SEC Plans for New Disclosures on Private Offerings Draw Fire

When the Securities and Exchange Commission said it was lifting the ban on general solicitation and advertising of private securities offerings next month, the move was hailed as long overdue and a blessing for start-ups and their capital-hungry entrepreneurs. At least it was at first.

The move—part of a JOBS Act initiative to make it easier for small- and medium-sized companies to raise capital—comes with a catch. The SEC also proposed new rules that increase disclosures on Form D filings that are required with such offerings. Now business community opponents of the added disclosures are mounting an offensive against the new requirements that they say negate the benefits that come with lifting the solicitation ban.

“You almost wonder if we are better off without it if these new requirements are going to end up trapping a lot of people,” says William Carleton, a lawyer with the law firm McNaul, Ebel, Nawrot & Helgren. “There is too much complexity and too many gotchas. This isn't the right time to overhaul Form D.”

Under the current offering process, Rule 506 provides the most commonly used exemption for businesses seeking to raise capital without having to register their offerings with the SEC. In an offering that qualifies for that exemption, an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors,” who meet minimum income or net worth levels, and up to 35 non-accredited investors. Until recently, companies that took advantage of the exemption were prohibited from advertising them in newspapers, on the Internet, or through other media outlets.

In April 2012, Congress passed the JOBS Act and directed the SEC to remove the prohibition on general solicitation for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors. The SEC finally adopted a measure lifting the ban last month that will take effect on Sept 23. Over the next months it will also consider the additional requirements. In a letter to some members of Congress, SEC Chairman Mary Jo White explained that the rules under consideration will not delay or postpone the ability of issuers to advertise.

Strings Attached

Currently, a company or fund using Rule 506 is required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. That form provides information about the issuer and the securities offering.

Intended to enhance the SEC's ability to assess developments in the private placement market, its proposal would require issuers of a Rule 506 offering to file Form D at least 15 calendar days before engaging in general solicitation. Within 30 days of completing an offering, issuers would then be required to update the information contained in the Form D and indicate that the offering has ended.

The new rules would also require issuers to provide additional information about themselves and the offering, including: the types of investors in the offering, the use of proceeds, the types of general solicitation used, and the methods used to verify accredited investor status. For the first time, failure to file Form D, or do so accurately, would also lead to punitive action. An offending issuer would be disqualified from using the Rule 506 exemption for one year.

“There is too much complexity and too many gotchas. This isn't the right time to overhaul Form D.”

—William Carleton,

Lawyer,

McNaul, Ebel, Nawrot & Helgren

Under the proposal, issuers are also required to include disclaimers and cautionary statements with any written general solicitation materials and file all such communications with the SEC through a non-public Website for at least the next two years.

Panning the Proposal

A 60-day public comment period is underway that ends on Sept 23. Nearly 300 comments have been filed so far, most of them overwhelmingly against the new rules. “The government can't bully startups into compliance they way it can to public companies who have tons of resources to remain compliant. A one-year ban is preposterous,” wrote Andrew Antar, founder of the startup hearo.fm.

Naval Ravikant, CEO of AngelList, a Web-based platform that matches accredited investors with startups, is equally critical of the proposal adding new disclosure requirements along with lifting the solicitation ban. “The newly proposed Form D filing rules could create disastrous unintended consequences for the startup community,” he wrote. “The proposed rules appear to be tailored to how Wall Street raises funds, not the startup community.”

Carleton calls the new demands out of left field and inconsistent with how Reg. D has worked in the past. “The point was to have general solicitation and worry at the back end about whether people are accredited investors or not,” he says. “The idea was to make it easier to conduct these offerings, not harder.”

While Carleton agrees with the need for stricter accredited investor standards and reviews, he says the current proposal is not the way to go about it. “We should question whether the definition is rigorous enough and that's going to be in play in the next year or two, but these information requirements are making things a tangled mess,” he says. “All of the penalties associated with non-compliance is going to make it very hard, and expensive.”

Others question the aims of the SEC's proposal to gather more information on how companies ensure they are marketing offerings to accredited investors. “It seems the proposed requirements are not so much rooted in investor protection, as they are a data mining expedition by the SEC,” says Bob Carbone, co-founder and CEO of CrowdBouncer, a company that offers compliance services for JOBS Act related crowdfunding efforts. “It could have a chilling effect.”  

GENERAL SOLICITATION RULE ALTERNATIVES

The following are among the alternatives to the SEC's proposed changes to Form D pitched by Naval Ravikant, CEO of AngelList, in his comment letter to the Securities and Exchange Commission.

Allow third parties to do the filing on issuer's behalf via API. Sites like AngelList can automatically register, via API, some very simple data with the SEC: Company, founder, contact information, date when they turned on financing, optional URL to view financing materials.

Allow the company (or a third party) to hold the financing materials so the SEC can access them. Companies should just need to give the SEC a simple URL where most of the financing activity happens, as opposed to making a formal filing with the SEC every time an update is made.

Only require legends and disclosures when terms are communicated. Acknowledging the existence of the financing somewhere publicly (media, Twitter, conferences, etc.) shouldn't require legends and disclosures.

Drop the 15-day-in-advance before financing rule entirely. This creates a minefield for startups without actually helping anybody—even the SEC states that they won't review the materials at that time. Make the Form D filing “after the fact” as it is today.

Don't impose death penalties for non-compliance. Instead, reduce the costs of compliance. The reason for the high non-compliance rates in the venture and startup community is that the information made public by the Form D is usually highly confidential. Startups often want to control the timing of their financing announcement and prefer not to reveal amounts raised for competitive reasons. If more of the Form D information was confidential rather than public, compliance rates would jump dramatically.

Source: SEC.

Form D has always been an administrative exercise in the past, he explains, and there were no real ramifications for not filing on time. While stopping short of proposing it as a rule, the SEC has requested comment on whether it should make the filing of Form D a condition of the securities registration exemption. “This would mean that if you don't file Form D on a timely basis, you could lose the exemption and open yourself up to shareholder rescission lawsuits,” says Carbone who is also a board member of the group Crowdfund Intermediary Regulatory Advocates. “That's a tremendous amount of liability for issuers to be exposed to for not doing something that is largely administrative.”

Because many startups may not have the in-house expertise or well-developed compliance functions, there is also the likelihood of good faith mistakes or being burned by an attorney who fails to file on their behalf. The penalties for these oversights are “too onerous” he says.

“The fact that if you fail to timely file your Form D you can be barred and disqualified from doing a future 506(c) offering for a year is putting teeth into a filing requirement that was never there in the past,” says Edward Dartley, of counsel for the law firm Pepper Hamilton. “Not everybody has been paying attention to their Form D filings the way they should.”

He describes the need to submit all advertising materials and updates to the SEC for review as thus far “floating under the radar screen” of many. “Yes it's not publicly accessible, but at the same time it gives the SEC the opportunity to review your information and perhaps make decisions about whether certain materials should be examined further,” Dartley says. “You had better make sure your advertising materials are not only accurate and truthful, but spot-on in terms of the requirements that the SEC imposes on advertising.”

While the ban on general solicitation for private securities offerings will be lifted on Sept. 23, the new disclosure rules will be considered separately and aren't a lock to get finalized. Carbone holds out hope that the SEC will reconsider the proposed rules, especially given the objections raised to them by at least one commissioner.

“I don't think they are necessarily pre-ordained and there will be a dialogue within the SEC as to whether these measures are reasonable,” he says. “I would think the lopsided response here in opposing these new rules at least will erode some of those measures.”