Showing posts with label securities law. Show all posts
Showing posts with label securities law. Show all posts

Friday, August 22, 2014

New Seed Financing Documents (500 Startups and Y Combinator)

The startup industry keeps on coming up with new innovative solutions to seed financing.  The latest trend is convertible equity.  Two startup venture funds and incubators, 500 Startups and Y Combinator, recently released their versions of convertible equity documents.


In 2013, Y Combinator, a well-known seed incubator and venture fund, released its own version of equity securities that it refers to as SAFE (simple agreement for future equity).

Benefits of SAFE

SAFE securities are not convertible notes because they don't have the common features of debt instruments: maturity and interest rate.  This means that there is no debt on the startup's balance sheet.  Since this investment does not mature, it removes the risk of startup insolvency in the case of non-repayment and non-conversion into equity.  Terms are simple, with valuation cap being the only negotiated item.  By investing in a SAFE security, the investor gives money to the startup in exchange for a promise to receive preferred stock in the event of future equity financing.  There is no deadline and there is typically no minimum size of equity financing.  SAFE securities terminate either at IPO or change of control or conversion into equity.

Different Types of SAFE Securities

There are essentially four types of SAFE securities proposed by Y Combinator.

1.  SAFE with a cap and a discount.
2.  SAFE with a discount, but no cap.
3.  SAFE with a cap, but no discount.
4.  SAFE without a cap or a discount, but with an MFN provision, which says that if the company were to issue another SAFE with more favorable terms, this SAFE documents will be amended to benefit from similar terms.  However, there is no automatic conversion into equity unless the amount of equity financing is at least $250,000.

SAFE securities are designed to protect the investor in the case if the startup valuation decreases in time for that equity financing.  So, if the SAFE valuation happens to be higher than the valuation at the time of a priced equity round, then SAFE converts into the preferred stock at the same lower valuation of the preferred stock.  If the SAFE valuation is lower than the valuation of the company right before the equity financing, then the holder of SAFE securities gets shares of preferred stock calculated using its own valuation cap, not the higher valuation of the equity financing.  Then, SAFE securities convert into a Series SAFE preferred (also referred to as "shadow preferred" or "sub-series preferred", which has the same features as the preferred stock that the company is issuing except for the conversion price, liquidation preference (which still equals to the original investment amount into SAFE securities) and dividend rate.  In the event of the company sale, the SAFE security holders get a choice of either converting its securities into shares of common stock based on its valuation cap, or having the investment returned.


However, investors may still feel weary of using SAFE equity or other convertible equity structures because they are too favorable to the companies.  There is just too little protection for the investors in the event that the company fails to raise any equity financing.  There is no maturity and no interest rate, so it is not possible for the investors to declare default.


On July 3, 2014, a well-known business incubator and fund 500 Startups released its own deal documents named KISS (keep it simple security) for convertible debt and convertible equity financings developed in collaboration with Gunderson Dettmer.

KISS Convertible Debt

I personally like their convertible note document.  It is clear and simple, and has no surprising terms.  Its maturity is 18 months, and the notes accrue interest at 5% that can be paid by the Company in cash.  It provides for an automatic conversion to preferred stock if the company raises a qualifying priced round ($1 million).  Conversion occurs at the lesser of a cap and a discount.  At a change of control event, investors have an option of either cashing out at a multiple of 2X or converting into common stock at the cap.  I particularly like that the KISS convertible note agreement addresses what happens at maturity in case of non-payment.  It provides for an option to convert into a newly created series seed shares using model documentation or explore other options (for example, extension of maturity).  This is not mandatory and is decided by the majority of note holders.  All KISS investors receive an MFN treatment and major investors (those who invested more than $50,000) receive basic information and participation rights.  

KISS Convertible Equity

KISS Equity securities have no interest rate (company-friendly feature) BUT have a maturity date of 18 months.  Just like the KISS convertible notes, they automatically convert into equity at the next round of equity financing but only if the financing is for $1 million or more (unlike SAFE securities that do not have a minimum financing amount unless this is SAFE with the MFN clause).  KISS Equity securities have both the discount and the valuation cap, and convert at the lesser of the two.  SAFE, on the other hand, has options in terms of how to structure the security (cap and discount or either cap or discount or none of the above but with an MFN treatment).  Treatment of KISS Equity in the case of a change in control or at maturity is the same as KISS Debt.  Like with convertible debt, the convertible equity securities offer the same MFN protection and major investors receive additional information and participation rights.  The convertible equity securities are treated on pari passu with other KISS securities and convertible debt securities, including in terms of repayment.

So, as far as I can see, the main difference between KISS Equity and KISS Debt is that KISS Equity securities do not have an interest rate.  Is it sufficient to treat these securities as "equity"?


In conclusion, I would like to thank 500 Startups for developing a solid convertible debt purchase agreement.  I would definitely resort to it in the future. However, as of now, I am unlikely to recommend to my clients to use convertible equity structures, although it is good to know that this option exists.

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, August 6, 2014

Crowdfunding Right Now (Fund Model, Broker-Dealer Model, Lending Platforms and Intrastate Offerings)

We are still waiting for the SEC to issue final rules with respect to the Title III crowdfunding that will allow the U.S. companies to issue up to $1 million in securities to non-accredited investors through the online funding portals. So, while we are all waiting, crowdfunding in the U.S. is alive and happening. And I am not talking here about rewards-based crowdfunding like campaigns on Kickstarter. I am referring to the equity / debt crowdfunding.

In the U.S., it is currently being done in several different ways. Here is a short summary of each.

Crowdfunding through the accredited investor portals: the fund model

This crowdfunding model came out of the two no-action letters: the AngelList LLC and the FundersClub Inc., both issued in March 2013. I previously wrote about them here. Essentially, both are online platforms that aim to invest accredited investors’ money in the startup companies. However, they do so indirectly. Each aims to pool investors’ money into a separate investment fund that in turn invests into the startup. A new fund is formed for each investment. Accredited investors become members (or limited partners) of the fund in a Rule 506(b) offering. Only accredited investors can participate in these types of offerings. Both FundersClub and AnglelList operate as investment advisers, which means that they either have to register with the SEC as such or comply with an available exemption. They receive carried interest (a share of profits distributed at the termination of an investment) from their funds. However, since they are not broker-dealers, they cannot accept any transaction-based fees.

Crowdfunding through the accredited investor portals: the broker-dealer model

Alternatively, funding portals can partner with registered broker-dealers in order to be able to receive transaction-based compensation (a percentage of the total offering proceeds). A good example is CircleUp Network, Inc. CircleUp itself is an online portal, but all securities-related activities are conducted through Fundme Securities LLC, a wholly owned subsidiary of CircleUp Network, Inc., which is a registered broker-dealer and a member of FINRA/SIPC.  In this model, securities of the startup itself, not the fund, are sold to accredited investors in a Rule 506 offering. This crowdfunding model can be used for any type of startup, irrespective of its industry. However, this model has its challenges, beginning with the need to find an interested broker-dealer and having to compete with the more established platforms and broker-dealers.

Lending platforms

LendingClub Corporation and Prosper Marketplace, Inc. have adopted a different crowdfunding model, that of the peer-to-peer lending. Each company is an online platform that enables individuals to borrow up to $35,000 from a large number of lenders each of whom commits only a very small amount. These platforms have been tremendously successful. However, these offerings are not exempt from registration with the SEC. Each platform has filed a registration statement on Form S-1 that allows them to engage in a continuous offering to the general public .  The LendingClub investors do not invest directly in loans (the minimum investment is only $25) but instead purchase Member Dependent Notes from LendingClub.  Loans are issued by WebBank, an FDIC insured Utah-chartered bank, that then assigns the loans to the LendingClub in exchange for money received from the investors.  The platforms earn a transaction-based fee on each loan as well as servicing fees while payment are made on the loans.

Crowdfunding within a single state (intrastate offerings)

It is permissible under Section 3(a)(11) and Rule 147 of the Securities Act to conduct an offering of securities to the general public that is not registered with the SEC so long as the securities are only offered to the residents of a single state by an issuer that is registered and doing business in that state.  These exemptions were available even before the JOBS Act.  However, now these exemptions are being actively used by intrastate crowdfunding portals.  All intrastate offerings must comply with the applicable state registration and offering requirements (which vary from state to state).

On April 11, 2014, the SEC issued new Compliance and Disclosure Interpretations ("CDIs") relating to intrastate securities offerings made pursuant to Rule Section 3(a)(11) and Rule 147 of the Securities Act.  The new CDIs provided guidance and clarification with respect to the recent numerous state crowdfunding exemptions that are rapidly increasing in number.  One aspect in particular was previously unclear: how and whether the use of general solicitation and advertising, including social media and online crowdfunding portals, in intrastate offerings could be reconciled with the requirement that offers only be made to persons resident in the issuer's home state.  You can find a good analysis of the new CDIs here.

According to this blog, as of June 2014, 12 states (Alabama, Colorado, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Michigan, Minnesota, Tennessee, Washington and Wisconsin) have intrastate crowdfunding exemptions in place and 14 states (Alaska, Arkansas, California, Connecticut, Florida, Illinois, Missouri, North Carolina, New Jersey, Pennsylvania, South Carolina, Texas, Utah and Virginia) are in various stages of enacting/considering sponsored legislation regarding such intrastate crowdfunding.

It may, in fact, be easier for the companies to comply with such intrastate requirements than to comply with the much expected crowdfunding rules. The disadvantages of such offerings include (i) the fact that the offers can only be made to made to residents of a single state; (ii) resales to out-of-state residents are restricted; (iii) if the offerings are subject to that state’s regulatory approval, if such approval is not obtained, the offering will never take place.

In conclusion, I find that the crowdfunding industry is not waiting in one place for the enactment of the SEC rules relating to Title III of the JOBS Act.  The crowdfunding is already taking place now, whether it is done through a broker-dealer portal, as a lending platform or in instrastate offerings.

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, July 19, 2014

The SEC Will Likely Update its Definition of “Accredited Investors” Very Soon

Most of the startup capital comes from accredited investors through investments made in reliance upon Rule 506 of Regulation D.  According to a study by the University of New Hampshire’s Center for Venture Research, in 2013, almost 71,000 benefited from $24.8 million in investments made by accredited investors.

So, who are these “accredited investors”? The definition of “accredited investors” is found in Rule 501 of Regulation D and includes the following individuals:

1. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or

2. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Section 413(b)(2)(A) of the Dodd-Frank Act requires the SEC to review the definition as it relates to the natural persons every four years to determine whether "it should be modified for the protection of investors, in the public interest and in light of the economy.” Now is the time for the SEC to do so. The last review of the “accredited investor” definition by the SEC was done in July 2010.  At that time, the definition was amended to exclude the value of a primary residence from the calculation of investor’s net worth.

In a letter to Representative Scott Garrett in November 2013, the SEC Chair Mary Jo White described potential changes to the accredited investor definition and factors that the SEC is considering.  It indicates that this time the changes to the definition may go beyond merely adjusting the net worth minimum requirements for inflation.

In particular, Ms. White’s letter states that the SEC is examining:
  • "whether the existing net worth and income tests are appropriate measures that should continue to be used (presumably this also includes consideration of whether and how the net worth and income thresholds could or should be adjusted);
  • whether financial professionals, such as registered investment advisers, consultants, brokers, traders, portfolio managers, analysts, compliance staff, legal counsel, and regulators should be considered accredited investors without regard to net worth;
  • whether individuals with certain educational backgrounds focused on business, economics, and finance should be considered accredited investors without regard to net worth;
  • whether an expanded pool of accredited investors would help provide liquidity in private placement investments and thereby reduce the risk profile of those investments;
  • whether reliance on a qualified broker or registered investment adviser should enable ordinary investors to participate in private placements; and
  • whether reducing the pool of accredited investors would harm U.S. GDP."
If the SEC were merely to adjust the amounts for inflation, according to the Angel Capital Association press release, the “inflation-based adjustments would increase the net worth standard to about $2.5 million and the annual income to $450,000."  This increase would “eliminate about 60 percent of current accredited investors.” Also, the Association said that such inflation-based adjustments would reduce its membership by 25%.

However, based on the November letter, it appears that the SEC is undertaking a more comprehensive review of the definition than just adjusting it for inflation. In my opinion, simply relying on net worth or income amounts is not enough to determine the investors' suitability for high-risk investments into startups.  I have come across many individuals who, although they satisfy the net worth or the income test of the current accredited investor definition, entirely lack financial sophistication and can be easily talked into investing into the most unbelievable schemes.   On the other hand, I have met financial industry professionals, who are quite able to "fend for themselves," although technically they do not satisfy the income or net worth tests.  

I also believe that it is important to keep a fairly large pool of accredited investors, because they help fuel the growth of our economy.  While the crowdfunding rules are still pending, it is essential to keep or even increase the angel community in order to provide continued support to the startups and entrepreneurs.  After all, today's startups are tomorrow's Fortune 500 companies.

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, July 11, 2014

How to Verify That Your Investor is Accredited - The SEC Provides New Explanations Regarding Rule 506(c) Offerings

On July 3, 2014 (right on my birthday), the SEC issued six compliance and disclosure interpretations (“CD&Is”) regarding the use of verification methods for determining whether a prospective investor is accredited.

First, a bit of background information. Effective September 23, 2013, the SEC introduced Rule 506(c) that allows issuers to use general solicitation and advertising in conducting private placements so long as their actual investors are accredited (meaning wealthy and sophisticated individuals and/or certain entities). Companies that conduct 506(c) offerings must take “reasonable steps” to verify that all investors in their offerings are accredited and have a reasonable belief that such investors are accredited at the time of the sale of securities. Before the JOBS Act, and still while conducting Rule 506(b) offerings, companies could rely on investors’ self-certification (for example, questionnaires where investors self-report their income and net worth). This is no longer enough for a successful Rule 506(c) offering. Instead, the companies or someone on their behalf must request and review evidence of investors’ income or net worth.

An issuer may satisfy the verification requirement of Rule 506(c) by either using the principles-based method of verification or by relying upon one of the specific, non-exclusive verification methods listed in Rule 506(c)(2)(ii). Since these methods are non-exclusive, the issuers are not required to use any of them. However, if they do, then they must meet all of the requirements of the chosen method, including that the documents provided are current. Regardless of what steps the issuer takes, it is important to retain adequate records of the verification steps they took.

Next, let’s review the acceptable methods of verification before discussing the new CD&Is.

Under the principles-based verification method, “the determination of what constitutes reasonable steps to verify is an objective determination based on the particular facts and circumstances of each purchaser and transaction.” CD&I 260.07. Here, the issuers should consider factors such as the nature of the purchaser and the type of accredited investor it claims to be; the amount and type of information the issuer has about the investor; the nature of the offering and the manner of solicitation.

Specific, non-exclusive verification methods for natural personal include the following methods:

1. If the person’s accredited investor status is based on income:
  • reviewing any IRS form that reports the person’s income for the two most recent years; and
  • obtaining a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
2. If the person’s accredited investor status is based on net worth:
  • as to the person’s assets, reviewing one or more of certain documents (including bank statements, brokerage statements and tax assessments) dated within the past three months; and 
  • as to the person’s liabilities, reviewing a report from one of the national consumer reporting agencies and obtaining a written representation that the person has disclosed all liabilities necessary to make a net worth determination.
3. Obtaining a written confirmation from a certain type of third party (a registered broker-dealer or investment advisor, a licensed foreign or domestic attorney in good standing or a foreign or domestic CPA registered and in good standing) that the third party has taken reasonable steps to verify the person’s AI status within the past three months and has determined that the person is an accredited investor.

There is also a fourth safe harbor that relates to individuals who invested in an issuer's Rule 506(b) offering as accredited investors prior to the effective date of Rule 506(c).

And now, let’s finally discuss the new CD&Is.

The new CD&I 260.35 discusses the use of the income-based verification method and the requirement to rely on an IRS form that reports the person’s income for the two most recent years. This method becomes unavailable during the first part of the year until the tax returns for the previous year have not yet been filed. According to the CD&I, the issuer then has to resort to other verification methods.

The new CD&I 260.36 explains that if the investor is not a US taxpayer and therefore does not have income tax returns, the income-based verification method is not available. So, the issuer has to resort to other verification methods.

The new CD&I 260.37 refers to the second, net worth-based, verification method. It underlines the importance that all documents provided by the investor regarding its assets and liabilities be dated within the prior three months. So, an annual tax assessment, if not dated within that time frame, would not be acceptable.

The next new CD&I 260.38 is also about the net worth-based verification method. It clarifies that a consumer report from one of the “nationwide consumer reporting agencies” means that such agency must be U.S.-based.

And finally, there are two new CD&Is (255.48 and 255.49) about the accredited status of an investor. Question 48 says that if the purchaser’s annual income is not reported in the U.S. dollars, the issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year. Question 49 states that if the assets in an account are owned jointly with another person who is not the purchaser’s spouse, then it is still fine to include the assets in the calculation for the net worth test, but only to the extent of the purchaser’s percentage ownership of the account or property.

Overall, the new CD&Is are undoubtedly helpful in providing guidance to the issuers that are conducting a Rule 506(c) offering. At the same time, the verification methods required of the issuers are becoming more complex and nuanced. Clearly, a careful study of all SEC guidance, the Rule itself, and the accompanying releases, is required before attempting to conduct a successful Rule 506(c) offering.

More recent developments

The SEC is not the only entity that is making navigation of Rule 506(c) requirements more difficult.  On June 23, 2014, SIFMA issued guidance for registered broker-dealers and investment advisers regarding verification methods that they should use if a client asks for a written confirmation of their accredited investor status. In short, the guidance includes two general conditions: (i) that the client has maintained an account with them for at least six months; and (ii) the client makes a representation that it is making the investment for his or her own account or a joint account with the spouse, is not borrowing money to make this investment and is an accredited investor. The guidance then discusses specific verification methods that broker dealers or investment advisers are encouraged to use. Note that according to the guidance, only the existing clients can ask for the verification letter, and not just any prospective investor. This narrows the universe of potential investors seeking to prove their accredited status through third party verification method.

In conclusion, I want to caution anyone using Rule 506(c) to conduct a private placement. This Rule is an exclusive safe harbor, and non-compliance with the verification requirements may jeopardize the whole offering. Also, I’d like to say that for attorneys, it would be helpful to have some guidance from the Bar Association that, similarly to the SIFMA one, provides advice on attorney-issued written confirmation letters of accredited investor status.

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, January 27, 2014

Are You a Broker or a Finder? Does It Really Matter?

I previously covered regulations relating to those who broker securities transactions and get compensated a "success" fee (a recurring question that comes up periodically in my practice).  Such persons have to register with the SEC as broker-dealers prior to conducting any such activities.  Here is my earlier blog about it.  Today I decided to bring it up again because I came across a comprehensive and well-written blog post "Finders Are Not Always Keepers"(found here) and wanted to share it with you.

Individuals who make introductions, identify potential investors, help structure the deal, and who get compensated a fee that is based on the amount of capital raised are considered to be "brokers" and are required to register as broker-dealers with the SEC.  The SEC has consistently viewed the presence of transaction-based compensation as one of the key attributes of a broker's activity.  According to the blog post, there is really no "finder" exemption to the rule.  Using unregistered broker-dealers presents risks to the companies as well as to the unregistered broker-dealers themselves.  If a sale of securities of a company was done through such unregistered "finders," investors may get the right to rescind the entire transaction, which can have disastrous consequences for the company.

To all companies out there raising capital:  beware of using the services of unregistered broker-dealers or finders.

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, 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.

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.

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.