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.

Your company is invited by a local meetup group to present at demo day with other startups, and you accept.  The group announces the demo day lineup of startups in an e-blast, on its website, on its Facebook page and through banner ads on a tech e-zine.  On demo day, the room is packed and you nail your presentation.  The following month, you close on an investment with a few angels who attended your demo day presentation.  Have you just violated the securities laws?

For years, startups and emerging companies have been presenting at capital raising forums organized by accelerators, meetup groups, professional organizations and other similar groups and securing funding from investors they met at such events. But it has never been clear to securities lawyers how issuers could do so without violating the ban on general solicitation in private offerings.

Historically, startups and emerging companies looking to raise capital in the private markets have relied overwhelmingly on Rule 506 of Regulation D, primarily because there is no limit on the amount that may be raised and because the shares offered and sold are deemed “covered securities” and thus exempt from the most onerous requirements under state securities laws.  The ban on general solicitation in Reg D offerings is contained in Rule 502 of Reg D, which states explicitly that:

“[N]either the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

  • Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
  • Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising”

Despite the popularity of Rule 506 offerings, growing criticism of the Rule’s prohibition on general solicitation as an antiquated and overly burdensome impediment to capital raising led to the passage in 2012 of the JOBS Act, which in part called on the SEC to promulgate final rules that would lift the general solicitation ban (among other reforms).  In September 2013, the SEC issued final rules on a new exemption under Rule 506(c) that permits general solicitation so long as certain additional requirements are met, but also left intact as new Rule 506(b) the traditional private offering exemption with no general solicitation (but without the additional requirements).  See my post on the general solicitation rules here.

Accordingly, companies making private offerings of securities under Rule 506 now have two alternatives:

  • Offerings without general solicitation: May sell to up to 35 non-accredited investors and to an unlimited number of accredited investors, with accredited investors being allowed to self-verify (generally by filling out a standard questionnaire).
  • Offerings with general solicitation:  All purchasers must be accredited investors, and the company must use reasonable methods to verify status.  The Rule includes a non-exclusive, non-mandatory list of documents that a company could review to verify accredited investor status.  These include tax returns, bank statements, brokerage statements and credit reports.  The Rule also allows a company to rely on a written statement provided by a lawyer, CPA, investment advisor or broker dealer.

Now that they have a choice, companies will need to consider carefully which route to take.  General solicitation clearly allows the company to reach a far greater audience.  But there are drawbacks.  The additional accredited investor verification requirements could turn off potential investors because of the intrusiveness associated with having to present tax returns or brokerage statements.  There are increased transaction costs (primarily higher lawyers’ fees) and a slowdown in the deal process.  The additional burdens will get even worse if proposed SEC rules are adopted, which would require companies using general solicitation to file a Form D in advance (currently it must be filed within 15 days following the first sale) and include solicitation materials in the filing.

As mentioned above, it is unclear on what basis companies were able to present at demo day events before September 2013 without violating the general solicitation ban.  The SEC may have chosen to look the other way because the events contribute to economic growth and are typically managed by credible organizers, and thus there has not been any urgency for anti-fraud enforcement.   But it stands to reason that now that there is a legitimate path to general solicitation private offerings, albeit with additional requirements, the SEC may begin scrutinizing demo day events more closely to ensure that those additional requirements are satisfied.  Companies may find themselves on the wrong side of an SEC investigation if:

  • they actually sell shares or their presentation is deemed to be an “offer” of securities;
  • the demo day event is deemed to be a form of general solicitation; and
  • not all purchasers are accredited or the company failed to use reasonable verification methods.

So whether or not a demo day presentation could result in securities exposure will depend on the content of the presentation and the manner in which the event is promoted.

The securities laws define the term “offer” fairly broadly to include every attempt or offer to sell a security for value.  Referring in a presentation to the terms of an ongoing offering, to an offering generally or even to the need and/or desire to raise capital would likely be deemed to be an offer to sell securities, even though under the contract laws of most states it would probably be construed as simply an invitation to make an offer or to begin negotiations.  The SEC has long held that statements are deemed to be “offers” if  they may have the effect of conditioning the market or arousing public interest in an issuer or its securities.

Assuming the presentation is an “offer”, the next question is whether it involved general solicitation.  Demo day organizers typically promote such events on their public website, in print, online or broadcast media and in postings to their social media accounts.  Determining whether or not a communication is a general solicitation requires a facts and circumstances inquiry.  Announcing the event on a medium that is accessible to everyone, such as an unrestricted website or a print or online newspaper, is per se general solicitation under Rule 502(c) (see above).  As to social media, even though the universe of people with access to a social media account may be much more limited than an unrestricted website, there is always the danger that a posting on Facebook or tweet on Twitter could be freely forwarded, and therefore in all likelihood would be considered general solicitation.

As mentioned above, there are solid reasons why companies would choose to structure an offering as one without general solicitation under Rule 506(b).  Doing so would avoid the extra compliance hassle and cost associated with a 506(c) offering (with general solicitation), as well as the difficulty of securing from purchasers the bank or brokerage statements or tax returns, or a third party certification, needed to verify status.

In conclusion, the following could be used as rules of thumb when considering an invitation to present at an event:

  • If the demo day is promoted on an open access website, through any print, online or broadcast media or in postings to social media accounts, the presenting company should either refrain from making any references to capital raising (i.e., limit the presentation to its products and services) or treat the effort as a Rule 506(c) offering by limiting sales of securities to accredited investors and obtaining copies of tax returns, or bank or brokerage statements.
  •  If the demo day is by invitation-only, or promoted through a password-protected website, and directed solely to persons with whom the organizers or the company have a financially substantive preexisting relationship, the company should be free to speak about its securities offering or capital raising needs generally and treat the effort as a Rule 506(b) offering.