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Direct Public Offerings by Shell Companies- Tread Carefully

by Laura Anthony, Esq. on July 29, 2014 in Blank Check Companies, Direct Public Offering (DPO), Form 10, Form S-1, OTC Market, Public Shell Company, Rule 144, Rule 419, S-1 Registration Statement, SEC Guidance, Small Cap Market, Uncategorized with No Comments

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As I’ve written about previously, recently (albeit not officially) the Securities and Exchange Commission (“SEC”) has materially altered its position on offerings by shell companies that are not blank check companies. In particular, over the past year, numerous shell companies that are not also blank check companies have completed direct public offerings using a S-1 registration statement and successfully obtained market maker support and a ticker symbol from FINRA and are trading.

Rule 419 and Blank Check Companies

The provisions of Rule 419 apply to every registration statement filed under the Securities Act of 1933, as amended, by a blank check company. Rule 419 requires that the blank check company filing such registration statement deposit the securities being offered and proceeds of the offering into an escrow or trust account pending the execution of an agreement for an acquisition or merger.

In addition, the registrant is required to file a post-effective amendment to the registration statement containing the same information as found in a Form 10 registration statement, upon the execution of an agreement for such acquisition or merger. The rule provides procedures for the release of the offering funds in conjunction with the post-effective acquisition or merger. The obligations to file post-effective amendments are in addition to the obligations to file Form 8-K to report both the entry into a material non-ordinary course agreement and the completion of the transaction. Rule 419 applies to both primary and resale or secondary offerings.

Within five (5) days of filing a post-effective amendment setting forth the proposed terms of an acquisition, the company must notify each investor whose shares are in escrow. Each investor then has no fewer than 20 and no greater than 45 business days to notify the company in writing if they elect to remain an investor. A failure to reply indicates that the person has elected to not remain an investor. As all investors are allotted this second opportunity to determine to remain an investor, acquisition agreements should be conditioned upon there being enough funds remaining in escrow to close the transaction.

The definition of “blank check company” as set forth in Rule 419 of the Securities Act is a company that:

Is a development-stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
Is issuing “penny stock,” as defined in Rule 3a51-1 under the Securities Exchange Act of 1934.

Shell Companies

The definition of “shell company” as set forth in Rule 405 of the Securities Act (and Rule 12b-2 of the Securities Exchange Act of 1934) means a company that has:

No or nominal operations; and
Either:
1. No or nominal assets;
2. Assets consisting solely of cash and cash equivalents; or
3. Assets consisting of any amount of cash and cash equivalents and nominal other assets.

Clearly, the definitions are different. Although a shell company could also be a blank check company, it could be a development-stage company or start-up organization or an entity with a specific business plan but nominal operations. Until recently, however, the SEC has firmly held the position that Rule 419 applies equally to shell and development-stage companies.

In fact, the SEC Staff Observations in the Review of Smaller Reporting Company IPO’s published by the SEC Division of Corporate Finance contains the following comments:

“Rule 419 applies to any registered offering of securities of a blank check company where the securities fall within the definition of a penny stock under the Securities Exchange Act of 1934. We frequently reviewed registration statements of recently established development stage companies with a history of losses and an expectation of continuing losses and limited operations. These companies often stated that they may expand current operations through acquisitions of other businesses without specifying what kind of business or what kind of company. In other cases, the stage of a company’s development, when considered in relation to the surrounding facts and circumstances, may raise questions regarding the company’s disclosed business plan. We generally asked companies like these to review Rule 419 of Regulation C. We asked these companies either to revise their disclosure throughout the registration statement to comply with the disclosure and procedural requirements of Rule 419 or to provide us with an explanation of why Rule 419 did not apply.”

SEC Policy

The SEC will now allow a shell company, as long as it is not also a blank check company, to embark on an offering using an S-1 registration statement without the necessity to comply with Rule 419. As noted above, an entity can be a shell company, but not a blank check company, as long as it has a specific business purpose and plan and is taking steps to move that plan forward, such as a start-up or development-stage entity. In the last couple of years, several companies have filed S-1 registration statements with little more than a specific business plan, and such S-1’s have been declared effective, the shares have been successfully placed, and the company’s common stock is trading on the over-the-counter market. A review of the comment letters associated with these shell company S-1 filings has not shown a single comment requesting that the issuing company comply with or explain why they did not have to comply with Rule 419.

Such entities clearly need to disclose that that they are a shell company as defined by Rule 405 of the Securities Act and accordingly, shareholders would not be able to rely on Rule 144 for resales unless all of the conditions of Rule 144(i) were met. Although investors that buy directly in the S-1 will receive registered securities and not need to rely on Rule 144, other investors would. In order to use Rule 144, the company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company—then, those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.

A question arises as to when a development-stage or start-up company ceases to be a shell. Generally shell companies complete a clear transaction removing them from shell company status, such as a merger or acquisition, and file Form 10 information on the newly acquired business. I would suggest that at some point, such as when the company generates its first revenues or launches its product, or upon some other identifiable marker that would reasonably be interpreted as a change in shell company status, the company file Form 10 information disclosing its own business and operations and thereafter begin the one-year holding period for use of Rule 144.

Unfortunately, some individuals have been taking companies public with little more than a business plan for the sole purpose of creating public vehicles, despite the assertions, subject to SEC enforcement, in the S-1 as to the intended business plan. That is, some people have been claiming shell status when in fact the entity is a blank check company and should be subject to Rule 419.

SEC Actions

On February 3, 2014, the SEC initiated administrative proceedings against 19 companies that had filed S-1 registration statements. The 19 registration statements were all filed with an approximate 2-month period around January 2013. Each of the companies claimed to be an exploration-stage entity in the mining business without known reserves, and each claimed they had not yet begun actual mining. Each of the 19 entities used the same attorney. Each of the entities was incorporated at around the same time using the same registered agent service. Each of the 19 S-1’s read substantially the same. Among other allegations, the SEC alleges that the claims of a mining business are false. Presumably, the SEC believes that the S-1’s were filed to create public companies for resale as opposed to pursuing the business plan set forth in the S-1 which the officer/director signed under penalties of law.

The SEC is playing hardball with this group as well. An S-1 does generally contain language that it may be amended or modified (or even withdrawn) until it is declared effective by the SEC. This pre-effective S-1 is not deemed filed by the SEC or a final prospectus for Section 5 and broker-dealer prospectus delivery requirements. Upon initiation of the SEC investigation, all 19 S-1 filers attempted to withdraw their S-1 registration statements. The SEC suggested that they withdraw their requests to terminate the S-1 and cooperate fully with the investigation. The entities did not comply. Accordingly, in addition for claims related to the filing of false statements in the S-1, the SEC has also alleged that the “Respondent’s seeking to withdraw its Registration Statement constitutes a failure to cooperate with, refusal to permit, and obstruction of the staff’s examination under Section 8(e) of the Securities Act.”

In addition, I am aware that many entities that completed direct public offerings by filing an S-1 registration statement, and then subsequently completed changes of control and/or businesses within a relatively short period of time, are now the subject of active SEC investigations.

Section 11 of the Securities Act of 1933, as amended provides for civil actions by investors against a company and its officers and directors for the filing of a false registration statement. Section 8 of the Securities Act provides for SEC civil administrative proceedings related to a false registration statement filing.

In addition to civil proceedings, the Securities Act provides that any person who “willfully” makes a false or misleading statement in a registration statement (or otherwise violates a provision of the Securities Act of 1933 or any rules or regulations promulgated thereunder) can be fined up to $10,000 and/or imprisoned for not more than five years.

Unfortunately, each time there is a change in the business surrounding small-cap entities, there will be a few unscrupulous players that will seek to illegally capitalize on policies that, in general, can benefit small business enterprises.

Click Here to Print Direct Public Offerings by Shell Companies-Direct Public Offerings by Shell Companies;

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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Tags: Blank Check Company, Direct Public Offering, Direct Public Offerings, Penny Stock, Regulation C, Rule 144, Rule 419, S-1 Filings, S-1 registration statement, S-1 Registration Statements, Section 8(e), securities act of 1933, Shell Company

Completing A Name Change Without Shareholder Approval

by Laura Anthony, Esq. on July 22, 2014 in Articles of Incorporation, CUSIP Number, OTC Market, SEC Proxy Rules, SEC Schedule 14A, Section 14, Shareholder Proposals, Small Cap Market with No Comments

Generally a name change is completed through an amendment to a company’s articles of incorporation. Moreover, amendments to articles of incorporation generally require shareholder consent, which can be time-consuming and expensive and become even more so if the company is subject to the reporting requirements of the Securities Exchange Act of 1934.

All companies with securities registered under the Securities Exchange Act of 1934, as amended, (i.e., through the filing of a Form 10 or Form 8-A) are subject to the Exchange Act proxy requirements found in Section 14 and the rules promulgated thereunder. The proxy rules govern the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the approval of any corporate action requiring shareholder approval. The information contained in proxy materials must be filed with the SEC in advance of any solicitation to ensure compliance with the disclosure rules.

Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which shareholders are asked to vote. The disclosure information filed with the SEC and ultimately provided to the shareholders is enumerated in SEC Schedule 14A.

Where a shareholder vote is not being solicited, such as when a company has obtained shareholder approval through written consent in lieu of a meeting, a company may satisfy its Section 14 requirements by filing an information statement with the SEC and mailing such statement to its shareholders. In this case, the disclosure information filed with the SEC and mailed to shareholders is enumerated in SEC Schedule 14C. As with the proxy solicitation materials filed in Schedule 14A, a Schedule 14C Information Statement must be filed in advance of final mailing to the shareholder and is reviewed by the SEC to ensure that all important facts are disclosed. However, Schedule 14C does not solicit or request shareholder approval (or any other action, for that matter), but rather informs shareholders of an approval already obtained and corporate actions which are imminent.

In either case, a preliminary Schedule 14A or 14C is filed with the SEC, who then reviews and comments on the filing. Upon clearing comments, a definitive Schedule 14A or 14C is filed and mailed to the shareholders as of a certain record date.

However, there is another option.

Using a Subsidiary to Effectuate a Name Change

Many states, including Delaware and Nevada, have provisions whereby a company can establish a new wholly owned subsidiary, which subsidiary is named with the desired new company name, and then complete a short-form parent subsidiary merger, whereby the parent is the surviving entity but concurrently adopts the name of the merged in subsidiary. The entire process can be completed with board of director approval and no shareholder consent is necessary.

The company will still be required to obtain a new CUSIP number and provide FINRA with notification of the corporate action. FINRA is the entity that processes the name change such that the company’s quotation on OTC markets will be updated with the new name. The company may also request a voluntary symbol change at the same time.

To break it down again in simple terms, an entity that desires to complete a name change without the expense, time and process of holding a shareholder meeting or obtaining shareholder consent and complying with the SEC proxy rules and state shareholder notice requirements, can do so as follows:

Obtain board of directors approval to form a new wholly owned subsidiary and complete the name change process through a short-form parent subsidiary merger;
Form a new subsidiary, which subsidiary is named with the desired new name of the parent entity;
File short-form merger documents with the state whereby the parent entity is the surviving entity and such parent adopts the subsidiary name as part of the merger process;
Obtain a new CUSIP number;
Notify FINRA of the corporate action at least 10 days prior to the desired effective date; and,
For a company subject to the reporting requirements of the Securities Exchange Act of 1934, file a Form 8-K disclosing the name change.

The Delaware and Nevada Specific State Law Provisions

As Delaware and Nevada are the most common states of incorporation for public entities, below are the corporate law provisions for these states that allow for the name change process without shareholder consent. Many states have similar statutory provisions.

Nevada

Nevada Revised Statutes (NRS) 92A.180 allows for the merger of a subsidiary into a parent or parent into a subsidiary without shareholder approval. An entity may only avail itself of the provisions of 92A.180 if the parent owns at least 90% of the subsidiary. NRS 92A.180 provides in pertinent part: “Articles of merger under this section may not contain amendments to the constituent documents of the surviving entity except that the name of the surviving entity may be changed.”

Delaware

Delaware General Corporation Law (DGCL) Section 251 allows for the merger of a subsidiary into a parent or parent into a subsidiary without shareholder approval. An entity may only avail itself of the provisions of DGCL 251 if the parent owns at least 80% of the subsidiary. DGCL 251 provides in pertinent part: “…the certificate of incorporation and bylaws of the holding company immediately following the effective time of the merger contain provisions identical to the certificate of incorporation and bylaws of the constituent corporation immediately prior to the effective time of the merger (other than provisions, if any regarding… the corporate name…)…”

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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Download our mobile app at iTunes.

Tags: Articles of Incorporation, CUSIP Number, Delware General Corporation Law, Nevada Revised Statutes, OTC markets, SEC Proxy Rules, SEC Schedule 14A, SEC Schedule 14C, Shareholder Approval

SEC Extends Valuable Guidance to Determine and Verify Accredited Investors

by Laura Anthony, Esq. on July 15, 2014 in Accredited Investors, C&DI, Rule 506, SEC Guidance, Section 4(a)(2), Securities Attorneys, Small Cap Market, Uncategorized with No Comments

On July 3, 2014, the SEC updated its Division of Corporation Finance Compliance and Disclosure Interpretations ) to provide guidance as to the determination and verification of accredited investor status for purposes of Rule 506 offering. The SEC published six new C&DI’s on the topic.

Background

Effective September 23, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act. For a complete discussion of the final rules, please see my blog Here.

Title II of the JOBS Act required the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors. The JOBS Act required that the rules necessitate that the issuer take reasonable steps to verify that purchasers of the securities are accredited investors using such methods as determined by the SEC. Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transaction by an issuer not involving a public offering. In a Rule 506 offering, an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors. The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer.

New Rule 506(c) which permits the use of general solicitation and advertising to offer and sell securities under Rule 506 provided that the following conditions are met:

the issuer takes reasonable steps to verify that the purchasers are accredited;
all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.

Rule 506(c) includes a non-exclusive list of methods that issuers may use to verify that investors are accredited. An issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors. An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited.

Reasonable Steps to Verify Accredited Investor Status

The SEC final rule requires that an issuer take reasonable steps to verify that purchasers are accredited. Moreover, the SEC included a non-exclusive list of methods that issuers may use to satisfy the verification requirement. Note that the verification requirement is separate from the requirement that all investors in fact be accredited.

According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.” Among the factors that issuers should consider under the fact and circumstance analysis are:

a.The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker-dealer registered with the SEC, verification could be a simple check on the FINRA website. Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements. Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that issuers may use to satisfy the verification requirement.

b.The amount and type of information that the issuer has about the purchaser. Clearly, the more information, the better. The SEC lists the obvious (W-2; tax returns; letters from a bank or broker-dealer). Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.

c.Nature and terms of the offering, such as type of solicitation and minimum investment requirements. The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former. The SEC highlights the obvious, such as that the greater the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.

After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. Moreover, where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.

The more information an issuer has evidencing that a prospective purchaser is accredited, the fewer additional steps it will have to take to verify the status, and vice versa. Examples of the type of information that issuers can review and rely upon include:

(i)Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages)

(ii)Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms

(iii) Third-party accredited investor verification service providers

Regardless of the methods an issuer uses to verify accredited status, they should keep adequate and complete records. If the exemption is challenged, the burden is on the issuer to prove that under the facts and circumstances of their particular offering, they took reasonable steps to verify and they reasonably believed that an investor was accredited at the time of the sale. However, although the rules do not address the issue, the SEC is cognizant of the privacy concerns raised by having issuers obtain and maintain personal financial records from investors.

Non-Exclusive Methods that Issuers May Use to Satisfy the Verification Requirement

In its final rule publication, the SEC included four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the issuer does not have actual knowledge that the purchaser is not accredited. Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:

a. Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.

b.Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.

c.Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.

d. A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.

New SEC Guidance

On July 3, 2014, the SEC updated its C&DI to add six new C&DI’s to provide guidance as to the determination and verification of accredited investor status for purposes of Rule 506 offering.

In the first two updates, the SEC provided some basic guidance in calculating income and assets. As relates to calculating income from foreign investors with income in a foreign currency denomination, the SEC states that an 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 in determining whether such income meets the income test for qualifying as an accredited investor. Related to jointly held property, the SEC states that assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property.

The SEC also provided guidance specific to the verification criteria published in the rule. Verification can be accomplished by reviewing the purchaser’s last two years of tax returns. The SEC provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, an issuer may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. An issuer can only rely on this expanded interpretation if the evidence presents supports that the investor is accredited and the issuer reasonably believes so. If the evidence is at all questionable, further inquiry should be made.

Although the review of tax returns filed in a foreign country does not qualify under the verification safe harbors in the rule, the SEC noted that an issuer could rely on foreign tax returns if the laws of that jurisdiction provide penalties similar to the laws of the IRS for making a false statement. Again, if the evidence is at all questionable, further inquiry should be made.

Verification can be accomplished by reviewing certain documents dated within three months, including tax assessments. In its guidance, the SEC recognizes that tax assessments are generally issued yearly and accordingly a tax assessment, even if the most recent issued, would not qualify if dated more than three months prior. However, if the most recent tax assessment shows a value that, after deducting the purchaser’s liabilities, results in a net worth substantially in excess of $1 million, it may be sufficient verification that the purchaser has met the net worth test. Again, if the evidence is at all questionable, further inquiry should be made.

The rules provide that an issuer can review a consumer report from one of the “nationwide consumer reporting agencies” to determine the purchaser’s liabilities. Although an issuer cannot rely on a report from a foreign consumer reporting agency under the rule, it can rely on the report together with taking other steps necessary to determine the purchaser’s liabilities (such as a written representation from the purchaser that all liabilities have been disclosed).

Reasonable Belief that all Purchasers are Accredited Investors

In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors. In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

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Tags: 506 Offering, C&DI, IRS, Net Worth Test, rule 502(a), rule 506, Rule 506(c), Schedule K-1, Section 4(a)(2), Third-Party Accredited Investor

Case Study of Online Funding as Related to Broker-Dealer Exemptions

by Laura Anthony, Esq. on July 07, 2014 in Broker-Dealer, JOBS ACT and Crowdfunding, Rule 506, Section 3(a)(39), Uncategorized with No Comments

Introduction

As a recurring topic, I am discussing exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services. On February 18th I published a blog about the new no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act. Further on, I wrote on the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer.

This blog addresses the statutory and related exemptions that affect, and would permit, the operation of a funding website, including the statutory exemption from broker-dealer registration enacted into law as part of the JOBS Act on April 5, 2012. This blog also includes an analysis of a fictional funding website.

Summary of Exemption from Broker-Dealer Registration Found in Title II of the JOBS Act

Title II of the JOBS Act created a limited exemption to the broker-dealer registration requirements for certain intermediaries that facilitate Rule 506 offerings. In particular, Section 4(b) of the Securities Act of 1933 (“Securities Act”) added an exemption to the broker-dealer registration requirements such that an individual or entity will not be deemed a broker-dealer as a result of the following:

(A) That person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means ;
(B) That person or any person associated with that person co-invests in such securities; or
(C) That person or any person associated with that person provides ancillary services with respect to such securities.

Ancillary services are defined as (i) the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and (ii) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.

The exemption from registration as a broker or dealer also requires that such person and each person associated with such person (i) does not receive any compensation in connection with the purchase or sale of the security; (ii) does not have possession of customer funds or securities in connection with the purchase or sale; and (iii) is not subject to statutory disqualification pursuant to Section 3(a)(39) of the Exchange Act (i.e., bad boy provisions).

SEC Guidance on the Title II Broker-Dealer Exemption

On February 5, 2013, the SEC issued guidance regarding the exemption from broker-dealer registration under Title II. The SEC confirmed that the broker-dealer exemption does not pre-empt state law and accordingly, persons acting in reliance on the new exemption must also confirm compliance with any and all applicable state securities regulations. State securities laws vary widely, including the laws related to broker-dealer registration.

Though the new statutory language appears self-evident, the SEC confirmed that the exemption is intended to apply to websites and social media sites as exempt platforms.

Although the SEC states that it interprets “compensation” very broadly to include any economic benefit, it notes that Congress specifically allowed for co-investing and accordingly, profits from such co-investments would not be considered compensation to disqualify this broker-dealer registration exemption.

Not only is it permissible for a venture capital fund or its adviser to operate a website where it lists offerings of securities by potential portfolio companies, co-invests in those securities with other investors, and provides standardized documents, the SEC believed from the start that this very scenario would dominate the use of the exemption. The SEC acknowledged that the profitability of running such a website will likely come from the co-investment aspect as opposed to the relatively small fee that could be charged for a site listing. The SEC stated, “[A]s a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.”

The SEC prediction has proven true; successful funding platforms such as Realty Mogul, Fundrise and Circle Up all follow this co-investment formula.

Reliance on the exemption in Section 4(b) is not limited to use by any type of person, as long as they follow the rules, including not receiving compensation in association with the sale of securities. Persons associated with issuers, including officers, directors and employees, can rely on the exemption and create websites advertising Rule 506 offerings.

On the other hand, if a privately offered fund, or syndicate of privately offered funds, pays a salary to an internal marketing person to operate such a website or platform, that person would be deemed to receive compensation and would not be able to rely on the new exemption. The SEC goes further to note that they are of the view that persons who market interests in private funds may be subject to the broker-dealer registration requirements found in Section 15(a)(1) of the Exchange Act. On a technical note, the SEC confirmed that the exemption is not an exclusion from the definition of broker-dealer. Platforms and intermediaries operating under the new Section 4(b) may be (and most likely are) broker-dealers; they are just exempted from registering as such.

Section 3(a)(39) Statutory Disqualification

The theme of a “bad boy” disqualification appears in many areas of the securities laws and unfortunately, there are at least three different statutes or rules that set forth such disqualification, each of which is similar but not exactly the same. The Dodd-Frank Act required the SEC to implement rules which disqualify certain Rule 506 offerings based on the individuals involved in the issuer and related parties. On July 10, 2013, the SEC adopted such rules by amending portions of Rules 501 and 506 of Regulation D, promulgated under the Securities Act of 1933. The new rules went into effect on September 10, 2013. That rule is similar to Rule 262 of Regulation A disqualifying bad actors from participating in Regulation A offerings, in that it encompasses all of the bad actor disqualifications in Rule 262, but also adds additional disqualifying events. In addition, the new rule did not modify the existing Rule 262 or other bad actor disqualification rules, but rather is limited to Rule 506 offerings. For a complete discussion on the Rule 506 bad actor provisions, see my blog Here and a discussion of SEC guidance Here.

However, the Section 3(a)(39) disqualification is consistently used to disqualify persons that are relying on exemptions to broker-dealer registration, such as in the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer.

Section 3(a)(39) disqualifies any person who (i) is or has been expelled, suspended or barred from association with FINRA or another self-regulatory organization based on an order from such self-regulatory organization; (ii) is subject to an order from the SEC or other regulatory organization denying, suspending or barring registration as or association with a broker-dealer; (iii) is subject to an order from the CFTC denying, suspending or revoking registration under the Commodity Exchange Act; (iv) is subject to an equivalent order as the above from a foreign governmental or regulatory authority; (v) has been found to be the “cause” of an order described above; (vi) is associated with a person who is expelled, suspended or barred as set forth above; (vii) has been convicted of a felony or other fraud-based securities law violation in the past 10 years; or (viii) has made a false or misleading statement or omission in any application to become associated with a broker-dealer or to become a broker-dealer.

Practical Application — a Case Study

I often represent clients that are establishing or have established funding websites under the Title II exemption. Based on my experience, I have put together a case study analysis based on a fictional website called Fundingwebsite.com.

An obvious initial starting point for review is to determine whether Fundingwebsite.com would be required to be registered with the SEC as a “broker” or “dealer” or “investment advisor” and further what facts or circumstances would alter my conclusion. The following assumptions would support a conclusion that Fundingwebsite.com would not be required to register as a broker-dealer or investment advisor.

Important assumptions:

Fundingwebsite.com does not charge success- or transaction-based fees;
All ultimate securities purchase and sale transactions are conducted separate from and without any involvement (or possibly even knowledge) by Fundingwebsite.com;
Fundingwebsite.com will have no involvement in the negotiation of transactions or structure of offerings;
Other than the one-sided providing of the advertisement or solicitation, Fundingwebsite.com will not have any communications with potential investors regarding an investment;
Fundingwebsite.com does not provide any advice about the merits of a particular investment;
Fundingwebsite.com does not directly assist investors with the completion of a transaction;
Fundingwebsite.com does not handle funds or securities related to a transaction;
Fundingwebsite.com does not hold itself out as providing any securities related services other than as a listing and matching service;
Fundingwebsite.com will not draft the contents of advertisements or solicitations (although it can, and should, provide editorial and grammatical input and refuse to publish anything that is, on its face, fraudulent or offensive);
Fundingwebsite.com will charge a flat fee for services or fee structure for services, but will not charge separately for advertising and marketing investment opportunities;
Fundingwebsite.com will not make representations that it has verified the accuracy of the content of advertisements;
Fundingwebsite.com does not recommend or suggest that an investor make an investment in a particular issuer, other than to make such investor aware that such an opportunity exists;
Fundingwebsite.com does not require that its standardized documents be used as a condition to listing on its website; and
Fundingwebsite.com is not subject to a statutory disqualification under Section 3(a)(39).

The JOBS Act

As discussed above, the JOBS Act, as codified in Section 4(b) of the Securities Act of 1933, expressly provides that entities engaged in activities similar to those contemplated by Fundingwebsite.com are not required to register as a broker or a dealer.

Fundingwebsite.com cannot collect compensation in connection with the purchase or sale of securities, take possession of customer funds or securities, or be either directly or through its associated persons statutorily disqualified.

Success-based compensation has always been an important factor in determining whether an entity is acting as a broker or dealer. Success based compensation is analyzed by the SEC as “compensation for participation in the transaction that depends upon, or is it related to, the outcome or size of the transaction or deal.” The language of Section 4(b) “in connection with” the purchase or sale of a security is a broader criterion. Reading this together with the SEC guidance, Fundingwebsite.com would be limited to charging reasonable fees for its services, which fee would be the same irrespective of the size or character of the posted offering.

The less clear-cut provision is whether Fundingwebsite.com may engage in general solicitation on behalf of the issuer and be compensated for such services and whether engaging in such general solicitation for compensation results in the giving of investment advice or recommendations to issuers or investors. My view is that Fundingwebsite.com can engage in solicitation on behalf of the issuer.

The exemption states, “…maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means…”

Although the plain reading of the statute indicates that the solicitation is to be performed by the issuer, it makes sense that the SEC is defining the responsible (and thus liable) party more than limiting who may actually perform the function. As with any information that appears in the public domain about an issuer and on behalf of an issuer (for example, filings with the SEC or press releases), the issuer is and should be ultimately responsible for the truth and legality of the content.

Fundingwebsite.com is providing a technologically-driven curation process whereby the recipient of deal information is curated based on algorithmic formulas; it is, in essence, a form of selling leads and data lists and the distribution of such information by “pushing the e-mail button.” Irrespective of the JOBS Act, both of these functions are legal.

No-Action Letter Support

Before the codification of the statute in the JOBS Act, lead generation through software and opt-in functions and resulting matching services were the subject of a series of no-action letters such as Angel Capital Electronic Network and Internet Capital Corporation which allow the operation of websites for the matching of potential investors with deals, so long as the information is password-protected and does not include general solicitation and advertising. These no-action letters set forth the “matching services” exemption to broker-dealer registration. There is no reason to believe that these no-action letters and the reasoning behind them changed, other than in favor of Fundingwebsite.com business, following the enactment of the JOBS Act.

Newsletter Exemption from Investment Advisor

Moreover, these services are arguably within the newsletter exemption from the definition of “investment advisor.”

The “newsletter” exemption as set forth in Section 202(a)(11) of the Investment Advisors Act of 1940 is as follows:

(11) ‘‘Investment adviser’’ means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities; but does not include ….. (D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

However, Fundingwebsite.com will need to make sure that its marketing materials (the EM content) cannot be interpreted as either investment advice or a recommendation to invest.

The Exchange Act – Broker-Dealer Registration Requirement

Section 15(a)(1) of the Exchange Act requires any “broker” that makes use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security) to register with the Commission.

The text of Section 15(a)(1) – Registration of all persons utilizing exchange facilities to effect transactions is as follows:

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.

Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

Fundingwebsite.com does not fit within the definition of “broker” based on a plain reading of this section. Fundingwebsite.com is not engaged in any securities transaction for the account of others. Any transactions for the purchase or sale of company securities by investors would take place entirely independently of Fundingwebsite.com and the Fundingwebsite.com website (see assumptions above). Fundingwebsite.com does not participate in those transactions, does not negotiate terms of those transactions, does not advise either party to those transactions, does not receive any compensation from or relating to those transactions, and in many cases may not even be aware of those transactions.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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Tags: 15(a)(1), Broker-Dealer Exemption, Broker-Dealer Registration Requirements, JOBS ACT, Rule 506 Offerings, Section 15(a)(1), Section 202(a)(11), Section 3(a)(39), Section 4(b)

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