The Craigslist Exemption (and the brave new world of the JOBS Act)
If you’re like me, you might be having trouble sorting out the new JOBS Act (properly, the Jumpstart Our Business Startups Act) that President Obama signed into law on April 5. The written and online analyses seem to be essentially correct but they are far too sketchy to let us all participate in the discussion. To understand the law and to have a well-thought opinion on what it means, you need to have a basic understanding of how U.S. securities laws function.
I’ll try to keep it brief, but, even so, I’ll need to break this up into sections. In this first section, I look at how the JOBS Act changes the rules on current fundraising techniques. In later sections, I will examine the new crowdfunding rules and the ways the JOBS Act allows companies to delay or avoid complying with Sarbanes-Oxley and other rules.
The Securities Act of 1933 (which is often called the ’33 Act or just the Securities Act) covers the offer and sale of securities while the Securities Exchange Act of 1934 (called the ’34 Act or the Exchange Act) governs the trading of securities on public stock exchanges. A “security” is an investment in a common enterprise, such as a corporation, for a return from the efforts of a third party, such as a corporation’s professional management team. The archetypal securities are stocks and bonds and, to simplify this discussion, let’s just leave it there, even though there are many other financial instruments that fall under this definition.
Broadly speaking, the Securities Act requires companies that issue securities (known as “issuers”) to make minimum disclosures to buyers and the Exchange Act requires them to continue making disclosures to the public generally. The theory is that so long as enough accurate information is available, investors can be left in charge of protecting themselves, whether they are buying directly from the issuer or from other investors on a stock exchange. This disclosure-based, buyer beware approach has been the cornerstone of U.S. securities regulation for almost a hundred years now. It makes sense, but, as with all things, the devil is in the details. The details, some say, tend to stifle markets and startup companies in particular. The two principal targets of the JOBS Act were impediments to startup fundraising and the burdens of Sarbanes Oxley compliance. The fundraising impediments come from the Securities Act while the SOX problems come through the Exchange Act.
Fundraising under the Securities Act
– Public Offerings
The Securities Act forces companies to make disclosures to buyers of their securities. It does this by outlawing all sales of securities unless the issuer has completed a registration with the Securities and Exchange Commission or a specific exemption applies. The registration statement is a complex and expensive document to prepare. It requires a whole team of investment bankers, accountants and lawyers, plus the issuer’s senior management, anywhere from three months to a year to prepare. Each line of text and every table of numbers is painstakingly reviewed for accuracy and potential to mislead investors or generate lawsuits. Accordingly, a registration statement under the Securities Act is quite beyond the resources of most young companies; it is only prepared for the company’s first sale of securities to the public, an “initial public offering” known as an “IPO”.
– Private Offerings
We all know that startups sell securities without registering under the Securities Act. They do this through one or more specific exemptions from registration that are contained in the Act itself. Probably the most well-known exemption is Section 4(2) of the Securities Act, which exempts “transactions by an issuer not involving any public offering.” The next question is, obviously, “What is a “public offering?” Unfortunately, the Securities Act doesn’t tell us and the SEC won’t. They feel that it’s better to keep people guessing and, on the advice of counsel, erring on the side of caution. Even now, the SEC will often settle enforcement actions rather than let the case go to court – a court opinion could upset decades of SEC policy, after all.
Nevertheless, the SEC has used its rulemaking authority to define some things that are not “public offerings.” These so-called “safe harbors” account for most of the unregistered, or “private” offerings of securities in the U.S. In Regulation D, the SEC has created a set of detailed steps that, if followed precisely, mean that an offering will not be a “public offering” and will fall within the Section 4(2) or other exemptions. The JOBS Act essentially forces a change in Reg D to permit advertising even during a supposedly “private” placement of securities that is not a public offering.
– Reg D / Section 4(2)
Regulation D actually includes several different safe harbors that technically fall under different sections of the Securities Act. The JOBS Act modifies Rule 506 which currently allows unlimited offers and sales of securities to so-called “accredited investors” and to no more than 35 non-accredited investors. The term “accredited investor” includes individuals with a net worth exceeding $1 million or with an income exceeding $200,000 (or $300,000 in joint income with a spouse). It is intended to cover sophisticated individuals that are wealthy enough to hire their own advisors and lawyers to protect their interests. These people, the reasoning goes, can demand the same level of information that would be in a registration statement filed with the SEC and so it would be wasteful to force companies to prepare and file one.
As a further condition, Rule 506 prohibits “general solicitation” and “general advertising” such as seminars open to the public and newspaper or broadcast advertisement. The JOBS Act requires the SEC to modify Rule 506 to remove this limitation but only if “all purchasers of the securities are accredited investors.” So, a general advertisement can be made, but only accredited investors can actually purchase.
There are some interesting conundrums for practitioners. Traditionally, a Rule 506 offering is made solely to accredited investors and perhaps a handful (but always less than 35) of specific non-accredited investors who might literally be friends and family. Because the 35-person limit for non-accredited investors applies to both offers and sales, any non-accredited investor who receives an offer “counts” for purposes of computing the limit even if they don’t buy. Most practitioners prefer to avoid non-accredited investors entirely just to avoid the danger of inadvertently going over the limit and also to keep a few in the “back pocket” in case some accredited investors turn out to be too poor to be accredited. In that event an “unused” non-accredited investor slot could save the entire fundraising from violating the Securities Act. By requiring that all purchasers be accredited investors, the JOBS Act takes away some of the safety net.
Perhaps for this very reason, the JOBS Act also mandates that the SEC rule changes require issuers to take “reasonable steps” to verify that purchasers are accredited investors. Going even further, the Act tasks the SEC with identifying these “reasonable steps.” So, the JOBS Act almost places the burden on the SEC to create a very explicit “paint by numbers” system. On the other hand, the SEC could punt on the question by issuing a vague rule calling for some discretion on the issuer’s part.
– Reg D / Section 3(b)
While Rule 506 and Section 4(2) exempt types of transactions, Section 3(b) of the Securities Act, now renumbered as 3(b)(1), allows the SEC to exempt types of transactions so long as the total amount of securities is limited to $5 million. Under that authority, the SEC issued two additional rules as part of Reg D. Rule 504 exempts offerings by issuers of up to $1 million solely in compliance with state securities laws while Rule 505 exempts offerings by issuers of up to $5 million to no more than 35 purchasers and without any general solicitation or general advertising.
Some commentators have implied that the JOBS Act raises the Rule 505 limit of $5 million to $50 million. Actually, the JOBS Act leaves Rule 505 untouched, but adds a new Section 3(b)(2) to the Securities Act which requires the SEC to issue rules for a new exemption for offers of up to $50 million. The statute spells out that public offers, sales and solicitations must be allowed, and that the securities can be freely resold without the need for a Section 4(1) exemption that would apply to most other exempted securities. However, this new exemption is not a free ride. The SEC must require the issuer to publicly file annual audited financials and “may” require that issuers also deliver an offering document to purchasers which must also be publicly filed and “may” require such issuers to also make periodic public filings. Given the SEC’s mission to protect investors, I read “may” as “definitely will.” This all begins to sound very much like the registration statement and annual reports already required of public companies. Presumably, the SEC will generate some form of abbreviated or fast-track version of the current process.
– Section 4(1), the 4“(1½)” exemption, and its future on Craigslist
Most readers who are still following this at all probably did not notice one important part of the 4(2) exemption. Here it is again with some emphasis added: “transactions by an issuer not involving any public offering” do not require registration with the SEC. Okay. So, what happens if I want to sell stock that has never been registered with the SEC and was not purchased under the new Section 3(b)(2) exemption? Remember, the Securities Act outlaws all sales of securities unless the issuer has completed a registration with the SEC or a specific exemption applies. I’m not the issuer, so I can’t use the 4(2) exemption or any SEC safe harbors, such as Reg D, that apply only to issuers of securities.
Some readers will suddenly understand the importance of the “registration rights” that they obtained when they bought shares in their startup company. A registration right is the ability to force a corporation to file a registration statement with the SEC so the investor can legally sell the corporation’s shares to the public. Startup companies commonly grant registration rights to investors when they conduct a large financing round. If you don’t have registration rights or if you decide not to exercise your rights, you probably need to sell under Section 4(1) of the Securities Act.
Section 4(1) exempts transactions by any person other than an issuer, underwriter, or dealer. Unfortunately for would-be sellers, the term “underwriter” is defined to include anyone who purchased securities with the intention of distributing them. Because most investors in fact intend to resell their shares eventually, the definition could include just about everyone who ever bought unregistered securities from the issuer. Luckily, the SEC has created another safe harbor in Rule 144 which, in broad strokes, allows a security holder to sell his or her securities after holding them for at least six months to a year. As usual, there are prickly details that can trip up your plans, but we won’t go through them here. Just be sure to consult a securities lawyer before you hang your hat on Rule 144.
The more interesting approach is to use the Section 4(1) exemption alone, without relying on Rule 144. First, there is the so-called “naked” 4(1) exemption. Just sell the shares and swear on a stack of bibles that you are not an underwriter. Hope fervently that the SEC agrees with you or at least gives you a pass. This is equivalent to walking a tightrope without a net and is not for the faint of heart. It is an act of desperation. The second approach is much better; follow in the footsteps of the elders and clothe yourself in the almost respectable 4 “(1½)” exemption.
The first thing to remember about the 4(1½) exemption is that there is no 4(1½) exemption. The ½ refers to a set of practices developed by securities lawyers that is intended to generate evidence that the seller did not originally purchase the shares with a view to distributing them and so, logically, cannot be an “underwriter” within the meaning of the Securities Act. To cut to the quick, the seller pretends that he is the issuer and wants to use a 4(2) exemption. So, sell only to accredited investors and do not engage in any form of general solicitation or general advertising. This has all been tacitly allowed by the SEC for decades.
Getting back to the JOBS Act, we can speculate that with general solicitation and advertising permissible for issuers, it may become possible for resellers to also solicit and advertise their shares before eventually selling to accredited investors. Conceptually, it seems only fair, but in practice it is far more likely that an individual seller would forego the expense of hiring an attorney to properly document and structure a new-fangled 4(1½) exemption with the result that Craigslist could become as popular for resales of unregistered securities as it is now for cheap apartments, used cars and other low-end purchases.
– Rule 144A
Rule 144A is yet another safe harbor under Section 4(1) which allows investors to avoid becoming “underwriters.” The rule was designed to facilitate a liquid electronic market in unregistered securities among very large institutions known as “qualified institutional buyers” or QIBS. These institutions, like accredited investors, would theoretically not need the full protection of a registration statement filed with the SEC. Rule 144A has become a significant vehicle for large transactions and a mainstay for foreign companies that sell shares into the United States without listing shares on a U.S. stock exchange.
The practice is to prepare a disclosure document under the home country’s regulatory regime (Hong Kong, for example), have a U.S. securities lawyer review and “improve” it to meet or at least approximate the requirements of a U.S. IPO and then add a new cover and additional disclaimers and risk factors based on U.S. practice in order to meet the Rule 144A requirements. The U.S. “wrap” is distributed to QIBS in the U.S. but not circulated to anyone else. The JOBS Act also changes this by requiring rule changes that permit general solicitation and general advertising of Rule 144A offerings and permit offers to any investor. Actual sales, however, are still limited to QIBS.
What it all means
– May Flowers
What will these changes mean? Obviously, we can’t know in advance and certainly not before the SEC issues its rules, due 90 days from the Act’s passage. But it’s always fun to speculate. I put myself in the optimist’s camp here and see this as a way to achieve far greater transparency in the financial markets, and perhaps far more de facto regulation of unregistered offerings than anyone seems to realize.
For starters, if “private” offerings can be advertised, many issuers will be inclined to do so. A greater awareness of an ongoing offering is likely to attract a greater number of accredited investors or QIBS who will bid up the price of the issuer’s securities. As a result, the general public will probably learn a lot more about how the Wall Street world works. Not many non-accredited investors (and not so many accredited investors either) have seen a private placement memorandum and very few have read a 144A PPM, but that will probably change. Under cover of the JOBS Act, a PPM can be circulated freely and receive public comment and analysis to be digested by accredited and non-accredited investors alike. Companies that release their PPMs will, in fact, establish a track record among industry followers that could help support interest and make an eventual IPO a success. Conversely, the market can identify duds early and cut off funding before unworthy companies reach an IPO where they can sell to the general public that will, presumably, be less well-informed. Investors will probably also become more familiar with overseas companies accessing the 144A markets.
Perhaps more importantly, scholars, economists and researchers will also have access to an entire area of the economy that has been essentially hidden from view based on legal restrictions. The conclusions that they reach will be available to us all, including our legislators.
– Rule 10b-5
All this public disclosure of private offerings should be a good thing for everyone. After all, the received wisdom is that “all publicity is good publicity.” Many commentators on the JOBS Act seem to leave it at that, but, as a lawyer, I would point out that Rule 10b-5 still applies to disclosures under private offerings.
For those not in the know, Rule 10b-5 is the rule you already know. This SEC rule was issued under the Exchange Act and prohibits insider trading (you knew that). It is, in fact, much broader. The rule prohibits fraud, untrue or misleading statements or omissions, and anything at all that, “would operate as a fraud or deceit upon any person.” The only way to avoid the rule when buying or selling securities is to also avoid any “means or instrumentality of interstate commerce.” So, if you can do the whole thing without using a telephone, the mail or the internet, you can escape liability. Not gonna happen.
The long term result, as I predict it, will be that companies raising money in a “private” offering will release information designed to comply with Rule 10b-5. The best guidance we have on how to do that is to comply with the spirit, and perhaps even the letter, of the disclosure requirements that would apply to a registered public offering. This is actually the main justification for having a U.S. lawyer review foreign disclosure documents destined for use in a Rule 144A offering. This is what I mean by de facto regulation. The benefit of casting a wider net through general solicitation and advertising will prompt greater public and regulatory attention, thereby forcing stricter compliance with general antifraud rules and resulting in public-offering caliber disclosure. At least for mainstream, reputable companies.
But what about the short term and less reputable companies? In the short term, the pessimists are probably correct – the JOBS Act is a bonanza for practitioners of fraudulent securities offerings.
– April Showers
You’ve probably been imagining this whole rosy regulatory picture in the framework of companies like Apple, Google or even the next Apple or Google (as yet unknown). The pessimists aren’t worried about those companies. Those companies are real, with real products and services that deliver real value to investors and consumers. The pessimists are more worried about the very, very small companies you never heard of. In fact, most of the companies involved either don’t exist yet or, when they do exist, will be phony shell companies that suck in investor dollars and disappear. In short, the pessimists are worried about a fool and his money.
Sadly, the pessimists are right to worry. Securities fraud accounts for several billion dollars in investor losses every year, not even counting the headline acts of recent years like Bernie Madoff. You can read an overview from the SEC here, or you can look at some old articles of my own here and here. The problem is called “microcap fraud” or “penny stock fraud” because the companies involved have very low share prices. Many are not listed on any exchange and even those that are listed have few investors, a single broker that handles all trades and zero to one independent researcher that follows them. This means that it is easy – way too easy – for management, a major shareholder or the securities broker to manipulate the market. It is not an exaggeration to say that often all of the above, aided by associates in organized crime, cooperate to spread rumors, drive up share prices, sell shares to unsophisticated investors and then dump their own shares at a profit. And that’s just the classic “pump and dump” scheme as depicted in season 2 of The Soprano’s. It really happens. A lot.
The SEC enforcement division is hopelessly outnumbered by the crooks. Allowing organized teams of practiced fraudsters to openly invite unsophisticated investors to sales meetings can only add fuel to the fire. If even one accredited investor (planted by the organizers) buys stock, the whole meeting becomes almost untouchable from a legal standpoint. The additional changes that the JOBS Act makes for crowdfunding and delaying application of the Exchange Act become outright terrifying to anyone who knows the shady underside of our financial markets. Hence the widely divergent views on the likely effects of the JOBS Act. An optimist looks forward to seeing a more vibrant private offering market that, through the magic of efficient market theory, will channel money quickly to the most innovative and competitive new companies. The pessimist looks at the already vibrant fraudulent market and sees it booming even more.