Tag: crowdfunding attorney

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.

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.

Title III Crowdfunding

Crowdfunding And The Investment Company Act

On By crowdfundattnyIn Crowdfunding, ICA, Investment Company Act, JOBS ActLeave a comment

I speak with lots of people about Crowdfunding and write this blog to answer questions they ask. I’ve had hundreds of conversations that start with Crowdfunding and end up with the Investment Company Act. I hope this post will help clarify the relationship between the two.

The Investment Company Act of 1940

Many entrepreneurs have never heard of the Investment Company Act, or ICA, so that part of my conversations begins with a short primer.

Think of a mutual fund, a company that exists only to invest in stock of other companies. That’s an investment company.  Unfortunately, the definition of “investment company” in the ICA is so broad it sweeps in many companies that would never think of themselves as mutual funds. Any company holding stock in another company can be treated as an investment company. 

Investment companies are subject to so many rules and expensive regulations, unless you’re a mutual fund you don’t want to be treated as an investment company.

Suppose a real estate sponsor forms ABC LLC to collect 87 investors, and ABC  LLC invests in the entity that owns the real estate, i.e., owns stock of one company. ABC LLC is an investment company and must comply with all the rules and regulations!  Suppose you and three friends form STU LLC to invest in the stock market together. You have an investment company and must comply with all the rules and regulations! Suppose XYZ LLC raises money from 220 people to invest in startups. XYZ LLC is an investment company and must comply with all the rules and regulations!

Unless, that is, ABC LLC, STU LLC, and XYZ LLC qualify for one of the exemptions describe below.

Common Exemptions

A Company with No More Than 100 Owners

A company with no more than 100 owners is exempt from the ICA. ABC LLC and STU LLC fall within this exemption.

A Venture Capital Fund with No More Than 250 Owners

A venture capital fund with no more than 250 owners is exempt from the ICA. A “venture capital fund” means a fund that holds itself out as a venture capital fund and:

  • Raises no more than $10,000,000;
  • Invests no more than 20% of its capital contributions in any single investments;
  • Doesn’t borrow money; and
  • Doesn’t give investors the right to withdraw, redeem or require the repurchase of their ownership interests.

Depending on its terms, XYZ LLC might fall within this exemption.

A Company with Only Wealthy Investors

A company where each investor is a “qualified purchaser” is exempt from the ICA. A qualified purchaser is, in general, an individual with at least $5,000,000 of investments.

ABC LLC, STU LLC, and XYZ LLC could be eligible for this exemption.

NOTE:  American securities laws have always distinguished between people who are wealthy and people who are not. The theory is that wealthy people, who can hire lawyers and accountants and possibly are smarter, don’t need the protection of the government while other people do. We see the theory in practice most commonly with the different treatment of accredited vs. non-accredited investors. With this exemption to the ICA, we see the theory taken one step farther. 

Intersection with Crowdfunding

These are the key points of intersection between Crowdfunding and the ICA:

The ICA Prohibits Many Good Investment Ideas 

I can’t count how many entrepreneurs have proposed a great idea, only to have me say it can’t be done because of the ICA. For example, suppose you believe in startup culture and want to give more Americans the chance to participate. You know that investing in just one startup is very risky, so you propose to raise money from hundreds of people and invest in 20 startups, a million dollars each.

You call me and I tell you that you can’t. Or more exactly, you can, but only if your hundreds of people are wealthy, which defeats the purpose. 

Neither Reg CF nor Regulation A can be Used by Investment Companies

Alright, you say, suppose I’m willing to limit the number of investors to 250, all non-accredited, raise $10 million rather than $20 million, and otherwise meet the requirements of a venture capital fund. Can I do that?

Yes! Or rather, No! 

Under that structure, your entity would fit within the ICA exemption described above. But to raise the $10 million, you have to find an offering exemption. The general rule, set forth in section 5 of the Securities Act of 1933, is that every time you raise money from investors you have to conduct a full-blown IPO. The most common offering types –Rule 506, Reg CF, and so forth – are exemptions from that rule. Which will you use for your new fund?

You can’t use Rule 506(c) because it doesn’t allow non-accredited investors. You can’t use Rule 506(b) because (i) it allows only 35 non-accredited investors, and (ii) it doesn’t allow advertising. And you can’t use Reg CF or Regulation A because they can’t be used by investment companies. With no offering exemptions available, the answer is No, you can’t do it. 

Hold on, you say. I understand that Reg CF and Regulation A can’t be used by an investment company, but didn’t you tell me five minutes ago that my venture fund won’t be treated as an investment company if I follow the rules? Are you experiencing dementia at such an early age, with such youthful features?

Possibly, but that’s not what’s going on here. Unfortunately, neither Reg CF nor Regulation A can be used by a company that would be an investment company if not for the three exemptions I described above. I didn’t say your fund wouldn’t be an investment company, I said it wouldn’t be subject to all the expensive rules and regulations of the ICA.  

It’s like a trick the law plays on you. ABC LLC STU LLC, and XYZ LLC will have “IC” emblazoned on their chests forever. 

The ICA Exemptions and the Offering Exemptions are Apples and Oranges 

People will say “I know I can’t have more than 100 non-accredited investors” or “Am I still subject to the Investment Company Act if I use Rule 506(c)?” 

Those are non-sequiturs. On one side of the fence sits the Investment Company Act of 1940 and its exemptions. On the other side of the fence sits the Securities Act of 1933 and its exemptions. The exemptions for one having nothing to do with the exemptions for the other. They aren’t friends.

Thus:

  • The ICA exemptions apply no matter how you raise the money. If you’re relying on the 100-owner exemption, for example, you can raise the money from 100 qualified purchasers, from 100 accredited investors, from 100 non-accredited investors, or a mix of investors. But you must qualify under one of the offering exemptions separately.
  • Of the offering exemptions commonly used, you can use Rule 506(b) (no advertising, up to 35 non-accredited investors) or Rule 506(c) (no non-accredited investors, unlimited advertising) without thinking about the ICA. But if you want to use Reg CF or Regulation A, you have to think about the ICA a lot.

Every conversation about Crowdfunding should include time for the Investment Company Act. Beware!

Questions? Let me know.

new risk factors for crowdfunding and beyond

Trump II: New Risks Factors for Crowdfunding and Beyond

On By crowdfundattnyIn Crowdfunding, Risk Factor, Tariffs, Trump AdministrationLeave a comment
New risk factors for crowdfunding & beyond

Disclosure is at the heart of the U.S. securities laws, and of all the information that can be disclosed, the most important are the risks associated with the investment. That’s why every disclosure document, from the most humble Private Placement Memorandum to the most extensive S-1, includes a list of risk factors.

Some risks are general: the risk that the business might be affected by another pandemic. Some are technical: the risk that our new technology might not work. Some are legal:  the risk that our product infringes on a patent that belongs to someone else.

Whatever their political persuasion, lawyers who draft disclosure documents should now include risks associated with the new Administration. Different businesses will be subject to different risks, but here is a partial list:

  • Risk of Higher Inflation and Interest Rates:  The new Administration has imposed tariffs on Canada, Mexico, and China, and is threatening tariffs on other allies, including the European Union. According to economists, the cost of tariffs will fall on American consumers, raising prices for a large number of goods and thereby fueling inflation. At the same time, the Administration is proposing large tax cuts funded by higher federal budget deficits, which will also contribute to inflation. The Federal Reserve has struggled to bring inflation down to its 2% target, and these policies will likely lead to interest rates h igher than they would have been otherwise.
  • Risk of Labor Shortages:  The new Administration is cracking down on undocumented immigrants, seeking to deport millions by force. Undocumented immigrants make up approximately 40% of the American agricultural labor market, approximately 15% – 25% of the housing labor market, and approximately 20% of the food services labor market, among others. The absence of these workers would cause acute shortages, leading to higher prices and scarcity.
  • Risk of Future Pandemics:  The COVID-19 pandemic in 2020 was devastating for many industries and for the American economy as a whole. The new Administration is populated by “vaccine skeptics,” chief among them Robert F. Kennedy, Jr., who has propagated misinformation not only about COVID vaccines but about vaccines of all kinds, claiming without evidence that childhood vaccines cause autism and opposing vaccines for illnesses ranging from measles to polio. As the Secretary of Health and Human Services, Mr. Kennedy has already taken action against vaccine research, just as the Administration is defunding scientific research generally. These actions increase the risk of another pandemic.
  • Risks to Agricultural Sector:  The American agricultural sector depends heavily on exports, including exports to China. With China now retaliating against the Administration’s tariffs, and the possible loss of almost half its workforce, the agricultural sector could face severe impacts.
  • Risks to Housing Sector:  The American housing industry contributes approximately $1.2 trillion annually, or about 4.5% of America’s gross domestic product. Tariffs imposed on Canadian exports, retaliation by Canada and other countries, increases in interest rates caused by Administration policies, and the possible loss of approximately 20% of its workforce could damage the housing sector severely.
  • Risks Associated with Government Closures:  The new Administration has slashed some government spending, including spending mandated by Congress, in ways that could disrupt the economy or specific industries. For example, in the weeks that followed a fatal midair collision near Reagan National Airport, the Administration announced a reduction in funding for the Federal Aeronautics Administration, which controls flight safety. These cuts could lead to more travel delays and possibly more fatalities, which would have negative effects on the economy.
  • Risk of Government Action Concerning DEI Initiatives:  The new Administration has moved aggressively against initiatives favoring “diversity, equity, and inclusion.” A project that relies on federal funding for any such initiatives will be affected adversely.
  • Risk of Climate Change:  Climate change (aka “global warming”) caused by human activity is already imposing costs and risks for the American economy, including unusual and unpredictable storms, droughts, and other weather-related events. The new Administration has moved aggressively against initiatives to address climate change, like alternative energy, removing mention of “climate change” from government websites, and defunding the National Oceanic and Atmospheric Administration, in favor of carbon-based energy. These actions will increase the rate of global warming and the associated risks.
  • Risks of Legal and Economic Uncertainty:  The new Administration has announced that it will not enforce laws it does not like, such as the Tik-Tok ban, while also putting in the hands of the White House decisions that have historically been made by administrative agencies like the Securities and Exchange Commission. The Administration has also reversed itself on important issues like tariffs, then reversed the reversals. Economic and legal uncertainty can create a climate where businesses are reluctant to invest, increasing the cost of capital and adding to overall economic risks.
  • Risk of Economic Disruption from Tariffs:  Facing a deepening depression, the administration of Herbert Hoover signed into the law the Smoot-Hawley Tariff Act of 1930, which raised tariffs on imported goods. That statute is widely regarded as having worsened, or even caused, the Great Depression by stifling international trade. The steep tariffs imposed by the new Administration could have a similar effect, or even worse.  World economies are far more connected today than they were in 1930. Everything from iPhones to automobiles are made not just in one country but in many. Canada, Mexico, and China have all announced plans to retaliate against the U.S., and a series of tit-for-tat actions could unravel the free trade networks that have been at the foundation of economic growth for 80 years. Any such disruption increases the risk of recession, if not worse.
  • Risks of Recession:    Consumer sentiment has dropped while expectations for future inflation have risen, even before consumers feel the impact of higher prices caused by tariffs. The yield on the 10-year treasury bill has also fallen on fears of recession. Labor shortages, higher prices, disruptions to supply chains, the possible scarcity of goods, and economic uncertainty could combine to create a recession, which would adversely affect most businesses.

The purpose of the “Risks of Investing” is to alert prospective investors to risks and thereby reduce the chance of a successful investor lawsuit after the fact. Lawyers will have to decide on a project-by-project basis whether these and other policy-related risks should be disclosed. Few, if any, businesses will go unscathed.

Questions? Let me know.

A Radical Proposal For Liquidity In Crowdfunding Investments

A Radical Proposal For Liquidity In Crowdfunding Investments

On By crowdfundattnyIn Uncategorized7 Comments

Many smart people believe the main impediment to Crowdfunding in general and Reg CF in particular is the lack of liquidity. Who wants to invest without the chance to get out?

I don’t agree. I note that:

  • Plenty of money flows into real estate projects with no guaranty of liquidity.
  • Enormous amounts of money has flowed through Silicon Valley over the last 40 years with no guaranty of liquidity.
  • Even before Crowdfunding and outside Silicon Valley, lots of money flowed into private companies with no guaranty of liquidity.

Nevertheless, I agree the lack of liquidity is important and have a proposal to fix it, for those willing to take some risk.

Too often, in my opinion, proposals to allow liquidity focus on the SEC. For example, smart people propose that the SEC should adopt a rule providing that an online marketplace for Reg CF securities won’t be treated as an “exchange.” 

I don’t agree with that, either. One, the SEC probably doesn’t have that authority. Two, and far more important, it wouldn’t help. As described here and here, the absence of vibrant secondary markets for private securities isn’t because of the law. It’s because private securities are really hard to market and sell. The lack of transparency, the reliance on a tiny management team, the lack of the investor protections built into NASDAQ and other national exchanges, the miniscule market cap and public float – all these things and more make private securities illiquid.

Forget about petitioning the SEC or introducing another “Improvements in Crowdfunding” bill in Congress. Trying to create liquidity by legal fiat is like pushing string.

Funding portals can provide liquidity on their own. A funding portal could simply require every issuer to provide for liquidity in its organizational documents. The organizational documents could provide, for example, that within some period of time, say seven years, the issuer would either (i) buy out investors, or (ii) arrange for an exit, either a cash sale or a merger with a company with publicly traded securities. Only with a majority vote of investors (super majority?) could the deadline be extended.

Even an individual issuer could provide such a guaranty, without a mandate from the funding portal.

Think of the marketing campaigns. “Our company guaranties liquidity!” “Every company on our platform guaranties liquidity!”

For those who think seven years is too long, don’t buy private securities if you might need to sell them sooner. For those who think seven years is too short, write your own blog!

Seriously, the proposal has one big flaw, from the perspective of issuers. I’ve recommended before that Crowdfunding investors shouldn’t have the right to vote. My liquidity proposal, in contrast, gives investors the right to force the sale of the company. That might hamstring the company and, more important, it might inhibit the company’s ability to attract future, large investors.

To address that flaw, should we provide that the right of liquidity goes away if the company raises $X in the future? 

Everything is a tradeoff. If you believe a guaranty of liquidity will open the floodgates of investors, you’ll consider taking the plunge. If you doubt that a guaranty of liquidity will attract investors, on the other hand, then the tradeoff might be too high. But that takes us back to the beginning. If you think liquidity is the key, and you acknowledge that no change in the law will get us there, a proposal like this could be an option worth considering. 

Questions? Let me know.

Crowdfunding Legal Links

Supreme Court Curbs SEC Enforcement Actions, And That’s Not All

On By crowdfundattnyIn Reg CF, SEC1 Comment

Last week, in a 6-3 opinion, the U.S. Supreme Court held that the SEC must use the regular federal court system, not its internal administrative proceedings, in an antifraud suit against an investment adviser seeking civil damages. The Court ruled that litigating the case through the SEC’s internal proceedings violated the defendants right to a jury trial under the Seventh Amendment of the U.S. Constitution.

The case throws into question all pending SEC administrative proceedings. Like most Supreme Court decisions, the opinion in SEC v. Jarkesy leaves important questions open. What about proceedings that do not involve fraud? What about proceedings where the SEC is not seeking civil penalties? 

SEC v. Jarkesy must be read in conjunction with two other Supreme Court decisions issued last week, Ohio v. EPA and Loper Bright Enterprises v. Raimondo. In the former, the Court held that the EPA had overstepped its bounds in interpreting the Clean Air Act. In the later, the Court overturned a 40-year precedent, the “Chevron Doctrine.” This doctrine, established by the Supreme Court in Chevron U.S.A. v. Natural Resources Defense Council in 1977, held that except in unusual cases, courts should defer to the judgment of administrative agencies in interpreting the laws with the jurisdiction of the agencies.

Many have welcomed the trio of decisions, believing they will free individuals and businesses from the biases of the “administrative state.” I am more skeptical.

Take an example close to my heart. As enacted by Congress, the exemption under section 4(a)(6) of the Securities Act of 1933, aka Reg CF, imposed a limit of $1,000,000, which proved completely inadequate. A couple years ago the SEC increased the limit to $5,000,000. Under Loper Bright Enterprises v. Raimondo, I’m not sure the SEC had the power to increase the limit. If someone challenges the limit, he or she might win.

You show me a regulation you don’t like, I’ll show you others you do like. You show me a decision by an SEC administrative law judge you don’t like, I’ll show you a decision by a federal judge, or by the Supreme Court itself, that you hate. Mr. Jarkesy, the investment adviser accused of fraud, might be happy that the administrative proceedings against him are stopped. Will he be better off in federal court?

As I see it, these cases are about a transfer of power away from the Executive branch to the Supreme Court. Chief Justice John Roberts said as much: “Chevron’s presumption is misguided because agencies have no special competence in resolving statutory ambiguities. Courts do.” 

The Chevron Doctrine was born when the Supreme Court realized in 1977 that courts were not equipped to handle the complexities of modern life and would therefore defer to experts. Since then, modern life has become far more complex. All the same decisions will have to be made. Personally, I see no reason to think the Supreme Court will reach better decisions for the environment or for Reg CF than bureaucrats with subject matter expertise will reach. With bureaucrats we hold an election every four years. With the federal court system, never.

One thing I know for sure, the changes will be great for lawyers. Lawyers benefit from change, and in legal terms the changes the Supreme Court made last week are monumental. The federal courts are about to be flooded with claims from every point on the ideological spectrum. There aren’t nearly enough federal judges to handle all the claims the Supreme Court has just invited, but there are plenty of lawyers!

Questions? Let me know.

Four Becomes Three: Regulation A Offerings Are Easier Now

On By crowdfundattnyIn Regulation A, SECLeave a comment

In this blog post from long ago, I wondered whether a company raising money through Regulation A could legally sell directly to investors. On one hand, the law in a handful of states require all sales to be through broker-dealers. On the other hand, those state laws might be invalid under section 18(b) of the Securities Act of 1933.

It looks as if common sense and the market are answering the question without litigation.

Late last year, Florida changed its laws to allow direct sales. Florida is a big state with lots of investors, so that’s a big deal. What we once referred to as four “problems states” has become three:  Texas, New Jersey, and Washington.

In my humble opinion, the state laws don’t make sense. A Regulation A offering is reviewed by the Securities and Exchange Commission through a process much like a public offering. Under federal law, the SEC review is enough to allow sales to both accredited and non-accredited investors. I cannot see a justification for a state to require more protection in the form of a broker-dealer review; in fact, this reasoning makes me think that section 18(b) should override the state laws.  

The state laws also add a very significant cost to a Regulation A offering. I’m not aware of any broker-dealer willing to sell Regulation A securities only to residents of three states. Instead, broker-dealers charge more than 2% of the whole raise. Broker-dealers need to charge these fees to cover their own costs and risks, obviously. By driving up the costs of the offering, however, the state laws undermine a primary goal of Crowdfunding, i.e., to make great investments available to ordinary Americans.

Off the soapbox now.

Of the three remaining problem states, New Jersey is the easiest. You file a form to register as a “dealer” and you’re done.

Washington is hard. Washington also allows registration as a dealer, but in my experience the designated dealer must be an individual who is also a general partner/manager of the issuer. For liability reasons, that might not be acceptable. If in doubt, don’t sell securities in Washington.

Texas also allows registration as a dealer. While Texas generally requires that the individual registering have FINRA licenses, that requirement can be waived. The process can take a couple months.

My recommendation:  register in New Jersey; register in Texas and ask for a waiver (start that process early); and don’t sell in Washington.

If anyone has more current advice or information I’d love to hear it.

Questions? Let me know.