Who should use a crowdfunding vehicle and why

Who Should Use A Crowdfunding Vehicle And Why

On By crowdfundattnyIn Crowdfunding Vehicles, Entrepreneurs, Exchange Act, Reg CF, SEC4 Comments

Most of the time, the SEC writes rules to clarify technical legal issues. When the SEC allowed crowdfunding vehicles, on the other hand, it was in response to a psychological issue, not a legal issue.

Entrepreneurs tempted to raise capital using Reg CF, thereby bypassing VCs and other professional investors, were told by those same VCs and professional investors that Reg CF would “screw up your cap table.” Even though that wasn’t true, many entrepreneurs believed it was true. The SEC gave us crowdfunding vehicles to solve the psychological problem:  with a crowdfunding vehicle, you can put all your Reg CF investors in one entity with one entry on your cap table. 

In that way, using a crowdfunding vehicle for your Reg CF offering is like using a C corporation rather than an LLC. You the entrepreneur might know it’s unnecessary, but if your prospective investors think it’s necessary, then it’s necessary. As I often say only partly tongue-in-cheek, that’s why they call it capitalism.

In fact, there is one reason for using a crowdfunding vehicle beyond the psychological. That’s because of a quirk in section 12(g) of the Securities Exchange Act of 1934.

Section 12(g) of Exchange Act

Section 12(g) of the Exchange Act provides that any company with at least $10 million of assets and a class of equity securities held by at least 2,000 total investors or 500 non-accredited investors of record must provide all the reporting of a fully public company. You don’t want that burden for your startup.

The good news is that Reg CF investors aren’t counted toward the 2,000/500 limits, provided:

  1. The issuer uses a registered transfer agent to keep track of its securities; and 
  2. The issuer has no more than $25 million of assets. 

Most startups will never have $25 million of assets. Most startups will never have 500 non-accredited investors or 2,000 total investors. Some startups will issue debt securities rather than equity securities. But some startups could find themselves subject to full public reporting under section 12(g). 

For those startups, a crowdfunding vehicle makes sense. That because, through a quirk in the rules, if you use a crowdfunding vehicle then the only investors who count toward the 2,000/500 limits are entities, like LLCs and corporations. Individual investors aren’t counted at all, and the assets of the company don’t matter.

Thus, if you’re a startup that might otherwise trigger section 12(g), a crowdfunding vehicle makes sense.

Requirements for Crowdfunding Vehicles

A crowdfunding vehicle must:

  • Have no other business.
  • Not borrow money.
  • Issue only one class of securities.
  • Maintain a one-to-one relationship between the number, denomination, type, and rights of the issuer’s securities it owns and the number, denomination, type, and rights of the securities it issues.
  • Seek instructions from investors with regard to:
    • Voting the issuer’s securities (if they are voting securities).
    • Participating in tender or exchange offers of the issuer.
  • Provide to each investor the right to direct the crowdfunding vehicle to assert the same legal rights the investor would have if he or she had invested directly in the issuer.

Those are requirements, not suggestions. In a later post I’ll explain what they mean. Here, I’ll just point out that some high-volume portals violate some of the requirements routinely, in my always-humble opinion. 

******

NOTE:  Crowdfunding vehicles work only with Reg CF. If you raise money from 127 accredited investors using Rule 506(c), you can’t put them in a separate entity. But don’t worry, it doesn’t have to screw up your cap table. 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Self-hosted Reg CF offerings legal analysis SEC crowdfunding rules

Improving Legal Documents In Crowdfunding: How to Write A Biography For A Disclosure Document

On By crowdfundattnyIn Form C, Legal Documents, Offering Statement, Regulation ALeave a comment

Investors want to know the people running the show. That’s why we always include a brief biography of the principals in a securities disclosure document, whether a Form C, a Private Placement Memorandum, or an Offering Statement. In Regulation A offerings, for example, companies must:

Give a brief account of the business experience during the past five years of each director, executive officer, person nominated or chosen to become a director or executive officer, and each significant employee, including his or her principal occupations and employment during that period and the name and principal business of any corporation or other organization in which such occupations and employment were carried on. When an executive. officer or significant employee has been employed by the issuer for less than five years, a brief explanation must be included as to the nature of the responsibilities undertaken by the individual in prior positions to provide adequate disclosure of this prior business experience. What is required is information relating to the level of the employee’s professional competence, which may include, depending upon the circumstances, such specific information as the size of the operation supervised.

Note the italicized language:  “What is required is information relating to the level of the employee’s professional competence. . . .” I point that out because to often we see business biographies like this:

John Smith is a visionary leader with an unwavering commitment to excellence, known for his dynamic approach to seizing opportunities and delivering unparalleled value. With a forward-thinking mindset and a passion for innovation, he leverages his far-reaching vision to create transformative strategies that align with stakeholder interests. His results-oriented leadership style empowers teams, drives growth, and positions the company for long-term success in a rapidly evolving market landscape. Outside of his professional achievements, Mr. Smith enjoys spending time with his [fourth] wife and three children, traveling to exotic destinations, and pursuing hobbies such as gourmet cooking, marathon running, and landscape photography.

Alas, that has nothing to do with Mr. Smith’s professional competence.

Mr. Smith’s biography should look more like this:

John Smith has more than 25 years of experience in the logistics and supply chain sector, with a track record of leading operational growth and efficiency in both privately held and publicly traded companies. From 2012 to 2021, he served as Chief Operating Officer of MidAtlantic Freight Systems, where he managed a network of five regional distribution centers, implemented a company-wide warehouse automation initiative that reduced order fulfillment times by 30%, and oversaw a workforce of more than 300 employees.

Before that, Mr. Smith was Director of Business Development at Eastern Transport Group, where he negotiated long-term contracts with Fortune 500 clients and led market expansion into three new states, increasing annual revenue by 45% over four years. Earlier in his career, he held senior operations roles at Interstate Logistics and Northstar Supply Chain Solutions, where he specialized in integrating newly acquired facilities and standardizing operational processes across multiple regions.

Mr. Smith holds a B.S. in Business Administration from Rutgers University and an MBA from Temple University’s Fox School of Business. He has extensive experience in vendor contract negotiations, ERP system implementation, transportation network optimization, and capital project management. Over the course of his career, he has built a reputation for data-driven decision-making, disciplined cost control, and the ability to align operational capabilities with long-term strategic goals.

That’s much more useful to investors. And it’s much more impressive, isn’t it?

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Choosing The Right Security For Your Crowdfunding Offering

Choosing The Right Security For Your Crowdfunding Offering

On By crowdfundattnyIn Crowdfunding Offerings, SAFE2 Comments

A company trying to raise capital is faced with a lot of decisions. One of the first is the type of security the company will issue to investors. To newcomers, that decision can seem daunting. In this post I’ll try to make it less so.

I’ll describe the most common types of securities in broad terms. As you read, bear in mind that within each category are an endless number of possible permutations. For example, the preferred stock used by one company might be very different than the preferred stock used by a second company.

Each type of security has advantages and disadvantages and some types might be better for your business than others. You will choose the security that’s right for your offering after speaking with your professional advisors.

Common Stock

Common stock represents the most basic kind of equity ownership of a company. You probably own common stock in your own company.

All other things being equal, the owners of common stock have the right to share in any dividends paid by the company and the right to receive the proceeds if the company is sold or liquidated, after all the company’s creditors have been paid.

A company can have more than one class of common stock – for example, one class could be entitled to vote while another class is not entitled to vote.

Investors almost never want common stock. They want something with economic rights superior to the rights of the company’s founders, i.e., your rights.

Preferred Stock

Preferred stock gets its name because it is usually “preferred” as compared to common stock.  That usually means that holders of preferred stock have a right to receive dividends and the proceeds of a liquidation before holders of the common stock receive anything.

EXAMPLE:  Company X raises capital by selling $1M of preferred stock. Three years later Company X is sold and after paying creditors there is only $900K left. Typically, the holders of the preferred stock would get the whole $900K and the holders of the common stock (typically the founders) would get nothing.

The holders of preferred stock usually have the right to convert their preferred stock into common stock if the common stock becomes valuable.

Sometimes, but not always, the company needs the consent of the holders of the preferred stock to take major corporate actions like amending the Certificate of Incorporation or issuing more securities.

Sometimes, but not always, the holders of preferred stock have the right to vote along with the holders of common stock. 

Preferred stock can come with all kinds of other rights, including these:

  • Preemptive Rights:  The right to participate in any future offering of securities.
  • Anti-Dilution Rights:  The right to receive more shares for free if the company sells shares in the future with a lower price.
  • Participation Rights:  The right to receive more than you invested when the company liquidates, before holders of the common shares receive anything.
  • Dividend Rights:  The right to receive annual dividends.
  • Control Rights:  The right to appoint Directors or otherwise exercise control.
  • Liquidity Rights:  The right to force a sale of the company, or to force the company to buy back the preferred shares.

LLC or Limited Partnership Interests

The ownership interests of limited liability companies and limited partnerships go by all kinds of names, including units, interests, percentage interests, membership interests, and shares. Giving a name to the ownership interests is really up the lawyer who writes the governing agreement for the entity.

Whatever name you use, these are all equity interests, just like the stock of a corporation. And just as a corporation can have common stock and preferred stock, an LLC can have common units and preferred units or common membership interests and preferred membership interests. And the common and preferred ownership interests of an LLC or limited partnership can have exactly the same characteristics as the corporate counterparts, described above.

In fact, an LLC or limited partnership can issue all the other types of securities described here, too.

In fact, another choice facing a startup is whether to use a corporation or an LLC in the first place. I talk about that choice here and explain why Silicon Valley prefers corporations here.

SAFEs

“SAFE” stands for Simple Agreement for Future Equity.

Investors in Silicon Valley grew tired of arguing about the value of a startup where the amount of the investment was small (for them). So they invented the SAFE. A SAFE bypasses valuation, or rather postpones valuation until the company raises a lot more money in the future. The idea is that when the company raises a lot more money in the future the new investors and the company will negotiate the value of the company, and the SAFE investors will piggyback on that. This makes SAFEs faster and simpler than common stock or preferred stock.

EXAMPLE:  A company raises $100,000 by selling SAFEs. Two years later the company raises $2M by selling stock for $10 per share. The SAFEs would convert into 10,000 shares, i.e., the same price paid by the new investors.

Nothing stays that simple for long. Today SAFEs come in in many shapes and varieties. Among other possibilities:

  • Discount:  Sometimes the SAFE investors are entitled to a discount against the price paid by the new investors. If SAFE investors had a 15% discount in the example above, the SAFEs would convert at $8.50 per share, not $10.
  • Valuation Cap:  Sometimes the SAFE includes a maximum conversion price. If the SAFE in the example above included a valuation cap of $1.5M, then the SAFEs would convert at $7.50 per share, not $10.
  • Delayed Conversion:  Sometimes the company can stop the SAFE from converting, even if the company raises more capital.
  • Right to Dividends:  Sometimes the holders of the SAFEs have the right to participate in dividends even before they convert.
  • Payment on Sale:  If the company is sold before the SAFE converts, the holder typically is entitled to receive the greater of the amount she paid for the SAFE or the amount she would receive if the SAFE converted just before the sale. But sometimes she’s entitled to more, e.g., 150% of what she paid.

A Silicon Valley SAFE probably isn’t the best for Crowdfunding. Read about it here.

Convertible Note

When a company issues a Convertible Note, the holder has the right to be repaid, with interest, just like a regular loan, but also has the right to convert the note into equity when and if the company raises a lot more money in the future.

EXAMPLE:  A company raises $100,000 by selling Convertible Notes. The Convertible Notes are due in three years and bear interest at 8%. Two years later the company raises $2M by selling stock for $10 per share. The Convertible Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

If you’ve already read the section about SAFEs, you’ll see that the conversion of a Convertible Note into equity is exactly the same as the conversion of a SAFE into equity. That’s not a coincidence. A SAFE is really just a Convertible Note without the interest rate or the obligation to repay. 

Convertible Notes were once the favored instrument in Silicon Valley but were replaced when SAFEs came along. The idea is that interest is immaterial in the context of a startup investment and that the obligation to repay is illusory because the startup will either be very successful, in which case the Convertible Note will convert to equity, or it will go bust. Today Convertible Notes are rare in the startup ecosystem.

Not surprisingly, all the features of SAFEs described above are also available with Convertible Notes:  conversion discounts, valuation caps, and so forth.

Revenue Sharing Note

A Revenue Sharing Note gives the investor the right to receive a portion of the company’s revenue, regardless of profits.

EXAMPLE:  A company issues a Revenue Sharing Note giving investors the right to receive 5% of the company’s gross revenue for three years or until the investors have received 150% of their investment, whichever happens first. If investors haven’t received 150% of their investment at the end of the third year the company will pay the balance.

For investors, a Revenue Sharing Note offers liquidity, assuming the company is generating revenue. In return, they give up the “grand slam” returns they might get with an equity security.

For the company, a Revenue Sharing Note is less dilutive than equity because the investors will soon be gone – in no more than three years in the example above. Plus, because investors have any interest only in gross revenues and not profits, there should be no disputes over expenses, including the salaries of management. But the company is using valuable cash to pay investors.

Some Revenue Sharing Notes convert to equity, just like SAFEs.

EXAMPLE:  Suppose that, in the example above, investors purchased Revenue Sharing Notes for $100,000. At a time when they have received total distributions of $50,000, the company raises $2M by selling stock for $10 per share. The Revenue Sharing Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

Revenue Sharing Notes make a lot of sense for early-stage companies. I’m surprised they aren’t used more.

Simple Loan

The simplest security of all – simpler than a SAFE, simpler than a Revenue Sharing Note – is a plain vanilla promissory note, where the investor lends money to the company and the company promises to pay it back with interest.

A simple loan is good for the company in the sense that there is no dilution of ownership. On the other hand, the company is obligated to pay the money back on a date certain.

A simple loan is good for the investor in the sense that he or she has the right to repayment, unlike an equity investment. On the other hand, the company might not be able to repay the loan. And if the company is a startup the investor might wonder whether the interest rate on the loan is adequate for the risk of non-payment.

******

Don’t be fooled by labels. You can do anything you want. Just make sure you choose a security that’s right for you and your company.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

how to get rid of artificially low targets in reg cf

How To Get Rid Of Artificially Low Targets In Regulation Crowdfunding

On By crowdfundattnyIn Crowdfunding Portals, Reg CF, SEC, Securities Exchange CommissionLeave a comment

As I’ve explained several times to both readers, I believe artificially low minimums are a huge impediment to Reg CF. A company needs to raise $750,000, sets its target at $10,000, and raises $17,439.98. Poof, that money disappears. The company offsets some of its expenses and the funding portal claims a successful offering.

In my opinion, very few serious investors will participate in such an offering. And because it’s so common, I believe most serious investors just stay away from the industry.

I’ve never heard anyone defend artificially low minimums. What I have heard from both portal and issuers is they need artificially low minimums for financial reasons. The issuer comes to the portal with no money. Both the issuer and the portal plan to use the first dollars raised to market the offering. If we can raise $10,000 and invest in marketing, maybe we can raise $50,000 more. If we raise $50,000 more and invest in marketing, maybe we can raise the rest. 

As my friend Irwin Stein says, a well-planned, well-funded Reg CF offering should succeed. The challenge is that many issuers come to the table without a marketing plan or budget. The issuer and the funding portal bridge the gap by effectively asking early investors to take a lot more risk without telling them about it or compensating them for it. 

Long ago I learned it’s better to deal with reality. If the reality is that the issuer lacks a marketing plan or budget, then rather than hide the ball from early investors, let’s split the offering into two parts. Let’s have a first offering for $50,000 to pay for marketing, then a second offering for $750,000 (or whatever) with a real target, maybe $550,000. The company is saying, “Ideally we’d like $750,000 but we can still manage to execute a viable business plan with $550,000.” 

Investors in the first offering are taking far more risk than investors in the second and should be compensated accordingly. They might get two or three times the shares per $1.00 invested or might even get a different security altogether.

We might find that the company’s most ardent supporters – friends and family – will fund the first round. We would also find, I expect, that companies seeking to raise money for marketing will explain their marketing plans in detail and want to advertise high-quality marketing firms.

Far too often, well-intentioned people look to the SEC or Congress to improve Crowdfunding, only to see their hopes dashed. For example, many people look to the SEC or Congress to improve liquidity in Crowdfunding. Last Autumn I suggested a way that portals and issuers could ensure liquidity themselves. I have a client doing that right now. 

We can do the same with artificially low minimums. They’re bad for investors and bad for the industry. And we don’t need them.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

shark tank for regulation crowdfunding

Shark Tank For Regulation Crowdfunding?

On By crowdfundattnyIn Reg CF, Regulation CF, Rule 2042 Comments

I’ve been asked by more than a handful of entrepreneurs about using Reg CF in a Shark Tank format. The founder appears in a TV studio with experienced investors, who pepper her with questions. If viewers like what they see, they scan a QR code at the bottom left, which takes them through the Reg CF investment process.

Non-accredited investors getting easy access to great startups, agnostic as to geography. Exactly what the JOBS Act wanted. 

I’ve had to tell each of those entrepreneurs No.

Each entrepreneur thought I was the bad guy, but the real bad guy is Rule 204, the Reg CF advertising rule. Rule 204 gives a company raising money two choices for advertising outside the funding portal. One, you can say anything you want as long as you don’t mention any of the six “terms of the offering.” Two, you can mention the terms of the offering but say almost nothing else, just the company’s name, address, phone number, and URL, and a brief description of the business (i.e., a “tombstone” ad).

The six deadly “terms of the offering” are:

  1. How much you’re trying to raise
  1. What kind of securities you’re selling (e.g., stock or SAFE)
  1. The price of the securities
  1. How you plan to use the money
  1. The closing date of your offering
  1. How much you’ve raised to date

Now imagine the founder answering questions in the studio. She can say anything she wants about the product, about herself, her team of advisors, the market, the social benefits of the company, all that stuff. Even with careful scripting, however, it’s unrealistic to think she can answer questions accurately and generate enthusiasm in the audience (which is the point) without mentioning any of those six items. Maybe a founder can do it here and there, but you wouldn’t bet your TV show on it.

The purpose of Rule 204 is to ensure that every Reg CF investor gets the same information as every other investor. The regulations want everything about the company and the offering to be in one place:  the funding portal. They don’t want someone who watches your TV show to know either more or less than someone who doesn’t.

Personally, I think Rule 204 is misguided. If there’s a risk that someone who watches your TV show will know either more or less than someone who doesn’t, you can (i) post a video of the TV show on the funding portal, and (ii) make sure TV viewers invest through the funding portal’s platform, where they can see everything. Eliminating Rule 204 would invigorate the Reg CF market without hurting investors.

Eliminate Rule 204 and stop issuers and portals from using artificially low minimums. That’s my platform for 2026.

In the meantime, I’m afraid a Shark Tank for Reg CF isn’t going to work.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com


Perks of crowdfunding in Delaware state

Another Reason To Use Delaware for Crowdfunding

On By crowdfundattnyIn Delaware, Delaware Crowdfunding, IDCsLeave a comment

Long ago, I posted about the advantages of using a Delaware entity. If you’re Crowdfunding in the oil and gas industry, there’s another.

The U.S. tax code provides for special treatment of expenses associated with drilling wells, things like labor costs and site preparation, known as “intangible drilling costs,” or “IDCs.” Under general tax principles, a taxpayer would be required to capitalize IDCs and amortize them over time, just as you would depreciate the costs of building an industrial complex. But §263(c) of the code allows taxpayers to deduct IDCs right away, rather than amortize them over time. That’s a significant economic advantage.

Section 469 of the code goes one step farther. In general, §469 prevents investors from deducting losses incurred in a “passive activity,” like investing in an industrial complex, against wages or other income from other sources. But §469(c)(3)(A) provides:

The term “passive activity” shall not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest.

Thus, §263(c) allows taxpayers to deduct IDCs immediately, and §469(c)(3)(A) allows even passive Crowdfunding investors to deduct their share provided they hold their interest through an entity that does not limit their liability.

This is where Delaware has the advantage.

In Delaware, as in every other state, the general rule is that the members of a limited liability company are not personally liable for obligations of the entity. Section 303(a) of the Delaware statute provides:

Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.

Unlike other states, however, Delaware adds another statute immediately afterward, §303(b):

Notwithstanding the provisions of subsection (a) of this section, under a limited liability company agreement or under another agreement, a member or manager may agree to be obligated personally for any or all of the debts, obligations and liabilities of the limited liability company.

By contrast, Texas (where many oil and gas firms operate) includes a statute providing for the limited liability of members (§114) but does not explicitly allow that rule to be changed by an Operating Agreement. 

In my opinion, Delaware §303(b) makes it much easier to conclude that, with the right provisions in the Operating Agreement, a Delaware LLC can be “an entity which does not limit the liability of the taxpayer.” Under the Texas statute, it is probably possible to provide for personal liability, but the absence of an explicit statutory exception makes the argument under §469(c)(3)(A) much more difficult.

Let me know if you’d like to see the appropriate Operating Agreement provisions.

Questions? Let me know.

Lawyers and AI

Lawyers And Artificial Intelligence: An Update

On By crowdfundattnyIn AI, Crowdfunding, PredictionsLeave a comment

I posted about lawyers and artificial intelligence in late 2023, predicting that AI tools would drive down the cost of legal services while making high-quality legal service available to more people. The great thing about predictions like that is that nobody can prove you were wrong until it’s too late. So far, however, it hasn’t happened.

I thought AI would enter the legal world through “intermediated” channels like Westlaw. With their enormous, curated databases of court cases, administrative rulings, and other source materials, as well as libraries of excellent legal forms drafted by top-notch lawyers, I expected companies like Westlaw to race quickly to the top, leaving “brute strength” tools like ChatGPT behind.

Since then, I’ve tried just about every AI tool on the market, including the most recent version of Westlaw’s AI tool, CoCounsel. Beginning each demonstration with high hopes, I am always left with great disappointment. 

Here are some things I’d expect from an AI tool for business lawyers:

  • Review Documents:  The tool should analyze an Asset Purchase Agreement or Operating Agreement and tell me (i) how it differs from “market” terms, and (ii) how it should be changed for the benefit of my client.
  • Summarize Documents:  The tool should summarize a legal document. One type of summary would tell me what’s in the document, at any level of detail I want. Another would prepare a summary I can use in an Offering Circular (e.g., “Summary of Management Agreement”).
  • Search Documents:  I’ve drafted approximately seven million Operating Agreements. If I’m looking for a clause I used two years ago, the tool should be able to find it.
  • Improve Documents:  The tool should review my document and point out ambiguities, inconsistencies, mistaken references, and logical gaps. 
  • Draft Sections of Documents:  If I’m drafting an IP License Agreement and need a section saying the Licensee is responsible for prosecuting infringement claims, the tool should produce one with a simple prompt.
  • Draft Whole Documents:  If I need a Rule 144 opinion, the tool should take me through the steps of preparing one, including the Certification from my client.
  • Legal Research:  The tool should vastly improve the process of legal research.
  • Reserve Flights:  Not necessary. 

In the earliest stages, I don’t expect an AI tool to produce great results. During a recent demonstration, the sales rep said, “You should view this as the work of a second-year lawyer.” Unfortunately, it was more like the work of a high school junior.

The good news is that brute strength tools like ChatGPT have improved dramatically. You still can’t rely on them – recently ChatGPT produced a quote from a court case speaking directly to my issue, but when I checked (always check), the quote was hallucinated – they are better than the intermediated tools, so far. 

When ChatGPT was released, many experts predicted that lawyers were the most vulnerable. Two and a half years later, that hasn’t happened, either. If you’re a lawyer, I guess that’s good news in a different way.

Questions? Let me know.

Crowdfunding

Crowdfunding Loan Participation Interests

On By crowdfundattnyIn Crowdfunding Laws, Loan Participation Interests, Rule 10b-5Leave a comment

Company A wants to borrow $1 billion and approaches Bank X. Bank X says sure, we’ll lend you $300 million ourselves and get the rest from other institutions. Bank X then approaches banks, insurance companies, and other lenders, raising the full $1 billion. Each lender holds a piece of the $1 billion loan, as if holding a separate promissory note. The pieces they hold are called “loan participation interests.”

The market for loan participation interests is gigantic and received a gigantic boost in 2023 when the Second Circuit Court of Appeals, in a case called Kirschner v. JP Morgan Chase Bank, N.A., decided that loan participation interests generally are not “securities” for purposes of the U.S. securities laws.

To illustrate why that matters, imagine that when Company A approached Bank X, Bank X formed a limited partnership, naming itself as general partner and offering limited partnership interests to the other banks, insurance companies, and other lenders. Those limited partnership interests (probably) are securities. And that means the other banks, insurance companies, and other lenders can sue Bank X for securities law violations, including violations of Rule 10b-5 (material misstatements or omissions).

The gigantic market for loan participation interests breathed a gigantic sigh of relief at the decision in Kirschner v. JP Morgan Chase Bank, N.A. Today, some entrepreneurs are taking the decision one step farther. Reading law firm blogs captioned “Loan Participation Interests Are Not Securities,” these entrepreneurs are offering loan participation interests to the public in Crowdfunding-like offerings, without bothering with securities laws. Unfortunately, this one step farther might be a step too far.

If we ignore the blog captions and look at the case itself, we see there is no bright-line rule. To determine whether the loan participation interests were securities, the court in Kirschner v. JP Morgan Chase Bank, N.A. relied on a case called Reves v. Ernst & Young, where the Supreme Court created a four-part test to determine whether a given loan participation interest (or promissory note generally) is a security. The decision balanced on the second test:  the “plan of distribution,” meaning how and to whom the interests were sold. The court stated, “This factor weighs against determining that a [loan participation interests] is a security if there are limitations in place that ‘work to prevent the [loan participation interests] from being sold to the general public.’”

In the case before it, the court found that the loan participation interests were offered only to “sophisticated institutional entities.” Hence, the court concluded that “This allocation process was not a ‘broad-based, unrestricted sale to the general investing public.’” No sale to the general investing public, no security.

In the Crowdfunding-like offerings I’ve seen, loan participation interests are offered to “sophisticated investors.” No doubt they hope to fall within the “sophisticated” language of the Kirschner v. JP Morgan Chase Bank, N.A. decision. But the decision doesn’t say just “sophisticated.” It says, “sophisticated institutional entities.” In the jargon of Regulation D offerings, a doctor with two real estate investments is often referred to as “sophisticated,” but under Rule 506(b)(2)(ii), that just means she “has such knowledge and experience in financial and business matters that she is capable of evaluating the merits and risks of the prospective investment.” The doctor is a far cry from a “sophisticated institutional entity.”

For that matter, selling loan participation interests on a website accessible to everyone seems very close to a “sale to the general public,” exactly what the court in Kirschner v. JP Morgan Chase Bank, N.A. was watching out for.

The blog caption “Loan Participation Interests Are Not Securities” would have been more accurate saying “Loan Participation Interests Are Not Securities If Sold to Sophisticated Institutions” or even “Loan Participation Interests Are Securities Unless Sold to Sophisticated Institutions” or even “Alert:  Loan Participation Interests Sold Through Crowdfunding Are Securities.”

Websites selling loan participation interests to the public – even to the “sophisticated” public – are taking great risks. By selling unregistered, non-exempt securities, they risk lawsuits from unhappy investors, both as a company and as individuals. They also risk enforcement actions by the SEC, actions that could leave the company and the individuals branded as “bad actors” for the next 10 years.

Questions? Let me know.

SEC Relaxes Accredited Investor Verification Rule For Wealthy People

SEC Relaxes Accredited Investor Verification Rule For Wealthy People

On By crowdfundattnyIn Investor, Investor Verification, Rule 506(c), SEC2 Comments

An issuer raising capital using Rule 506(c) must take “reasonable steps” to verify that all the investors are accredited. Until now, that has normally meant using a third party like VerifyInvestor, which in turn gets a letter from the investor’s accountant. Now it’s going to be a little easier, at least for investors writing big checks.

In a private no-action letter, the SEC allowed the issuer to verify investors without looking at the investor’s tax returns, seeing a letter from the investor’s accountant, or using any of the other methods described in the regulations under Rule 506(c) if:

  • The investor is writing a big enough check — $200,000 for an individual and $1 million for an entity; and
  • The investor promises that he, she, or it is accredited and has not financed the investment through a third party; and
  • The issuer does not have actual knowledge of any facts indicating that the investor is not accredited or has financed the investment.

Technically, the no-action letter doesn’t have the same force as a statute or a regulation. It does, however, reflect the view of the staff of the SEC. Issuers and their lawyers generally can rely on no-action letters, with the understanding that the staff could decide to withdraw or modify its position at any time.

Verifying that an investor is accredited was already so easy, the question is why anyone bothered to ask for this no-action letter. I’m afraid the answer is that growing income and wealth disparities in this country. In some socio-economic circles and for some funds, everyone writes big checks, just as everyone is a “qualified purchaser” for purposes of section 3(c)(7) of the Investment Company Act. The result of the no-action letter is that for that segment of American society, the verification rules no longer exist. 

Two sets of rules, one for the wealthy, another for everyone else. I certainly understand the logic of the no-action letter, but I’m not sure it’s healthy in a macro sense. 

Questions? Let me know.

title III crowdfunding outline for portals and issuers

The Crowdfunding Bad Actors Rule: Applying For A Waiver

On By crowdfundattnyIn Applying For A Waiver, Bad Actors Rule, Reg CF, Regulation A, Regulation CFLeave a comment

Reg CF, Rule 506(c), and Regulation A all include what have come to be known as “bad actor” rules, codified in 17 CFR §227.503, 17 CFR §230.506(d), and 17 CFR §230.262. In each case, the rule provides that the company can’t use the exemption in question to raise capital if the company itself or certain people affiliated with the company (directors, officers, etc.) have violated certain securities-related laws.

(The bad actor rules don’t apply to investors!)

In each case, the rule allows a company to apply for a waiver. The waiver provisions are codified in 17 CFR §227.503(b)(2), 17 CFR §230.506(d)(2)(ii), and 17 CFR §230.262(b)(2). Each provides for waiver “Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied.”

The SEC Has Complete Discretion

The SEC has identified some factors it will consider but, in truth, whether it is “necessary under the circumstances that an exemption be denied” is highly ambiguous and therefore highly subjective. As a result, the SEC has enormous discretion whether to grant waivers. Faced with two waiver requests with similar facts, the SEC might reach different conclusions. 

What Factors Matter

With that said, the SEC has identified the following factors, for now:

  • Did the Violation Involve the Sale of Securities?  An individual can become a bad actor without violating securities laws – for example, if a state regulator prohibits her from being associated with savings and loan associations. The SEC might be more inclined to give her a waiver, as compared to a person found guilty of having violated federal securities laws.
  • Did the Violation Involve Bad Intent?  Some violations involve bad intent (in legalese, “scienter”), like the intentional failure to disclose important information to investors. The SEC is less likely to grant waivers in those cases than where the violation was technical and unintentional, like the inadvertent failure to file a report.
  • Who Was Responsible for the Misconduct?  Suppose that while Mr. X was its Managing Partner, Company Y engaged in conduct causing it to become a bad actor, and that Mr. X was responsible. Two years later, Mr. X is no longer with Company Y. The SEC is more likely grant Company Y a waiver than if Mr. X were still at the helm. 
  • Is the Culture of the Company Good or Bad?  Underlining that waiver requests are highly subjective, the SEC believes that, where the bad actor is an entity rather than individual, it should take into account the culture, or “tone at the top,” of the entity. If the C-suite executives are trying to comply, the SEC would be more likely to grant a waiver than if they have obstructed the SEC’s investigations.
  • How Long did the Misconduct Last?  If the misconduct was brief, even an isolated event, the SEC would be more inclined to rule favorably than if it occurred over an extended period.
  • What Remedial Steps Have Been Taken?  The SEC will consider “what remedial measures the party seeking the waiver has taken to address the misconduct, when those remedial measures began, and whether those measures are likely to prevent a recurrence of the misconduct and mitigate the possibility of future violations.” Remedial steps could include (i) improving internal training, (ii) adopting or revising policies and procedures, (iii) improving internal controls, (iv) terminating employees responsible for the misconduct, and (v) completing educational courses. I believe the most effective remedial action, from the SEC’s perspective, would be to hire an outside compliance consultant, take her recommendations seriously, and implement as many as possible. 
  • Will Bad Things Happen if the Waiver is Denied?  The SEC will consider who will be hurt if the waiver is denied, and how badly. For example, suppose Company XYZ has already raised $50 million from 2,700 investors for a real estate development, using Regulation A. It needs to raise $5 million more using Rule 506(b) but has been designated a bad actor. If it is unable to raise the additional capital all the existing investors will lose their money. The SEC would take the potential harm to existing investors into account, along with other factors.

The SEC has also stated that it might develop a longer and more objective list in the future, based on its experience with actual waiver requests.

Waivers Are Not Black and White

The SEC can say No. It can also say Yes, but with conditions. For example, it might require additional disclosure. It might require additional notices to investors. It might limit the scope or term of the offering(s) for which a waiver is requested. In one instance, the SEC granted the waiver provided that (i) the applicant would retain an independent consultant and submit a written report, (ii) the applicant would implement all the consultant’s recommendations or obtain the SEC’s consent to alternatives, and (iii) the initial waiver would last for only 30 months, with the opportunity to request an extension.

You Might Not Need a Waiver

The bad actor rules apply to offerings under Rule 506, Regulation A, and Reg CF (they also apply to offerings under Rule 505, but that’s not Crowdfunding). Rule 506, Regulation A, and Reg CF are exemptions to the general rule, set forth in section 5 of the Securities Act of 1933, that every time you raise money from investors you have to conduct a full-blown IPO. 

But they are not the only exemptions. Section 4(a)(2) of the Securities Act still provides an exemption for “transactions by an issuer not involving any public offering.” In the early days of our securities laws, the ambiguity of the italicized language led to an enormous amount of litigation, which in turn led the SEC to create some of the exemptions, or “safe harbors,” used regularly today.

But the language is still there and, despite the ambiguity, there is no doubt that exempt offerings can be conducted without relying on Rule 506, Regulation A, or Reg CF. Consider Company XYZ above, which needs $5 million to complete its real estate development. If Company XYZ knows (has an existing relationship with) five wealthy investors each willing to write a $1 million check, it can forego the waiver request.

How to Apply 

Written requests for waivers should explain in detail (i) how the person came to be treated as a bad actor, (ii) her background in the securities industry and otherwise, and (iii) the nature of the offering(s) for which the waiver is sought. Is it a single real estate syndication under Rule 506? A large fund raising capital using Regulation A? A private equity fund raising capital from only qualified purchasers, i.e., people with more than $5 million of investable assets?

Most importantly, the request should explain why disqualification is not necessary. A request that amounts to “He’s a really great person and promises to do better this time” will be denied. A request should correlate with the factors identified by the SEC and identify any other objective factors showing that what happened in the past has little or no bearing on the new offerings. 

Waiver requests should be sent to:

Sebastian Gomez Abero, Chief
Office of Small Business Policy
Division of Corporation Finance
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, DC 20549-3628

Confidentiality

Requests for waivers become public documents, just like requests for no-action letters. If you want parts of your waiver request to be treated as confidential, you can ask for confidential treatment separately. Be prepared for the SEC to say No, whereupon you will decide whether to withdraw the request.

Questions? Let me know.