Further Thoughts on JOBS Act and Investor Fraud

Over the New Year, I saw the new Leonardo DiCaprio/Martin Scorsese film, “The Wolf of Wall Street,” which told the apparently mostly-not-embellished true story of boiler room scammer Jordan Belfort.  In addition to setting a record for use of the f-word in a film, this movie was the most relevant to what I do for a living since “The Social Network” improbably addressed the issue of dilution of startup founders.

JOBS Acts and Crowdfunding

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The Shift to Electronic Signatures on Contracts

It’s always entertaining to tell younger attorneys about the inefficient ways that lawyers did their jobs back in the day, without modern technology (and probably extremely boring for the younger attorneys to hear those stories). For example, as a junior attorney, I recall that email was just starting to come into common usage, and the job of the paralegal often involved early evening distributions – sending out FedEx distributions of revised drafts of documents before the 9pm overnight delivery cutoff. One aspect of current legal practice that will likely be looked at in the coming years as equally antiquated is the obtaining of manual signatures on contracts.

e-signaturesThis Slate Explainer has a short but informative history of the use of signatures on legal documents. Technology has made the process somewhat more streamlined (fax machine, then PDFs), but signatures remain a practical impediment to quick completion of agreements. In 2016, there are still delays when a party cannot immediately sign an agreement as a result of being, for example, traveling without access to a scanner. Attorneys with good organizational skills know to obtain and hold onto signature pages from a client who is about to travel ahead of a closing, but there is more stress and scrambling than there needs to be.

Fortunately, the technology is improving further, as we speak, via electronic signature services like DocuSign. The federal ESIGN Act, enacted in 2000, provided broad recognition of the validity of electronic signatures, which paved the way for these types of services. They allow parties to sign agreements easily via any internet-enabled device, without a scanner or fax machine, so really the only time an agreement can’t be signed is if the signatory is on a plane and doesn’t want to spring for wi-fi or is deep in the wilderness. My clients are increasingly requesting that these services be used, and I expect them to be widely adopted in the coming years. And the coming generation of new corporate attorneys can laugh at the likes of me for having spent time chasing down manual signatures.

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The SEC Acts on Title III Crowdfunding

The SEC has, at long last, issued final rules on crowdfunding under Title III of the JOBS Act, issuing a press release with fact sheet and a long final rule release.  The rules will become effective in the middle of next year.  These rules are likely to transform the manner in which small businesses raise capital.  The following are some big picture points about Title III crowdfunding to keep in mind, some of which I’ve written about in the past:

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The SEC is Enforcing Accredited Investor Verification Rules

The SEC is Enforcing Accredited Investor Verification RulesThe SEC recently brought an enforcement action against a fund investing in digital assets for a failure to register a sale of securities under Section 5 of the Securities Act. The fund had filed a Form D with the SEC that, in itself, offers no clue as to what went wrong. The form reports the sale of fund interests under the exemption provided by Rule 506(b) of Regulation D. This is the common exemption used for private placements of securities, and by complying with the applicable rules under Regulation D, there would be a safe harbor protecting the issuer against a registration violation.

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Reluctance to Engage in Accredited Investor Verification

Reluctance to Engage in Accredited Investor Verification | Andrew Abramowitz, PLLCRule 506(c), the provision arising out of the JOBS Act that enables companies to raise capital using general solicitation and advertising while still being exempt from SEC registration requirements, has always had the potential to revolutionize the capital raising process. With the ability of companies to connect easily with potential investors anywhere via the internet and social media, one could imagine a world where this supplants private placements under Rule 506(b), in which the investor base is, by definition, limited based on existing relationships with the company or its broker-dealer. While the use of Rule 506(c) has grown since enactment, it has nowhere near the usage rate of Rule 506(b). In 2017, Rule 506(c) offerings represented only 4% in dollar amount of all Regulation D offerings.

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The Presumed Sophistication of Accredited Investors

The Presumed Sophistication of Accredited InvestorsA recent Wall Street Journal article highlighted how sketchy brokers have been marketing problematic private placements to accredited investors. While the article focused on the brokers, I was struck by the identity of one of the investor victims noted in the article as having lost a lot of money: George Stephanopoulos, the ABC News anchor and former Clinton Administration official. I don’t mean to cause Mr. Stephanopoulos any further embarrassment by highlighting this here (though I’m guessing that the readership of my blog is far less than that of the Journal), but the fact that he was scammed is a useful illustration of the misguidedness of the accredited investor definition and associated rules.

The current definition of “accredited investor” under SEC rules essentially uses wealth as a proxy for sophistication, as an individual can qualify by either having an annual income of $200,000 or a net worth of $1 million not including the value of one’s primary residence. An offering made to all accredited investors does not have an information requirement, meaning the investors do not need to be provided with a similar level of disclosure that would be associated with a registered public offering.

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Simultaneous Regulation CF and Rule 506(c) Offerings

Simultaneous Regulation CF and Rule 506(c) OfferingsBack when the equity crowdfunding rules were proposed following passage of the JOBS Act, the $1 million offering limit per year for what are now known as Regulation CF offerings was viewed as making this procedure impractical. The amount raised would not be sufficient in light of the legal, accounting and other costs needed to prepare for the offering. However, as crowdfunding is now a reality and companies are giving it a shot, a fix to the dollar limit has evolved: raise funds not just under Regulation CF, but under other exemptions that are not subject to that dollar limit.

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Links to Some of My Greatest Hits

If you are a regular reader of my blog posts (Hi, Mom!), you’ve noted that I address several substantive topics of interest in corporate and securities law to my clients and other attorneys, along with “softer” topics about the business of law practice, dealing with clients, etc. The substantive posts are, by design, short and to-the-point, unlike a big firm’s detailed summary of the latest 500-page rule release from the SEC (because there’s no need to duplicate those law firm memos, which are freely available to all, and also, more importantly, because I don’t want to write long memos). But hopefully, these posts have some value to my readers.

I thought it would be helpful to list these posts (through January 2017) in one handy place for easy reference, with links, in reverse chronological order within each category:

Financing Transactions/Securities Offerings

SEC Disclosure Matters

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Crowdfunding as a Time-Saver

Equity Crowdfunding | Title III CrowdfundingErnest Holtzheimer blogs with some statistics about how the new JOBS Act-authorized forms of securities offerings are being used following enactment. Both the revamped Regulation A and new Regulation Crowdfunding have seen somewhat underwhelming use to date. The most common objection to Regulation Crowdfunding, the $1 million offering limitation, has led companies to consider using Regulation A, which is more involved compliance-wise. Legislation to increase the offering cap for Regulation Crowdfunding might have a better chance of enactment with the coming all-Republican government, with its anti-regulatory bent. Of course, companies that are willing to limit their investor base to all accredited investors aren’t subject to the offering limit.

Holtzheimer mentions an advantage of crowdfunding that is less remarked-upon than some others: that crowdfunding can help save company founders time, as compared to more traditional forms of investment like angel investment and venture capital. Traditional capital-raising involves spending an enormous amount of time with potential investors, explaining the business, responding to due diligence requests, etc. In addition, when there is an investor syndicate rather than just one investor, the different members of the syndicate may have different requests/concerns, so the process is like herding cats. In contrast, at least in theory, with crowdfunding and Regulation A, once the proper disclosure is prepared and posted for investor review, the investors make their choices, and if there’s enough interest, you just go ahead and close.

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Title III Crowdfunding is Now Live

The effectiveness of Title III crowdfunding got the high-profile Sunday New York Times treatment this past weekend. I think it will take some time for the flow of these deals to come, as portals apply for and receive approval from the SEC and the overall infrastructure develops.

Title III Crowdfunding | JOBS ActThe Times article has a quote from a Mintz Levin securities attorney expressing skepticism and noting that unlike venture capital investing, crowdfunding does not provide institutional validation of a company. I would agree that it doesn’t, but at the same time, it shouldn’t be considered a red flag. Because of the $1 million per year offering limit currently applicable to Title III crowdfunding, this route will only make sense if the business can execute its plans with those kind of funds. Capital-intensive ventures, like those in the life sciences industries, will likely continue to need venture funding. But for those who don’t, even if they don’t get the external validation of an institutional investment, they can get the funds they need to operate relatively easily and without the onerous terms often imposed by venture investors.

The article closes with an interview with a potential crowdfunding investor who said she skimmed the offering circular but says she’s financially sophisticated enough to take the risk. (The offering circular, which is linked to in the article, is actually for a Regulation A+ offering, not Title III crowdfunding.) Much of the commentary about risks for fraud in recent years has focused on Title III crowdfunding, rather than other JOBS Act initiatives, like Regulation A+, but ironically it’s only Title III crowdfunding that has the strict investment limits imposed on investors with low net worth or income, which protect them from being wiped out. The investor profiled in the Times may well lose a lot of money on her Regulation A+ investment (as she could, as well, by investing in a public company), but she’d automatically limit her risk exposure by sticking to Title III crowdfunding offerings only, because of these limits.

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