect the privacy of information collected from investors.

The successful crowfunding portals are going to have to master difficult regulations, successfully court attractive investment opportunities, master the 50 states of privacy legislation, come up with effective investor eduction tools, and successfully attract investors willing to write checks.

I still think crowdfunding will end up being a minor league system for the investment banks. They have the resources to conquer these hurdles. They can use the database of investors to mine for more conventional investment opportunities. They can use the few successful crowdfunded companies to sell bigger opportunities for raising more capital. It seems to me that we are still many, many months away from seeing the first crowdfunding portal under the JOBS Act.

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506(c) and General Solicitation and Advertising in Securities Offerings

Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directs the Securities and Exchange Commission to amend Rule 506 of Regulation D. Congress wants to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. With one caveat: the issuer must take reasonable steps to verify that purchasers of the securities are accredited investors. After some delays, the SEC has finally published a proposed rule to implement the Congressional mandate.

After waiting all summer for a proposed rule, the SEC decided to finally take action during my vacation. And on the day I promised to take my kids to Story Land. My review of the rule and commentary would have to wait until my kids had their fill of Cinderella and the Bamboo Chutes.

Thanks to William Carleton’s live blog and a review of speeches, I could see that the five commissioners were not in full agreement about the rule or the procedure for adopting the rule. Commissioner Gallagher was in favor of the proposed rules, but wanted it to be an interim final rule. Commissioner Aguilar thought the proposed rules did not go far enough in protecting investors. In the end, that may not mean much.

As expected, the removal of the general solicitation and public offering prohibitions, comes with a few caveats.

Does Not Remove Ban

I found it interesting that the SEC chose to create a new regulatory scheme, rather than merely eliminate the ban. The proposed rule includes a new Rule 506(c) that permits general solicitation and advertising provided all investors are accredited and the issuer takes reasonable steps to verify that they are accredited. 506(b) stays in place allowing an issuer to have up to 35 sophisticated, but non-accredited investors, provided there is not general solicitation or advertising, but does not have to take reasonable steps to verify the investors’ status.

“Take reasonable steps to verify”

The SEC did not do what many feared would be the worst result under the JOBS Act. The proposed rule does not impose any specific requirement to verify that an investor meets the standard of an accredited investor. “Whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.”

To some extent that seems okay. In the private equity fund model we have a particular concern that a potential investor will be able meet a capital call. It should just mean having to document the diligence process.

However, the SEC did strike one common aspect of fundraising practice.

[W]e do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

Offering documents will need to be changed.

A Non-Accredited Investor Sneaks In

The language of the JOBS Act made some, including me, nervous that if a non-accredited investor could sneak into an offering and blow up the exemption. A person of limited means really wanted to be an investor, lied on the questionnaire, but passed through the reasonable steps taken by the issuer to verify status. Fortunately, the SEC took that position that the issuer would not lose the ability to rely on the Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

Changes to Form D

In addition, to the new 506(c) the SEC is proposing to amend Form D. The notice filing with the SEC would have a check box to indicate whether an offering is being conducted pursuant to the proposed Rule 506(c) that would permit general solicitation.

Blessing for Private Funds

Private funds typically rely on the Rule 506 safe harbor to raise funds without having to register under the Securities Act. Private funds were also restricted under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act from making a public offering of securities. Historically, the SEC has considered rule 506 transactions to be non-public offerings. But would the SEC change that position given its hostility towards the JOBS Act?

Thankfully, the answer is no.

We believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.

Comments

Now there is 30 comment period. I’m just guessing, but I’d be surprised to see changes to the proposed rule. I think the benefit of the comment period will be to add some additional commentary around the “reasonable steps to verify” standard.

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Is Decimalization Good or Bad?

Although commentators have been viewing the Jumpstart Our Business Startups Act as a rollback of 2010’s Dodd-Frank financial reform, it’s been showing itself as much more of an attack on the earlier Sarbanes-Oxley Act. The latest attack is a required report on a possible rollback of decimalization. A decade ago, the SEC and the exchanges moved to have the price of securities quoted in pennies to deliver cost-savings to investors. The JOBS Act offers up the possibility of increasing the tick size for the new class of “Emerging Growth Companies.” The first step was a Report to Congress on Decimalization (.pdf) as required by Section 106 of the JOBS Act.

The report finds many benefits to investors.

Bessembinder finds that the average quoted bid-ask spreads for all companies declined from pre- to post-decimalization in both NYSE and NASDAQ stocks. His study results showed that large capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 11 cents to 6 cents and on the NASDAQ from 10 cents to 4 cents. Middle capitalization stocks’ equally-weighted quoted spreads on the NYSE declined from 16 cents to 10 cents and on the NASDAQ from 17 cents to 13 cents. In comparison, small capitalization stocks’ equally-weighted quoted spreads declined from approximately 23 cents to 18 cents on the NYSE, and from 26 cents to 23 cents on the NASDAQ. He found that the corresponding decline, as a percentage of trading price for small capitalization stocks, is from 1.75% to 1.16% on the NYSE and from 1.84% to 1.58% on the NASDAQ.

That’s a cost savings to investors and a profit loss to market makers. However Section 106 of the JOBS Act asks “whether there is sufficient economic incentive to support trading operations” in small and middle capitalization companies after decimalization. Both the IPO Task Force Report and a Grant Thornton paper argue that because brokerage analysts have to depend on revenue from trading commissions, they have an incentive to cover only high volume stocks. The concern is that smaller capitalization stocks do not have the trading volume to offer enough profitability for analyst coverage.

Though regulatory decimalization in the market lowered the minimum allowable tick size to $0.01, it did not mandate that market participants quote narrower spreads. Rather, the quoting of narrower spreads appears to have been a result of continued market forces.

That leaves the SEC staff recommending that the Commission not proceed with a rulemaking to increase tick size. Hopefully that will be the end of this for the foreseeable future. This section of the JOBS Act was a blatant grab by Wall Street to regulate for increased profitability.

Sources:

  • Report to Congress on Decimalization (.pdf) (As Required by Section 106) July 20, 2012
  • Bessembinder, Hendrik, 2003, Trade execution costs and market quality after decimalization, Journal of Financial and Quantitative Analysis 38(4), 747-777.

The Rebirth of Regulation A Offerings

The Jumpstart Our Business Startups Act requires the Securities and Exchange Commission to amend Regulation A, raising the threshold for use of that exemption from $5 million to $50 million. From the numbers I’ve seen, Regulation A was rarely used as a source of raising capital. It seemed strange that it was included in the JOBS Act. But there were many strange things in the JOBS Act.

Section 402 of the JOBS ACT required the GAO to study the impact of state securities laws on Regulation A offerings. The GAO released its study: Factors That May Affect Trends in Regulation A Offerings.

The report confirmed the lack of use of Regulation A in capital raising. The number of Regulation A offerings filed with the SEC decreased from 116 in 1997 to 19 in 2011. Similarly, the number of qualified offerings dropped from 57 in 1998 to 1 in 2011.

The big difference is that Regulation A offerings are still subject to state securities laws. In contrast, Rule 506 offerings under Regulation D are not subject to the state securities law.

To contrast, there were 15,500 initial Regulation D offerings for up to $5 million in 2010 and 2011, compared to the 8 qualified Regulation A offerings during the same period.

One aspect of a Regulation A offering compared to a Regulation D offering is that it is subject to review, comment, and qualification by the SEC. According to the GAO report 20% of Regulation A filings were abandoned during the SEC comment process.

Another aspect of Regulation A is that the securities’ sales are not limited to accredited investors. So there is a larger pool of potential investors.

On the state side of the process, all states conduct a similar disclosure review as the SEC. Apparently some states will also engage in a merit review to determine if potential investors are getting a good deal. According to the report, businesses are generally advised by legal counsel to avoid Regulation A offerings in states that have a merit review.

So where does this leave Regulation A offerings in the new world of capital formation after the JOBS Act? I would guess in the same place. The big advantage of Reg A offerings over Reg D offering is that they can be sold to non-accredited investors. That comes with a lot of cost and lost time to go through the review process. I would guess that the new crowdfunding offering would be a more attractive alternative to reaching non-accredited investors. Of course, the regulations on crowdfunding do not yet exist and the mandatory equity crowdfunding portals do not yet exist.

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Wait a Bit Longer for Removing the Ban on General Solicitation and Advertising

On June 28 Securities and Exchange Commission Chairman Mary L. Schapiro testified that the SEC will not make the deadline for lifting the ban on general solicitation and advertising and the reasonable process for verification of accredited investors. Title II of the JOBS ACT gave the SEC 90 days to craft the regulation.

“As I stated to Congress prior to the passage of the Act, time limits imposed by the JOBS Act are not achievable. Here, the 90 day deadline does not provide a realistic timeframe for the drafting of the new rule, the preparation of an accompanying economic analysis, the proper review by the Commission, and an opportunity for public input.”

Since there has not even been a proposed rule available for comment, there was no doubt the SEC was going to miss the deadline.

The regulation will likely be a key change for private fund managers.

I don’t expect private funds to engage in bulk email or late night television commercials. I would expect more advertising in trade publications and more engagement with the media.

For me the bigger concern is what the SEC is going say about the “reasonable steps to verify that purchaser of the securities are accredited investors…” that the SEC has been empowered in include in this new regulation. The SEC has been empowered to implement requirements for years. It has just chosen not do any thing. The JOBS Act has given the SEC a little nudge to act.

Perhaps the SEC will not act.

The current method of self-certification for accredited investors seems to work for now. Imposing some requirement to gather financial information would dramatically increase the amount of sensitive personal information being transmitted and stored. That will mean firms will need to beef up their data security and deal with this new source of personal information. Inevitably, there will be a breach and investors identity’s will be stolen.

The current process of self-certification of investors seems to work well. Of course, I could see how the failure to review a potential investor could lead to fraud. It would seem to hurt the investor, committing to an investment he or she could not afford. perhaps it would be a red flag to regulators that the adviser is not conducting the diligence to conclude that an investor is accredited, and is therefore preying on unsophisticated investors.

However, for private funds the minimum investment amount is usually equal to or in excess of the standard for being an accredited investor. If the fund requires a minimum investment of $1 million, then the investor presumably has the $1 million net worth required by the accredited investor standard. Hopefully, the rule will contemplate that situation and not overly burden private funds.