Curing the “Bad Actor” Disqualification: Waivers and Due Diligence - Part II

In the previous blog post, I began discussing the “bad actor” concept as it relates to Rule 506 private placements. In that post, I focused specifically on who the potential “bad actors” are, and what sort of “bad acts” would lead to that designation. In this blog post I am going to discuss four exceptions to disqualification.

1. Timing of the Disqualification Events.

The “bad actor” disqualification rule became effective on September 23, 2013, and is a prospective rule. Therefore, only bad acts which occurred on or after that date are disqualifying events. It is important to note that it is the date of the conviction, suspension, or similar bad act (see my previous post here for the list of disqualifying “bad acts” which is important for timing purposes, rather than the date(s) of the conduct which resulted in the conviction, etc. Thus, any conviction, etc. occurring on or after September 23, 2013 is a disqualifying event, regardless of when the actual conduct took place.

However, Rule 506(e) requires disclosure, “to each purchaser, a reasonable time prior to sale” of a written description of any “bad acts” which would have been disqualifying but are not solely by virtue of the timing rule. Thus, if a broker participating in the sale had been suspended in January 2013, he would not be a “bad actor” and his participation would not destroy the Rule 506 exemption, but this fact would need to be disclosed to every purchaser of the securities (and, importantly to note, not only to those who would be purchasing securities through that particular broker).

2. Court or Agency Request

If the disqualifying event is due to, for example, a judge’s order or a regulatory agency’s finding, and the relevant judge or agency provides written notice to the SEC that the finding should not result in disqualification, then the disqualification will not arise. This notice may be provided either in the ruling itself, or may be separately provided to the SEC staff. In such cases, the issuer will not be required to also seek a waiver from the SEC; the judge or agency’s written notice is sufficient to “cure” the otherwise disqualifying “bad act.” Question 260.22 of the Securities Act Rules Compliance and Disclosure Interpretations ("C&DIs") addresses this point.

3. The “Due Diligence” Defense

If an issuer fails to discover a disqualifying event, it may in some instances rely on a “due diligence” defense. As with due diligence in other contexts, the standard is one of “reasonable care.” The burden is on the issuer to show that, after exercising reasonable care, it did not know, and could not have known, of the disqualifying event. To satisfy this burden, the issuer will need to show that it conducted a factual inquiry tailored to the facts and circumstances of the particular offering and its participants. Whether the issuer can rely on this defense is very fact-dependent. The better the internal monitoring controls, and the more care the issuer takes in investigating the “covered persons” it is working with, the better its chances of being able to make use of a due diligence defense.

If the issuer fails to disclose a prior “bad act” to purchasers of its securities, the consequences are the same as if the “bad act” was disqualifying—that is, loss of the ability to rely on Rule 506 registration exemption. That said, it does not mean that the offering cannot continue.  A disqualified Rule 506 offering can be conducted as a registered offering or under another registration exemption or safe harbor that is not subject to bad actor disqualification.

If an issuer newly discovers a Rule 506(d) disqualifying event or covered person during the course of an ongoing Rule 506 offering, it must then consider what steps would be appropriate. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure to investors or take other remedial steps to address any Rule 506(d) disqualification. (Question 260.23 of C&DIs.)

4. Waivers of Otherwise Disqualifying “Bad Acts”

Rule 506(d)(2)(ii) provides that the SEC may waive an otherwise disqualifying bad act if “upon a showing of good cause...the Commission determines that it is not necessary under the circumstances that an exemption be denied.” More colloquially, this can be referred to simply as the “waiver rule.” The SEC provided a guide to submitting a waiver request, which is available here. It also maintains a list of waivers it has granted (through “no-action” letters) here (you should scroll down specifically to the subsection “Regulation D—Rule 506(d) Waivers of Disqualification.”) To get a sense of what kind of factors the SEC takes into account when deciding whether to grant these waivers, it may be helpful to read through some of these decisions. In addition, on March 13, 2015, the SEC provided its own separate guidance on what kinds of factors it will look at, which is available here. These factors include:

• The nature of the violation or conviction and whether it involved the purchase or sale of securities
• Whether the conduct involved a criminal conviction or scienter [intent]-based conviction (bad), as opposed to a civil or non-scienter based provision (less bad.) (Note that the SEC guidance specifically notes that the burden on the person seeking a waiver will be “significantly higher” in the case of the former category.)
• Who was responsible for the misconduct? (For example, was it an executive officer at the company which is seeking the waiver? Or a participating officer of the placement agent working with the company? Generally speaking, a company will have a better chance of receiving a waiver in the former case as opposed to the latter.)
• What was the duration of the misconduct? Here, of course, the longer the misconduct goes on, the less likely a waiver will be granted. Again, this goes to show the importance of putting in place a robust internal system to watch out for and correct wrongdoing. Here, because smaller companies often lack the resources to put in place the sophisticated internal controls that a larger, public company can, this may put them at a disadvantage when it comes to seeking a waiver.
• What remedial steps have been taken? Once the misconduct is identified, what has the company done to fix the damage? For example, has it terminated its relationship with the persons involved? Has it instituted new policies to prevent a reoccurrence in the future? The more a company can show that it has taken steps to address the problem, the more likely it will be successful in its waiver application.
• What is the impact if the waiver is denied? Here, the impact which the SEC is worried about is not merely about the impact on the party seeking the waiver itself, but also its customers, clients, and investors. This again can put smaller start-up companies at a significant disadvantage, because the aggregate impact of its not receiving a waiver will necessarily be less than that of, for example, a huge investment banking firm which is involved in hundreds of Rule 506 offerings a year. 

Going off of this last factor, there has in fact been significant criticism levied against the SEC for its willingness to grant Rule 506 waivers (among others) to large institutions (think of “too big to fail” or “systemically important” institutions.) Much of this criticism has come from members of the SEC themselves. On May 21, 2015, for example, Commissioner Stein penned a stinging dissent from the granting of a waiver to several large firms after they had received criminal convictions for manipulating currency exchange rates (the full text of her dissent is available here. In fact, the vast majority of waivers which are granted go to very large institutions. As Herrick Lidstone asks here: “One can question whether the SEC will show the same leniency to smaller issuers applying for waivers under Rule 506...”.  Indeed, given the backlash against the SEC for its leniency in granting waivers in the past, there may be a risk that any future crackdown will also disproportionately affect smaller issuers.

Conclusion

In conclusion, I would like to say that Rule 506(d) should not be taken lightly. It adds a layer of complexity to the Rule 506 private placements, which should be navigated with the assistance of experienced counsel. The main task for the company conducting a private placement in reliance on Rule 506(b) or (c) is to conduct adequate due diligence of its “covered persons” through the use of questionnaires, representations and covenants, as well as online research, to ensure that any involvement with a “bad actor” is terminated prior to the commencement of the offering.

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 corporate, securities, and intellectual property law.

Rule 506(d) “Bad Actor” Disqualifications: Who’s a Bad Actor and Why are They Bad? - Part I

Rule 506 is by far the most widely used Regulation D exemption for conducting private placements. According to the SEC, about 90-95% of all private placements are conducted pursuant to Rule 506. This Rule permits sales of an unlimited dollar amount of securities without Securities Act registration, provided certain requirements are satisfied. Traditionally, issuers relied on Rule 506(b) that allows unlimited amounts to be raised from accredited investors and up to 35 non-accredited investors, so long as there was no general solicitation and advertising and other conditions were met. In implementing Section 201(a) of the JOBS Act, the SEC added a new Rule 506(c) that allows general solicitation and advertising in Rule 506 offerings so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verity their accredited investor status.

As of September 23, 2014, the SEC added a new section (d) to Rule 506. Rule 506(d) applies to all Rule 506 offerings, i.e., Rule 506(b) and Rule 506(c) offerings. It is important that all companies raising capital by means of Rule 506 know and understand the new addition to Rule 506 because failing to comply with Rule 506(d) will disqualify the entire offering.

Rule 506(d) identifies certain persons that may potentially become “bad actors.” It also lists certain events (“disqualifying events” or “bad acts”). An offering cannot be made using Rule 506 if it includes a “bad actor” that is engaging or has engaged in a “bad act.” This blog post focuses on (1) who may be a potential “bad actor” and (2) what constitutes a “disqualifying event” or “bad act.” The follow up blog will discuss certain exceptions from disqualification and how to obtain waivers.

Who are the potential bad actors?

Rule 506(d)(1) casts a wide net in terms of who can potentially be a bad actor (and can destroy the Rule 506 exemption). Possible "covered persons" include:

• The issuer of the securities (as well as any predecessor of the issuer or any “affiliated issuer.” An affiliated issuer, as the name suggests, is an affiliate (a person who controls or is controlled by the issuer) who is also issuing securities in the same offering.
• Any director, executive officer, or other officer participating in the offering. (Participation can include such activities as preparing due diligence and/or disclosure documents or communicating with other participants in the offering, including potential investors. In general, when trying to determine whether a particular officer is “participating” when it comes to performing a “bad actor” check, err on the side of caution and assume that the SEC is likely to answer “yes”, particularly when it comes to smaller start-up companies which may not yet have well-entrenched and explicit divisions of labor and responsibility.)
• Any general partner or managing member of the issuer.
• Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities.
• Any “promoter” connected to the issuer in any capacity during the actual sale of securities. (The SEC defines “promoter” broadly: the term includes any natural person or legal entity that “directly or indirectly takes initiative” in founding the company, as well as any person who, in connection with the founding, receives (other than solely as underwriting compensation or in exchange for property) at least 10% of either the proceeds of any sale of securities by the issuer or at least 10% of any class of the securities themselves.)
• Any investment manager of the issuer (if the issuer is a pooled investment fund), as well as its directors, executive officers, other participating officers, general partners, and managing members.
• Any natural person or legal entity who has been or willed be paid to solicit purchasers of the offered securities (e.g. a placement agent), as well as their directors, executive officers, other participating officers, general partners, or managing members.

As you can see, the list of potential “bad actors” that an issuer will need to vet can potentially be a long one, especially, for example, if they will be working with several different placement agents. That being the case, a company seeking to raise money in a Rule 506 private placement should be proactive in determining if they are subject to bad action disqualification at time they are offering or selling securities in reliance of Rule 506. Some steps a company should take include adding bad actor disqualification representations and covenants in their placement agency agreements or securities distribution agreements and asking all participants covered by Rule 506(d) to complete a bad actor questionnaire and/or certification (and bring-downs of the same if the offering is long-lived). Also, the issuer may add a provision in its bylaws requiring each “covered person” to notify it of a potential or actual bad actor event. Further, the issuer should check and re-check public databases for any triggering events. We will talk more about the reasonable care exception in the next blog.

What constitutes a “disqualifying event” or a “bad act"?

Rule 501(d)(1)(i)-(viii) lists the bad acts.  A bad actor is any of the covered persons who:

• Has been convicted within ten years of the sale (five years for issuers and their predecessors or affiliates) of any felony or misdemeanor in connection with the purchase or sale of any security; involving making any false filing with the SEC; or arising out of the business conduct of certain financial intermediaries;
• Is subject to any final order, judgment or decree entered within five years of the sale that at the time of the sale restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of a security, involving the making of a false SEC filing, or arising out of the conduct of certain types of financial intermediaries;
• Is subject to a final order from state securities regulators, insurance, banking, savings association or credit union regulators, federal banking agencies, the CFTC or the National Credit Union Administration that either (1) at the time of the current sale, bars the person from association with any entity regulated by such a commission, agency, etc.; engaging in the securities, banking, or insurance business; or engaging in savings association or credit union activities, or (2) constitutes a final order based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct.
• Is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons;
• Is subject to an SEC order (entered within five years of the current sale) that, at the time of the sale, orders the person to “cease and desist from committing or causing a violation or future violation” of 1) any scienter-based [i.e. intentional] antifraud provision of the federal securities laws (e.g. Section 10(b) and Rule 10b-5 of the Securities Exchange Act, Section 17(a) of the Securities Act); or 2) Section 5 of the Securities Act (dealing with selling unregistered securities (which have not received an exemption) in interstate commerce) (Cease and desist orders regarding violations which do not include a scienter (intent) element would not be included, and thus would not be disqualifying “bad acts.”)
• Is suspended or expelled from membership in, or barred from associating with a member of, a registered national securities exchange (e.g. NYSE) or an affiliated securities association (e.g. FINRA) for actions found to be inconsistent with the just and equitable principles of trade;
• Has filed either as a registrant or issuer, or who acted or was named as an underwriter for, any registration statement or Regulation A offering which, within the five years prior to the current securities offering, was the subject of an SEC stop order, refusal order, or an order suspending the Regulation A exemption, or who is currently the subject of an investigation or proceeding to determine whether such an order should be issued.
• Is subject to a USPS false representation order entered within five years of the current sale of securities, or who has received a temporary restraining order or preliminary injunction regarding conduct alleged by the USPS to constitute a scheme to obtain money or property through the mail by means of false representations.

Only “bad acts” occurring on or after September 23, 2013 can destroy the exemption; those occurring prior to that date require disclosure, but do not themselves destroy the exemption. One important thing to note here is that this cut-off refers to the date of the conviction, order, etc. in question, not the underlying activities which eventually resulted in that action. For example, a broker who was suspended on October 1, 2014 for activity that occurred on June 3, 2014, would be a “bad actor” under the Rule, because the actual suspension occurred on or after September 23. Accordingly, the relevant look-back periods in the Rule are measured from the date of conviction or sanction, not from the date when the conduct occurred.

Final thing to note is that Rule 506(d) is not triggered by actions of foreign courts or regulations, such as convictions, court orders or injunctions.

Given the serious, even devastating potential consequences that can follow from failing to catch a “bad actor” disqualification, I strongly encourage companies considering raising capital through a Rule 506 private placement to devote the necessary time and resources to ensuring that the company and its covered persons are in full compliance with the “bad actor” disqualification provisions of Rule 506(d).

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 corporate, securities, and intellectual property law.

NY DPC - New York Design Professional Services Corporation - What Is It and How To Form It?

New York has long been recognized as having some of the strictest laws on the books when it comes to what is known as the “professional service corporation” (a “PC” for short), a specialized kind of business entity that must be formed by individuals providing professional services, such as lawyers, doctors, or engineers.  You can recognize these corporations by the inclusion of PC at the end of their names (just like "Inc." for the traditional “C” corporation).

In particular, the NY law is very strict with regard to who may be shareholder,  officer or director of such a corporation.  In a traditional professional corporation, all of the directors and officers must be professionals licensed in New York to provide the kind of services the company is involved in (and the company can only provide one kind of service; it cannot, for instance, provide both legal and accounting services, even if it had both licensed attorneys and licensed accountants as employees.)  In addition, only licensed professionals with the company are allowed to own equity; non-licensed employees, even highly important ones, cannot. A common complaint has been that this restriction has made New York firms less competitive with out-of-state firms that do not have similarly strict restrictions when it comes to attracting and retaining key employees. Although the law includes a “grandfather” clause, it is highly restrictive and very difficult and expensive to make use of.

In January 2012, however, the NY state amended Section 1503 of its Business Corporation Law to allow for a new kind of professional services corporation, the Design Professional Services Corporation (DPC for short). In a DPC, as opposed to the traditional PC, a limited number of the company’s officers and directors (less than 25%) may be non-professionals; in addition, a limited amount of equity ownership (again, less than 25%) is permitted to be held by non-professional employees or within employee stock ownership plans (ESOPs). While any increased flexibility in the ability to choose the appropriate corporate form is welcome, the law’s changes are limited, and it will be important for anyone considering this new DPC form to be aware of those limitations. This blog post will give you a brief introduction to this relatively new kind of corporate form in New York and discuss the changes (and continuing limitations) it provides.

Although the law does provide greater flexibility than the traditional rules with regard to equity ownership and who may serve as an officer or director, it still requires that greater than 75% of both the equity ownership (i.e. outstanding shares) and officer/director positions remain in the hands of employees who are licensed professionals.  In addition, the company president, chief executive officer, and chairperson of the board of directors must be licensed professionals. With regard to the equity provisions, the “less than 25%” of equity which does not have to be held by licensed professional employees must, in the alternative, be held by non-professional employees and/or an ESOP. No other person (either a natural person or a legal entity such as a partnership or another corporation) is permitted to own any equity stake. In addition, the largest single shareholder must be either 1) a licensed professional; or 2) an ESOP where greater than 75% of the plan’s voting trustees and committee members are licensed professionals. Note, however, that even an ESOP eligible to be the largest shareholder must own less than 25% of the company’s shares, because the law explicitly says that “an ESOP... shall not constitute part of the greater than 75% owned by design professionals.”

Another important restriction to keep in mind is that the DPC form is available only to companies providing four specific kinds of professional services. These are:

• Professional engineering
• Architecture
• Landscape Architecture
• Land Surveying.

Unlike the traditional professional services corporation, however, a DPC is allowed to provide more than one kind of such service, as long as the company employs at least one professional in each service it will be providing.

Now that we’ve examined the requirements that must be met in order to form your company as a DPC, how do you go about it? Here are the steps:

• Prepare and fully execute the Certificate of Incorporation.  The NY Division of Corporation provides a sample.  Note that there are special disclosure requirements that apply to the DPCs.
• Prepare Moral Character Attestations for all unlicensed shareholders, officers and directors.  
• Submit the Certificate of Incorporation, the Attestations and a filing fee to the NY State Education Department, which will then issue a Certificate of Authority (there is currently a wait of almost a month to get it).
• Submit the Certificate of Incorporation and the Certificate of Authority to the NY State Department for filing. 
• Finally, send a certified copy of the Certificate of Incorporation and a filing fee to the New York State Education Department.  
• As a very final step, - all DPCs that provide engineering and/or land surveying services must also obtain a Certificate of Authorization to provide such services (and if both of these services are provided, then the DPC needs to obtain two certificates).  
• Once every three years, DPCs must submit a statement and pay a filing fee to the NY State Education Department.

The new law also allows a currently existing PC to convert into a DPC if it meets the DPC requirements. This can be done by amending the existing PC’s certificate of incorporation to include all of the information indicated above (and the name should be changed to include the DPC signifier). The certificate of amendment must also include:

• A tax clearance issued by the Department of Taxation and Finance certifying that the existing PC is current on all of its state tax liabilities; and
• A certificate of good standing from the state Department of Education certifying that the existing PC is authorized to provide professional services without restriction

The state’s Office of Professions also provides a guide to converting a PC into a DPC on its website.

As you can see, the new DPC form does provide some greater flexibility for certain kinds of professional services corporations when it comes to stock ownership and officer/director positions. It will be interesting to see how popular this new form will be in the years to come and whether these initial, incremental reforms to New York’s professional services corporation law will herald additional reforms in future years.

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 corporate, securities, and intellectual property law.

New Regulation A: Will It Get an A+ From the StartUp Community?

On March 25, 2015, the Securities and Exchange Commission (the “SEC”) announced that it was adopting final rules amending and updating Regulation A.  These new rules, which become effective on June 19, 2015, have been informally dubbed “Regulation A+.” (Please note that all references to Regulation A going forward refer to the new rules unless otherwise specified.) These Regulation A amendments implement Section 401 of the JOBS Act, which added Section 3(b)(2) to the Securities Act of 1933 directing the SEC to adopt rules exempting from the registration requirements offerings of up to $50 million. By far the biggest change is in the amount that a company may raise under the new rules (up to $50 million in any 12-month period) versus $5 million under the original rules. The new Regulation A+ breaks offerings into two tiers depending on the offering’s size, and imposes different disclosure, reporting, and investor qualification requirements for each tier. This blog discusses the changes made to Regulation A, as well as the different requirements under Tier 1 and Tier 2 offerings, in an attempt to figure out how useful will this new Regulation A+ be for startups raising capital.

Regulation A+: What’s Changed?

As mentioned above, the most important change in the new Regulation A+ is the maximum offering amount ($50 million over any 12-month period). The new rules break Reg. A+ offerings into two tiers. Under Tier 1, a company (the “issuer”) may raise up to $20 million. Of that amount, no more than $6 million may be offered by the company's affiliates (i.e., those who can exercise significant control over the company, such as large shareholders). Under Tier 2, the issuer may raise up to $50 million, with no more than $15 million of that offered by its affiliates.  Securities sold in an offering under either Tier 1 or Tier 2 are “unrestricted” securities, meaning that investors who purchase them (other than affiliates of the issuer) can immediately resell them to others (that is, the securities have greater “liquidity”, or ability to be bought and sold), which (at least theoretically) should increase their value to (and price that can be asked of) investors. However, given the relatively rare use of Regulation A in the past, it remains an open question as to whether a truly liquid secondary (investor to investor) market will develop.

Although the initial disclosure and filing requirements for both Tier 1 and Tier 2 offerings are similar, Tier 2 offerings (as would be expected given the larger amounts of money that can be raised) are subject to significantly more extensive disclosure, filing, and investor qualification requirements, which are discussed in more depth below.

Who Can Use Regulation A+?

Before delving into that, let’s first examine who is eligible to use Regulation A+. Under the new rules, the Regulation A+ will not be available to the following categories of issuers:

• companies subject to the ongoing reporting requirements of Section 13 or 15(d) of the Exchange Act;
• companies registered or required to be registered under the Investment Company Act of 1940 and business development companies;
• blank check companies;
• issuers of fractional undivided interests in oil or gas rights, or similar interests in other mineral rights;
• issuers that are required to, but that have not, filed with the SEC the ongoing reports required by the rules under Regulation A during the two years immediately prior to the filing of a new offering statement (that applies to companies that have conducted a Reg A offering in the past)
• issuers that are or have been subject to an order by the SEC denying, suspending or revoking the registration of a class of securities pursuant to Section 12(j) of the Exchange Act that was entered within five years before the filing of the offering statement;
• issuers subject to "bad actor" disqualification under Rule 262 (Note that these are similar to, but not precisely the same as, the “bad actor” provisions of Regulation D).

Note that the SEC included two new categories of ineligible issuers, but the rule is still available to shell companies, issuers of penny stock or other types of investment vehicles.

Disclosure, Reporting, and Investor Qualification Requirements

At this point, because the disclosure and other requirements under the new Regulation A primarily depend on whether the offering is a Tier 1 or Tier 2 offering, let's separately discuss the requirements under each tier, starting with Tier 1.

Disclosure, Reporting, and Investor Qualification Requirements for Tier 1 Regulation A Offerings

As already mentioned, an issuer may raise up to $20 million over any rolling 12 month period using the new Reg A+. The primary advantage of the new rules for Tier 1 offerings is that it significantly raises the dollar amount that can be raised without significantly increasing the disclosure or other requirements. The primary disadvantage is that, as under the old Regulation A, issuers raising money in a Regulation A+ Tier 1 offering must comply with the individual “blue sky” laws of each state where they plan to sell the securities. This compliance requirement was one of the biggest reasons that the old Regulation A was not nearly as popular as Regulation D, despite the minimal federal disclosure and registration requirements, and it will be interesting to see whether the larger amounts that can be raised will be enough to offset the inconvenience of complying with individual state laws.

Aside from increasing the amount that can be raised from $5 million to $20 million, a Tier 1 offering under Regulation A+ is, with respect to filing and other requirements, largely unchanged from the original Regulation A. Although a full discussion of these requirements is beyond the scope of this post, I want to briefly touch on some of the most important points. The primary form that must be filed with the SEC is Form 1-A (“Regulation A Offering Statement”). The Form 1-A requirements include certain financial information, but for Tier 1 offerings such financial statements need not be audited, unless audited financial statements already exist. (In other words, there is no need to prepare audited financial statements specifically for a Tier 1 Regulation A+ offering.) Once the offering has been completed (or if it is terminated prior to completion), the issuer must file a Form 1-Z.  Both forms must be filed electronically on the SEC’s EDGAR system, and there is no filing fee connected with either form.  An issuer may, if he chooses, file a draft Form 1-A confidentially with the SEC (if, for example, the issuer is unsure of whether there will be enough investor interest, and so wants to, for the moment, avoid the potential embarrassment of filing it publicly only to have to later cancel or terminate the offering.)

As under the original Regulation A, a Tier 1 Regulation A+ offering is not limited to any specified number of investors, nor are there are any requirements that the investors be “accredited” or otherwise sophisticated. There is no limit (other than the overall aggregate limit of $20 million) that may be invested by any single investor.  Issuers may “test the waters” (i.e. engage in general advertising and solicitation) both before and after filing Form 1-A, but it is important to note that there are specific rules regarding certain disclaimers as well as filing requirements.  For example, any solicitation materials used before filing Form 1-A must be included when the Form is submitted, and any solicitation materials sent after it has been filed must be accompanied either by a current preliminary offering circular (Part II of Form 1-A tells you what needs to be included in an offering circular) or information indicating where the investor can obtain the offering circular him or herself.

In deciding whether to offer securities under Tier 1 of Regulation A+, there are a few questions an issuer should be asking.  First and foremost—where are the potential investors located?  Remember, Tier 1 offerings are not exempt from state blue sky laws, and so the greater number of states your potential investors are located in, the greater your compliance costs are going to be.  I would also suggest that, because the SEC imposes relatively few restrictions on the kinds of investors who can invest in such offerings and the lack of any limit on how much they can invest, state regulators are likely to give particularly close scrutiny to such offerings, particularly at the outset.  If the company thinks it may need to raise more than $20 million over the course of the year, possible integration problems may come into play.  Finally, as with any newly effective changes in the law, there is always the possibility of unforeseen issues cropping up somewhere down the road.

With all that being said, let’s move onto where the new Regulation A+ really makes its mark: Tier 2 offerings.

Disclosure, Reporting, and Investor Qualification Requirements for Regulation A Tier 2 Offerings

As mentioned above, the limit for Tier 2 offerings under Regulation A+ is $50 million, as opposed to $20 million for Tier 1 (note, however, that an issuer could, if it wanted to, engage in a Tier 2 offering of $20 million or less; in other words, an offering of $20 million or less is not automatically a Tier 1 offering.)  As would be expected, the disclosure and filing requirements for Tier 2 offerings are significantly greater than Tier 1.  Unlike Tier 1 offerings, however, Tier 2 offerings are exempt from complying with state “blue sky” laws (although states can (and generally will) still require that information provided to the SEC also be filed with the state, and that the issuer pay filing fees for the privilege.

The new Regulation A+ also allows securities offered under Tier 2 to be registered for sale on a national exchange (NYSE, for example) using Form 8-A (if in connection with a qualified Form 1-A), which is generally less expensive and less time-consuming to file than the traditional registration form, Form 10. (Some commentators have taken to calling this a “mini-IPO” option.)  Keep in mind, however, that if an issuer does register using this option, it becomes a “reporting company” subject to the traditional reporting requirements of the Securities Exchange Act. (Note that if the company does so, it will not also be subject to the Tier 2 reporting requirements mentioned below; the Exchange Act requirements replace them.)

Under Regulation A+ itself, an issuer which sells securities in a Tier 2 offering becomes subject to certain ongoing SEC reporting requirements. These include:

• Annual audited financial reports using Form 1-K
• Semi-annual reports using Form 1-SA
• Current event reports using Form 1-U (“current events” which would require filing include, for example, a material change in shareholder rights or a fundamental change in the business)

The issuer can suspend these reporting requirements by filing Form 1-Z (an “exit report”) if certain requirements are met, including that 1) fewer than 300 persons are shareholders of record of the securities sold in the Tier 2 offering; 2) the issuer has filed all of the necessary reports over the past three fiscal years (or for as long as the issuer has been obligated to file the reports, if less than three years); 3) the relevant Tier 2 offering statement was not qualified in the same fiscal year as the filing of the Form 1-Z (in other words, the Tier 2 issuer must file reports for at least one full fiscal year before they are eligible to suspend reporting); and 4) the issuer is not currently offering the same class of securities (e.g. Series A, Series B) in another Tier 2 offering.

As is clear from just this basic introduction, an issuer should not undertake a Tier 2 offering lightly, as the ongoing reporting requirements can be complex, confusing, time-consuming, and expensive.  If the company is going to be taking advantage of the option to register the securities on an exchange, the requirements can be even more onerous.  Especially in the latter case, the company should seriously consider whether the Tier 2 offering provides any significant advantage over a traditional IPO.  If the company believes there is sufficient demand from institutional and “accredited” investors, it may make more sense to engage in the “tried and true” Rule 506 private placement, especially now that Rule 506(c) allows for general advertising and solicitation.

In addition to the increased disclosure requirements, Tier 2 imposes some restrictions on investor participation when the securities being sold are not going to be registered on a national exchange. The important term here is “accredited investor,” which has the same definition in Regulation A+ as it does in Regulation D. The term is specifically defined under Rule 501 of Regulation D, and in general includes most institutional investors (banks, investment companies, insurance companies, etc.) as well as high net worth and high-income individuals. Although Tier 2 offerings may be made to any number of both accredited and non-accredited investors, non-accredited investors are limited in how much they can invest. Specifically, non-accredited individuals cannot invest more than 10% of either their net worth or annual income (whichever is greater), and non-accredited entities cannot invest more than 10% of the greater of their revenue or net assets (again, whichever is greater) as of the last completed fiscal year. To comply with this 10% requirement, the issuer is allowed to rely on a representation of the purchaser that their investment falls within the limits, as long as the issuer “does not know at the time of sale” that the representation is false.

At this point, I’ve hopefully imparted at least a basic understanding of the changes the new Regulation A+ rules make. What remains to be seen, however, is how often, and by whom, they will be used.  From what I’ve seen, the general consensus seems to have some doubt that these new rules will boost the use of Regulation A as much as the SEC is hoping.  Particularly with regard to larger offerings using Tier 2, the enhanced reporting requirements, and the “fishbowl” effect it results in, may be too much of a negative, even with the ability to raise up to $50 million and to offer unrestricted securities.  Companies may simply continue to rely on Rule 506 private placements (which have no dollar limit), even if the securities are “restricted”, or conversely may decide to just go all the way with a “true” initial public offering.

Just as importantly, how will investors, particularly retail investors, react? Will a truly liquid secondary market for these kinds of securities develop? It’s too soon to know for sure, of course, but here as well there is ample room for doubt.

Finally, it should be pointed out that a number of state regulators are none too pleased with the SEC’s decision to preempt state “blue sky” securities laws for Tier 2 offerings, and in fact regulators from two states, Massachusetts and Montana, have both sued to prevent the rules from going into effect. Even if these challenges fail, it is clear that they will be keeping a very watchful eye on Tier 1 securities, which do remain under their purview.

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 corporate, securities, and intellectual property law.

All You Ever Wanted To Know About Form D: When, Why and How to File

Why File Form D?

When raising money in a private placement, the most common path for companies to take is to make use of one of the Regulation D exemptions from registration, utilizing either Rule 504, 505 or, most commonly, Rule 506. Once the offer for private placement is made, Rule 503 of Regulation D requires the companies engaging in the private placement (let's refer to them as the “issuers”) to file a Form D—Notice of Exempt Offering of Securities—with the Securities and Exchange Commission (the “SEC”).

What Information Do I Need To Have To Be Able To File Form D?

Here is the information you need:

• Company name, principal place of business and contact information (including a phone number)
• Type of entity, state and year of incorporation
• List of related parsons (executive officers, directors, promoters)
• Size (based on revenue or NAV) - this info is optional
• Federal exemption claimed for the offering of securities
• Date of first sale
• Whether the offering will last for longer than a year
• Type of security offered (debt, equity...)
• Whether the offering is made in connection with a business combination
• Minimum investment accepted
• Information related to sales compensation (if any)
• Total offering amount, amount already sold and amount remaining to be sold
• Number of investors (and separately the number of non-accredited investors) 
• Amount of sales commissions and finders' fees
• Use of proceeds and amounts paid to officers, directors and promoters as compensation.

When to File Form D?

Form D must be filed no later than fifteen calendar days following the first sale of securities in the offering. If the fifteenth calendar day falls on a weekend or holiday, the deadline is pushed back to the next following business day (but note that otherwise both weekends and holidays are counted for purposes of the fifteen day total.) The “date of first sale” is the date on which the first investor is contractually obligated to invest (e.g. if an investor signs a binding contract to invest on January 1, requiring payment for the securities on January 10, the date of first sale is January 1.)

Form D is also the correct form to use when the issuer seeks to amend an original Form D filing. Part 7 of the Form allows the issuer to indicate whether the filing is an original filing or an amendment to one previously filed. An issuer may choose to file an amendment at any time (i.e. a permissive filing). However, there are also certain situations, laid out in Rule 503, where the issuer must file an amendment. These are:

• To correct a material factual mistake in the previously filed Form D. The amendment must be filed “as soon as practicable after discovery of the mistake or error.”
• To reflect any change in (i.e. update) the information provided in the previously filed Form D (but only if the offering has not already terminated). Although this second requirement seems very broad, Rule 503 also carves out a number of exceptions where certain changes in information will not require an amended filing, if the only information that has changed includes only:
• The address or relationship to the issuer of a “related person” (i.e. executive officer, director, and/or promoter);
• The issuer’s revenues or aggregate net asset value;
• Any change in the minimum investment amount of 10% or less;
• The address or state of solicitation for anyone receiving sales compensation in connection with the offering;
• Any change in the total offering amount of 10% or less;
• The amount of securities being sold or remaining to be sold;
• The number of non-accredited investors who have invested in the offering (so long as not over 35)
• The total number of investors participating in the offering; or
• Any change in the amount of sales commissions, finders’ fees or use of proceeds for payments to executive officers, directors, or promoters or of 10% or less.

In addition, so long as an offering is ongoing, the issuer must file annually, either on or before the first anniversary of the original filing or the anniversary of the latest filed amendment (whichever is later.)

How to File Form D?

Now that we’ve discussed when to file Form D and what information to include, let’s move on to discussing how to file it. The first thing to know is that the SEC requires that Form D be filed electronically using its Electronic Data Gathering, Analysis, and Retrieval System (more affectionately known as EDGAR). To access the EDGAR filing system (located here), a company must have both a Central Index Key (CIK) and an EDGAR access code.

If the issuer has never previously filed anything with the SEC, electronically or otherwise, it needs to apply to get the CIK and EDGAR access codes by using what is known as Form ID. The SEC website provides a super helpful guide to this process here (see specifically Steps 2 and 3). Remember that the Form ID must be printed, signed and notarized by an authorized person, and then submitted as an attachment to the SEC.  Then, the SEC sends the filer the CIK number by email, typically within a couple of days.  Next, the filer uses the CIK number to obtain the EDGAR access codes.  Once the company has obtained its CIK and EDGAR access code, it can log on to EDGAR here and from there follow the instructions to submit Form D.  I would suggest allocating 2-3 days to get through this process.  

Who Can Sign Form ID and Form D?

The forms can be signed by the issuer's executive officer or director.  An attorney for the company may also sign, but that attorney must be duly authorized by the company or be acting under a power of attorney or other corporate authorization.  So, when the attorney for the company is attaching a notarized Form ID, he or she should also attach the authorization from the company.  

One final thing to note about EDGAR: although it is an online filing system, it is not available 24-7. The system may be accessed between 6 a.m. and 10 p.m. Mondays to Fridays (excluding federal holidays).

This blog article was written and published on June 16, 2015, and the information is accurate (to the best of our knowledge) as of this date.  As you know, with time rules and forms change, and this information may become inaccurate or obsolete.

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 corporate, securities, and intellectual property law.

What Should Start-up Founders Know About Rule 701?

In my opinion, all startup founders should be familiar with and actually understand Rule 701 under the Securities Act because this is precisely how they get to issue equity (restricted stock or options) in their startup to their employees, officers, directors, consultants and advisors in order to provide them with the right kind of incentives. Rule 701 allows startups to do so in a private placement, without registration with the SEC, and with minimum compliance requirements (unless the aggregate offerings exceed $5 million in any 12-month period). One important thing to keep in mind is that the exemption applies only to the registration requirements of the Securities Act; other provisions, most importantly the antifraud provisions, remain fully applicable, which means that any disclosures made by the company may not be materially false or misleading.

Where does Rule 701 fit in?

As you know, all issuances of securities by a company have to be registered with the SEC unless a particular offering falls under an exemption from registration. You are familiar by now with Rule 506 that provides an exemption from registration for securities issued in a private placement. Well, Rule 701 provides an exemption from registration (also on a federal level) for securities that private companies may issue as equity compensation to its employees, directors, officers, consultants and advisors.

Principal requirements and restrictions relating to a Rule 701 offering.

1. Only the issuer (i.e. the company) may use the Rule 701 exemption. This rule is not available for resales.

2. The company has to be a private company (i.e., not be subject to reporting requirements under Section 13 or 15(d) of the Exchange Act). But a company that files Exchange Act reports on a voluntary basis or in accordance with a contractual obligation, is eligible to use Rule 701.

3. The persons to whom offers and sales of securities may be made pursuant to the Rule 701 exemption include employees (including employees of majority-owned subsidiaries), directors, general partners, trustees, where the issuer is a business trust, officers, consultants and advisors. There are many SEC no-action letters regarding who are the eligible recipients of Rule 701 equity (there is some uncertainty about who are the eligible advisors and consultants), so startups should check with their attorney to ensure that they do not issue Rule 701 equity to ineligible persons.

4. Securities offered under Rule 701 are “restricted” securities, and cannot be resold unless they are registered with the SEC or are resold pursuant to another exemption (such as Rule 144).

5. Offering and sale under Rule 701 must still comply with any applicable state “blue sky” laws.

6. Rule 701 equity may be offered and sold only pursuant to a written compensatory benefit plan (or compensation contract). The Rule defines “compensatory benefit plan” as “any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan.” This means that the startup should invest into developing an equity compensation plan early on in its existence.

7. The Rule is not applicable to transactions entered into for capital-raising purposes.

8. For equity offered and sold to consultants or advisors, several special rules apply. The Rule is only available to them if they are 1) natural persons; and 2) they provide bona fide services to the company which are not connected to any offering or sale of securities in a capital-raising transaction and which are not intended to promote or maintain a market in the issuer’s securities (whether directly or indirectly).

What else do you need to know about Rule 701?

1. Aggregation Limits

Over the course of any rolling 12-month period, the total aggregate sales price or amount of securities sold may not exceed the greatest of:

1) $1 million;

2) 15% of the issuer’s total assets, as measured on the date of its most recent balance sheet (if no older than its last fiscal year end); or

3) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the Rule (again as measured as of the date of its most recent balance sheet).

There is no (theoretical) limit to the amount of money that can be raised pursuant to Rule 701, provided that whatever amount raised remains within the aforementioned limits. However, there are some enhanced disclosure requirements when the aggregate sales price or amount of securities sold exceeds $5 million in any consecutive 12-month period.

2. Disclosure Requirements

1. For aggregate offerings equal to or less than $5 million, the company must deliver to the recipients only a copy of the compensatory benefit plan or compensation contract.

2. For aggregate offerings exceeding $5 million, the company must, in addition to a copy of the compensation plan/contract, provide in a reasonable amount of time prior to sale:

• A summary of the material terms of the plan (or, if subject to ERISA, a copy of the summary plan description required by that Act);
• Information about risk factors associated with the investment in the offered securities; and
• Financial statements (prepared in accordance with GAAP) required by Part F/S of Form 1-A under Regulation A, including at a minimum the company’s latest balance sheet as well as statements of income, cash flows, and stockholder equity for the preceding two fiscal years (or for the period of the issuer’s existence, if less than such a period). Note that audited financial statements must be provided only if the company has already prepared them; the company need not undergo a financial audit to comply specifically with these disclosure requirements.

Conclusion

Rule 701 can be a very useful and relatively inexpensive tool for start-up companies wishing to provide equity compensation to their employees, directors, and others. There are no SEC reporting requirements, and the disclosure requirements are, in general, not particularly onerous. At the same time, the Rule does impose a number of limitations and exclusions which the company must carefully abide by. The company should always have a knowledgeable attorney to develop or review any proposed Rule 701 compensation plan to ensure compliance with its requirements.

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.

Handshake Agreements: Still a Good Idea?

I’ve seen this many times before: entrepreneurs enter into handshake agreements with others, trying to save on legal fees. Often, the counterparties are contractors, employees, investors, or co-founders. These entrepreneurs are not entirely wrong to do so. Oral agreements are still enforceable for the most part. Here is a short summary of when handshake agreements can be enforced in a court of law, when agreements must be in writing, and why it is still a good idea to write it all down.

What You Need to Do To Make an Oral Agreement Enforceable

Most agreements can be oral. The exception is agreements that are required to be in writing by the Statute of Frauds (see below). Like any other contract, oral agreements are enforceable if they have all the requisite terms: an offer, an unconditional acceptance of that offer, and an exchange of consideration. The contracting parties must be capable of contracting (no minors please), and they must be in consensus, i.e, have a “meeting of the minds.” The existence of oral agreements may be difficult to prove: a party’s word might not be enough. So, you need to dig up other evidence that a contract existed, such as receipts, emails, photographs, memos, testimony of third parties, etc.

These Agreements Must Be in Writing

I’d like to introduce a new (for some) legal concept: the Statute of Frauds. The exact requirements vary state by state, but here are the essentials: the Statute of Frauds tells us which contracts MUST be in writing in order to be enforceable. Here is the list:

• Contracts that cannot be performed within a year
• Contracts relating to transfer of interests in real property (including options to purchase and leases)
• Contracts by which a person agrees to pay or guarantee another person’s debt
• Prenuptial agreements
• Contracts for the sale of goods for $500 or more.

Even if a contract does not specify its duration, courts can infer it from the intention of the parties. For example, this can happen to oral employment agreements if the court determines that the intended duration of the employment relationship was for over a year.

Why It is Still Better To Write Things Down

We are all optimistic about the future of our relationships. We firmly believe that nothing bad will happen to our venture because we trust one another. Unfortunately, a few things can happen. First, without even realizing it, we may fail to agree on ALL aspects of our business deal. Yes, we discussed the essentials, but perhaps failed to think through all of the steps. Second, memory fades. If we base our agreement only on a handshake, we may find it difficult to recall some of the terms down the road. Third, we may have misunderstood one another, and won’t realize it until it is too late.

Writing things down allows parties to negotiate all of the aspects of the proposed transaction. Let’s take a software consulting agreement as an example. Defining the scope of services, the time frame for the delivery of services, the acceptance process, the payment amount and timetable, ownership of IP (both created and pre-existing), the term of the agreement, who can terminate the agreement and with what consequences, etc. takes time and effort. Often I find that parties haven’t even thought about some of the specific terms that they need to agree on in order for their project to work. A contract can be viewed as an ultimate expression of the parties' intentions. It should overrule everything that’s been said during the negotiations. Only what is in writing matters. That’s why a well-written contract should address all scenarios that can happen in a project. A party failed to deliver services on time? No problem, check Section 3(a) for the remedies available to you. You are not satisfied with the quality of the service? Check Section 4. You still haven’t received payment? Go to Section 5… and so on.

Conclusion

It is not always necessary to hire lawyers to draft contracts. A quick summary of all essential terms, signed by both parties, even if it is in an email or on the back of a napkin, will suffice. But if you can afford it, hire a professional to help you draft a full-blown agreement. It is like having insurance, - it might protect you down the road.

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.