preexisting relationship

On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

SEC 2August 6, 2015 was a productive day for the Staff of the Securities and Exchange Commission’s Division of Corporation Finance on the issue of the prohibition on general solicitation in the context of online private offerings under Rule 506(b). My last blog post, entitled “It’s Complicated”: Establishing “Preexisting Relationships” with Prospective Investors, analyzed the Citizen VC no-action letter delivered that day dealing with establishing pre-existing relationships with investors online to demonstrate the absence of general solicitation in a Rule 506 offering. On the same day, the Staff provided additional guidance on the issue of general solicitation in the form of new Compliance and Disclosure Interpretations (“CDIs”).

Background

Rule 502(c) promulgated under the Securities Act of 1933, as amended, prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings intended to be exempt from registration under Regulation D. The prohibition on general solicitation has been perceived as perhaps the single biggest obstacle to raising capital in the private general solicitationmarkets. In September 2013, the SEC released final rules for a new offering exemption contained in Rule 506(c) that permits general solicitation efforts, provided securities are sold only to accredited investors and the issuer uses reasonable methods to verify that each purchaser is an accredited investor. What constitutes reasonable verification methods will depend on the facts and circumstances of each case, but generally involves a more intrusive inquiry than an offering under traditional Rule 506(b), which is why most private offerings are still being conducted under Rule 506(b) despite the prohibition on general solicitation.

New Guidance

The new CDIs come in the form of Q&As, some of which provide official confirmation of existing practice while others provide new flexibility in online offering activities. Here’s an outline of the new CDIs:

Factual Business Information

Factual business information that does not condition the public mind or arouse public interest in a securities offering is not deemed an offer and may be disseminated widely. In the new guidance, the Staff stated that factual business information is a facts and circumstances concept, but is typically limited to information about the issuer’s business, financial condition, products or services, and generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.

Angel Investors

angelThe Staff confirmed that it is possible for angel investors who have a relationship with an issuer to make introductions to other prospective investors in their personal network and share information about a securities offering without such issuer being deemed to engage in a general solicitation. Whether or not a general solicitation has occurred requires a facts and circumstances analysis, but an issuer could rely on such network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Establishing “Pre-Existing” and “Substantive” Relationships

A relationship with an offeree is “pre-existing” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the relationship was formed prior to the commencement of the securities offering or, alternatively, when it was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participating in the offering. Similarly, a relationship is “substantive” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when 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 status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

Demo Days

Whether or not “demo days” or “pitch days” constitute general solicitation is also – you guessed it – a factsimages12NM2J0D and circumstances question. If the presentation does not discuss the securities being offered, the securities laws are not implicated. Where the presentation does discuss the securities being offered, however, attendance at the demo day or pitch day should be limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or who have been contacted through an informal, personal network as described above under “Angel Investors”. For more on this issue involving demo days, see my previous blog post “Will Your Demo Day Presentation Violate the Securities Laws?”.

In my last post, I blogged about online funding platforms. In that post, I described the typical model of indirect investing through a special purpose vehicle (“SPV”) with the platform sponsor taking a carried interest in the SPV’s profits from the portfolio company and no ourcrowdtransaction fee, as a means of avoiding broker-dealer regulation. I also discussed the concept of a pre-screened password protected member-only website as a means of establishing a preexisting fundablerelationship with prospective investors and thus avoiding the use of any act of “general solicitation,” which would otherwise violate the rules of the registration exemption under Rule 506(b).

SEC logoIn a no-action letter dated August 6, 2015 entitled Citizen VC, Inc., the SEC has provided important guidance on the procedures needed for an online funding platform to establish the kind of preexisting relationship needed to avoid being deemed to be engaged in general solicitation. As an aside, the concern over general solicitation and preexisting relationships is relevant to offerings under new Rule 506(b), but not under Rule 506(c).   Despite the creation in 2013 of an exemption under new Rule 506(c) pursuant to the JOBS Act for general solicitation offerings in which sales are made only to accredited investors, most online funding platforms continue to prefer to conduct portfolio company offerings indirectly through SPVs under Rule 506(b), despite the prohibition on general solicitation, primarily because of the additional requirement under Rule 506(c) that issuers use reasonable methods to verify accredited investor status.

In its request for a no-action letter, Citizen VC described itself as an citizen vconline venture capital firm that facilitates indirect investment in portfolio companies (through SPVs) by pre-qualified, accredited and sophisticated “members” in its site. It asserted to have qualification procedures intended to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the website. Anyone wishing to investigate the password protected sections of the site accessible only to members must first register and be accepted for membership. To apply for membership, prospective investors are required to complete an “accredited investor” questionnaire, followed by a relationship building process in which Citizen VC collects information to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks related to an investment. It does so by contacting the prospective investor by phone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist Citizen VC in understanding the investor’s sophistication, utilizing third party credit reporting services to gather additional financial information and credit history information and other methods to foster online and offline interactions with the prospective investor. In the request letter, Citizen VC asserted that the relationship establishment period is not limited by a specific time period, but rather is a process based on specific written policies and procedures created to ensure that the offering is suitable for each prospective investor.

Citizen VC stated in its request letter that prospective investors only become “members” and are given access to offering information in the password protected section of the site after Citizen VC is satisfied that the prospective investor has sufficient knowledge and experience and that it has taken reasonable steps necessary to create a substantive relationship with the prospective investor. Once a sufficient number of qualified members have expressed interest in a particular portfolio company, those members are provided subscription materials for investment in the SPV formed by Citizen VC to aggregate such members’ investments, the sale of interests of such SPV is consummated and the SPV then invests the funds, and becomes a shareholder of, the portfolio company.

In its request letter, after providing the foregoing background, Citizen VC asked the SEC staff to opine that the policies and procedures described in the letter are sufficient to create a substantive, pre-existing relationship with prospective investors such that the offering and sale on the site of interests in an SPV that will invest in a particular portfolio company will not constitute general solicitation.

sec no-actionIn its no-action letter, the SEC staff concluded that Citizen VC’s procedures were sufficient to establish a preexisting relationship and do not constitute general solicitation. It stated that the quality of the relationship between an issuer and an investor is the most important factor in determining whether a “substantive” relationship exists and noted Citizen VC’s representation that its policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff went on to say that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship, and that whether an issuer has sufficient information to evaluate a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances of each case. The staff also based its conclusion on Citizen VC’s representation that an investment opportunity is only presented after the prospective investor becomes a “member” in the site.

An argument could be made that SPV-based online funding platforms represent the future of VC investing. The Citizen VC no-action letter provides valuable guidance relating to the establishment of the kind of substantive relationship with prospective investors needed to enable the online funding platform to conduct Rule 506(b) offerings without being deemed to engage in general solicitation.