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, 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.