Tag: Regulation D

Updates on Private Placements

One of the troubling aspects of private placements is trying to draw the line between public advertising for the business and public advertising for selling securities. This aspect is even more apparent for private equity funds and real estate funds that want to tout their deals without jeopardizing their fundraising. The Securities and Exchange Commission offered some updated guidance.

private placement

The SEC published The 11 Securities Act Rules Compliance and Disclosure Interpretations that provide guidance on “general solicitation” under Rule 502(c)

Question 256.24 What information can an issuer widely disseminate about itself without contravening Rule 502(c)?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c). [August 6, 2015].

Which of course leads to the next question:

Question 256.25: What is factual business information?

Answer: What constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund. (Release No. 33-5180). [August 6, 2015]

Not deep guidance, but it’s still guidance.

Questions 256.26 through 256.33 offer insight into the pre-existing, substantive relationship you need to avoid general solicitation.

A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

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Guidance on Accredited Investor Verification

The Securities and Exchange Commission revised the private placement rules last year to permit public private-placements. Of course it took some prodding from Congress in the JOBS Act to get that change. The law and the new regulation require the issuer to take “reasonable steps” to determine that the investor is an “accredited investor.”

The SEC rule has four non-exclusive safe harbor methods which meet the verification requirement. One of those methods is to rely on the written confirmation of accredited investor status issued by a registered broker-dealer or investment adviser. The Securities Industry and Financial Markets Association has put together guidance on that verification method.

For individuals, SIFMA recommends that the investor have been a client for at least six months so the firm has sufficient knowledge. Second, SIFMA recommends that the broker or adviser obtain a representation from the investor that he or she is not borrowing money to make the investment.

To make the determination, SIFMA has two methods. In the account balance method, the investor must have at least $2 million with the broker or adviser. This assumes $1 million liabilities. If the investor discloses debt greater than this, obviously the account balance threshold will increase.

The second method is the investment amount method. In this situation, the investor must commit at least $250,000 to the investment and represent that it is less than 25% of the investor’s net worth.

I’m not sure the guidance breaks new ground, but its good to see some filling in the holes. The SEC safe harbor also permits CPAs and lawyers to issue the accredited investor verification. It will be interesting to see if the bar association and PCAOB offers any guidance to its members.

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Fund Investing and Crowdfunding

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As the Securities and Exchange Commission has been dragging its feet on new crowdfunding regulations, companies are finding a way to crowdfund using the current rules. The biggest challenge is dealing with the broker-dealer registration requirements. If you sell securities on a transaction basis, you are likelya broker-dealer and need to deal with the registration requirements.  The other limitation is dealing with the current ban on general solicitation and advertising.

One company that appears to be successfully employing a crowdfunding  strategy is Solar Mosaic. The company is selling interests directly in its own projects so it avoids the broker-dealer requirements. It uses a Rule 504 exemption instead of Rule 506 exemption under Regulation D. Rule 504 exempt offerings are not subject to the ban on advertising that impedes Rule 506 offerings, but are subject to a $1 million limit on capital raised. I even invested a small amount of cash in a Solar Mosaic project.

I have seen a few other platforms, like Circle Up, that partner with a broker-dealer. Effectively, the web crowdfunding platform sits on top of the broker-dealer’s regulatory platform.

The latest crowdfunding approach to catch my eye is FundersClub. They even obtained a no-action letter from the Securities and Exchange Commission blessing their approach. (I should disclose that Mrs. Doug works at the law firm that requested the no-action letter.)

FundersClub acts as a venture capital fund manager and registered as a venture capital fund manager with California. It starts a separate private fund for each company that it funds.

The compensation it tricky. According to the SEC no-action letter and the FundersClub FAQ, the company charges an administrative fee to cover out of pocket costs. None of that fee goes to salaries or personnel. That lack of transaction compensation and operations was enough to keep the company away from broker-dealer registration.

FundersClub does take a promote on the performance of the investment fund. It has a long road ahead for compensation to come in, but is aligned with the investors.

I decided to try out the platform. Signing up is straightforward.

As for vetting users as accredited investors, the platform does a better job than others. It asks for your income, joint income and net worth. Other platforms just have a check button exactly tied to the right answers for those questions. With FundersClub, you need to know your income or know the right answers to be accredited.

It does have one simple check for knowledge:

By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of investment opportunities in private companies generally, and you are able to bear the economic risk of such investments including the risk of complete loss.

After passing the entrance hurdle, there are several investment opportunities in the works.

The current regulatory environment for crowdfunding is tricky, but navigable for accredited investors. Non-accredited investors are left out, so maybe crowdfunding is not the right term. I’m skeptical that the JOBS Act mandate for new crowdfunding regulations is going to truly open the floodgates to non-accredited investors.

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UPDATED: To clean up more than my usual collection of typos.

Comments on Advertising Restrictions for Private Funds

Section 201 of the recently passed Jumpstart Our Business Startups Act will change the advertising limits on private funds and any other company that raises capital through the private placement safe harbor in Rule 506 of Regulation D. That rule has historically prevented the use of general solicitation and advertising in selling private fund interests. Section 201 requires the SEC to lift the ban through a new rulemaking and gave the SEC 90 days (July 4) to do so.

I still find it strange that Congress did not just create revise the underlying statutes to allow solicitation and advertising in private offerings not registered with the SEC. Instead, Congress took the convoluted route of requiring the SEC to change a rule that interprets a statutory provision of the Securities Act. That injects some uncertainty into what limitations, if any, the SEC will continue to require after July 4 (or whenever the new rule goes into effect).

There are a few other points in Section 201 that concern me and make me worry about fundraising in the post JOBS Act regulatory world.

First, Section 201 limits sales only to accredited investors when using general advertising or solicitation. Currently, a Rule 506 offering can have up to 35 non-accredited investors. That would typically include friends and family investors. It would also include employees.

Second, Section 201 requires the SEC to include a requirement that the issuer take reasonable steps to determine accredited investor status using methods determined by the SEC. That could radically change the current practice and safeguards in the fundraising process.

Third, I’m concerned what the effect will be for a fund or other issuer that ends up selling to a non-accredited investor. A fund can take reasonable steps to determine if a potential investor is accredited. But the investor could be deceptive. That would leave the fund in violation even though it reasonably believed the investor was accredited.

Fourth, Section 201 purports to lift the ban across all federal securities law. In particular, I’d prefer clarification that the advertising and solicitation applies to the Section 3(c)(1) and 3(c)(7) of the Investment Company Act that permits most private funds to avoid regulation under that law.

In looking through the comments letters to Section 201, I see that I am not alone in these concerns.

The American Bar Association’s Federal Regulation of Securities Committee does a a great job of focusing on my fourth concern and asks for a clear statement that “an offering of fund shares pursuant to Rule 506 or Rule 144A utilizing general solicitation or general advertising will not be a ‘public offering’ for the purposes of Section 3(c)(1) or 3(c)(7) of the Investment Company Act.”

The letter also requests clarification of the reasonable belief standard in the Rule 501 definition of accredited investor.

“any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person…”

The letter falls short in its comments to the verification practice. It merely asks the SEC to have the rule reflect “current custom and practice” without letting the SEC what the customs and practice is. (It’s asking the investor to fill out a questionnaire.)

In it’s comment letter, the Managed Fund Association focuses on reasonable steps for the verification process.

In general, each potential hedge fund investor must complete a subscription document provided by the fund’s manager that provides a detailed description of, among other things, the qualification standards that a purchaser must meet under the federal securities laws. In completing the subscription materials, each investor must identify which applicable qualification standard it meets. In addition to these procedures, many hedge funds managed by MFA members obtain further assurance of the qualification of their investors by virtue of minimum investment thresholds that meet or exceed the net worth requirement in the definition of accredited investor.

The Managed Fund Association also asks that the knowledgeable employee exemption be extended to Rule 506. With private funds, investors prefer (demand?) that senior management have a significant investment in the fund. This aligns interests among the investors and management. When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employee when it’s unlikely that your key employees will have the $5 million in investments needed to qualify as  a Qualified Purchaser. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. The Managed Fund Association recommends

that as part of the implementation of Section 201, the SEC amend the definition of “accredited investor” to include those individuals who meet the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act.

The New York City Bar splits the verification process by asking for a principle-based approach with a non-exclusive safe harbor. Their comment letter points out the body of existing practice and asks the SEC to build on it, rather than replace it.

The clock is ticking and the SEC has very little time to produce a proposed rule for comment. I wouldn’t be surprised to see the SEC miss the deadline given all of the other rule making piled up in front of them. That means the advertising may have to wait that much longer.

Sources – Comment letter from:

How Popular is Regulation D Fund Raising?

 

With the passage of the Jumpstart Our Business Startups Act, it makes sense to look at the regulations around capital formation and see how they affect the ability of companies to raise capital and how they chose to do so. Of course larger economic effects may outsize the influence of the choices.

The SEC’s Division of Risk, Strategy and Financial Innovation published a report on capital raising using Regulation D. (.pdf) The Division looked at Form D filings from January 2009 to March 2011.

The most startling aspect of the report is that the SEC has only been collecting Reg D filings in a machine-readable form since March, 2009. There are decades worth of data sitting in paper format. The other flaw is that the Reg D filings do not require a filing as to the final dollar amount of securities sold through the offering. Although the SEC has very exact information about publicly available securities, it only has estimates of private offerings.

Some key findings:

  • In 2010, Reg D offerings surpassed debt offerings as the dominant offering method in terms of aggregate amount of capital raised in the U.S.: $905 billion.
  • The average Reg D offering is $30 million, but the median Reg D offering is modest in size: approximately $1 million.
  • Public issuances fell by 11% from 2009 to 2010 while private issuances increased by 31% over the same period.

I also found it interesting to compare this report’s findings with a recent article published in the Business Lawyer: The Wreck of Regulation D: The Unintended (and Bad) Outcomes for the SEC’s Crown Jewel Exemptions by Rutheford B. Campbell, Jr. The two studies cover different time frames and the SEC excludes some types of filings, but there are some startling differences.

The SEC found that 55% of the offerings were under Rule 506. Campbell found that 94% of the offerings were under Rule 506. The biggest problem is that Rule 504 and Rule 505 offerings are subject to state blue-sky laws. Campbell’s argument is that the failure to preempt state regulation pushes more issuers into the tougher requirements of Rule 506, even though the fundraising totals are small enough to fit under Rule 504 or Rule 505. That still with the ban on general solicitation and advertising under Rule 506.

Both found that very few non-accredited investors purchased securities through the Reg D offerings. The SEC found that 90% of the offering had no non-accredited investors, with average amount of 0.1 non-accredited investors and a median of 0. Campbell merely used a sample, but similarly found that the vast majority of offering were limited to accredited investors.

The SEC study emphasizes that Reg D offerings are the opposite of crowdfunding. The median number of investors in an offering is 4, with almost 90% of the offerings involving 30 or fewer investors and 99% of offerings having fewer than 155 investors.

What’s clear is that capital raised in private offering under Regulation D rivals the capital raised in public offering.

It does leave you questioning why Congress felt the need to remove the ban on general solicitation and advertising on private offering to accredited investors under the JOBS Act. It looks like private offerings are raising lots of capital.

It seems clear to me that the private capital market is poorly understood by the Securities and Exchange Commission and poorly understood by Congress. There needs to be better data and better studies.

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Will Private Funds Be Excluded?

Title II of the Jumpstart Our Business Startups Act directs the SEC to lift the ban on general solicitation and advertising under Rule 506 of Regulation D. That rule creates a safe harbor that deems the covered transactions to not involve any public offering within the meaning of section 4(2) of the Securities Act.

However, private funds also have to deal with the restriction in the Investment Company Act that also limits public offerings. Under the exclusions in 3(c)1 and 3(c)7 the fund must be an issuer “which is not making and does not presently propose to make a public offering of its securities”. Historically, the SEC has interpreted the meaning of “public offering” to be the same between the two acts. So not being a public offering under Rule 506 meant the offering was not public under the Investment Company Act.

For real estate fund managers relying on the 3(c)5 exclusion, there is no ban on a public offering in that exclusion.

The JOBS Act requires the SEC to revise its rule, so we don’t know exactly how the changes to Rule 506 will work. It’s possible that the SEC will limit the changes to the Securities Act and not open general advertising to funds under 3(c)1 and 3(c)7 who are required to be private.

However, Section 201(b) of the JOBS Act contains this:

(b) CONSISTENCY IN INTERPRETATION.—Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) is amended—

(1) by striking ‘‘The provisions of section 5’’ and inserting

‘‘(a) The provisions of section 5’’; and

(2) by adding at the end the following:

‘‘(b) Offers and sales exempt under section 230.506 of title 17, Code of Federal Regulations (as revised pursuant to section 201 of the Jumpstart Our Business Startups Act) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.’’.

(My emphasis)

I assume the Investment Company Act is part of the “Federal securities laws.” I suppose you could argue that the Investment Advisers Act and the Investment Company Act operate separately from the Securities Act and the Exchange Act. That would be a tough argument for the SEC to make. The SEC could explicitly not include 3(c)1 and 3(c)7 under the changes to Rule 506.

That would seem unlikely. Take a look at the SEC’s own website “Researching the Federal Securities Laws Through the SEC Website” where it lists the Investment Company Act and Investment Advisers Act as part of the federal securities laws.

More likely would be the SEC issuing a rule with no mention of 3(c)1 and 3(c)7 or the Investment Company Act. That might leave practitioners a bit nervous about the gap.

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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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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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Lifting the Ban on General Solicitation

From a  securities compliance perspective, when you  see an advertisement or an email seeking capital for an investment opportunity there is most likely a problem. Now there is a bill in Congress that would change that view.

When selling a security, you need to register the security or find an appropriate exemption from registration. Most likely a private fund or an entrepreneur would try to fall under one of the exemptions under Regulation D. If the company is seeking over $1,000,000 they are prohibited from offering to sell the securities “by any form of general solicitation or general advertising“. Before asking someone to make an investment, you need to have a preexisting, substantive relationship.

“The types of relationships with offerees that may be important in establishing a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the person with whom the relationship exists or that otherwise are of some substance and duration.” Mineral Lands Research & Marketing Corp., S.E.C. No-Action Letter, 1985 WL 55694 (Dec. 4 1985).

Representative Kevin McCarthy (R-CA) introduced the Access to Capital for Job Creators Act (HR 2940) which require the Securities and Exchange Commission to revise its rules to permit general solicitation in offerings under Rule 506 of Regulation D.

In my view, I don’t think there should be an elimination of the ban on general advertising and general solicitation. That would just expose large segments of the population to potential securities fraud. Currently, ads for investment opportunities are red flags for state and federal regulators.

However, I do think it needs to a little easier for entrepreneurs to raise capital. The SEC should offer some better guidance on the limitation. They could also offer some programs and safe harbors. I assume the SEC is waiting for someone to approach them with examples. They continue to be too underfunded and too understaffed to be proactive.

Will the Access to Capital for Job Creators Act be enacted? I doubt that it would pass in its current form. It takes away some investor protection and warning system for securities regulators. That would seem a bad position when the country is stealing trying to recover from the massive losses of 2008.

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