Tuesday, December 3, 2013

Should Startups Participate in Pitches and Demo Days?

Every day, New York City is the host to multiple startup pitch or demo events where hundreds of startup founders introduce their companies to the public and the investors. I have attended a number of such presentations. A pitch event typically starts with pizza and beer networking, followed by 5- or 1-minute pitches by pre-selected startup founders. During those pitches, the founders talk about the company in general and specifically mention their capital raising goals. There is a panel of VC representatives asking questions. The event ends with a panel discussion led by the VCs regarding funding and how to get noticed by investors. A demo day differs slightly because it is not the company but their products that are being showcased, so there is typically no mention of raising capital.

As a securities lawyer, I question whether presenting at a pitch or a demo event may cause the startup to violate the federal securities laws.

By far the most common securities law rule that startups rely on when raising capital is Rule 506(b) of Regulation D. This Rule allows companies to raise unlimited amount of funds from accredited and up to 35 sophisticated investors, so long as there is no general solicitation and advertising. Through a series of no-action letters and interpretive releases, the SEC established that the condition of no general solicitation and advertising is satisfied when startups approach only those investors with whom they have a pre-existing relationship that allows them to determine their financial circumstances or level of their financial sophistication. Alternatively, if the startups are working with a broker-dealer, they can access their network of potential investors.

Recently, the SEC implemented a new Rule 506(c) (which I described in this blog post in more detail). The new Rule 506(c) allows the startups to engage in general solicitation and advertising so long as they take reasonable measures to verify that all their investors are accredited. The pros of being able to generally solicit and advertise the offering should be weighted against the potential drawbacks of the new rule, which are the following:
  • The Rule 506(c) imposes a burdensome verification requirement on the issuers to ensure that all investors are accredited. Investors may be reluctant to share their tax returns with the startups to verify their status.
  • Complying with the new Rule 506(c) will likely increase the costs of the offering by adding extra attorney’s fees, fees of a third-party accreditation service and costs related to record keeping.
  • If the Rule 506(c) offering fails, the issuer cannot resort to other exemptions because none of the other exemptions allow general solicitation and advertising. The traditionally used Rule 506(b) is a non-exclusive safe harbor, which means that if the offering fails for some technical reason, the issuer can still claim exemption under Section 4(a)(2) of the Securities Act.
  • When the SEC additional proposed rules go into effect, the issuers will have to pre-file Form D, include legends and submit all solicitation and advertising materials to the SEC.
If the startup is raising capital at the time of the pitch or demo event, the analysis turns on whether their presentation constitutes an “offer” of securities as opposed to a routine presentation solely about the business and its operations. Remember, even presentations that do not mention the startups’ securities or the offering may be deemed to be “offers,” so long as they have the effect of conditioning the market or arousing public interest in the company and its securities.

So, the question really becomes: is presenting at a pitch or a demo event considered to be “making an offer of securities by using general solicitation and advertising”? The answer is: it depends on how that particular event is conducted. If the event is broadly advertised on the Internet and is available to the community at large, then presenting at such an event is likely to constitute offering securities using general solicitation and advertising, so the presenters would have to rely on the new Rule 506(c) in conducting its offering. If the startup wishes to resort to the traditionally used Rule 506(b), then it is best not to present at such an event even if they do not mention the offering.

If the event is only available to a pre-selected group of invitees and the startup has pre-existing relationship with all of the invitees, then an argument can be made that the presentation is not made by means of general solicitation and advertising.

Participating in demo days warrants the same analysis. If the offering of securities is not mentioned and the focus of the presentation is on the particular products of services rather than the company in general, then it may be possible to conclude that no offer of securities was made. The analysis here is very fact-specific.

The bottom line is, the company and its counsel should decide whether they are prepared to conduct a Rule 506(c) offering. If not, then perhaps it is best to not present at demo or pitch events at all.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Saturday, November 16, 2013

Part III: Fiduciary Duties of LLC Managers in Delaware, New York and Other States

You have probably heard about fiduciary duties. These are the duties owed by a corporation’s directors and officers to the corporation and its shareholders. The duties include a duty of care and a duty of loyalty. Several courts also include the duty of good faith and fair dealing, while others treat it as a subset of the duty of loyalty. The duty of loyalty requires directors to act in good faith and in the best interests of the corporation, and put the corporation’s interests above their personal interests. This also means that directors must abstain from any conduct that would harm the corporation. The subset of duty of loyalty is the duty of good faith and fair dealing that requires that directors “act at all times with an honesty of purpose and in the best interest and welfare of the corporation.” Duty of care requires directors to make informed decisions and consider carefully all of the available information before arriving at a decision. I previously wrote about the duty of loyalty and duty of care here and here.

Today, I want to focus on the question of whether managers in an LLC owe any fiduciary duties to the LLC and its members. After all, we know that internal governance of a corporation is regulated to a large extent by applicable statute that expressly includes the fiduciary duties (in Delaware, only the fiduciary duty of care can be eliminated, but not the duty of loyalty according to Section 102(b)(7) of the DGCL), whereas an LLC is largely a creature of contract and its internal governance is subject mostly to the contractual language of the operating agreement.

In Delaware

Until recently, the Delaware courts have gone back and forth on this question. Finally, effective August 1, 2013, the Delaware General Assembly amended Section 18-1104 of the Delaware Limited Liability Company Act to provide that, unless the limited liability company agreement says otherwise, the managers and controlling members of a limited liability company owe fiduciary duties of care and loyalty to the limited liability company and its members.

This means that if the operating agreement is silent on the issue, the presumption is that managers owe those fiduciary duties. However, according to Sections 18-1101(c) and Section 18-1101(e) of the Delaware LLC Act, members remain free to expand, restrict or eliminate fiduciary duties in their limited liability company agreement, except for one duty that they cannot make go away: the implied contractual covenant of good faith and fair dealing.

In New York

In New York, Section 417 of the New York LLC Law allows managers and members to eliminate or limit fiduciary duties and liability of the LLC members, but sets limits. Exceptions include the liability of any manager for acts or omissions that were made in bad faith or involved intentional misconduct or a knowing violation of law or that caused the manager to personally gain a financial profit or other advantage to which he was not legally entitled, and other instances.

Recently, in late 2012, the New York’s highest court enforced a contractual waiver of fiduciary duties among LLC members in Pappas v. Tzolis (2012). In that case, three individuals formed a New York limited liability company to acquire and manage a long-term lease for a building in Manhattan. Shortly after they formed the LLC, significant business disputes arose among the members, and one of the LLC members, Tzolis, offered to buy out the other two for 20 times what they had contributed to the LLC only a year earlier. The other members accepted the offer. Several months later, Tzolis assigned the LLC’s long-term lease to a developer for $17.5 million, or more than 200 times the initial members’ investment. The former LLC members sued, alleging that Tzolis had been negotiating with the developer even before the buy-out and had violated his fiduciary obligations to them by not disclosing these negotiations. The New York Court of Appeals disagreed and dismissed their complaint. The Court looked at the buy-out documents, in which the departing members certified that they: (a) had performed their own due diligence; (b) had engaged legal counsel to advise them; and (c) were not relying on any representation other than those set forth in the documents. They also certified that Tzolis owed no fiduciary duty to them in connection with the buy-out. Based on these facts, the Court of Appeals held that Tzolis owed no duty to the departing members to disclose his alleged negotiations with the developer. The Court further explained that members could not reasonably rely on Tzolis’ fiduciary obligations to them, if any, given that there was no longer a relationship of trust among them. The Court said “where a principal and fiduciary are sophisticated entities and their relationship is not one of trust, the principal cannot reasonably rely on the fiduciary without making additional inquiry."  What can I say, other than that Tzolis had great lawyers advising him.

Therefore, In New York, it now appears that fiduciary duties of LLC members may be waived by contract (to the extent allowed by Section 417 of the NY LLC Law), at least in the situations where the parties are sophisticated, represented by counsel and demonstrate an understanding of the relinquished rights. It is unclear whether New York courts will extend this contractual waiver of fiduciary duties in other contexts.

In Other States

According to the other blogs, statutes vary all over in terms of fiduciary duties of members and managers. For example, in Washington state, the default standard is that members do not owe any duties to other members unless an act or omission constitutes gross negligence, intentional misconduct or a knowing violation of the law. California statutes allow members to limit fiduciary duties, but California courts have not yet ruled on whether a party can disclaim all fiduciary duties. The Pennsylvania LLC Law is silent about the parties’ ability to alter fiduciary duties. Since the Pennsylvania courts have yet to rule on this issue, it is unclear whether parties can eliminate, restrict or expand fiduciary duties in an operating agreement. In Texas, members can expand or restrict fiduciary duties, but it is not clear which exactly duties may be restricted. Illinois, on the other hand, has gone in the opposite direction and imposed, by statute, the fiduciary duties of loyalty and care upon members of member-managed LLCs without providing any explicit basis for waiving such duties.

In Practice

Modifying fiduciary duties must be done expressly and unambiguously. Actually, instead of simply disclaiming any and all fiduciary duties, it is advisable to have several provisions addressing this and other related issues. First, set the standard of care (it may, for example, provide that covered persons (members, managers) are only liable for acts of fraud, gross negligence or willful misconduct). Second, add a provision on limitation of liability that expressly states that each of the covered persons waives fiduciary duties that absent such waiver, may be implied by applicable law (of course modifications have to be made to ensure that fiduciary duties are waived only to the extent allowed by applicable law). Together, these two provisions will act to limit covered person’s fiduciary duties. Finally, remember to insert exculpation and indemnification provisions in the LLC operating agreement.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Tuesday, November 12, 2013

What Should Be Included in LLC Operating Agreements? Part II of III

As I said in my recent post about LLCs, the internal governance of LLCs is largely determined by contract among the LLC members. This contract, called an operating agreement, is the centerpiece of each LLC. I strongly recommend every multi-member LLC to have a written operating agreement.

The core elements of an LLC operating agreement include provisions relating to equity structure (contributions, capital accounts, allocations of profits, losses and distributions), management, voting, limitation on liability and indemnification, books and records, anti-dilution protections, if any, restrictions on transfer, buyouts, dissolution and liquidation, confidentiality and restrictive covenants, and general provisions such as governing law and dispute resolution. Let's quickly review them.

Equity Structure

(a) Membership Interest. A member’s membership interest is often expressed as a percentage interest. It can vary as new members are added. It is also important to remember that membership interest is comprised of two components: (i) an economic interest and (ii) a management interest. Often, membership interest is expressed in units to give LLC’s equity more of the look and feel of stock. Some LLCs even refer to their units as “shares” and have an authorized and issued number of shares, just like in a corporation.

(b) Classes of Membership Interests. Given the flexible capital structure of LLCs, it is possible to create the equivalents of equity structures of partnerships or corporations. An LLC can have non-voting interests, common interests, preferred interests, convertible interests, profits interests, etc.

(c) Contributions and Capital Accounts. Each member has a capital account. Initial percentage interests are determined based upon value given to initial capital contributions. A member's capital contribution to the LLC may take the form of cash, property, services rendered, a promissory note, or some other obligation to contribute cash or property or to render services, or any combination of the foregoing. If a member contributes property or something other than cash, the value of such contribution often gets negotiated. Also, members need to address in the operating agreement whether there will only be initial capital contributions, or whether members will be asked to make ongoing contributions or there will be potential future capital calls.

(d) Allocation of Profits, Losses, and Distributions. The operating agreement may alter the default rule of proportionate allocation of profits, losses, and distributions among members. The operating agreement may provide each class of units with unique economic rights and may even alter the allocation rules between members of the same class. It is possible, for example, for a member that holds 50% of percentage interest in an LLC to be allocated 100% of the LLC’s profits or losses in a given year or to receive preferred returns.

Management

An LLC may be managed by members or managers. If LLC is manager-managed, this section of the operating agreement would describe the appointment of managers (which members may appoint), the nature and frequency of manager meetings and voting procedures, duties and responsibilities of managers, term, and procedures for manager removal and replacement.

Voting

The operating agreement may alter the standard rule that members vote in proportion to their percentage interests.  It can even withhold entirely the voting right of a member or class of members to vote upon any matter. Voting rights can also be determined on the basis of capital contributions, capital commitments or capital accounts. Also, certain members or managers can have veto rights or supermajority votes. For example, a class may not have general voting or managerial rights, but have veto right on certain actions to be taken by the managers.

Limitation on Liability, Indemnification

This section deals with fiduciary duties of the managers. There have been interesting legal developments in this area, and I would like to discuss it in a separate blog post.

Books and Records

This section is self-explanatory. It addresses record keeping and the rights of members to inspect corporate and accounting records of the company.

Anti-dilution Protections

The anti-dilution provisions allow a member to maintain its membership interest percentage in the case when the LLC issues membership interests to new members. Such protections may include: a veto right on new issuance of membership interests and admission of new members; limitation on capital calls (for example, no additional capital calls without consent of all members); and pre-emptive rights that allow a member to purchase any class of membership interest being offered in order to maintain their percentage interest.

Restrictions on Transfer

(a) Assignability of Interests.  Frequently, a membership interest can be assigned, but such assignment does not include management rights. To transfer both the economic and management rights of a membership interest, a member needs to comply with restrictions on transfer and (if the operating agreement so provides) obtain the managers’ consent.

(i) Veto / approval rights. Transfer of a membership interest can require the consent of all members or all managers or a certain percentage thereof.

(ii) Right of first refusal. The company and/or other members receive the right within a set period of time to match the offer of a third party for another member’s membership interest.

(iii) Permitted transfers. Members can agree to carve out certain transactions from the restrictions on transfer, such as transfers to affiliates and / or for estate planning purposes.

(b) Buyout. Certain events (such as death, disability, bankruptcy, termination of employment) can give an option to the company or other members to buy out such member (or a right to the member to be bought out by the company or other members). If the operating agreement has buyout provisions, it is important to describe the procedure of how such buyout will take place, the buyout price and the payout terms (can be over time or perhaps from the proceeds of a key man life insurance).

It may be difficult to determine the buyout price, especially for smaller, pre-revenue LLCs.  There is a lot of room for creativity here.  Sometimes, members agree on a certain fixed price ahead of time. Other times, the price will equal to the fair market value, to be determined by one or more appraisers.

(c) Tag Along and Drag Along Rights.  The tag along rights protect minority members from being left behind upon the sale of a majority member’s interest, whereas the drag along rights assist majority member(s) in packaging all membership interests to facilitate full equity sale of the company.

Confidentiality and restrictive covenants include provisions such as non-compete and non-solicit.

Liquidation and dissolution

This section specifies who determines when to dissolve an LLC or what events can trigger dissolution. There are also winding up procedures and a waterfall of distributions of LLC’s assets upon dissolution.

General provisions

Last but not least, the general provisions can include a provision requiring members to settle disputes first through non-binding mediation, followed by binding arbitration. There should also be a provision regarding required vote to amend the operating agreement (perhaps, a vote by managers and a certain percentage of members). There may also be a “adverse affect” proviso, requiring consent of each member who is adversely affected by such amendment if such amendment relates to the limited liability of such member, or it adversely alters its interest in profits, losses or distributions (other than as a result of admission of additional members).

As you can see, an LLC operating agreement is a complex document that often reaches 30+ pages. It is also a “living” document that should be amended as the needs of the LLC change. A meaningful operating agreement that provides the means to address various situations is a key to success in operating a limited liability company.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Sunday, November 10, 2013

General Solicitation and Hedge Funds

This week I gave a talk about the new and proposed amendments to Form D to the students at NYU Professional Studies program class on Hedge Funds Operations and Due Diligence.  Here are the detailed slides from my presentation.

First, I gave an overview of private placements in general, and how Regulation D and Rule 506 fit within them.  I then talked about the new amendments to Rule 506 (meaning the introduction of Rule 506(c) that allows general solicitation and advertising if all purchasers are accredited investors and what are the reasonable steps that funds will need to take to verify the investor status) and the new bad actor disqualification provisions.

Finally, I discussed the proposed rules that propose to add new Form D filing and disclosure requirements as well as the additional disqualifying events, required legends and proposed rule 510T.

My whole presentation was accompanied by lively Q&A.  It was interesting to get a perspective on these new legal developments from the people who work in the fund industry.  Two things to note here.  First, the group did not seem to be enthusiastic about using general solicitation and advertising to raise capital for hedge funds.  The consensus was that it was strictly a relationship-based business.  Second, people felt uneasy about the proposed additional legends and disclosures when using performance data in solicitation materials.   Everyone agreed that some warnings were needed.  However, the group felt that there was no single standard or criteria used by the funds to calculate and present performance data, so standardized performance reporting could lead to more confusion.

I guess, we are all impatiently waiting for the final rules.

 This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Thursday, October 31, 2013

Why Do Members Need LLC Operating Agreements? Part I of III

On October 23rd, I participated in a panel discussion relating to the LLC operating agreements.  This was a webinar on drafting LLC agreements conducted by Financial Poise, a provider of CLEs and informational webinars for accredited investors, executives, and their legal and financial advisors.  Preparation for the webinar made me think about the main differences between LLCs and corporations.  So, I’ve decided to share my thoughts on what these differences are and what should go into an operating agreement in a series of posts.   

I think of an LLC as a hybrid between a corporation and a partnership.  Consequently, an LLC operating agreement is a hybrid between, on one hand, the corporate bylaws, charter and a shareholders agreement and on the other hand, a partnership agreement.

Internal affairs of a corporation are largely governed according to state statutes.  For example, in Delaware the relevant statute is called the Delaware General Corporation Law, and in New York it is called the Business Corporation Law.  This is not the case for LLCs.  It is actually the opposite.  The LLC state statutes provide default provisions that govern in the absence of corresponding provisions in the LLC’s operating agreements.  So, in a sense, these are gap fillers, and in most cases, can be overridden by contract.  Although registered with the state authorities, LLC internal affairs are governed by contract, which is called an “LLC agreement” or an “operating agreement”.  

This is the reason why most jurisdictions require LLCs to have an operating agreement, although not all of these jurisdictions require it to be in writing (for example, in California and Delaware members can have an oral agreement, which in my opinion, is a recipe for disaster).   In New York, Section 417 of the New York LLCLaw requires members to adopt a written agreement that is not inconsistent with the law or the LLC’s articles of organization.  Note that according to Section 417, even sole member LLCs should have a written operating agreement.  The NY law is silent about the consequences of not adopting an operating agreement, and since operating agreements are not public documents, I assume it is difficult to police.

Below are some illustrations of how LLC statutes typically work. For example, Section 402 of NY LLC Law says that unless provided in operating agreement otherwise, each member votes in proportion to its share of current profits of the LLC. Also, unless provided in operating agreement otherwise, a majority vote of all members is required for admission of new members, issuance of new LLC interests, approval of indebtedness other than in ordinary course, amendment to the articles of organization or operating agreement, approval of dissolution, or sale of all or substantially all assets of the LLC. Section 403 of NY LLC Law says that except as set forth in the operating agreement, LLC shall hold annual meetings. Sections 503 and 504 of NY LLC Law, respectively, say that unless otherwise provided in the operating agreement, each member is allocated profits, losses and receives distributions of available cash on the basis of the value of any contributions made.  As you can see, an operating agreement can alter many of the provisions of the NY LLC Law.

This is why we see such a variety of LLC structures. Some LLCs resemble corporations. Their members are called shareholders, there is a board of directors, and the LLCs authorize and issue shares instead of membership interests. Other LLCs do not have shares at all, but rather their membership interest is expressed in percentages. Members may be passive investors, the LLC may be managed by members or by one or several managers, and profits and losses may be allocated disproportionately to the members’ percentage interests or the value of their contributions.  There may be a priority waterfall with respect to allocations of profits and losses, distributions of available cash, and also distributions in the case of dissolution.

Since this post is already getting to be too long, in the next post, I’ll go over the core provisions that each LLC Agreement should have or members should at least consider including.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Wednesday, October 30, 2013

NYC Conflicts of Interest Law Impedes Growth of Teacher-Led Education Startups

New York City's Ethics Law, Chapter 68 is also referred to as the Conflicts of Interest Law.  It applies to all city employees and contains rules regarding gifts, part-time jobs in other sectors, volunteer activities, post-City employment, use of confidential information and ownership interests in company that do business with the City.  In particular, the Law does not allow public employees to incur financial gain derived from the operation of their own business separate from their public job if it involves selling products or services to the City.

This Law also applies to all NYC public school teachers and prohibits them from selling to schools or entering into any Department of Education-sponsored challenges, such as the Gap App Challenge while they are employed by the City as teachers and for a full year thereafter.

Although the Law makes sense, it is now viewed by some as an impediment to innovation in education, as it makes it difficult for teachers to form education startups if such startups aim to sell their products or services to the DOE.  The Law therefore gives non-teacher founders an advantage as they can freely sell products to NYC district schools and get vendor contracts with the DOE.

The consequences for violating the Conflicts of Interest Law may be severe.  According to the NYC Conflicts of Interest Board (the "Board"), the punishment can include any of the following:
  • You may be suspended for some period or fired; 
  • You may be fined by the Board up to $25,000 per violation; 
  • The Board can recommend to your agency that you be suspended or fired;
  • The Board can also disgorge any money you gained by violating the law; 
  • It is also a misdemeanor that the District Attorney's office may prosecute; 
  • Upon conviction, you may be fined and sent to jail and lose your City job; 
  • The Board may also void any contract or transaction that violates the Conflicts of Interest Law.
Mary Jo Madda recently wrote at length about the Conflicts of Interest Law and how to deal with potential conflict of interest situations in case of educational startups in her article "Arrested Development for Teacher-Led Startups" that you can find here.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Thursday, October 24, 2013

FINRA Funding Portal Rules

On October 23rd, FINRA proposed rules and forms relating to the funding portals, referred to as the Funding Portal Rules.  Once finalized and adopted, these rules will govern the SEC-registered funding portals that will also have to become members of FINRA pursuant to the JOBS Act.  

The public comment period ends on February 3, 2014, shortly after the end of the commenting period on the newly proposed SEC rules implementing the crowdfunding provisions of the JOBS Act.

Happy reading!

The SEC Releases the Long-Awaited Crowdfunding Rules

On October 23rd, the SEC voted unanimously to propose rules implementing the crowdfunding portion of the JOBS Act.  The comment period is 90 days.  The proposing rule release is over 500 long (!), but I anticipate there to be many many comments and commenters.  For those who want a brief synopsis, refer to the SEC press release.

The press release highlighted the following:

Under the proposed rules:
  • A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
  • Investors, over the course of a 12-month period, would be permitted to invest up to: $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.
  • 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
Certain companies would not be eligible to use the crowdfunding exemption. Ineligible companies include non-U.S. companies, companies that already are SEC reporting companies, certain investment companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Companies resorting to crowdfunding would be required to provide the following information:
  • Information about officers and directors as well as owners of 20 percent or more of the company.
  • A description of the company’s business and the use of proceeds from the offering.
  • The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.
  • Certain related-party transactions.
  • A description of the financial condition of the company.
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.
These companies will also have to file an annual report with the SEC and provide it to investors.

Crowdfunding transactions will take place only through an SEC-registered intermediary, either a broker-dealer or a funding portal. 

The proposed rules would require these intermediaries to:
  • Provide investors with educational materials.
  • Take measures to reduce the risk of fraud.
  • Make available information about the issuer and the offering.
  • Provide communication channels to permit discussions about offerings on the platform.
  • Facilitate the offer and sale of crowdfunded securities.
The proposed rules would prohibit funding portals from:
  • Offering investment advice or making recommendations.
  • Soliciting purchases, sales or offers to buy securities offered or displayed on its website.
  • Imposing certain restrictions on compensating people for solicitations.
  • Holding, possessing, or handling investor funds or securities.
Yes, this is a lot to read, to discuss, to digest and comment on!  Happy reading, everyone!  

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

  

Monday, September 23, 2013

The New Rule Now Permits General Solicitation and Advertising When Raising Capital

On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted a new rule that implements a part of the JOBS Act. This rule lifts the ban on general solicitation and advertising with respect to certain types of securities offerings.

The new rule 506(c) goes into effect today, Monday, September 23rd. Here is what you need to know about it, if you would like to adverse your offering to the general public and through the means of general solicitation.

1. All investors must be accredited. Unlike Rule 506(b), this new Rule only allows accredited investors to participate in the offering. Who are accredited investors? These are individuals who have earned income over $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). A bank, partnership, corporation, a nonprofit, an LLC or a trust can also be accredited investors as long as they satisfy certain tests. The full definition of accredited investor is available here.

2. Take “reasonable” steps to verify the accredited status of your investors. Under the new Rule, it is no longer enough to have the investors fill out an eligibility questionnaire. What steps are “reasonable”? This is determined in the context of each offering, looking at the particular facts and circumstances of each prospective purchaser and transaction. Rule 506(c) provides a non-exclusive list of verification methods that companies can use when looking to verify the individual investors’ accredited status, including:

  • Verification based on income: by reviewing IRS forms that report income, such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and Form 1040 for the two most recent years and obtaining a written representation that investors have a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
  • Verification based on net worth: by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, certificates of deposit, tax assessments, appraisal reports by independent third parties, and obtaining a written representation from the investors that they disclosed all liabilities necessary to make a determination of net worth, and/or obtaining a credit report from at least one of the nationwide consumer reporting agencies to verify the liabilities;
  • A written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and
  • For accredited investors who purchased your securities before September 23, 2013 and who want to participate in your 506(c) offering, - a certification by such person that at the time of sale he or she qualifies as an accredited investor. 
You should keep very good records that can provide that you have taken reasonable steps to verify the accredited status of your investors.

3. Check a new box that was added to Form D. It is important to remember that if a Rule 506(c) fails, the company cannot simply switch to using Rule 506(b) or Section 4(2) private placement because Rule 506(b) or Section 4(2) do not permit general solicitation or advertising.

4. Make sure that the offering is not disqualified under the new bad actor disqualification provisions in Rule 506(d). Note the list of persons covered by these provisions is very broad and includes:
  • the issuer, any predecessor of the issuer, and any affiliates of the issuer;
  • any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
  • any beneficial owner of 20% or more of the issuerʼs outstanding voting equity securities;
  • any promoter connected with the issuer at the time of the sale;
  • any investment manager of an issuer that is a pooled investment fund;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in the offering;
  • any general partner or managing member of any such investment manager or solicitor; or
  • any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.
Under the final rule, a “disqualifying event” includes any of the following:

Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries;

  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries;
  • Certain final orders from the CFTC, federal banking agencies, the National Credit Unit Administration, or state regulators of securities, insurance, banking, savings associations or credit unions;
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons;
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws;
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities;
  • Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member; and
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.
There is an exception from disqualification where an issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering, so due diligence with respect to all covered persons participating in a Rule 506 offering is necessary. Such due diligence may include questionnaires and representations from certain participants, and may also include background checks.

Disqualification under Rule 506(d) only applies to disqualifying events occurring after September 23, 2013. Disqualifying events that occurred before the effective date of the rule must be disclosed to investors.

In conclusion, remember that if you are not yet ready to conduct an offering under the new Rule 506(c), you can always conduct a private placement under the old Rule 506(b) that remains unchanged. Although that Rule does not allow general solicitation or advertising, it is not limited to accredited investors only (up to 35 sophisticated purchasers can participate) and the issuer does not have to take “reasonable” steps to ensure the accredited status of its investors. Also, keep in mind that the new Rule may still change. The SEC has proposed more rules (the comment period on those expires on September 23rd) that may add complexity to Rule 506(c), such as advance Form D filings, legends, filings of offering materials with the SEC, among others.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.



Friday, September 6, 2013

Book Review: Securities Law and Practice Deskbook: Sixth Edition – a Great Resource for Securities Law Practitioners

I was fortunate enough to receive a copy of the latest (sixth) edition of Securities Law and Practice Deskbook by Gary M. Brown.  This is not a book for everyone.  This is a concise summary of the entire body of the securities law, and is written for the securities attorneys.  It serves as a great reference book especially for those lawyers who do not have the time to read endless treatises where most of the text is in the footnotes.  This is a book of answers.  The information is presented in a concise, well-organized manner, and is written in “plain English”.  I would particularly like to acknowledge the helpful tables summarizing certain rather nuanced rules, such as Table 3-1 that provides a summary of communication rules during the IPO’s pre-filing, waiting and the post-effective periods; Table 6-1 that lists all regulation exemptions available to companies raising capital; and in particular Table 7-1 that consists of a Rule 144 decision tree (a great tool to have).  And what is truly important, it is updated with the latest information (or almost the latest, since as of the date of this writing, the SEC has already adopted the amendments relating to general solicitation and advertising in Rule 506 offering). 

I find that for the last decade or so, the U.S. securities laws have been one of the fastest evolving areas of the law (just think about the Regulation FD of 2000, the Sarbanes-Oxley Act of 2002, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Jumpstart Our Business Startups Act of 2012), not to mention numerous regulations and guidance adopted by the SEC throughout these years.  Many of us, securities attorneys, are frankly struggling to keep up with the new developments.  Missing a key development may become a costly mistake.  Therefore, Securities Law and Practice Deskbook is a must-have for those attorneys who do not want to be left behind. 

I’d like to add that Mr. Brown does not only provide an accurate and concise overview of the securities laws and regulations, but also adds valuable commentary.  For example, consider his discussion of Rule 504 of Regulation D in Section 6:5.2.  The whole chapter 6 is about the Securities Act registration exemptions.  The chapter covers the current and proposed exemptions, often providing background information on how particular exemptions came about.  Mr. Brown correctly points out that Rule 504 of Regulation D has been underutilized in the market, even though the requirements and limitations of the Rule are few.  Although the offering amount is limited to only $1,000,000 per year, the Rule does not limit participation to accredited or sophisticated investors.  Nor does it limit the number of investors or require any disclosure documents.  The only two limitations are: the Rule generally does not permit solicitation or advertising, and the offering must be done in compliance with applicable Blue Sky laws.  It appears that the Rule may be used by startups to raise seed rounds of capital, yet I know of many securities attorneys who would not work on a Rule 504 offering due to high degree of risks involved.  Such capital offerings by startups or “fledgling ventures” tend to post the most risk to investors, because the companies are still in the early stages of development.  Also, since investors are not accredited or sophisticated, it cannot be assumed that they will be able to understand the risks involved in such highly speculative investments.  Therefore, Rule 504 offerings are subject to liability and antifraud provisions of the Securities Act and the Exchange Act, so providing a detailed disclosure document to investors and limiting investors to those who can “fend for themselves” seem like reasonable steps to take.  But then, why not use Rule 506 to begin with (especially given that securities issued under Rule 506 are exempt from state regulation)? 

As Mr. Brown point out, another reason why Rule 506 is preferable is because, unlike Rules 504 and 505, Rule 506 is a safe-harbor rule that exists along with the private placement exemption provided in Section 4(a)(2) of the Securities Act.  Rules 504 and 505 are not safe-harbor rules because Section 3(b)(1), under which they were promulgated, provides no statutory exemption outside the rules.  Consequently, if a Rule 506 transaction is attempted but fails, the requirements for the basic private placement exemption under Section 4(a)(2) may still be met.  But when a Rule 504 or 505 transaction fails, the issuer has nothing in Section 3(b)(1) to fall back on. 


These are just examples of the valuable information contained in Securities Law and Practice Deskbook.  Thank you, Mr. Brown, for sharing your knowledge and insights with us. 



This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.


Tuesday, September 3, 2013

The Case of SoMoLend: Crowdfunding Platforms and Other Startups Beware of Potential Securities Law Violations



SoMoLend – Social Mobile Local Lending – is a crowdfunding platform that has peer-to-peer lending technology that allows businesses to obtain loans from a network of lenders, typically located in the same geographic area (banks, credit unions, community-development financial institutions, cities, churches, foundations, chambers of commerce and individual investors). SoMoLend is like eHarmony for small businesses and lenders. It was founded by Candace Klein in 2011, who until recently served as its CEO. According to Entrepreneur.com, since the beta site launched in May 2012, SoMoLend has facilitated some 100 small-business loans totaling nearly $3.5 million. Loans range from $500 to $1 million, with interest rates ranging from 3% to 22% and terms – from six weeks to five years, depending on a business's needs and creditworthiness.

This is the way how SoMoLend works: a borrower first sets up a public profile. Then, it is asked to complete an equivalent of an SBA loan application, provide business plan, formation documentation, EIN, business financial statements as well as personal financials of every 20% plus owner. SoMoLend evaluates the borrowers using their own underwriting algorithm that focuses on social reputation of the business, not only the FICO score, so that even a business with a low score can get funding through the platform. Investors lend money directly to the borrowers through the platform, which packages the loans and sells them as notes. SoMoLend handles the contracts and the payment processing. SoMoLend is compensated for its services by charging borrowers a 4% and lenders 1.8% transaction fee on funds borrowed.

According to Forms D filed with the SEC, SoMoLend raised money twice: $1,170,000 during the period of September 2011 through April 2012, and $1,000,000 during August 2012 - February 2013.

It recently became known that in mid-June 2013 SoMoLend received a Notice of Intent toIssue Cease and Desist Order from the Ohio Division of Securities that raises issues that are not unique to SoMoLend or the crowdfunding platforms in general. All young companies have lots to learn by reading this Notice.

First, the Notice alleged that SoMoLend violated the state securities laws by conducting an offering through the use of general solicitation and advertising in Ohio and other states. Currently, the federal securities laws provide for an exemption from registration under Rule 506 that prohibits the use of general solicitation and advertising in the sale and offer of securities to accredited and sophisticated investors (Ohio has a corresponding exemption). This Rule has been significantly amended by the SEC (a blog that will review the new amendments that will become effective on September 23, 2013 is coming soon). However, as of now, this Rule stands “as is.” An issuer can generally avoid violating the ban on general solicitation and advertising if it reaches out only to potential investors with previous relationship to the issuer or the persons promoting the offering. SoMoLend, on the other hand, allegedly solicited investments through investor presentations and investor pitch events, videotaped recordings of investor presentations and events posted on the Internet, links to the social media sites, and press releases published in newspapers, magazines and other media.

Second, the Notice alleged that Ms. Klein and SoMoLend engaged in securities fraud by making false and misleading statements to potential investors regarding the company’s financial projections, current and past performance (including the number of loans made, their total value and the revenue derived from them), and the nature and extent of relationships with banks. For example, in October 2012, Ms. Klein claimed that SoMoLend had closed 31 loans for just under 50 businesses totaling $3.5 million and generating $50,000 in revenue, whereas SoMoLend at that time had closed only 13 loans for 9 businesses totaling $94,000 and generating $3,404 in revenue. In March 2013, Ms. Klein said in her interview with Entrepreneur Magazine that SoMoLend had raised $15 million for 100 businesses, whereas at that time it had closed only 25 loans for 18 businesses for an aggregate loan amount of only $234,000. Also in March 2013, Ms. Klein stated at the SXSW Pitch event that the funds came from 1,000 peer lenders and 50 different banks, whereas only one bank had ever made a loan through the SoMoLend platform. These do, of course, seem like material discrepancies and inconsistencies.

Startups and small businesses should be aware that, even through they are not public (yet), their activities still fall under the regulation of the Securities and Exchange Commission. One of the rules that apply to private companies as well as public ones when they are raising capital is Rule 10b-5. It states, in part, that “it shall be unlawful for any person, directly or indirectly, … (a) to employ any device, scheme, or artifice to defraud; (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading … “. This Rule is used in prosecuting insider-trading cases and also in cases where a company issues misleading information to the public, or keeps silent when it has a duty to disclose. A large number of indictments were brought under this Rule in connection with the 2001 Enron scandal, the 2009 Bernie Madoff Ponzi scheme, and the scheme by attorney Marc Dreier, who sold millions of dollars of bogus notes, among others.

Third, the Division of Securities alleged that SoMoLend failed to register as a broker/dealer with the Ohio and federal authorities since it received a commission in connection with the solicitation or sale of securities. I discussed requirements for broker/dealer registration in more detail here. Interestingly, the other crowdfunding platforms, the FundersClub and AngelList took a different approach to compensation by agreeing to be paid at the exit. They also first obtained a no-action letter from the SEC validating their models. I talked about the FundersClub and AngelList no-action relief here.

Finally, the Notice alleged that all those businesses that received loans through the SoMoLend platform had to register their offerings with the Ohio Division of Securities or qualify for an available exemption. The promissory notes are generally considered to be “securities” and we already know that any offer or sale of “securities” must be registered with the SEC (and if applicable, the corresponding state authorities) or be made pursuant to an exemption. See my earlier post about this here. According to the Notice, as a result of these actions, SoMoLend exposed approximately 200 small businesses to potential liability.

Klein resigned as the CEO and a board member of SoMoLend on August 14th, three days after The Enquirer first reported that Ohio’s Division of Securities was investigating SoMoLend for alleged fraudulent practices.

The next step for SoMoLend is to appear at a hearing that is scheduled for October. I hope that at least now, in preparation for the hearing, SoMoLend will engage qualified securities attorneys to resolve this action and advise the company on its future path.

This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.