Placement Agents: Part II: When Should You Use a Placement Agent, and How to Pick the Right One?

At this point, having discussed the services a placement agent can provide, the kinds of compensation used, and other important terms to keep an eye on when negotiating for the services of a placement agent, there is still the threshold matter of determining whether using placement agents makes sense (and when it doesn’t) in the first place. In addition, how to decide which specific placement agent to use?

The first thing to keep in mind is that placement agents are much more common in later-stage financing rounds. Placement agents are almost never used in seed rounds or early-stage financing. One reason for this is that the universe of potential early-round investors (e.g., VC firms and funds) is much smaller and, for lack of a better word, self-contained. In addition, pertinent information, such as what sorts of companies particular VCs invest in and at what dollar amounts, is often publicly available to a much greater extent than for later-stage investors. On a practical level, companies in the early fundraising stages may also be less willing or able to pay the significant commissions demanded by placement agents for their services. This does not mean, of course, that it is never helpful or necessary to use a placement agent in an early-stage fundraising round, but they are used much more commonly—and are in general much more helpful—in later-stage rounds by companies with some kind of established track record.

That being said, if an issuer feels that it can be successful in raising capital without employing the services of a placement agent (for example, perhaps it has only a few major investors who are willing to fully finance a later round), then there is nothing which requires that a placement agent be used. Any money not paid out to placement agents as commissions in a private placement is money the company retains for its own use.

Sometimes, however, using a placement agent is necessary or helpful. For example, if the company is contemplating multiple rounds of private placements over an extended period of time, hiring a placement agent that can introduce the company to a significant number of potential investors (and who may be willing to invest in multiple financing rounds) could be very beneficial. Obviously, if the company has had difficulty raising capital in the past or is facing low interest in the present, hiring a placement agent may be helpful. If conditions in the broader economy are difficult, the services of a placement agent may also be necessary. In the end, the decision whether to hire a placement agent will depend on the circumstances.

If you are considering using a placement agent, you will want to do your homework, as with any potential partner. From a legal standpoint, the most crucial requirement is that you only use a registered BD as a placement agent. This is because any BD acting as a placement agent will be deemed to be “participating” in the offering, and according to both SEC and FINRA regulations, only registered BDs are allowed to so participate. A company should be particularly wary of so-called “finders”, which are not registered BDs. A “finder” may offer to introduce companies to investors, but nothing else—they do no assist with the PPM, do not talk to investors on behalf of the company, etc. It is very important to keep in mind, however, that both the SEC and FINRA define “participation” very, very broadly, and if they find that non-registered persons have participated in the offering, the penalties can be severe, including, for example, “rescission” (i.e. returning any money accepted back to investors).

After making sure that the placement agent you use is a duly-registered BD, there are additional considerations to keep in mind. Some placement agents, for example, may specialize in certain kinds of companies (e.g. software companies or pharmaceutical companies), certain kinds of offerings or transactions (e.g. debt or equity offerings), certain kinds of investors, or certain regions (whether within the United States or with overseas investors). You should ask potential placement agents to put you in contact with other companies who have used their services in the past (though note that the particular terms, such as compensation, are likely covered by confidentiality). Information, as always, is power, and the more information your company can obtain about your potential placement agent partner, the more confident you can be that the placement agent you are partnering with will help you achieve your company’s goals.

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 corporate, securities, and intellectual property law.

Citizen VC No-Action Letter - the SEC Guidance on Online Private Placements

As a follow up to my previous blog post where I discussed the new CDIs relating to the definition of "general solicitation" in private offerings conducted under Rule 506(b), I decided to discuss the recently issued SEC no-action letter to Citizen VC.  This no-action letter is all about the application of the new SEC guidance regarding general solicitation in practice.  This can serve as a useful tool for conducting private placements over the Internet.

The main question was the establishment of a "substantive pre-existing relationship" between CitizenVC and prospective investors that would allow the issuer to conduct Rule 506(b) private placements without engaging in general solicitation.  The definitions of "substantive" and "pre-existing" were recently clarified by the SEC (CDI Questions 256.26-31).  According to the SEC (CDI Questions 256.29 and 30), a "pre-existing" relationship is one that is established prior to the commencement of the offering.  There is no minimum waiting period so long as the relationship was established before the offering started.  According to the SEC (CDI Question 31), a "substantive" relationship is one where the issuer "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."

Now, let's take a look at the facts described in the CitizenVC request for the no-action letter.

CitizenVC is an online venture capital firm that offers LLC membership interests in SPVs formed for the purpose of investing into emerging growth companies.  The offering is done through their website.  CitizenVC intends to conduct the private placements under Rule 506(b) that does not allow the use of general solicitation.  To avoid general solicitation, CitizenVC first seeks to establish substantive relationships with its prospective investors.

First, the CitizenVC website that is viewable by the general public does not contain any information that could be viewed as an "offer".  There is no information about the current SPVs, portfolio companies, investment opportunities or offering materials.  This is consistent with the SEC guidance (CDI Questions 256.23-25) that states that the use of a publicly available website that contains an offer of securities constitutes a general solicitation.  To avoid this, the issuer should only disclose "factual business information that does not condition the public mind or arouse public interest in a securities offering" by that issuer.

Second, all visitors to the site that are interested in becoming a member of an SPV must complete an online accredited investor questionnaire.  Only those members who self-certify themselves as "accredited" will eventually receive a password that will allow them to access restricted portions of the site.

Third, CitizenVC implements its pre-set procedures (that contain six separate steps) to establish a substantive relationship with the prospective investor, including (1) contacting the prospective investor offline to discuss their experience and sophistication and to answer questions; (2) sending an introductory email; and (3) using third party credit reporting services to confirm identity and gather additional financial information and credit history information.  Once CitizenVC is satisfied that the prospective investor has sufficient knowledge and experience in financial and business matters and that a substantive relationship has been created, it will admit him or her as a member of the website and send a password to the "member only" areas of the website that contain investment opportunities.

Once enough members indicate interest in an opportunity, CitizenVC will create an SPV to aggregate such members' investments.  Members will be given subscription materials that will contain additional risk disclosures and detailed accredited investor certifications and representations.

The most important aspect of this no-action letter is that the issuer has no minimum waiting period to establish a substantive relationship with a prospective investor.  For CitizenVC, it is the question of quality of such a relationship rather than its duration.  Completion of a "check the box" accredited investor questionnaire alone does not establish such a relationship.  On the other hand, a 30-day waiting period is also not necessary (See Lamp Technologies No-Action Letter).  As the SEC confirmed in its response to CDI Question 256.31, a "substantive" relationship is established when the issuer "has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree's financial circumstances and sophistication."  That may take a week or a month, depending on the circumstances.

In conclusion, the CitizenVC no-action letter offers an excellent step-by-step guide on how to conduct online private placements in compliance with the requirements of Rule 506(b).  All issuers currently structuring their investment platforms should closely study and analyze this example.

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 corporate, securities, and intellectual property law.

General Solicitation Restrictions for Private Placement Issuers

On August 6, 2015, the Securities and Exchange Commission (the "SEC") issued a number of Compliance and Disclosure Interpretations ("CDIs") related to the issue of “general solicitation” (or “general advertising”) as it pertains to issuers seeking to raise capital in private placements in a Rule 506 transaction. As this blog has discussed elsewhere, Rule 506 under the Securities Act of 1933 allows companies to raise unlimited amounts of capital without having to register the securities with the SEC. Under Rule 506(b), these securities may only be sold to “accredited investors” (a category generally restricted to high net worth individuals and large institutional investors such as investment banks, pension funds, insurance companies, etc.) and to a limited number (no more than 35) “sophisticated” non-accredited investors. Traditionally, this limit on investor participation has been bolstered by a complete ban on the use of “general solicitation” by issuers (or their agents, such as registered BDs acting as placement agent) offering Rule 506 securities to investors. This restriction on general solicitation is found in Rule 502(c) (To avoid any confusion, Rule 502(c) will henceforth be referred to simply as Rule 502 to differentiate it from Rule 506(c)). The rule does not define the term “general solicitation” or “general advertising”, though it does offer a non-exhaustive list of what would be considered to be so, including the use of “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio.”

The JOBS (Jumpstart Our Business Startups) Act amended Rule 506 by adding a new Section 506(c), which did away with this restriction on general advertising for issuers relying on this new Section 506(c), while also imposing more stringent requirements on who could actually invest (i.e. all of the actual purchasers must be accredited investors; even the most sophisticated non-accredited investors are barred from participation) as well as the steps an issuer or its agent had to take to ensure that such investors are, in fact, accredited. One reason for this amendment was that the prior complete ban on general solicitation for all Rule 506 private placements was seen as a barrier to the ability of some companies, particularly startups and smaller companies, to raise the capital they needed.

This amendment has, therefore, largely been welcomed. At the same time, however, there has been some concern that, given that companies now could engage in general solicitation (so long as they complied with the other requirements of Rule 506(c)), the SEC would begin to take a stricter enforcement approach regarding what they would consider to be general solicitation for companies choosing to raise capital under the “old” Rule 506(b). (Note that “old” here is merely used to differentiate Rule 506(b) from Rule 506(c); the availability of Rule 506(b) has not been eliminated by the new amendment.) The eleven CDIs issued by the SEC on August 6th were, in part, an effort to respond to these concerns. This blog post will discuss and analyze each of these eleven CDIs in turn. (On the SEC website, these appear in the Securities Act Rules and Interpretations Section as Questions 256.23 through 256.33, and will be numbered accordingly here).

Question 256.23

Here, the SEC states explicitly that the use of an unrestricted, publicly accessible website to offer or sell securities would constitute general solicitation or advertising. Therefore, a company relying on the “old” Rule 506(b) to offer securities would be barred from doing so on a publicly accessible website. This is hardly surprising, though it is nice to have it stated so explicitly.

Question 256.24

Here, the SEC addresses what kinds of information a company can widely disseminate without violating the Rule 502 ban on general solicitation. This can be an issue because the SEC takes a very broad view of what constitutes an “offer” to sell securities. Information which is designed or which can have the effect of arousing investor interest in a company, even if no actual mention of any securities being offered or sold is included, may in some instances be considered to be “general solicitation or advertising.” An example might be a press release that includes rosy projections about future potential growth or future earnings. The idea is that, if the company is considering raising capital in the near term, widely distributed communications that have (or appear to have) the intent of ginning up interest may be deemed to be “general solicitation,” which again would preclude the company from relying on the registration exemption under Rule 506(b). As the SEC puts it, information which “condition[s] the public mind or arouse[s] public interest” in a securities offering (even where the offering is not mentioned or alluded to) would result in a violation of the general solicitation ban. Conversely, information that does not condition or arouse the public’s interest would be acceptable. Thus, disseminating purely factual business information about the company would not violate the restriction on general solicitation.

Question 256.25

This brings us directly to the next question, which asks: What is factual business information?

As with many securities-related issues, the SEC’s answer stresses that its determination of what constitutes factual business information is dependent on the specific circumstances in each instance. In general, however, “factual business information” means information about the issuer itself, its general financial condition, the products and/or services it offers, and the advertising of those products and services in the normal course of business. This definition largely tracks the definition of “factual business information” found within Rule 169, although it should be noted here that this Rule does not apply directly to Rule 506 transactions and thus should be viewed strictly as a general guideline. Where a company must be careful is when information it is providing includes what are often called “forward-looking statements,” such as projections or predictions about future performance, and in particular any forecasts or opinions about the future value of the company’s securities.

Companies which are contemplating making use of Rule 506(b) to raise capital in the near-term must be aware that the information they send out may be more closely scrutinized with respect to whether these efforts constitute “general solicitation or advertising” in connection with their intended offering. Although, as the SEC says, each situation is fact and circumstance-specific, one thing to consider is whether the company is acting in a way similar to or different from its own past practices. For example, if a company has not previously been in the habit of releasing quarterly sales results in the past, and then begins to do so shortly before attempting to raise capital in a private placement, this change in behavior may be flagged and scrutinized by the SEC. In general, companies which are considering using Rule 506(b) to raise capital should whenever possible consult with legal counsel to ensure that they do not inadvertently include information extending beyond what the SEC here refers to as “factual business information.”

Question 256.26

This question discusses one way to demonstrate the absence of general solicitation, namely where an offer to purchase securities is made to a person or persons with whom the issuer, or a person acting on its behalf (such as a registered broker-dealer acting as a placement agent) has a “pre-existing, substantive relationship.” For example, if a company is engaging in a later-stage financing round, offering securities to persons who have invested in prior rounds would generally not be considered general solicitation. Similarly, if the issuer is offering the securities through an intermediary such as a registered broker-dealer (BD), the issuer can “piggyback” onto the pre-existing, substantive relationship that the BD has with its clients, and thus the offering of securities to these persons would also not constitute general solicitation.

Question 256.27

This question asks whether there are situations where an issuer or its agent can provide information about a securities offering to persons with whom it does not have a pre-existing, substantive relationship without that information being deemed to constitute general solicitation.

The short answer is yes; the more precise answer is yes, but only in certain instances. In their answer to this question, the SEC acknowledges the “long-standing practice” where issuers or their agents are introduced to prospective investors who constitute an informal, personal network of individuals experienced with investing in private placements. The universe of early-stage investors, particularly those individuals who regularly serve as so-called “angel” investors, tends to be small and somewhat tight-knit (particularly in areas like technology). Angel investors often introduce companies they like to others in their groups. Making offers of securities to these individuals would not, per se, constitute general solicitation or advertising. In a sense, the issuer would be relying on the assumption that all of the investors in this network have the necessary financial experience and sophistication. Thus, an individual investor’s membership in this informal network serves to convey to the issuer (or its agent) the information that the issuer would normally attain by virtue of a pre-existing, substantive relationship with that investor.

Caution should be exercised before relying on this SEC guidance too heavily; as the SEC itself notes, the greater the number of people with whom an issuer does not already have a pre-existing, substantive relationship, the more likely it will be that the SEC will find that there has been general solicitation. There is, of course, no predetermined number; as with everything else, the determination will depend on the specific facts and circumstances of each case.

Question 256.28

This question asks straightforwardly whether someone other than a registered BD is able to form a pre-existing, substantive relationship with a prospective offeree (of securities), thus avoiding the general solicitation trap. According to the SEC, investment advisers who are registered with the SEC may also be able to establish such a relationship because they owe a fiduciary duty to its clients to provide only suitable investment advice (BDs owe similar duties to their clients.) The theory is that, in order to fulfill this fiduciary duty, the investment adviser would need to reasonably determine that its client is financially sophisticated and experienced enough to invest in the issuer’s securities. (Remember that a reasonable determination of an investor’s sophistication is the primary impetus behind the requirement of a pre-existing, substantive relationship in the first place.)

Question 256.29

This question asks for a definition of what “pre-existing” means in the context of a pre-existing, substantive relationship. Here, thankfully, the term is rather self-explanatory. For an issuer itself, this means that the issuer formed its relationship with the prospective offeree before the commencement of its offer to sell securities. If the relationship was formed through an intermediary such as a BD or investment adviser, this means that the relationship was formed before the BD or investment adviser became involved in the offering.

Question 256.30

This question deals with a related follow-up: Is there a minimum waiting period required for an issuer (or its intermediary) to establish a pre-existing, substantive relationship with a potential investor before it can commence an offering of securities? In short, the answer is no; so long as the relationship was established before the offering, offering securities to that potential investor will not constitute general solicitation.  This is a departure from the previously endorsed waiting period of 30 days between the self accreditation of a prospective investor and the ability of an agent to make an offer to such person.  See Lamp Technologies No-Action Letter (May 29, 1997).

In practice, of course, it would be prudent to impose at least some nominal waiting period, but there is no technical requirement for any particular length of time to pass between the establishment of the pre-existing, substantive relationship and the offering of securities.

The SEC also mentions a specific, limited accommodation it will allow for certain private funds that offer investments on a semi-continuous (e.g. quarterly or annual) basis, but as this accommodation is not applicable to most companies raising capital, I will forego further discussion of it here.

Question 256.31

This question asks for a definition of what constitutes a “substantive” relationship for the purposes of demonstrating the absence of general solicitation. Here, the SEC is kind enough to oblige by offering an actual definition: 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.” The SEC also specifically cautions here that mere “self-certification” is insufficient, in and of itself, to establish a substantive relationship. (Note that it may be possible, however, for an issuer to rely on an intermediary’s own reasonable belief; e.g. if the investor’s BD tells you the investor is sufficiently sophisticated and informed, that may be enough to establish the issuer’s own reasonable belief.)

Question 256.32

This question asks whether anyone other than BDs and investment advisers can form a pre-existing, substantive relationship with a potential investor in order to demonstrate the absence of general solicitation. The short answer here, again, is yes. What should be kept in mind is that it is the nature of the relationship which broker-dealers and investment advisers have with their clients, rather than the mere fact of the relationship itself, which allows them to demonstrate the existence of such a relationship. Thus, as the SEC puts it, “there may be facts and circumstances in which a third party, other than a registered broker-dealer [or registered investment adviser] could establish a pre-existing, substantive relationship.”

Practically speaking, it’s possible but difficult. Unless the third party (such as the issuer itself) has either a pre-existing business relationship or some kind of recognized legal duty to its offerees, the SEC cautions that it will be more difficult to establish a pre-existing, substantive relationship. For this reason, if the issuer will not be using an intermediary such as a registered BD or investment adviser, it may wish, for pragmatic reasons, to consider offering securities under Rule 506(c), rather than Rule 506(b), thus avoiding the general solicitation issue.

Question 256.33

Finally, Question 256.33 asks whether the holding of a “demo day” or “venture fair” will necessarily constitute general solicitation. The short answer is no; whether such an event constitutes general solicitation depends, as usual, on the specific facts and circumstances. Here, the two primary considerations are 1) what is being presented; and 2) who is the audience.

First, if the presentation does not involve anything that would be considered an “offer” of securities, there is no general solicitation issue. (Keep in mind, of course, the SEC’s broad interpretation of “offer” discussed above with respect to “factual business information.”) Second, if the presentation does involve an “offer” of securities, whether the event constitutes general solicitation will depend on who is invited to the event. If the only people attending are those with whom the issuer (either itself or through its intermediary) already enjoys a pre-existing, substantial relationship (or to whom it is being introduced through the sort of informal, experienced investor networks discussed above in Question 256.27), then the event will not constitute a general solicitation. (Keep in mind, however, that if materials related to the offering are distributed at such an event, and find their way to a wider public audience later, there may be a general solicitation issue.)

Thus, if an issuer is considering holding an event such as a demo day or venture fair, and intends to rely on the “old” Rule 506(b) for its private placement, it must first determine whether its activities will be deemed by the SEC to constitute an “offer” of securities; if so, it must carefully restrict access to this event to those with whom it has a pre-existing, substantive relationship (or, again, to those who may be excepted from this general rule by virtue of their involvement in an informal investing network as discussed above.)

I have previously discussed securities law-related issues about pitches and demo days here.

In a nutshell, if your company is intending to raise capital in a Rule 506(b) private placement, it must be careful about what information it provides and who it provides that information to. As this blog post has hopefully made clear, even following this recent round of CDIs, there are few hard and fast rules or “lines in the sand” when it comes to determining what constitutes general solicitation, and it is always prudent to consult with legal counsel experienced in securities law matters.

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 corporate, securities, and intellectual property law.

Curing the “Bad Actor” Disqualification: Waivers and Due Diligence - Part II

In the previous blog post, I began discussing the “bad actor” concept as it relates to Rule 506 private placements. In that post, I focused specifically on who the potential “bad actors” are, and what sort of “bad acts” would lead to that designation. In this blog post I am going to discuss four exceptions to disqualification.

1. Timing of the Disqualification Events.

The “bad actor” disqualification rule became effective on September 23, 2013, and is a prospective rule. Therefore, only bad acts which occurred on or after that date are disqualifying events. It is important to note that it is the date of the conviction, suspension, or similar bad act (see my previous post here for the list of disqualifying “bad acts” which is important for timing purposes, rather than the date(s) of the conduct which resulted in the conviction, etc. Thus, any conviction, etc. occurring on or after September 23, 2013 is a disqualifying event, regardless of when the actual conduct took place.

However, Rule 506(e) requires disclosure, “to each purchaser, a reasonable time prior to sale” of a written description of any “bad acts” which would have been disqualifying but are not solely by virtue of the timing rule. Thus, if a broker participating in the sale had been suspended in January 2013, he would not be a “bad actor” and his participation would not destroy the Rule 506 exemption, but this fact would need to be disclosed to every purchaser of the securities (and, importantly to note, not only to those who would be purchasing securities through that particular broker).

2. Court or Agency Request

If the disqualifying event is due to, for example, a judge’s order or a regulatory agency’s finding, and the relevant judge or agency provides written notice to the SEC that the finding should not result in disqualification, then the disqualification will not arise. This notice may be provided either in the ruling itself, or may be separately provided to the SEC staff. In such cases, the issuer will not be required to also seek a waiver from the SEC; the judge or agency’s written notice is sufficient to “cure” the otherwise disqualifying “bad act.” Question 260.22 of the Securities Act Rules Compliance and Disclosure Interpretations ("C&DIs") addresses this point.

3. The “Due Diligence” Defense

If an issuer fails to discover a disqualifying event, it may in some instances rely on a “due diligence” defense. As with due diligence in other contexts, the standard is one of “reasonable care.” The burden is on the issuer to show that, after exercising reasonable care, it did not know, and could not have known, of the disqualifying event. To satisfy this burden, the issuer will need to show that it conducted a factual inquiry tailored to the facts and circumstances of the particular offering and its participants. Whether the issuer can rely on this defense is very fact-dependent. The better the internal monitoring controls, and the more care the issuer takes in investigating the “covered persons” it is working with, the better its chances of being able to make use of a due diligence defense.

If the issuer fails to disclose a prior “bad act” to purchasers of its securities, the consequences are the same as if the “bad act” was disqualifying—that is, loss of the ability to rely on Rule 506 registration exemption. That said, it does not mean that the offering cannot continue.  A disqualified Rule 506 offering can be conducted as a registered offering or under another registration exemption or safe harbor that is not subject to bad actor disqualification.

If an issuer newly discovers a Rule 506(d) disqualifying event or covered person during the course of an ongoing Rule 506 offering, it must then consider what steps would be appropriate. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure to investors or take other remedial steps to address any Rule 506(d) disqualification. (Question 260.23 of C&DIs.)

4. Waivers of Otherwise Disqualifying “Bad Acts”

Rule 506(d)(2)(ii) provides that the SEC may waive an otherwise disqualifying bad act if “upon a showing of good cause...the Commission determines that it is not necessary under the circumstances that an exemption be denied.” More colloquially, this can be referred to simply as the “waiver rule.” The SEC provided a guide to submitting a waiver request, which is available here. It also maintains a list of waivers it has granted (through “no-action” letters) here (you should scroll down specifically to the subsection “Regulation D—Rule 506(d) Waivers of Disqualification.”) To get a sense of what kind of factors the SEC takes into account when deciding whether to grant these waivers, it may be helpful to read through some of these decisions. In addition, on March 13, 2015, the SEC provided its own separate guidance on what kinds of factors it will look at, which is available here. These factors include:

• The nature of the violation or conviction and whether it involved the purchase or sale of securities
• Whether the conduct involved a criminal conviction or scienter [intent]-based conviction (bad), as opposed to a civil or non-scienter based provision (less bad.) (Note that the SEC guidance specifically notes that the burden on the person seeking a waiver will be “significantly higher” in the case of the former category.)
• Who was responsible for the misconduct? (For example, was it an executive officer at the company which is seeking the waiver? Or a participating officer of the placement agent working with the company? Generally speaking, a company will have a better chance of receiving a waiver in the former case as opposed to the latter.)
• What was the duration of the misconduct? Here, of course, the longer the misconduct goes on, the less likely a waiver will be granted. Again, this goes to show the importance of putting in place a robust internal system to watch out for and correct wrongdoing. Here, because smaller companies often lack the resources to put in place the sophisticated internal controls that a larger, public company can, this may put them at a disadvantage when it comes to seeking a waiver.
• What remedial steps have been taken? Once the misconduct is identified, what has the company done to fix the damage? For example, has it terminated its relationship with the persons involved? Has it instituted new policies to prevent a reoccurrence in the future? The more a company can show that it has taken steps to address the problem, the more likely it will be successful in its waiver application.
• What is the impact if the waiver is denied? Here, the impact which the SEC is worried about is not merely about the impact on the party seeking the waiver itself, but also its customers, clients, and investors. This again can put smaller start-up companies at a significant disadvantage, because the aggregate impact of its not receiving a waiver will necessarily be less than that of, for example, a huge investment banking firm which is involved in hundreds of Rule 506 offerings a year. 

Going off of this last factor, there has in fact been significant criticism levied against the SEC for its willingness to grant Rule 506 waivers (among others) to large institutions (think of “too big to fail” or “systemically important” institutions.) Much of this criticism has come from members of the SEC themselves. On May 21, 2015, for example, Commissioner Stein penned a stinging dissent from the granting of a waiver to several large firms after they had received criminal convictions for manipulating currency exchange rates (the full text of her dissent is available here. In fact, the vast majority of waivers which are granted go to very large institutions. As Herrick Lidstone asks here: “One can question whether the SEC will show the same leniency to smaller issuers applying for waivers under Rule 506...”.  Indeed, given the backlash against the SEC for its leniency in granting waivers in the past, there may be a risk that any future crackdown will also disproportionately affect smaller issuers.

Conclusion

In conclusion, I would like to say that Rule 506(d) should not be taken lightly. It adds a layer of complexity to the Rule 506 private placements, which should be navigated with the assistance of experienced counsel. The main task for the company conducting a private placement in reliance on Rule 506(b) or (c) is to conduct adequate due diligence of its “covered persons” through the use of questionnaires, representations and covenants, as well as online research, to ensure that any involvement with a “bad actor” is terminated prior to the commencement of the offering.

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 corporate, securities, and intellectual property law.

Rule 506(d) “Bad Actor” Disqualifications: Who’s a Bad Actor and Why are They Bad? - Part I

Rule 506 is by far the most widely used Regulation D exemption for conducting private placements. According to the SEC, about 90-95% of all private placements are conducted pursuant to Rule 506. This Rule permits sales of an unlimited dollar amount of securities without Securities Act registration, provided certain requirements are satisfied. Traditionally, issuers relied on Rule 506(b) that allows unlimited amounts to be raised from accredited investors and up to 35 non-accredited investors, so long as there was no general solicitation and advertising and other conditions were met. In implementing Section 201(a) of the JOBS Act, the SEC added a new Rule 506(c) that allows general solicitation and advertising in Rule 506 offerings so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verity their accredited investor status.

As of September 23, 2014, the SEC added a new section (d) to Rule 506. Rule 506(d) applies to all Rule 506 offerings, i.e., Rule 506(b) and Rule 506(c) offerings. It is important that all companies raising capital by means of Rule 506 know and understand the new addition to Rule 506 because failing to comply with Rule 506(d) will disqualify the entire offering.

Rule 506(d) identifies certain persons that may potentially become “bad actors.” It also lists certain events (“disqualifying events” or “bad acts”). An offering cannot be made using Rule 506 if it includes a “bad actor” that is engaging or has engaged in a “bad act.” This blog post focuses on (1) who may be a potential “bad actor” and (2) what constitutes a “disqualifying event” or “bad act.” The follow up blog will discuss certain exceptions from disqualification and how to obtain waivers.

Who are the potential bad actors?

Rule 506(d)(1) casts a wide net in terms of who can potentially be a bad actor (and can destroy the Rule 506 exemption). Possible "covered persons" include:

• The issuer of the securities (as well as any predecessor of the issuer or any “affiliated issuer.” An affiliated issuer, as the name suggests, is an affiliate (a person who controls or is controlled by the issuer) who is also issuing securities in the same offering.
• Any director, executive officer, or other officer participating in the offering. (Participation can include such activities as preparing due diligence and/or disclosure documents or communicating with other participants in the offering, including potential investors. In general, when trying to determine whether a particular officer is “participating” when it comes to performing a “bad actor” check, err on the side of caution and assume that the SEC is likely to answer “yes”, particularly when it comes to smaller start-up companies which may not yet have well-entrenched and explicit divisions of labor and responsibility.)
• Any general partner or managing member of the issuer.
• Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities.
• Any “promoter” connected to the issuer in any capacity during the actual sale of securities. (The SEC defines “promoter” broadly: the term includes any natural person or legal entity that “directly or indirectly takes initiative” in founding the company, as well as any person who, in connection with the founding, receives (other than solely as underwriting compensation or in exchange for property) at least 10% of either the proceeds of any sale of securities by the issuer or at least 10% of any class of the securities themselves.)
• Any investment manager of the issuer (if the issuer is a pooled investment fund), as well as its directors, executive officers, other participating officers, general partners, and managing members.
• Any natural person or legal entity who has been or willed be paid to solicit purchasers of the offered securities (e.g. a placement agent), as well as their directors, executive officers, other participating officers, general partners, or managing members.

As you can see, the list of potential “bad actors” that an issuer will need to vet can potentially be a long one, especially, for example, if they will be working with several different placement agents. That being the case, a company seeking to raise money in a Rule 506 private placement should be proactive in determining if they are subject to bad action disqualification at time they are offering or selling securities in reliance of Rule 506. Some steps a company should take include adding bad actor disqualification representations and covenants in their placement agency agreements or securities distribution agreements and asking all participants covered by Rule 506(d) to complete a bad actor questionnaire and/or certification (and bring-downs of the same if the offering is long-lived). Also, the issuer may add a provision in its bylaws requiring each “covered person” to notify it of a potential or actual bad actor event. Further, the issuer should check and re-check public databases for any triggering events. We will talk more about the reasonable care exception in the next blog.

What constitutes a “disqualifying event” or a “bad act"?

Rule 501(d)(1)(i)-(viii) lists the bad acts.  A bad actor is any of the covered persons who:

• Has been convicted within ten years of the sale (five years for issuers and their predecessors or affiliates) of any felony or misdemeanor in connection with the purchase or sale of any security; involving making any false filing with the SEC; or arising out of the business conduct of certain financial intermediaries;
• Is subject to any final order, judgment or decree entered within five years of the sale that at the time of the sale restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of a security, involving the making of a false SEC filing, or arising out of the conduct of certain types of financial intermediaries;
• Is subject to a final order from state securities regulators, insurance, banking, savings association or credit union regulators, federal banking agencies, the CFTC or the National Credit Union Administration that either (1) at the time of the current sale, bars the person from association with any entity regulated by such a commission, agency, etc.; engaging in the securities, banking, or insurance business; or engaging in savings association or credit union activities, or (2) constitutes a final order based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct.
• Is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons;
• Is subject to an SEC order (entered within five years of the current sale) that, at the time of the sale, orders the person to “cease and desist from committing or causing a violation or future violation” of 1) any scienter-based [i.e. intentional] antifraud provision of the federal securities laws (e.g. Section 10(b) and Rule 10b-5 of the Securities Exchange Act, Section 17(a) of the Securities Act); or 2) Section 5 of the Securities Act (dealing with selling unregistered securities (which have not received an exemption) in interstate commerce) (Cease and desist orders regarding violations which do not include a scienter (intent) element would not be included, and thus would not be disqualifying “bad acts.”)
• Is suspended or expelled from membership in, or barred from associating with a member of, a registered national securities exchange (e.g. NYSE) or an affiliated securities association (e.g. FINRA) for actions found to be inconsistent with the just and equitable principles of trade;
• Has filed either as a registrant or issuer, or who acted or was named as an underwriter for, any registration statement or Regulation A offering which, within the five years prior to the current securities offering, was the subject of an SEC stop order, refusal order, or an order suspending the Regulation A exemption, or who is currently the subject of an investigation or proceeding to determine whether such an order should be issued.
• Is subject to a USPS false representation order entered within five years of the current sale of securities, or who has received a temporary restraining order or preliminary injunction regarding conduct alleged by the USPS to constitute a scheme to obtain money or property through the mail by means of false representations.

Only “bad acts” occurring on or after September 23, 2013 can destroy the exemption; those occurring prior to that date require disclosure, but do not themselves destroy the exemption. One important thing to note here is that this cut-off refers to the date of the conviction, order, etc. in question, not the underlying activities which eventually resulted in that action. For example, a broker who was suspended on October 1, 2014 for activity that occurred on June 3, 2014, would be a “bad actor” under the Rule, because the actual suspension occurred on or after September 23. Accordingly, the relevant look-back periods in the Rule are measured from the date of conviction or sanction, not from the date when the conduct occurred.

Final thing to note is that Rule 506(d) is not triggered by actions of foreign courts or regulations, such as convictions, court orders or injunctions.

Given the serious, even devastating potential consequences that can follow from failing to catch a “bad actor” disqualification, I strongly encourage companies considering raising capital through a Rule 506 private placement to devote the necessary time and resources to ensuring that the company and its covered persons are in full compliance with the “bad actor” disqualification provisions of Rule 506(d).

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 corporate, securities, and intellectual property law.

All You Ever Wanted To Know About Form D: When, Why and How to File

Why File Form D?

When raising money in a private placement, the most common path for companies to take is to make use of one of the Regulation D exemptions from registration, utilizing either Rule 504, 505 or, most commonly, Rule 506. Once the offer for private placement is made, Rule 503 of Regulation D requires the companies engaging in the private placement (let's refer to them as the “issuers”) to file a Form D—Notice of Exempt Offering of Securities—with the Securities and Exchange Commission (the “SEC”).

What Information Do I Need To Have To Be Able To File Form D?

Here is the information you need:

• Company name, principal place of business and contact information (including a phone number)
• Type of entity, state and year of incorporation
• List of related parsons (executive officers, directors, promoters)
• Size (based on revenue or NAV) - this info is optional
• Federal exemption claimed for the offering of securities
• Date of first sale
• Whether the offering will last for longer than a year
• Type of security offered (debt, equity...)
• Whether the offering is made in connection with a business combination
• Minimum investment accepted
• Information related to sales compensation (if any)
• Total offering amount, amount already sold and amount remaining to be sold
• Number of investors (and separately the number of non-accredited investors) 
• Amount of sales commissions and finders' fees
• Use of proceeds and amounts paid to officers, directors and promoters as compensation.

When to File Form D?

Form D must be filed no later than fifteen calendar days following the first sale of securities in the offering. If the fifteenth calendar day falls on a weekend or holiday, the deadline is pushed back to the next following business day (but note that otherwise both weekends and holidays are counted for purposes of the fifteen day total.) The “date of first sale” is the date on which the first investor is contractually obligated to invest (e.g. if an investor signs a binding contract to invest on January 1, requiring payment for the securities on January 10, the date of first sale is January 1.)

Form D is also the correct form to use when the issuer seeks to amend an original Form D filing. Part 7 of the Form allows the issuer to indicate whether the filing is an original filing or an amendment to one previously filed. An issuer may choose to file an amendment at any time (i.e. a permissive filing). However, there are also certain situations, laid out in Rule 503, where the issuer must file an amendment. These are:

• To correct a material factual mistake in the previously filed Form D. The amendment must be filed “as soon as practicable after discovery of the mistake or error.”
• To reflect any change in (i.e. update) the information provided in the previously filed Form D (but only if the offering has not already terminated). Although this second requirement seems very broad, Rule 503 also carves out a number of exceptions where certain changes in information will not require an amended filing, if the only information that has changed includes only:
• The address or relationship to the issuer of a “related person” (i.e. executive officer, director, and/or promoter);
• The issuer’s revenues or aggregate net asset value;
• Any change in the minimum investment amount of 10% or less;
• The address or state of solicitation for anyone receiving sales compensation in connection with the offering;
• Any change in the total offering amount of 10% or less;
• The amount of securities being sold or remaining to be sold;
• The number of non-accredited investors who have invested in the offering (so long as not over 35)
• The total number of investors participating in the offering; or
• Any change in the amount of sales commissions, finders’ fees or use of proceeds for payments to executive officers, directors, or promoters or of 10% or less.

In addition, so long as an offering is ongoing, the issuer must file annually, either on or before the first anniversary of the original filing or the anniversary of the latest filed amendment (whichever is later.)

How to File Form D?

Now that we’ve discussed when to file Form D and what information to include, let’s move on to discussing how to file it. The first thing to know is that the SEC requires that Form D be filed electronically using its Electronic Data Gathering, Analysis, and Retrieval System (more affectionately known as EDGAR). To access the EDGAR filing system (located here), a company must have both a Central Index Key (CIK) and an EDGAR access code.

If the issuer has never previously filed anything with the SEC, electronically or otherwise, it needs to apply to get the CIK and EDGAR access codes by using what is known as Form ID. The SEC website provides a super helpful guide to this process here (see specifically Steps 2 and 3). Remember that the Form ID must be printed, signed and notarized by an authorized person, and then submitted as an attachment to the SEC.  Then, the SEC sends the filer the CIK number by email, typically within a couple of days.  Next, the filer uses the CIK number to obtain the EDGAR access codes.  Once the company has obtained its CIK and EDGAR access code, it can log on to EDGAR here and from there follow the instructions to submit Form D.  I would suggest allocating 2-3 days to get through this process.  

Who Can Sign Form ID and Form D?

The forms can be signed by the issuer's executive officer or director.  An attorney for the company may also sign, but that attorney must be duly authorized by the company or be acting under a power of attorney or other corporate authorization.  So, when the attorney for the company is attaching a notarized Form ID, he or she should also attach the authorization from the company.  

One final thing to note about EDGAR: although it is an online filing system, it is not available 24-7. The system may be accessed between 6 a.m. and 10 p.m. Mondays to Fridays (excluding federal holidays).

This blog article was written and published on June 16, 2015, and the information is accurate (to the best of our knowledge) as of this date.  As you know, with time rules and forms change, and this information may become inaccurate or obsolete.

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 corporate, securities, and intellectual property law.

How to Comply with New York Blue Sky Laws?

As I previously explained here, Rule 506 private placements involve the filing of a Form D with the SEC as well as complying with blue sky notice filings requirements in each state where the investors participating in the offering reside.  Rule 506(b) or (c) offerings are exempt from regulation on the state level. According to the National Securities Markets Improvement Act, securities offered under Rule 506 of Regulation D qualify as "covered securities" under Section 18(b)(4) of the Securities Act. Consequently, securities sold under Rule 506 enjoy an exemption from the registration requirements of state-level securities laws (blue sky laws).

But states can (and do) ask the issuers to make notice filings and pay filing fees with respect to Rule 506 private placements if any of the investors are their residents.  In this blog post, I am going to discuss how to do a blue sky filing in New York.

The filing requirement for general securities offerings is set out in Section 359-e of the New York General Business Law. The filing requirement for offerings of real estate securities is set out at Section 352-e of the New York General Business Law. The NY regulator is the Investor Protection Bureau (or Real Estate Finance Bureau) of the State of New York Office of the Attorney General.  

The first thing you need to know about the blue sky filing in New York is that it must be done before any offer or sale is made in the State of New York.  So, what should you send them?

• Two copies of completed Form 99 (one is manually signed).
• A copy of the private placement memorandum. 
• Notice of appearance.
• Form D.  If it hasn't been filed yet with the SEC, then follow up with the printout of the Form D as filed later.  
• A copy of the consent to service of process (the original should be sent to the NY Department of State).
• A check for the blue sky filing fee.

But the notice filing obligation does not end here.  The Department of State, Division of Corporations should receive from the company the original consent to service of process (with a special "backer") and a $35 check.

And that's not all.  The Miscellaneous Records Bureau of the Department of State should receive the original State Notice and Further State Notice and two checks for $75 each (this applies if the issuer is not a NY entity).

A word about fees.

For general securities offerings:

• $300 for an offering of up to $500,000.
• $1,200 for an offering of over $500,000.

For offerings of real estate securities:

• $1,050 for an offering up to $500,000.
• $1,950 for an offering of over $500,000.

Considering that these filings can be viewed as onerous and expensive, it is not a surprise that some NY attorneys have adopted a position that no blue sky filing or fee is required.  It is certainly supported by the 2002 position paper prepared by the Committee on Securities Regulation of the New York State Bar Association. However, this position paper has not been accepted by the Office of the Attorney General of New York. 

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.

Blue Sky Filings Made Easy?

One of the reasons that explains why Rule 506 offerings have been so popular as a means of conducting a private placement is because they are exempt from state regulation.  In 1996, the National Securities Markets Improvement Act stated that securities offered under Rule 506 of Regulation D qualify as "covered securities" under Section 18(b)(4) of the Securities Act.  Consequently, securities sold under Rule 506 enjoy a exemption from the registration requirements of state-level securities laws (blue sky laws).

But states can still ask the issuers to make notice filings and pay filing fees with respect to Rule 506 private placements if any of the investors are their residents.  Most states make it easy for the issuers: they ask for a copy of Form D and a fee that typically ranges around $100-$300.  Some states take it a lot further.  I think New York State blue sky compliance requirements merit a separate blog post (to come).

On December 15, 2014, the North American Securities Administrators Association (NASAA) launched an Electronic Filing Depository system, EFD, that allows issuers to submit Form D and applicable fees to different states at once.  It also allows the public to view blue sky filings made by any issuer in any state that participates in the EFD.  Here is NASAA's training video.  The system provides an electronic receipt as proof of compliance and allows issuers to monitor the progress of states' review of the filing and respond to any deficiencies that may arise.  

Of course, when it comes to blue sky compliance, things cannot be made that simple that fast.  First, not all states participate.  As of now, 41 states and territories participate (New York is not one of them).  Some state regulators want filings to be made only through the EFD, other states accept only hard copies, and yet the third group accepts either.  To confirm what the state regulators expect, attorneys can contact the relevant state regulator using this contact information.  Second, some states may ask for additional documentation (such as consent to service of process or a copy of the offering memorandum) that would need to be sent to them separately.  Third, there is a $150 system use fee for each offering.  The fee covers the issuer's initial Form D filing and all amendment and renewal filings made through the EFD for that offering.

Still, as a lawyer who diligently spends hours (if not days) figuring out each state's blue sky requirements for each private placement I work on, I am thankful for the EFD. Even if it is not perfect, and even if there is a fee to use it, it will save time and will actually increase blue sky compliance.   

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.