A LOOK AT THE PRACTICAL IMPLICATIONS OF THE NEW JOBS ACT RULES ON PRIVATE OFFERINGS OF SECURITIES

Transcription

1 A LOOK AT THE PRACTICAL IMPLICATIONS OF THE NEW JOBS ACT RULES ON PRIVATE OFFERINGS OF SECURITIES December 4, 2013 Materials Written By: Nicholas J. Bakatsias, JD, LL.M. Carruthers & Roth, P.A. P.O. Box 540 Greensboro, NC (336) *Materials reflect updates to 2012 Carruthers & Roth, P.A. Seminar manuscript titled Promising Rain But Delivering Only Blue Skies A CPA s Guide to the State and Federal Securities Laws, following SEC adoption of the JOBS Act implementing rules 1

2 TABLE OF CONTENTS I. Introduction II. Overview of Securities Regulation Policies A. Balancing Capital Investment Promotion vs. Need for Regulation B. General Overview of Current Registration Requirements C. Passage of the Jobs Act III. What Constitutes a Security? A. In General B. Investments Contracts the Catchall of Securities C. Partnership Interests D. LLC Membership Interests E. Sale of Business Structured as a Stock Sale F. Promissory Notes IV. Overview of the Federal Securities Registration Laws A. Background B. Examination of the Exemptions to Registration 1. The Intrastate Offering Exemption 2. The Private Offering Exemption 3. Regulation A The Small Public Offering Exemption 4. Regulation D Exemptions 5. Who Qualifies as an Accredited Investor 6. Form D Filing V. Overview of the North Carolina Blue Sky Laws A. In General B. Securities under North Carolina Blue Sky Laws C. Registration Requirements D. North Carolina Exemptions E. Notice Filing Requirements F. North Carolina s Direct Participation Rules G. North Carolina Enforcement of Securities Violations VI. Overview of Broker-Dealer Registration Rules A. Introduction B. Federal Broker-Dealer Registration Requirements C. Use of Finders to Attract Investors D. Use of Finders under SEC Scrutiny E. North Carolina s Broker-Dealer Registration Requirements VII. Overview of the Recently Enacted JOBS Act A. In General B. Modifications to Regulation A Offerings C. The New Crowdfunding Exemption 1. In General 2. Issuer Disclosure Requirements 3. Intermediary Rules and Regulations D. Removal of Prohibition on General Solicitation in Rule 506 Offerings E. Requirements of New Rule 506(c) F. F. Bad Actor Disqualification under New Rules 506(d) and (e) G. Advantages of New Rule 506(c) H. Changes to Exchange Act Registration Requirements I. Finding Investors in the New JOBS Act Regime J. Effect of Increased SEC Finder Scrutiny on Trading Platforms K. The Real Crowdfunding Exemption Public Private Offerings VIII. Conclusion 2

3 I. Introduction. It s no secret that revitalizing a slumping economy often requires, among other things, stimulating small business markets with the infusion of capital. Well functioning capital markets enhance the development of the small business community, which in turn spurs job growth and economic recovery. However, when banking institutions are hesitant to provide adequate financing to fledging or struggling companies on reasonable terms, attracting equity capital can be a difficult endeavor for many such small businesses. Consequently, small business owners often look to family and friends, angel investors or third party investment options to solicit the funds needed to finance the start-up and/or growth of their businesses - yet these options have also been limited during the recent destructive recession that has plagued the global economy. In an effort to revive the United States national and state economies and foster responsible job growth, in late 2011, Congress examined various legislative proposals designed to make the capital formation process more efficient and less expensive to aspiring entrepreneurs. While expanding the reach of equity markets to small businesses through the reduction of barriers to capital investment is certainly desirable, an unregulated investment environment can increase the incidence of securities fraud and reduce investor protection. Just as increasing small business investments can provide an economic stimulus and encourage growth in the employment sector when done properly, there is also the possibility of undermining market integrity and punishing Main Street investors if done recklessly. Balancing (i) the need for more accessible and less expensive capital formation options through a less burdensome regulatory environment against (ii) the need to maintain investor protection against fraudulent actors and promote investor confidence, has been the overarching objective of state and federal securities regulations over the last one hundred years or so, particularly leading up to the passage of the JOBS Act discussed below. Under the current regulatory landscape, whenever a business seeks to attract outside capital by selling equity interests to investors, the enterprise basically has two choices: (i) register the securities with the SEC and the applicable state securities authorities, or (ii) find an exemption from registration under the federal and state securities laws. Securities registration can be an extremely time-consuming effort that is often prohibitively expensive for many small businesses, thereby leaving exemption qualification as the more attractive option. As discussed in more detail throughout this paper, if a business does not fit within the parameters of a registration exemption, and fails to properly register the securities, its investors may be able to recover, at a minimum, their entire investment, even if the soliciting business did not intentionally mislead the investors or engage in any other illegal behavior. Given the convoluted nature of the current securities regulation framework, capitalseeking businesses are well advised to seek qualified legal and accounting advice before proceeding with any plan to raise capital through equity sales. In addition to the securities registration laws, businesses that make overly optimistic promises to investors may also find themselves embroiled in an expensive and drawn out securities fraud lawsuit. 3

4 The remainder of this paper will provide an overview of the current securities registration requirements and attendant exemptions with an aim towards assisting small businesses and their professional advisors successfully navigate through the capital formation process. In addition, this manuscript will summarize the key features of the Jumpstart Our Businesses Startups Act (the JOBS Act ), and examine how the recently enacted implementing regulations will impact the private offerings of securities in the future. As posited below, the impact of the new JOBS Act rules on the securities market is likely to be substantial. II. Overview of Securities Regulation Policies A. Balancing Capital Investment Promotion against the Need for Regulation. The title of the prior version of this manuscript ( Promising Rain but Delivering Only Blue Skies ) alluded to the initial efforts of states to find the appropriate balance between investor protection and investment growth within the federal regulatory framework that controlled investment solicitations in the early part of the twentieth century. While the current regulatory canvas is a complimentary regime of both state and federal securities rules, federal authorities initially had a monopoly on regulation until Kansas enacted the first statepromulgated investor protection statutes known as Blue Sky laws in Historians point to the legislative measures designed by Kansas legislators to protect unsuspecting local farmers (or their widows) against wild investment schemes promoting untested contraptions that promised to induce atmospheric rain, but delivered only blue skies 1, as a seminal moment in the history of securities offerings regulation. Unfortunately, the current labyrinth of federal and state rules and regulations restricting the transferability of stock, limited liability company membership interests, and other equity interests in businesses has not made it easy to achieve that balance. For the most part, the federal and state laws do not match up well, and contain widely varying sets of rules, restrictions, safe harbors, and boundaries of which a capital-seeking business must be cognizant. Generally, these regulations are indiscriminate as between large corporations and small, growing businesses, and apply to most businesses forms equally. Dangerously, many small companies (and even their professional advisors) often assume that the Securities and Exchange Commission ("SEC") and the applicable state securities divisions will simply overlook offerings by small companies. Perhaps leading to the enactment of the JOBS Act, as discussed below, many economists and politicians alike argued that advancing the economic recovery required greater access to capital for small businesses with less regulatory oversight. An alarming number of businesses have failed since the near-financial collapse of not as a result of any operational deficiencies or limitations in their ability to competitively operate, but rather as a direct result of their inability to obtain bank loans or other outside capital infusions. The theory promoting deregulation rests on the principal that a more relaxed regulatory environment encourages capital investment yielding high returns and sustained economic growth, since regulatory roadblocks 1 See Fleming, Rick and Bob Webster, A Century of Investor Protection, North American Securities Administration Association (2011). 4

5 impede the ability of mom and pop business to raise the capital needed to survive in the marketplace. On the other hand, proponents of regulation argue that, while opportunities to invest in small businesses should be encouraged, an unregulated securities environment carries high risk and potential loss to unsophisticated investors. 2 Investing in small, and in particular start-up, businesses can be a risky enterprise. Typically, small business equities are illiquid in nature due to the absence of a viable market for investment in their securities. Further, many start-ups have a limited or nonexistent operational history, with unproven business models, unprotected proprietary property, and untested technologies. Accordingly, securities regulators seek to limit these investment opportunities to sophisticated investors capable of understanding the inherent risks underlying speculative investments and with the financial wherewithal to sustain potential losses that could result should the business fail. The overall mission of federal and state securities laws is to promote an environment in which the securities and financial markets function efficiently and without unnecessary regulatory impediments. 3 In light of the tight lending and capital markets pervading our current economy, state and federal legislators are seeking to implement policies that encourage private equity investment in promising and legitimate business opportunities through relaxed registration and reporting requirements, while still providing the safeguards necessary to protect investors against unnecessarily risky or fraudulent investment ventures. Although achieving this balance can undoubtedly be difficult, Congress recently took action to stimulate private investment by relaxing regulations that govern private securities offerings through enactment of the Jumpstart Our Businesses Startups Act (the JOBS Act ) on April 5, The sweeping changes to securities regulation brought about by the promulgation of the JOBS Act are considered in greater detail below. B. General Overview of Current Registration Requirements. Generally, the sale of securities is subject to both state and federal securities registration requirements. Accordingly, a company contemplating the solicitation of private equity must be aware of, and carefully analyze and adhere to, both bodies of law to avoid securities violations. As a basic premise, state Blue Sky laws and federal regulations require that a prospective offeror of securities to the public must register with the SEC and the applicable state securities authorities (typically the securities division of the applicable Secretary of State) before or soon after soliciting potential investors. The registration requirements under the Securities Act of 1933 and the various Blue Sky laws preclude using the means or instrumentalities of interstate commerce to sell unregistered securities unless the offered securities are registered, which can be an expensive and time-consuming enterprise. 2 See Absure, Heath, Legislative Proposals to Facilitate Small Business Capital Formation and Job Growth, Testimony of Arkansas Securities Commissioner Heath Abshure before the House Subcommittee on Capital Markets and Government Sponsored Enterprises (Sept. 21, 2011). 3 See Id. 5

6 Fortunately, the seemingly draconian nature of the registration requirements is tempered by the availability of numerous exemptions and safe harbors available to private equity issuers even more so following the SEC s recent adoption of implementing rules necessary to make many key provisions of the JOBS Act effective. As discussed in more detail below, the exemptions that most commonly benefit private companies are: (i) (ii) (iii) private placement offerings that are available to a limited number of investors over a twelve-month offering period; an intrastate exemption for securities sold only to investors in the same state; and offerings made to investors who satisfy certain net worth requirements defined within the parameters established by Rules 504, 505 and 506 of the Securities Act of Again, the securities registration process is often a burdensome, lengthy, and expensive process, so understanding the exemptions available under various classes of offerings is critically important to most private companies seeking equity investors. Qualifying for one of the registration exemptions examined below significantly simplifies the road to securing capital investment from potential investors. However, the failure of a business to properly register its securities or fall within an available exemption exposes the issuer to possible rescission of the invested funds and/or potential securities fraud allegations. C. Passage of the JOBS Act. In light of the substantial costs and burdens associated with the public sale of securities alluded to above (including expensive SEC registration process, extensive filing requirements and ongoing SEC reporting obligations), most companies seeking to attract capital attempted to qualify for exemption from registration by qualifying for one of the private offering safe harbors permitted under Rule 506 of Regulation D. However, prior to the SEC s recent adoption of final rules required for implementation of key components of the JOBS Act, issuers seeking to raise capital through a private offering of securities faced various restrictions with respect to the manner in which those securities could be offered. Primarily, issuers were hampered in their ability to reach the large pool of potentially interested investors due to the prohibition on general solicitation and general advertising in private securities offerings. Accordingly, many financial market participants welcomed the passage of the JOBS Act in April of 2012, which was reportedly designed to enhance the ability of entrepreneurs and private equity funds to raise capital by reducing barriers to investor solicitation. Among the new provisions enacted to enhance the economic impact of securities offerings generally, several 6

7 significant changes focused primarily on reducing the burdens of private offerings exempt from SEC registration, including lifting the prohibition against general solicitations of potential investors, creating a new crowdfunding exemption to expand the pool of eligible investors in limited offerings, and raising the holder-of-record threshold for registration under the Securities Act of However, notwithstanding the excitement surrounding the potential impact the JOBS Act would have on the securities markets, most of the new rules would not become effective until the SEC promulgated regulations necessary for implementing the JOBS Act provisions. Despite the JOBS Act mandate that the SEC issue such regulations within ninety (90) days for the lift of the ban on general solicitations, and within two hundred seventy (270) days for the crowdfunding exemption, the new provisions still lacked the requisite implementing regulations for over a year after the passage of the JOBS Act, and accordingly, could not be relied upon by issuers seeking to undergo private offerings of their securities. Finally, in July of 2013, the SEC adopted the necessary regulations to implement the new rules, which became effective a few months later as described below. Two salient features of the JOBS Act will likely have a tremendous impact on the manner in which capital is raised in private placement offerings by eliminating many of the disadvantages that previously restricted capital formation efforts of private issuers: (1) the lift on the ban against general solicitation in Rule 506(c) offerings; and (2) increasing the holder-of-record threshold with respect to the number of investors to whom securities can be sold without registration under the 1934 Act. The combined effect of these two key provisions will likely generate a new wave of offerings under Rule 506 of Regulation D, sometimes referred to as publicly offered private offerings. The SEC adopted the amendments necessary for implementation of these two provisions on July 23, 2013 and they became effective on September 23, Significantly, as discussed in more detail below, these offerings qualify as covered securities and thus will generally avoid substantive federal and state regulation. The remainder of this manuscript will explore the various rules, restrictions, safe harbors, and parameters embedded in the state and federal securities regulation landscape and identify exemption opportunities that could greatly increase a company s chances of attracting private capital without violating the federal and state securities laws, especially within the new securities regime parameters created by the passage of the JOBS Act. III. What Constitutes a Security? A. In General. Before diving into the minutia of the securities laws, it is important to first analyze what constitutes a security for purposes of state and federal securities laws, since these rules are 7

8 only implicated when the sale of a security is involved. Under the 1933 Act, a security is defined as: any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 4 Under North Carolina law, a security : "means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract including without limitation any investment contract taking the form of a whiskey warehouse receipt or other investment of money in whiskey or malt beverages; voting-trust certificate; certificate of deposit for a security; certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under a title or lease; viatical settlement contract or any fractional or pooled interest in a viatical settlement contract; or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. "Security" does not include any insurance or endowment policy, funding agreement, as defined in G.S , or annuity contract under which an insurance company promises to pay (i) a fixed sum of money either in a lump sum or periodically for life or for some other specified period, or (ii) benefits or payments or value that vary so as to reflect investment results of any segregated portfolio of investments or of a designated separate account or accounts in which amounts received or retained in connection with a contract have been placed if the delivering or issuing insurance company has currently 4 Securities Act of 1933 (2)(1), 15 U.S.C.A. 77(b)(1). 8

9 satisfied the Commissioner of Insurance that it is in compliance with G.S The definition of a security under the federal laws and the various Blue Sky laws is essentially the same. Obviously, conventional securities such as stocks and bonds are fairly easy to identify. However, less obvious contracts or interests such as promissory notes, oil and gas interests, debentures, tenants in common real property interests, franchise interests, 6 orange groves, 7 condominium interests, 8 and gold and silver bullion interests 9 have all been held to qualify as securities in various contexts. In addition, the Supreme Court has liberally broadened the concept of what constitutes a security by including a catchall category, investment contracts, within its definitional scope. B. Investments Contracts the Catchall of Securities. In the often-cited case of SEC v. W.J. Howey Co., the Supreme Court adopted a flexible approach to the determination of what constitutes an investment contract. 10 In Howey, the Court held that contracts for the sale of Florida citrus groves, coupled with a service contract for maintaining the groves, should be characterized as investment contracts. Providing some guidance highlighting the liberal interpretation adopted by the Supreme Court in identifying an investment contract (and thus a security subject to registration), the decision stated that [a]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. 11 Since the Howey case was decided, many courts have interpreted the common enterprise element of the Howey test to require both horizontal commonality and vertical commonality for an investment contract to exist. Horizontal commonality is satisfied if the putative security involves pooling of funds, sharing of profits, and loss sharing among investors. 12 Vertical commonality is present if the investors expectations and fortunes are dependent on the efforts and expertise of the promoter. 13 C. Partnership Interests. Limited partnership interests are almost universally deemed to be securities under the investment contract definition since they involve investment in a common enterprise with 5 N.C.G.S. 78A-2(11) 6 See SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476 (9 th Cir. 1973). 7 See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). 8 See Sec. Act Release No (Jan. 4, 1973). 9 See SEC v. Great W. Land & Dev., Inc. (D. Ariz. 1965) U.S. 293, 90 L.Ed. 1244, 66 S.Ct (1946) S.Ct. at See SEC v. Life Partners, 87 F.3d 536, (D.C. Cir. 1996). 13 See SEC v. Pickney, 923 F. Supp. 76 (E.D.N.C. 1996). 9

10 profits derived from the efforts of others. 14 In addition, a right of first refusal to purchase a limited partnership interest was held to be an investment contract. 15 On the other hand, general partnership interests and joint venture interests may not always constitute securities because of the rights of general partners to participate in the management of the business. The analysis of whether a general partnership interest constitutes an investment contract centers on whether the partnership agreement leaves such minimal power in the hands of a general partner investor that the interest more closely resembles the relative power hierarchy inherent in a limited partnership. Similarly, a general partnership interest could be an investment contract where the investor lacks the business experience and acumen necessary to appropriately exercise partnership authority, or where the investor-partner is so heavily dependent on the unique entrepreneurial talents of the promoter that such investor cannot meaningfully exercise its partnership interest powers. 16 D. LLC Membership Interests. Limited liability company membership interests are often deemed to be securities, depending on the rights attendant to such interests. Similar to partnership interests, the analysis focuses on the ability of, and the extent to which, the LLC member can meaningfully participate in the management of the business such that he or she is not primarily dependent on the efforts or experience of the promoter or manager to realize profits. 17 As noted below, there is a special rule in North Carolina which establishes a presumption that member-managed limited liability companies with fewer than fifteen (15) members are not securities, while manager-managed interests are securities. In order to not constitute a security, the member-manager must have substantial rights or be expected to provide substantial services to the company. E. Sale of a Business Structured as a Stock Sale. Generally, under the sale of business doctrine, the sale of business through a 100% stock sale to a single purchaser will not be considered a security transaction subject to registration. 18 The rationale supporting this proposition is that the sale of a business fails the Howey test due to (i) the lack of a common enterprise, and (ii) lack of reliance of the purchaser to expect profit realization solely through the efforts of third parties. However, in Landreth Timber Co. v. Landreth, the 9 th Circuit suggested that the sale of 100% of the stock of a business to several purchasers, coupled with post-sale continued and sustained involvement by the seller, 14 See Mayer v. Oil Field Systems Corp., 721 F.2d 59 (2d Cir. 1983). 15 See Lawrence v. Cohn, 932 F. Supp. 564 (S.D.N.Y. 1996). 16 See KBR v. L.A. Smoothie, 1996 WL (E.D. la. Apr. 3, 1996). 17 See SEC v. Parkersburg Wireless Ltd. Liability Company, 156 F.R.D. 259 (D. D.C. 1994). 18 See Chandler v. Kew, Inc., 691 F.2d 443 (10 th Cir. 1982). 10

11 could warrant securities analysis. 19 This is especially true if the facts include the inability to conduct due diligence, projections of future revenues by the seller, and misrepresentations by the seller in the stock purchase agreement. 20 Accordingly, sellers of a business through a stock sale should be wary of warranties and representations made to the purchasers, especially if the seller will remain active in the business post-closing. F. Promissory Notes. Depending on its terms, a promissory note, bond or debenture can also be characterized as an investment contract and thus a security subject to securities enforcement. The Exchange Act of 1934 excludes from the definition of a security any note, draft, or bill of exchange which has a maturity at time of issuance not exceeding nine months. 21 Further, there is a rebuttable presumption that a note with a maturity in excess of nine months is not a security unless it resembles more conventional securities. The Supreme Court has held that a demand note has a maturity exceeding nine months, although there was a strong dissent in this holding. 22 Courts have utilized the risk capital approach in analyzing whether a promissory note constitutes a security. The basic test is whether the lender has contributed risk capital which is subject to the entrepreneurial or managerial efforts of the borrower. 23 In other words, a demand or short-term note will not be a security unless payment is dependent upon the success of a risky enterprise or the parties contemplate indefinite extension of the note or perhaps conversion to stock. 24 The Supreme Court in Arthur Young & Co. v. Reves, provided a list of notes that are typically not considered to be securities. The list includes: (i) consumer financing notes, (ii) notes secured by a mortgage on a home, (iii) a note secured by business assets, (iv) open-account debt notes, and (v) short term notes secured by accounts receivable. 25 The Reves decision also disputed the position that only high-risk notes issued by a financially struggling company are securities and that fixed interest payable on a note is not a return on investment. Ultimately, the determination of whether a promissory note constitutes a security will depend on the note s maturity, stated interest rate, the fixed or variable nature of interest repayment, and the convertibility of the note into stock, among other factors. IV. Overview of the Federal Securities Registration Laws F.2d 1348 (9th Cir. 1984). 20 See Harsco Corp. v. Segui, 91 F.3d 337 (2nd Cir. 1996). 21 Exchange Act 3(a)(10). 22 See Securities Indus. Ass n v. Federal Reserve Bd., 468 U.S. 137 (1984). 23 See Great W. Bank & Trust v. Kotz, 532 F.2d 1252 (9th Cir. 1976). 24 See Arthur Young & Co. v. Reves, 856 F.2d 52 (8th Cir. 1988). 25 Id. 11

12 A. Background. Precipitated by the crippling effects of the Stock Market Crash of 1929 (which was largely attributable to the sale of securities by companies promising substantial profits without disclosing relevant and meaningful information to investors), the United States Congress created the Securities and Exchange Commission to administer the two primary federal laws governing the sale of securities to the public: (1) the Securities Act of 1933 (the Securities Act or the 1933 Act ), and (2) the Securities Exchange Act of 1934 (the Exchange Act or the 1934 Act ). The Securities Act of 1933 basically requires the full disclosure of all material facts necessary to permit potential investors to make an informed investment decision. The 1933 Act also requires companies to register with the SEC by filing a registration statement that includes information germane to investment decisions. Note that the 1933 Act does not require the SEC to evaluate the legitimacy of the offerings or ascertain their appropriateness for investment the Commission must only review the registration documents and determine whether the disclosure requirements were satisfied so that the registration would be deemed effective. The Exchange Act of 1934 requires publicly held companies to file reports and other disclosure documents relevant to their business operations, financial condition, management structure, and their officers, directors and significant shareholders. Prior to the passage of the JOBS Act, the threshold for registration as a public company under the Exchange Act was 500 record holders. The 1934 Act also requires that the company deliver certain information directly to its investors under certain circumstances. Another critical piece of legislation that dramatically affected the securities regulation regime was the enactment of the National Securities Markets Improvement Act of 1996 ( NSMIA ). The importance of this Act is the federal preemption of state registration of offerings made under Rule 506 of Regulation D, thereby stripping much of the regulatory review authority of state securities regulators who, to that point, had routinely policed questionable offering practices. Since congressional adoption of the NSMIA, the use of Rule 506 private placements has increased dramatically. In fact, Rule 506 of Regulation D has been used for more than 90% of all exempt private offerings conducted in the United States and more than 90% of such offerings are limited to accredited investors. 26 It is anticipated that the enactment of the JOBS Act will only serve to increase the incidence of Rule 506 offerings, especially given the lift on the prohibition against general solicitation and the increase in the holder-of-record registration threshold for purposes of the 1934 Exchange Act. Section VII of this paper will explore the likely impact the JOBS Act rules will have on the use of Rule 506 private offerings. B. Examination of the Exemptions to Registration. 26 Campbell, The Wreck on Regulation D, 66 The Business Lawyer 919 (August 2011). 12

13 As stated above, securities offered for sale to the public must either be registered with the SEC under Section 5 of the 1933 Act, or otherwise meet one of the exemptions permitted under the federal securities laws. However, it is important to remember that securities that qualify for an exemption remain subject to both the 1933 and 1934 Acts and cannot be resold unless they are registered or meet another exemption. Due to the substantial time and expense involved in registering a contemplated sale of securities, which is cost prohibitive for many capital seeking businesses, many issuers seek to qualify for an exemption from registration. The registration exemptions include: (1) private offering exemption under Section 4(2) of the Securities Act 27 ; (2) intrastate exemption under Section 3(a)(11); (3) conditional exemptions adopted by SEC not exceeding $5 million under 3(b) of Securities Act; (4) exemption under Section 4(6) of the Securities Act 28 for offerings under $5 million made exclusively to accredited investors ; (5) Rule 146 safe harbor for private offering exemption; (6) Rule 147 intrastate exemptions; (7) Rule 240 exemption under Section 3(b) for offerings not exceeding $100,000; (8) Rule 242 exemption under Section 3(b) for offerings not exceeding $2 million in any 6-month period; (9) Regulation A for public offerings not exceeding $5 million in any 12-month period; and (10) Private offerings conducted under Regulation D of the Securities Act of This section will examine some of these more widely used registration exemptions. 1. The Intrastate Offering Exemption. Under Section 3(a)(11) of the Securities Act, an issuer is not required to register its public offering of securities where all the interested parties, including the issuer and all offerees, are located in one state. The exemption is designed to facilitate the financing of local business operations. In order to qualify for the intrastate exemption, the issuer must: 27 Now designated as Section 4(a)(2) of the Securities Act of 1933 following the passage of the JOBS Act. 28 Now designated as Section 4(5) by Section 944 of the Dodd-Frank Wall Street Reform and Consumer Protection Act signed in to law on July 21,

14 (i) (ii) (iii) be incorporated in the state where the securities are offered; conduct a significant amount of its business in that state; and deliver offers and execute sales only to residents of that state. The Section 3(a)(ii) intrastate exemption is strictly and narrowly construed, such that a sale to a single investor residing outside the home state will result in a loss of the exemption. Further, the exemption could be lost in the event the issuer conducts substantial business, derives a significant amount of its revenues, or holds assets, outside the applicable state where the securities will be offered. In addition, to the extent the offering is a public offering, the issuer must comply with the state blue sky laws. There is no limit on the size of the offering or the number of investors. 2. The Private Offering Exemption A commonly used exemption in the contemplated sale of securities is the private placement codified in Section 4(a)(2) of the 1933 Act 29, which exempts from registration transactions by an issuer not involving a public offering. In order to meet the private offering exemption, the following criteria must be met: (i) (ii) (iii) (iv) the purchasers must be sophisticated investors, i.e., they must have sufficient knowledge and experience in finance and business to evaluate the potential benefits and risks associated with the proposed investment, or they must be able to bear the investment s economic risk; information typically provided in a prospectus must be available and accessible by the purchasers; the investors must agree not to resell or distribute the securities to the public; and the issuer may not use general solicitations or advertising in connection with the offering. By way of comparison, note that the safe harbor exemptions provided by Rule 506 (discussed below) contains objective standards that issuers can rely on to satisfy the criteria above. Issuers are less likely to rely on Section 4(a)(2) to avoid registration when conducting a private offering now that a new safe harbor (Rule 506(c) exemption) permits general solicitation of investors. In addition, North Carolina limited liability company issuers relying on this exemption may have to comply with certain Direct Participation Program ( DPP ) rules discussed below. 3. Regulation A The Small Public Offering Exemption Following the authorization given to the SEC under Section 3(b) of the 1933 Act to exempt small securities offerings, the Commission established Regulation A, which provides a registration exemption for public offerings of securities up to $5,000,000 in any 12-month period. Securities offered pursuant to the Regulation A umbrella can be offered publicly and are 29 Formerly Section 4(2) of the Securities Act of

15 not restricted under the 1933 Act, i.e., they are freely tradeable in secondary markets after the initial offering. The enactment of the JOBS Act required the SEC to create a new exemption often referred to as Regulation A+ which permits offerings up to $50,000,000. However, the new exemption will not be effective until the SEC adopts implementing rules, with respect to which no deadline was imposed on the Commission. The exemption is contingent upon the filing of an offering statement similar to the prospectus required in connection with a registered offering. The offering statement required to be filed with the SEC must include a notification, offering circular, and certain exhibits detailing the underpinnings of the offering. Despite the condition that an offering statement must be filed with the SEC to qualify for the Regulation A and A+ exemptions, the disclosure requirements are less burdensome than those required in connection with a full registration. As a result, a Regulation A offering will prove to be substantially less expensive than a full blown registration, as the legal, accounting, underwriting, and other administrative support needed to satisfy the filing requirements are substantially reduced. For example, (i) the financial statements required to be filed do not need to be audited 30, (ii) there are no reporting obligations under the Exchange Act unless the issuer has more than $10 million in total assets and more than 500 shareholders, 31 (iii) the offering circular can prepared using a simplified question and answer format, and (iv) issuers are afforded the opportunity to test the waters to gauge interest among potential investors prior to committing to the expense associated with the SEC filing. 32 In addition, shareholders of securities offered under the Regulation A exemption can resell up to $1.5 million in a secondary offering under certain circumstances. Regulation A is not available to every issuer, as issuers subject to the 1934 Act s periodic reporting requirements and blank check or development stage companies (those without a specified business) are not permitted to rely on its protection. In addition, Reg. A is not available for the offer or sale of fractional undivided interests in oil, gas or mineral rights, or for investment companies required to be registered under the Investment Company Act of The exemption afforded under Regulation A also incorporates a bad boy provision which significantly restricts issuers from benefitting from the safe harbor where the issuer or its predecessors or affiliates have previously been subject to proceedings resulting from federal securities laws violations. However, the SEC may waive the bad boy disqualification if, upon review of the waiver application, it determines upon a showing of good cause, that it is not necessary under the circumstances that the exemption be denied. 33 See discussion below regarding the JOBS Act for a discussion of the new Regulation A+ exemption. 30 Note, however, that under Regulation A+, the annual financial statements must be audited. 31 Now 2,000 holders-of-record following passage of the JOBS Act. 32 See Securities and Exchange Commission Q&A: Small Business and the SEC, available at 33 See 17 C.F.R

16 4. Regulation D - Coordination of the Small Issue and Limited Offering Exemptions The Securities and Exchange Commission coordinated its small issue and limited offering exemptions with the enactment of a set of rules known as "Regulation D" in order to address concerns over the effectiveness of the existing exemptions with respect to the capital formation needs of small businesses. With the release of Regulation D (and related Rule 215), the SEC essentially integrated all registration exemptions except the intrastate exemption and the exemption allowed under Regulation A. Specifically, the passage of Regulation D established three exemptions from the Securities Act registration and provided prospective investors with detailed guidance on when an offering qualifies for such exemptions. The three exemptions addressed by Regulation D include the Section 4(a)(2) 34 private placement exemption (Rule 506) and two additional safe harbors for qualified "small offerings" authorized by Section 3(b) of the Act (Rule 504 and Rule 505). Regulation D consists of Rules , with definitions and common elements of the exemptions detailed in Rules , and the replacement of Rules 240, 242 and 146 with new Rules Rule 502 establishes four conditions that are applicable to all Regulation D offerings: (i) the integration doctrine (i.e., offers and sales made more than six months before the start of a Reg. D offering will not be integrated so long as there are no efforts during that 6- month period to sell a similar class of security offered under the Reg. D offering) 35, (ii) the information required to be provided to the offerees, (iii) the method of soliciting investors, and (iv) limitations on resale of the securities. Rule 503 mandates that issuers must file with the SEC the Form D notice of exempt sales within fifteen (15) days of the first security sale in a Rule 506(b) Reg. D offering. 36 In addition, Regulation D provides a definition of accredited investor which was adopted by Rule 215 with respect to the Section 4(6) exemption (encompassing sales of securities made to accredited investors where the aggregate amount sold does not exceed $5 million). It is important to note that, since the Rule 504 and Rule 505 exemptions were adopted under the SEC s authority under Section 3(b) of the 1933 Act to provide exemptions for small offerings of less than $5 million, state registration authority for offerings relying on these exemptions is not preempted by the National Securities Markets Improvements Act of 1996 (NSMIA). On the other hand, Rule 506 relies on the SEC s authority under Section 4(a)(2) of the Securities Act which preempts state registration regulation since the passage of the NSMIA. 34 Formerly Section 4(2) of the Securities Act of 1933 prior to passage of the JOBS Act (a) under the Securities Act, 17 C.F.R (a). 36 Note the SEC has proposed amendments to Form D filing requirements with respect to offerings conducted under new Rule 506(c), as discussed below. 16

17 Note that Regulation D is not the exclusive mechanism for exempting securities offerings from SEC registration, since issuers may still rely on the exemptions available under Sections 3(b), 4(a)(2) and 4(5) to avoid the costly and cumbersome registration process. For most issuers, however, the three exemptions created by Regulation D have been the preferred vehicle for registration exemption and the new exemption found in Section 506(c) of Regulation D will likely join that category of preferred offering mechanisms. a. Rule 504 Exemption The exemption from securities registration allowed under Rule 504 is predominantly utilized by small issuers due to the limitations contained in the rule. To qualify for the Rule 504 safe harbor, an offering can raise no more than $1,000,000 in the aggregate during any 12-month period. In addition, the issuer may not carry out any advertising or solicitation to the general public, provided, however, that general solicitation of accredited investors is permitted if conducted in accordance with an applicable state exemption. This ability to solicit accredited investors through general advertising efforts permits some issuers to raise seed money before going public, with the caveat that the public offering cannot be initiated until six months after completion of the Rule 504 offering in order to avoid integration issues. 37 One attractive feature of this exemption is that the issuer is not required to prepare an offering circular or make any other disclosures to offerees. However, the issuer must file Form D with the SEC no later than 15 days after the first sale. 37 See Bloomenthal, Harold and Samuel Wolf, The Securities Law Handbook, sec. 9.5, Thomas Reuters (2012). 17

18 The Rule 504 safe harbor provides several meaningful advantages for small issuers. First, it allows offers and sales to an unlimited number of investors without restrictions on the geographical area of investment solicitation. Second, securities investors need not be accredited (subject to the use of general solicitation efforts mentioned above). 38 Further, the issuer is not required to prepare and file a disclosure document, resulting in minimal federal filing requirements, and the resale restrictions are limited. Notwithstanding the relaxation of the resale prohibition, securities purchasers who wish to resell their security must secure their own exemption from registration. In addition, the issuer must (i) make reasonable inquiry as for whom the purchaser is actually buying the securities, (ii) prior to the sale, provide written disclosure to the offerees that the securities are unregistered and must therefore be subsequently registered or meet an exemption before they can be resold, and (iii) include a legend on the securities or subscription agreement stating that the securities have not been registered. Also, as in all offerings, the antifraud laws still apply to Rule 504 offerings. Given the $1,000,000 ceiling on Rule 504 offerings, coupled with the permitted use of general solicitation and advertising in offerings conducted under new Rule 506(c), reliance on Rule 504 will likely be minimal. Significantly for North Carolina limited liability companies, Rule 504 offerings are limited to 25 people under the Direct Participation Rules. In addition, the issuer must file Form D and all sales materials with the North Carolina Securities Division of the Secretary of State ten days before the first sale, but not if all but 5 purchasers are actively engaged in the business. Many mom and pop companies accidentally fall within this exemption. See discussion on North Carolina securities exemptions described below. b. Rule 505 Exemption Pursuant to Rule 505, an issuer can sell up to five million dollars ($5,000,000) in securities in any 12-month period. 39 Included in the calculation of the aggregate dollar limitation is the aggregate offering price of the issue, together with all securities previously offered pursuant to the Section 3(b) exemption. 40 In order to qualify under Rule 505, the company can not engage in any general advertising concerning the offering or solicitation of any potential investors. The issuer must also file a Form D with the SEC within 15 days of the first sale. Rule 505 is not available for investment companies or to issuers disqualified under the bad boy provisions contained in Regulation A (discussed above). 41 An offer relying on Rule 505 can be sold to an unlimited number of "accredited" investors, but there can be no more than 35 "nonaccredited" investors who do not need to satisfy any suitability or sophistication requirements under federal law, but who must receive full Regulation A private placement disclosure documents. Note that, in order to qualify under North Carolina s Blue Sky Law, the offering can be made to no more than 25 persons if and LLC is involved and the Direct Participation Rules apply (b)(1)(iii) under the Securities Act, 17 C.F.R (b)(1)(iii) (b)(2)(i) under the Securities Act, 17 C.F.R (b)(2)(i). 40 Id (b)(2)(iii) under the Securities Act, 17 C.F.R (b)(2)(iii). 18

19 Note that securities sold under the Rule 506 exemption are included in the Rule 505 qualification analysis unless the integration doctrine can be avoided with respect to the two offerings. This issue can come into play where an issuer sells securities to its officers and directors upon formation in reliance on Rule 506. Although these executives qualify as accredited investors, and thus not included in the 35-person cap, such sales to accredited investors must be included in the calculation of the $5,000,000 limitation. Significantly for North Carolina limited liability companies, Rule 505 offerings are typically unattractive as the issuer must reasonably believe the investment is suitable for all investors, even those that are accredited. In addition, sales by LLC issuers are limited to 25 people under the Direct Participation Rules. Further, the issuer must file Form D and all sales materials with the North Carolina Securities Division of the Secretary of State ten days before the first sale, but not if all but 5 purchasers are actively engaged in the business. Many mom and pop companies accidentally fall within this exemption. See discussion on North Carolina securities exemptions described below. Given the $5,000,000 ceiling on Rule 505 offerings, coupled with the permitted use of general solicitation and advertising in offerings conducted under new Rule 506(c), reliance on Rule 505 will likely be decrease substantially. c. Rule 506(b) Exemption. Prior to the creation of the Rule 506(c) exemption under the JOBS Act, the registration exemption allowed under Rule 506(b) 42 was widely deemed to be the most attractive and often used safe harbor for small companies, mostly due to the limited blue sky law compliance required as a result of federal preemption under the National Securities Markets Improvements Act of 1996 (NSMIA). The exemptions available under Rule 505 and Rule 506(b) are substantially similar in that the securities can be sold to an unlimited number of accredited investors and 35 non-accredited investors. There are several differences between the two safe harbors which provide significantly more flexibility under a Rule 506(b) offering. Specifically, (i) a Rule 506(b) offering is unlimited in the amount of the offering, and (ii) prior to the enactment of Rule 506(d) and Rule 506(e), there were no Reg. A bad boy disqualification limitations or prohibitions against the payment of commissions in connection with the offering. However, unlike Rule 505, the exemption allowed under Rule 506(b) requires that nonaccredited purchasers (or their purchaser representative) must have sufficient knowledge and expertise in financial and business matters to evaluate the merits and risks of the prospective investment. 43 In addition, there is currently a prohibition against general solicitations under Rule 506(b), but this restriction is not applicable to offerings conducted pursuant to new Rule 506(c) following the enactment of the JOBS Act (discussed below). Note that, despite the creation of the Rule 506(c) safe harbor, Rule 506(b) is still an available option for private issuers. 42 Formerly referred to as Rule 506 prior to the adoption of Rule 506(c) (b)(2) under the Securities Act, 17 C.F.R (b)(2). 19

20 Similar to the requirements under Rule 505, expansive financial information must be furnished to non-accredited investors through private placement memoranda under a Rule 506 offering. Accordingly, most issuers often limit sales to accredited investors only to avoid such burdensome disclosures. The following disclosure requirements apply: (1) Offerings up to $2,000,000. Non-accredited investors must receive the information required in Item 310 of Regulation S-B, except that only the issuer's balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. (2) Offerings up to $7,500,000. Non-accredited investors must receive the financial statement information required in Form SB-2. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer's balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant. (3) Offerings over $7,500,000. Non-accredited investors must receive the financial statement as would be required in a registration statement filed under the Act on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer's balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of federal income tax requirements and examined and reported in accordance with generally accepted auditing standards by an independent public or certified accountant. 5. Who Qualifies as an Accredited Investor? Section 4(5) 44 of the Securities Act provides an exemption for offers and sales of securities to accredited investors of up to $5,000,000. The concept of accredited investor permeates the Rule 504, Rule 505 and Rule 506 exemptions allowed under Regulation D. So what makes an investor accredited under these rules? The term "accredited" investor is defined in Section 2(a)(15) of the Act to include "any person, who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, qualifies as an accredited investor under rules and regulations which the Securities and Exchange Commission shall prescribe." The Securities and Exchange Commission has adopted Rule 215, which sets forth net worth and income requirements for qualification of accredited investors. 44 Formerly Section 4(6) prior to enactment of the JOBS Act. 20

21 For natural persons, the basic tests are either net worth, with one's spouse, of more than $1 million (excluding the value of the principal residence) or net income of more than $200,000 in each of the two most recent years (or $300,000 with one's spouse). These threshold amounts will be adjusted for inflation every 5 years starting in Debt secured by a principal home up to the estimated fair market value of the home at time of sale are not included as a liability, but any debt in excess of the fair market value of the residence is included in the calculation. The definition of accredited investor under Rule 501 includes: (i) a bank, insurance company, registered investment company, business development company, or small business investment company; (ii) an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; (iii) a charitable organization, corporation or partnership with assets exceeding $5 million; (iv) a director, executive officer, or general partner of the company selling the securities; (v) a business in which all the equity owners are accredited investors; (vi) a natural person with a net worth of at least $1 million; (vii) a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; and (viii) a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person. 6. Form D Filing Rule 503 of Regulation D requires an issuer to file a Form D when relying on a registration exemption. 45 In 2008, the SEC enacted rules requiring the electronic filing of Form D in accordance with the SEC s EDGAR rules found in Regulation S-T. 46 Filers must first secure a unique EDGAR code before filing. Despite the electronic filing requirement with the SEC, most states require receipt of a hard copy of the Form D which was submitted electronically using EDGAR in connection with the notice filing made to such state. While the information to be provided in a Form D is not overly extensive, filers are advised to print out the Form and complete it prior to logging on for electronic submission since there are certain time restrictions imposed in completing the filing on EDGAR s file management system. Also, issuers should be aware that Form D requires disclosure of compensation to be paid to executive officers, directors and promoters from the solicited investment proceeds. Also, the SEC has precluded issuers from using Form D to gauge or generate interest in the offering. 47 See below for a discussion of the proposed changes to the Form D filing requirements under the Securities Act, 17 C.F.R (a)(4)(a)(1) under the Securities Act, 17 C.F.R (a)(4)(a)(1). 47 See Sec. Act Release No (Feb. 6, 2008), 2008 WL

22 V. Overview of the North Carolina Blue Sky Laws A. In General. In addition to adherence to the federal securities laws, issuers must also comply with the applicable state securities registration laws to the extent they aren t preempted by the NSMIA (as discussed above). North Carolina has its own set of securities exemptions, including some which compliment the Regulation D exemptions under Rules 504, 505 and 506. However, North Carolina securities laws include certain Direct Participation Program rules which are unique in their application to limited liability companies. B. Securities under North Carolina Blue Sky Laws The North Carolina Securities Act governing securities sales in its state are found in Chapter 78A of the North Carolina General Statutes (N.C.G.S.). The general prohibition against unregistered securities sales is found in N.C.G.S. 78A-16, which provides: It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly: (1) To employ any device, scheme, or artifice to defraud, (2) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or (3) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. N.C.G.S. 78A-16 exempts the following securities from state registration: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) US or state securities, Canadian or foreign government securities, debt securities of US banks, debt securities of savings and loan institutions, insurance debts/annuities not dependent on investment results, credit union securities, railroad securities, nonprofit securities, commercial paper payable within 9 months, employee profit sharing or benefit plans, stock of a professional corporation, mutual or agricultural or utility associations, and securities listed with SEC. 22

23 In addition, N.C.G.S. 78A-17 exempts a number of transactions from securities registration, including: (i) issuances of bonds or other debt secured by real or personal property, 48 (ii) transactions by a bona fide security interest holder, 49 (iii) sale to corporate entity with net worth greater than $1 million, 50 (iv) sales under federal Rules 504 and 505, but limited to 25 purchasers, 51 (v) certain sales to existing shareholders. 52 C. Registration Requirements. As stated above, it is unlawful to offer or sell securities in North Carolina unless (i) the offer is registered with the North Carolina Securities Division, (ii) it is exempt from registration, or (iii) it is a covered security under federal law. The registration requirements under North Carolina s Security Act are rigid and expensive. For instance, under N.C.G.S. 78A-27, registration by qualification requires the following from the issuer: (i) a signed Consent to Service of Process, (ii) information and renumeration relating to directors, officers, 10% owners, promoters, (iii) a description of the proposed capitalization and any long term debt, (iv) details of any underwriting costs, selling expenses, and plan of distribution, (v) estimated cash proceeds to be received; use of proceeds, allocation of proceeds; other fund sources, (vi) a description of any stock options, management contracts, (vii) a copy of prospectus, circular, advertisements and other sales literature, (viii) a legal opinion, (ix) written consent of an accountant, and (x) a balance sheet and profit and loss statements. In addition, securities registrants must file an expansive registration statement and pay a $2,000 filing fee. 53 D. North Carolina Exemptions. 1. The de minimus Exemption N.C.G.S. 78A-17(9) includes a de minimus registration exemption that must be met when relying on the federal intrastate exemptions under Rule 147 of the 1933 Act, the Section 4(a)(2) common law exemption, and SEC Rule 504. The following criteria apply: (i) the issuer must be doing business and resident in North Carolina; (ii) the offering is limited to 25 or fewer offerees who are all residents of North Carolina; (iii) all offers and sales must be completed within North Carolina; (iv) no out of state resales of the securities; (v) no federal or state filings are required (unless the Direct Participation Rules (DPP) apply); 48 N.C.G.S. 78A-17(5) 49 N.C.G.S. 78A-17(7) 50 N.C.G.S. 78A-17(8) 51 N.C.G.S. 78A-17(9) 52 N.C.G.S. 78A-17(11) 53 N.C.G.S. 78A-28 23

24 (vi) the federal "accredited investor" requirements do not apply, but DPP suitability requirements do apply to passive investors; and (vii) there are no specific disclosure requirements. In addition, if the issuer is a limited liability company, it may have to comply with Direct Participation Program ("DPP") rules: (i) the investors are subject to the NC Rule 1313 suitability requirements (see below for explanation) UNLESS the investor will be actively engaged in management of issuer's business; (ii) the issuer must file an informational filing with the North Carolina Securities Division 10 days prior to first sale UNLESS security offered to not more than 5 passive investors (i.e. not actively engaged in management of business) 2. NC Regulatory Exemption 78A-17(17) and NC Rules 1205, 1206, 1207, and 1208 This exemption particularly applies to SEC Rule 505 offerings. The following restrictions apply: (i) aggregate offering limit of $5,000,000; (ii) the issuer may sell to unlimited "accredited investors" but only 35 "unaccredited investors"; (iii) if any investor is unaccredited, the issuer must prepare and provide such investor with an expansive Reg. A disclosure document (discussed above); (iv) the issuer must reasonably believe the investment is suitable for investor (there is a safe harbor for determining suitability under N.C. Rule 1205 which says the investment is presumed to be suitable if the investment is less than 10% of investor s net worth); 54 (v) the issuer must file Form D and other disclosure documents required under NCAC Rule 2108 with the North Carolina Securities Division unless the securities are offered to not more than five North Carolina residents; and (vi) payment of a $150 NC filing fee. In addition, if the issuer is a limited liability company, compliance with the Direct Participation Program ("DPP") rules is required: (i) NC Rule 1313 suitability requirements (see below for explanation) UNLESS investor will be actively engaged in management of issuer's business; and (ii) an informational filing is required 10 days prior to first sale UNLESS security offered to not more than 5 passive investors (i.e. not actively engaged in management of business) NCAC 06A

25 3. NC Regulatory Exemption 78A-31 and NC Rule 1211 As discussed above, federal law preempts state registration requirements with respect to Rule 506 offerings. However, North Carolina notification rules require the issuer to furnish to the North Carolina Securities Division a hard copy of the Form D electronically filed with SEC and pay a $350 filing fee. Importantly, the DPP Rules do not apply to these offerings since Section 18 of 1933 Act overrides all state filings for these private placement offerings. E. Notice Filing Requirements However, in the event an offering of securities is covered by Section 18(b)(2) of the Securities Act, the issuer must file a notice filing for such covered securities. Under the notice filing requirements found in N.C.G.S. 78A-31, among other requirements, the issuer must: (i) furnish the North Carolina Securities Division with the federal registration statement filed with the SEC and pay a $1725 filing fee plus an $275 for each series of securities; (ii) report of value of securities sold in North Carolina; (iii) since the notice expires on 12/31 of each year, the issuer must annually renew the filing and pay the same filing fees (see above); In contrast, notice filings with respect to covered securities under 18(b)(4)(D) of 1933 Act, only require (i) filing of the Form D, (ii) filing of the Consent to Service of Process no later than 15 days after first sale, and (iii) payment of a reduced $350 filing fee. F. North Carolina s Direct Participation Program Rules The DPP regulations imbedded in NCAC Rule 1205 and 1313 generally apply only to limited liability companies and other entities taxed as partnerships, however, they do not apply to S corporations. The DPP regulations require that each North Carolina investor meet certain suitability standards. The suitability standards impose certain net worth and income restrictions on investors, but DO NOT APPLY if the investor will be "actively engaged, on a regular basis, in the management of the issuer's business." Under Rule 1313, a company may not sell securities to an investor unless the investor has either (1) a net worth of $225,000 or (2) a net worth of $60,000 and income of at least $60,000. For purposes of this regulation, net worth does not include the value of a person s home, home furnishings, or automobiles. Furthermore, each person to whom an offer is made must receive a notice of the suitability standards before any sale. The issuer may rely on written statements or questionnaires to determine whether or not an investor meets the minimum standards. In addition, Rule 1205 requires a notice filing for all offers of DPP securities to the Securities Division 10 days before the first offering, UNLESS the offering is limited to not more than 5 passive investors (i.e. persons not participating in management of the issuer). 25

26 G. North Carolina Enforcement of Securities Violations. Pursuant to N.C.G.S. 78A-46 securities violations are investigated by the North Carolina Deputy Securities Administrator. The office has the power to investigate putative securities violations, require statements under oath, subpoena witnesses, take evidence, compel the production of documents, issue injunctions or cease and desist orders, appoint receivers and request judicial order of restitution. 55 In addition, the Administrator has the authority to impose civil penalties of up to $2,500 per violation with a maximum penalty of $25,000 for multiple violations, and require reimbursement from the violator for the investigation costs incurred by the Securities Division. The Administrator also has the authority to issue "No Action Letters" under N.C.G.S. 78A-50 upon request by the prospective issuer. Pursuant to N.C.G.S. 78A-56, the Administrator can impose a number of civil liabilities on violators of the North Carolina securities laws including: (i) (ii) (iii) repayment of all consideration paid by securities buyers; payment of interest on the investment proceeds at the established legal rate from date of payment; payment of investigation costs and reasonable attorneys fees minus the amount of income received by the purchaser on the securities. In addition, every person who directly or indirectly controls the issuer, and all partners, officers, directors, dealers or salesmen who materially aid in the investment offering can be held jointly and severally liable unless such person satisfies the burden of proof that he or she did not know, and in the exercise of reasonable care could not have known, of the facts underlying the liability. Further, every employee can also be held to be jointly and severally liable if such employee actually knew of the facts underlying the liability. All actions must be filed within 2 years of the sale of a registered security and within 3 years of discovery of the violation for all other violations under N.C.G.S. 78A. In addition to the civil penalties summarized above, criminal penalties can also be imposed under N.C.G.S. 78A-57. The Administrator s jurisdiction to bring any civil or criminal action arises if the offer to sell or buy is made in North Carolina. 56 A securities offer is deemed to be made in North Carolina if (i) the offer originates from North Carolina, or (ii) the offer is directed by the offeror to North Carolina and received by someone in North Carolina (e.g., in a post office). 55 N.C.G.S. 78A N.C.G.S. 78A-63 26

27 VI. Overview of Broker-Dealer Registration Rules. A. Introduction In addition to complying with the federal and Blue Sky securities registration requirements, issuers who utilize promoters or finders to locate and solicit investment capital must adhere to the broker-dealer registration rules to avoid losing the benefits offered by the registration exemptions discussed above. Specifically, companies seeking private placement investments must be cognizant of the federal and state broker-dealer rules which dramatically limit the availability of the exemptions when unregistered brokers or sales representatives receive compensation or other remuneration in connection with the sale of securities. Due to the onerous Blue Sky broker-dealer rules that often serve as a trap for the unwary, the ability to satisfy the Rule 506 exemptions under Regulation D is critically important since it preempts the Blue Sky laws under the National Securities Markets Improvement Act cited above. If the issuer is unable to carry the burden of proof with respect to compliance with the exemption requirements, the exemption will be lost, thereby subjecting the issuer and its brokers to state and federal liability for the sale of unregistered securities. In addition, contemporaneously with the recent passage of the JOBS Act and its implementing rules, there has been a renewed SEC focus on the use of unregistered brokers who participate in securities transactions. Given the significant consequences resulting from the loss of an exemption when intermediaries are involved, there has been a recent push for the adoption of a simplified broker lite registration process in connection with private offerings. B. Federal Broker-Dealer Registration Requirements Under the Securities Exchange Act of 1934, any issuer seeking protection from securities registration under the umbrella of a federal exemption must also demonstrate that any person who is paid transaction-based compensation in connection with effecting a securities investment is either registered with the Securities and Exchange Commission or qualifies for an exemption from broker-dealer registration. Pursuant to the Exchange Act, a broker is defined as someone who "effects" the purchase or sale of any security. 57 Section 3(a)(5) of the Exchange Act defines dealer as "any person engaged in the business of buying and selling securities for his own account but does not include any person insofar as he buys or sells securities not as a part of a regular business." Under Section 15(a)(1) of the Exchange Act, it is unlawful for any broker or dealer to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security unless such broker or dealer is registered with the SEC. 57 Exchange Act 3(a)(4). 27

28 Accordingly, under the Exchange Act, there are three criteria that must be analyzed to determine if a party constitutes a broker subject to the extensive registration scheme prescribed by the SEC and applicable self-regulatory organization (SRO). The three elements are: (i) (ii) (iii) the broker must be engaged in the business, of effecting transaction in securities, for the account of others. Generally, to be engaged in "effecting" sales transactions, a person must be involved in either soliciting investors, serving as an adviser, serving in an evaluative or decision-making function, or negotiating or executing sales agreements. The SEC s Guide to Broker-Dealer Registration poses the following as relevant issues that are considered by the SEC in the analysis of whether a person or entity is a broker, a dealer or a broker-dealer: (i) (ii) (iii) (iv) (v) (vi) (vii) Does the person participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction? Does the person s compensation for participation in the transaction depend upon, or is related to, the outcome or size of the transaction or deal? Do they receive any other transaction-related compensation? Is the person otherwise engaged in the business of effecting or facilitating securities transactions? Does the person handle the securities or funds of others in connection with securities transactions? Does the person advertise or otherwise let others know that they are in the business of buying and selling securities? Does the person market in, or quote prices, for both purchases and sales of one or more securities? Does the person provide services to the investor such as handling money securities, extending credit, or giving investment advice? The analysis is highly fact specific but the aforementioned questions are often considered by the SEC when ruling as to whether a particular person or entity qualifies as a broker, dealer or broker-dealer. 28

29 C. Use of Finders to Attract Investors Notwithstanding the foregoing, a party who does not conduct broker-like activities, but merely assists in providing the service of "identifying" potential investors with whom he or she has a substantial and preexisting relationship and putting a person who is offering investments in contact with them, arguably is only a "finder" and not a broker. One commentator has noted that, although a pure finder may "induce the purchase or sale of" a security within the meaning of Section 15(a)(1), he or she is not normally a "broker" because he or she "effects" no transactions. 58 In a No-Action Letter issued by the SEC in 1974, the enforcement staff provided some interpretative guidance as to what delineates a broker from finders and other non-broker intermediaries: "An intermediary who did nothing more than bring merger or acquisitionminded people or entities together and did not participate in negotiations or settlements between them probably would not be a broker in securities and not subject to the registration requirements of Section 15 of the Exchange Act; on the other hand, an intermediary who plays an integral role in negotiating and effecting mergers or acquisitions that involve transactions in securities generally would be deemed to be a broker and required to register with the Commission." 59 Other No-Action Letter decisions issued by the Securities and Exchange Commission illustrate a host of red-flag factors that suggest the point at which a finder has become sufficiently instrumental in "effecting" the securities transaction that he must be registered as a broker-dealer. These factors include: (i) involvement in negotiations; (ii) discussing details concerning securities or making recommendations; (iii) receiving "transaction-based" compensation; and (iv) previous involvement in the sale of securities. 60 The SEC has taken the position that a finder is not required to register as a broker, dealer or investment adviser if he or she merely brings a buyer, with whom the finder has a substantial and preexisting relationship, and seller together and does little more. This means that the finder should not make any recommendations as to the attractiveness of the securities, be a part of the negotiating process or offer any investment advice to an offeree. Importantly, any participation by a finder, however slight, in the securities negotiations may convert the finder to broker status, requiring registration with the SEC as a broker, dealer or investment adviser. Further, issuers and brokers can be jointly liable to investors who exercise their rescission rights when an unregistered broker is involved. 58 See Louis Loss, Securities Regulation, Volume VI, page 3004, (1990). 59 See Henry C. Coppelt d/b/a/ May Pac Management Co., Fed. Sec. L. Rep. (CCH), paragraph 79, See SEC v. Michael Milken, Litigation Release No (Feb. 26, 1998); Davenport Management, Inc., SEC No-Action Letter (April 13, 1993); Paul Anka, SEC No-Action Letter (July 24, 1991); Victoria Bancroft, SEC No- Action Letter (Aug. 9, 1997). 29

30 D. Use of Finders in Private Placements under Heightened SEC Scrutiny Recent enforcement action and interpretive guidance provided by the SEC indicates the Commission will enhance its focus on the participation of unregistered brokers in private capital raising efforts. As discussed above, issuers in Regulation D offerings have often relied on the so-called finders exemption when engaging outside intermediaries to assist in locating potential investors in connection with their capital formation campaign. Until recently, SEC no action letters permitted participation of finders in private placements provided such intermediaries limited to their activities to simply identifying prospective investors with whom they have a substantial and preexisting relationship and introducing them to the issuer, with little other involvement in the process. The SEC s recent imposition of sanctions against unregistered finders and capital raising issuers suggest private companies who engage intermediaries to assist in locating potential capital investment must take extreme care to ensure the activities of these intermediaries do not overstep the boundary between finder and broker-dealer status. On March 8, 2013, the SEC settled two enforcement actions in connection with the engagement by Ranieri Partners LLC, a private equity fund sponsor, of a finder to assist in its investor solicitation efforts for certain private funds. In the Matter of William M. Stephens, the SEC determined Mr. Stephens had violated the broker-dealer registration requirements of the Exchange Act of 1934 and issued an order imposing a monetary penalty on Stephens and barring him from participating in the securities industry. Stephens was not registered as a broker-dealer and previously had been temporarily barred by the SEC from associating with a registered investment advisor. Stephens, an independent consultant of the private fund in its capital formation efforts, sought to establish his activities as a finder of potential investors on behalf of the fund did not rise to level of broker status that would require registration under the 1934 Act. However, the SEC rejected Stephens finder argument and instead determined he had actively solicited investors for the fund in consideration of a finders fee equal to 1% of all capital committed by investors whom Stephens had introduced to Ranieri Partners this fee totaled upwards of $2.4 million. The SEC s factual findings determined Stephens solicitation activities included: (i) delivering private placement memoranda, subscription documents and other important investment documentation to prospective investors; (ii) consistently communicating with such investors and their advisors; (iii) advising at least one investor to adjust its portfolio allocations in connection with the potential investment in the private fund; (iv) providing analysis of the fund s investment strategies and prior investment performance to potential investors; (v) disclosing to his clients confidential information related to the identity and potential capital commitments of other investors; and 30

31 (vi) coordinating and attending meetings and phone conferences related to the fund with prospective investors. The SEC determined Stephens activities went beyond those of a typical finder in acting as an unregistered broker-dealer and he was ordered to disgorge all fees paid to him and barred from future association with an investment advisor or broker-dealer. In a related action, In the Matter of Ranieri Partners LLC and Donald W. Phillips, the SEC issued a cease and desist order and imposed substantial fines against the fund and its senior managing partner (Phillips) for aiding and abetting Stephens in his failure to register as a brokerdealer under the 1934 Act. The Commission determined Ranieri Partners and Mr. Phillips had failed to adequately oversee the purported finder activities of Stephens and, when becoming aware of Stephens extensive solicitation efforts, knowingly and willingly provided the consultant with assistance instead of monitoring his activities and limiting his involvement in the offering. Note Ranieri Partners unsuccessfully argued that their agreement with Stephens specifically prohibited the consultant from delivering the PPM and other subscription documents to potential investors and from discussing the merits and risks of investment in the fund with such prospective investors. The SEC actions in the Ranieri Partners, LLC cases should serve as a clear warning to issuers as to the dangers of engaging an unlicensed broker-dealer in its investor solicitation efforts. Not only are the unlicensed intermediaries subject to SEC investigation and enforcement, but issuers who engage such intermediaries ostensibly as a finder or consultant may be subject to increased SEC scrutiny, especially where the issuers are aware of brokerage activities and actively support such solicitation activities. Although the SEC has never articulated a definition of a finder, and although the broker vs. finder analysis is highly dependent on the specific facts and circumstances involved, the SEC has provided several factors it considers in ascertaining whether an investment unlicensed intermediary has entered into broker-dealer territory. Factors that suggest permitted finder activity is at play include: (i) Introducing investors to issuers without participating in further discussions with the investor or providing advice related to the offering or the issuer; (ii) The compensation received is not a commission or otherwise contingent on the success of the offering; and (iii) The issuer does not assist the investor in securing financing for the prospective investment. In contrast, activities which the SEC views as broker-dealer activity include: (i) Engaging in discussions and negotiations with potential investors and the issuer; (ii) Assisting in structuring the offering; 31

32 (iii) Receiving transaction-based compensation; (iv) Assisting with the sale of securities; (v) Disseminating offering documents or confidential information related to the offering to investors; and (vi) Providing advice as to the desirability of the investment. Note the existence of transaction based compensation is often viewed as the hallmark of a broker relationship. However, it is not dispositive and transaction-based compensation alone likely will not trigger broker-dealer registration. So what are the consequences of failing to register as a broker-dealer in connection with a private offering of securities? Section 29(b) of the Exchange Act of 1934 provides that contracts made in violation of the 1934 Act are void in respect of the rights of any person in violation of such registration requirements. Consequently, disgruntled investors will have the right to rescind their security purchase and have their investment funds returned. Accordingly, issuers and their officers, managers and principals may expose themselves to SEC enforcement if they engage unregistered broker-dealers to assist in the solicitation of investors, even in the absence of fraud or other misconduct. E. North Carolina s Broker-Dealer Registration Requirements In addition to federal laws, any securities offering and finder arrangement must also comply with North Carolina s Blue Sky Law. Since registering a securities offering can be expensive and burdensome, issuers should be wary of entering into agreements with unregistered brokers who will assist in the capital solicitation process. Under North Carolina law, an issuer will likely not qualify for any of the applicable registration exemptions if any transaction-based compensation was paid to a unregistered broker or finder. Specifically, in order to qualify for an exemption from the registration requirements under North Carolina s laws, [n]o commission, discount, finder s fee or other similar remuneration or compensation shall be paid, directly or indirectly, to any person for soliciting any prospective purchaser of the security sold to a resident of this state unless such person is either registered as a dealer or the issuer reasonably believes that such person is so registered or exempt from registering. 61 The Blue Sky Law defines dealer as any person engaged in the business of effecting transactions in securities for the account of others or for his own account. Notably, a finder exemption has not yet been established under North Carolina. However, since North Carolina s Blue Sky Law parallels the 1933 Act and the 1934 Act, if the putative finder does nothing more than identify potential investors with whom he or she has a substantial and preexisting relationship for an issuer, one could argue that there hasn t been sufficient activity to constitute the "solicitation" or effecting of a securities transaction. 61 See N.C. Blue Sky Regulations 1205(b)(1), 1206(c), 1207, and 1208(c)(4). 32

33 Unfortunately, unless such finder is registered under North Carolina, the risk of violating state securities laws cannot be ignored. North Carolina s Blue Sky Law requires registered offerings to be sponsored by a North Carolina registered broker-dealer. However, as mentioned above, the reach of state securities law has been significantly limited by the preemption regime created in the National Securities Markets Improvement Act. Under the NSMIA, the Blue Sky Law will be preempted for certain securities offerings that are exempt from the federal registration requirements. Preemption for offerings exempt under federal law applies to security offers which are exempt from federal registration by SEC rule issued under Section 4(2) of the Act, which under current law is limited to Rule 506 offerings. Accordingly, issuers who satisfy Rule 506 s requirements could potentially avoid the rigorous demands of North Carolina s Blue Sky Law. Issuers who hope to circumvent burdens of broker registration should consider paying a flat fee to its finders/solicitors as opposed to a commission predicated on the success of the offering. Commission compensation demonstrates success in effecting transactions for the account of others and is heavily scrutinized by the SEC. Irrespective of the method of finder compensation, any financial relationship between the issuer and the finder must be disclosed to potential investors. Further, minimizing the involvement of a finder in the negotiation and structuring of a transaction and demonstrating the existence of a substantial and preexisting relationship between the finder and the investor will assist in this effort. VII. An Overview of the Recently Enacted JOBS Act A. In General In an effort to spur job growth by easing the registration requirements for capital deprived companies, Congress passed the aptly named Jumpstart Our Businesses Startups Act ( JOBS Act ) on April 5, 2012, a culmination of year long bipartisan efforts from both houses of Congress. 62 The legislative objective was to facilitate access to capital for small and medium size companies by creating a new regulated market for crowdfunding ventures and by reducing onerous regulatory reporting requirements. The hope is that the availability of a new source of investment funds, and the resulting infusion of much needed capital for private companies, would encourage the startup of new businesses and expansion of existing operations, thereby stimulating job growth. The JOBS Act seeks to accomplish this objective through the introduction of four new capital raising concepts that either create new solicitation options or increase the flexibility of existing investment vehicles. Primarily, these include: (i) Increasing the maximum aggregate offering threshold for Regulation A offerings; The JOBS Act, H.R. 3606, passed in the House of Representatives on March 8, 2012, and the Senate passed H.R with an amendment to the crowdfunding exemption on March 22, The Senate s amendment was approved by the House of Representatives on March 27, Title IV of the JOBS Act. 33

34 (ii) Creating of a crowdfunding offering exemption; 64 (iii) Relaxing the general solicitation and advertising prohibitions under Rule 506 offerings; 65 and (iv) Increasing the investor limits for purposes of triggering registration under the Exchange Act of However, despite the excitement surrounding the potential impact the JOBS Act would have on the securities markets, the new law could not be relied upon by issuers seeking to undergo private offerings of their securities until the SEC promulgated regulations necessary for implementing the JOBS Act provisions. Following months of growing frustration with the SEC s failure to adopt the necessary implementing measures, the Commission finally adopted the necessary amendments of these two provisions on July 23, They became effective on September 23, As mentioned in the introductory portion of this manuscript, the extent of the impact the JOBS Act will ultimately have on the manner in which capital is raised in private placement offerings will likely result from issuers capitalizing on two significant features of the legislation: (1) general solicitation in Rule 506(c) offerings; and (2) increased thresholds on the number of investors to whom securities can be sold without registration under the 1934 Act. As discussed below, the availability of these two amendments will likely result in the proliferation of a new form of private securities offerings under Rule 506 recently referred to by one securities expert as publicly offered private offerings. 67 The remainder of this paper will summarize the new issuer friendly rules created under the JOBS Act and explore the potential implications they may have on the current capital formation landscape. B. The Modifications to Regulation A Offerings As noted above, Regulation A (the small public offering exemption ) currently provides a registration exemption for public offerings of securities up to $5,000,000 in any 12-month period. Securities offered pursuant to the Regulation A safe harbor can be offered publicly and are not considered to be restricted under the 1933 Act, i.e., there are no restrictions on reselling securities in secondary markets after the initial offering. 64 Title III of the JOBS Act. 65 Title II of the JOBS Act. 66 Titles V and VI of the JOBS Act. 67 Robbins, Robert P., Looking Forward: Practical Implications of the JOBS Act Changes to Private Placements, SEC s New Rule 506: Implications and Risks of the New General Solicitation Rule, An American Law Institute Seminar (September 25, 2013). 34

35 In addition, issuers are afforded the opportunity to test the waters to gauge interest among potential investors prior to committing to the substantial expense associated with the SEC filing. However, due to the lack of federal preemption from state blue sky registration requirements, coupled with the substantial expense associated with state registration of securities offerings, there is a not a significant amount of reliance on the Regulation A exemption vis-à-vis the Rule 506 safe harbors. The promulgation of Title IV of the JOBS Act contemplated a modified Regulation A exemption (often referred to as Regulation A+ in the securities industry) which will expand the aggregate offering threshold during any 12-month period from $5 million to $50 million. 68 In addition, securities sold in an offering that satisfies the requirements of Regulation A+ will continue to avoid characterization as restricted securities, thereby permitting their resale under Rule 144 (as discussed above). However, issuers relying on this modified exemption will be required to prepare and file audited financial statements and regularly provide other disclosures to the SEC under guidelines to be announced by the Commission, subjecting themselves to civil liability for any false or misleading statements or omissions contained in any such communications. 69 Significantly, the JOBS Act preempted Regulation A+ offers from state securities registration requirements, but only with respect to offers made (i) on a national securities exchange or (ii) solely to qualified purchasers. However, the SEC has yet to define what constitutes a qualified purchaser, a delay which will undoubtedly curb the number of small and medium sized companies who will rely on Regulation A+ for purposes of qualifying for registration exemption. Further, the new Regulation A+ will not become effective until the SEC issues its rules of implementation, a condition which has not yet to come to fruition. In light of this delay on the effectiveness of the broadened Regulation A+ exemption, issuers will not be able to rely on its protection until the SEC issues the Congressionally mandated rules necessary for implementation. Further, federal preemption from state securities registration is largely contingent on the SEC s issuance of a definition for qualified purchasers. However, as one commentator notes, once the SEC provides the necessary definition and issues the required implementation rules, Regulation A+ is likely to be attractive to certain late-stage companies who can expand the ambit of potential investors while avoiding the restrictions on reselling the securities imbedded in Rule 506 offerings. 70 Until such time, issuers seeking protection under Regulation A must continue to be cognizant of the blue sky laws of the various states in which its securities are offered. Notably, on October 30, 2013, the Securities, Insurance and Investment Subcommittee of the Senate Committee on Banking Housing and Urban Affairs heard testimony from representatives of the SEC s Division of Corporate Finance, the NASAA and the private business community regarding the implementation of Regulation A+. The Subcommittee questioned the SEC on the expected timing of the issuance of the necessary implementing rules and emphasized the need to 68 Section 3(b)(2) of the Securities Act of See Jones, Benji T., The JOBS Act Becomes Law, Notes Bearing Interest, the North Carolina Bar Association (November 9, 2012). 70 See Id. 35

36 promulgate those rules as soon as possible. The Subcommittee s objective in encouraging the passage of the implementing rules was to create an attractive alternative for certain mid-market and smaller enterprises for whom the new 506(c) exemption and crowding funding exemption may not be a good fit. Given Congressional pressure to implement the Regulation A+ exemption, the SEC may issue the required rules sooner than later. C. The New Crowdfunding Exemption (1) In General Another significant change to the securities regulation milieu ushered in with the passage of the JOBS Act is, at least for smaller and mid-size businesses, the new crowdfunding exemption which provides a platform for companies to raise small increments of capital from an unlimited number of investors without registering the securities. 71 The exemption was designed to create a new market for raising capital and can be generally thought of as a hybrid of social networking and a recognized stock exchange. By introducing Internet portals such as kickstarter.com to the capital formation process, Congress sought to facilitate the aggregation of small amounts of capital from a large pool of investors. Of particular significance is the fact that such offers can be made to unsophisticated investors as well, subject to certain limitations described below. Capitalizing on the speed and efficiency that internet-based platforms can provide for capital seeking companies, many securities experts predicted that this component of the JOBS Act would revolutionize the securities investment marketplace, especially for many startups that lack the seed capital to launch their operations. However, as discussed below, with the SEC s promulgation of the patently onerous implementing regulations, the impact of the new crowdfunding exemption may not be as substantial as many had initially anticipated. Codified as new Section 4(a)(6) of the 1933 Act, the crowdfunding exemption created under Title III of the JOBS Act is subject to the following conditions: (i) The aggregate amount of capital that can be raised during any rolling 12-month period is limited to $1,000,000; (ii) The maximum dollar amount that can be sold to any individual investor is limited as follows: a. If the investor s annual income or net worth is less than $100,000, the maximum permissible investment amount is limited to the greater of $2,000 or 5% of the investor s annual income or net worth; b. If the investor s annual income or net worth is equal to or greater than $100,000, the maximum permissible investment amount is limited to 10% of 71 Title III of the JOBS Act has been codified in new Section 4(a)(6) of the Securities Act of

37 the investor s annual income or net worth, provided the maximum investment cannot exceed $100,000; (iii) All sales must be facilitated through a registered broker-dealer or qualified funding portal intermediary (see restrictions on intermediaries below); (iv) The issuer is subject to certain SEC filing requirements and intermediary and investor reporting obligations designed to disclose information about the issuer, its officers, directors, managers, and significant equity owners, the investment risks associated with the security, and certain other information (see required disclosures below); (v) Resale of the securities is prohibited for a one-year holding period, provided that transfers to accredited investors, the issuer, purchasers in a registered offering, and pursuant to a divorce or death of the purchaser, are not subject to the one-year holding period; and (vi) Federal preemption of blue sky laws apply (excluding antifraud statutes of the states). (2) Issuer Disclosure Requirements In addition to the disclosure requirements articulated in the proposed SEC regulations applicable to issuers relying on the crowdfunding exemption, the JOBS Act also requires issuers to provide the following information to the SEC, investors and participating intermediaries: (i) Name, entity type, website address and physical address of the issuer; (ii) Names of all officers, directors, managers and 20% or more owners; (iii) Description of the business plan and anticipated business activities; (iv) Financial disclosures as follows: a. If the target issue amount is less than $100,000, the issuer must provide its most recent income tax return and financial statements certified by the principal executive officer; b. If the target issue is between $100,000 and $500,000, the issuer must provide independently reviewed financial statements; c. If the target issue is greater than $500,000, the issuer must provide audited financial statements; (v) Description of the expected use of the security sales proceeds; (vi) The issue target amount, the deadline for reaching that target, and regular progress reports relative to meeting the target amount; (vii) A written disclosure of the security price and a notice to investors alerting them of their right to rescind their purchase commitment prior to the sale; (viii) Description of the capital structure and ownership of the issuer; (ix) The terms of the securities; (x) The valuation methodology used to price the securities; and (xi) Certain other information related to the issuer. 37

38 (2) Intermediary Rules and Restrictions Under new Section 4(a)(6) of the 1933 Act and new Section 3(a)(80) of the Exchange Act, each crowdfunding intermediary must: 72 (i) Register with the SEC as a broker or funding portal; (ii) Register with the applicable self-regulatory organization (SRO); (iii) Take measures to ensure each investor understands the risks associated with the particular investment and with investments in startups and small business in general, and the risks of investment illiquidity; (iv) Take appropriate steps to reduce fraud, including conducting background and securities regulation history checks on each director, officer and 20% equity owner of the issuer; (v) Within 21 days prior to the first security sale, provide the SEC and potential investors with the information required to be provided to the SEC and investors by the issuer (see above); (vi) Restrict the issuer s access to the sales proceeds and allow investors to cancel their subscription at any time prior to reaching the target offer amount; (vii) Take measures to protect the privacy of investor information; (viii) Not compensate promoters or finders of potential investors; (ix) Not provide directors or officers of the issuer with a compensatory interest in consideration of services performed; (x) Not offer investment advice or provide investment recommendations; (xi) Not solicit purchases or sales of the securities or compensate its employees for performing such services; and (xii) Not possess or handle investment funds. Before the crowdfunding exemption could become effective and utilized by issuers, the SEC was first required to issue implementing rules and regulations (which Congress required to be done within 270 days of the promulgation of the JOBS Act around January 2013). 73 The Commission has been widely criticized for its failure to issue the implementing rules in a timely manner, as issuers could not yet rely on this exemption without registering the offering or qualifying for an existing exemption. In response to the increasing criticism, the SEC finally issued proposed implementing rules on October 23, A comment period on the proposed rules extends until January 2014, at the conclusion of which, changes to the proposed rules may be incorporated before the crowdfunding exemption actually becomes effective (likely sometime in the spring of 2014). However, many analysts believe that once the final crowdfunding regulations are adopted by the SEC, it will have a significant impact on the ability of small and startup businesses to raise much needed capital from a large number of investors whom, prior to the JOBS Act, would typically not be targeted by most issuers (who generally look solely to accredited investors 72 See Jones, Benji T., The JOBS Act Becomes Law, Notes Bearing Interest, the North Carolina Bar Association (November 9, 2012). 73 See Id. 38

39 when undertaking a private offering in order to avoid onerous reporting and filing requirements). Others are more skeptical due to the expense an issuer must incur in order to comply with the proposed crowdfunding rules, and still others fear the new crowdfunding exemption will foster opportunities for fraud or create a bubble that could destabilize securities markets in light of the inherently speculative nature of crowdfunding businesses. 74 As Benji Jones acknowledges in The JOBS Act Becomes Law, the advent of the funding portal intermediary could increase the transactional costs of, and risks associated with, an offering, at least in the early stages of the new exemption. 75 As the demand for the funding portal intermediaries increases, a variety of actors will likely enter the market in an effort to service the issuer s needs. Until the funding portal market stabilizes, issuers would be wise to exercise due diligence in choosing the appropriate intermediary to facilitate securities sales. D. Removal of Prohibition on General Solicitations in Rule 506 Offerings Despite the ban on engaging in general solicitations, the Rule 506 exemption (now recodified as Rule 506(b)) has been the most attractive safe harbor for issuers seeking to avoid the costs and burdens associated with securities registration due to its flexibility and preemption of state registration laws. In a move that may materially increase the attractiveness of Rule 506 offerings, the JOBS Act mandated that the SEC adopt rules allowing general solicitations and advertisements in connection with Rule 506 offerings, provided that all purchasers qualify as accredited investors. In August 2012, the SEC proposed amendments to Rule 506 s prohibition against general solicitation that issuers should consider when verifying whether an investor qualifies as accredited or not. Without providing specific measures the issuer could rely on to ensure verification compliance, the SEC listed a number of objective factors it will consider in determining the reasonableness of the issuer s verification process including: (i) the nature of the purchaser; (ii) the amount and quality of information the issuer has regarding the potential investor; (iii) the manner in which the investor was solicited; (iv) the minimum investment amount of the offer; and (v) other terms of the offer. 76 The SEC has indicated that relying on an investor to check the box as to their accredited status, without more, will not satisfy the verification requirement. In addition, issuers are encouraged to retain information relevant to the verification process in order to demonstrate 74 Id. 75 Id. 76 Id. 39

40 the reasonableness of its verification procedures. Finally, as with the other exemption amendments under the JOBS Act, the relaxation on general solicitations in Rule 506 offerings would not be effective until the SEC issued implementing rules and regulations, which finally transpired on July 22, Thus the new 506(c) exemption became effective on September 23, 2013 a historic date in the securities world that will likely bring monumental changes to the manner in which private placements are conducted. E. Requirements of New Rule 506(c) 1. In General Following the passage of the JOBS Act in April of 2012, the SEC adopted new Rule 506(c) rules on July 10, 2013, with an effective date of September 23, 2013, which will likely revolutionize the manner in which private capital markets will function by eliminating the ban against general solicitation and advertising in certain Regulation D private offerings. To address consumer protection concerns arising from the deregulation measures, the SEC also proposed rules designed to (i) enhance the ability of the SEC to observe and analyze the resulting impact on private placement markets, and (ii) prevent reliance on Rule 506 safe harbors where certain felons or other bad actors participate in the offering on behalf of the issuer. The new Rule 506(c) safe harbor contains elements and advantages similar to the 506(b) exemption from SEC registration. For instance, in both a 506(b) and 506(c) private placement, the issuer can raise an unlimited amount of capital from a large number of investors. However, in a divergence from the requirements of Rule 506(b), issuers relying on Rule 506(c) can now reach a larger pool of potential investors by engaging in general solicitation and advertising communications that previously were prohibited as long as certain conditions are satisfied: o (i) the issuer takes reasonable steps to verify each purchaser is an accredited investor; o (ii) at the time of sale of the securities, all purchasers are in fact accredited investors or the issuer reasonably believes that they are accredited; and o (iii) the requirements of Rule 501, Rule 502(a) and Rule 502(d) of Regulation D are satisfied. It is significant to note that a purchaser who does not actually qualify as an accredited investor will not undermine the availability of 506(c), provided that the issuer took reasonable steps to verify accredited investor status and the issuer had reasonable belief that all such purchasers were accredited at the time of sale. Similarly, the fact that all purchasers are in fact accredited will not relieve the issuer of its obligation to undertake the accredited investor verification process. 40

41 2. Reasonable Steps to Verify Accredited Investor Status An issuer relying on the registration exemption created under new Rule 506(c) is permitted to engage in broad-based general solicitations, even if it has no information on the financial status of the investors, provided the issuer (i) has reasonable belief of accredited investor status and (ii) has taken reasonable steps to verify the same with respect to actual purchasers of its securities. Instead of requiring adherence to rigid verification procedures, the SEC chose to adopt a more flexible principles based regime, to be evaluated using a sliding-scale approach, in determining whether the issuer has taken the necessary reasonable steps to verify accreditation. As articulated by the SEC, the sliding-scale approach means the more likely it appears that a purchaser qualifies as accredited, the fewer steps the issuer would have to take to verify accredited investor status, and vice-versa. 77 Under this principles based approach, the SEC identified the following factors that should be analyzed by the issuer in conducting its verification process: (i) the nature of the purchaser and the type of accredited investor involved; (ii) the amount and type of information the issuer has with respect to the prospective purchaser; and (iii) the nature and terms of the offering. Essentially, the principles-based methodology implicates an objective determination that a purchaser is accredited under all the facts and circumstances. (a) Nature of the Purchaser. If the prospective investor is an individual, the purchaser would likely need to provide the issuer information about his or her net worth or income in order for the issuer to credibly analyze accreditation status. Note that some individuals may be hesitant to provide such financial disclosures due to concerns over privacy, especially if the issuer does not engage a third party intermediary to conduct the verification process. In light of the high failure rate of may startup businesses, investors may be concerned about what will happen to their confidential financial information in the event the startup closes its doors. (b) Amount and Type of Information the Issuer has about the Purchaser. Obviously, the more information the issuer has regarding the accredited investor status of the potential investor, the fewer steps it will need to take to fulfill the verification requirement. The SEC indicated the following types of information would be relevant in the analysis: (i) information included in public filings (such as compensation disclosed in a proxy statement), (ii) reliable independent third party information (such as industry publications that provide the average compensation received by those in employment positions similar to the prospective 77 SEC Release No

42 purchaser), and (iii) other information produced by a third party whom the issuer engaged to determine the accredited investor status of the purchaser. (c) Nature and Terms of Offering. The SEC also indicated that the means through which the issuer communicates to prospective investors is also relevant in determining whether the issuer satisfied its reasonable verification obligations. 78 The broader and more extensive the general solicitation/advertising is (e.g., through a website open to the public or through mass mailings), the more steps that must be taken to verify accredited investor status. As mentioned above, simply permitting the investor to check a box representing accredited investor status will not be sufficient according to the SEC. 79 With respect to the terms of the offering, fewer verification measures will be required where the minimum investment requirements are more substantial, provided the issuer is reasonably satisfied that third-party financing will not fund the purchaser s ability to satisfy the minimum subscription expenses. Providing additional guidance to the principles-based approach described by the SEC where there are not sufficient principles-based factors present, the Commission also articulated four non-exclusive methods for verifying whether individual prospective investors qualify as accredited investors. The non-exclusive methods include: (i) when predicated on income levels, a review of applicable IRS forms related to the two most recent years that evidence the requisite income levels necessary for accreditation, coupled with a written representation stating the investor reasonably expects to qualify as an accredited investor in the coming year; (ii) if based on net worth, a review of relevant financial documents stating assets and liabilities (such as bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, appraisal reports, and consumer credit reports issued by one of the nationwide consumer reporting agencies) dated within the last three months, coupled with a written representation that all liabilities of the investor have been disclosed; (iii) if based on the written verification from a qualified independent third party (such as a licensed attorney, certified public accountant, a registered broker-dealer or investment advisor, etc.), a written acknowledgment that such third party has taken reasonable steps within the last three months to verify the investor has met the accredited investor criteria; and (iv) if relying on the prospective purchaser s previous participation in a 506(b) offering conducted by the issuer prior to the enactment of Rule 506(c) who remains an investor in such issuer, a written certification by such investor that he or she is still an accredited investor. 78 SEC Release No Id. 42

43 Importantly, while these verification options are not the exclusive methods for satisfying the purchaser verification requirements of Rule 506(c), the SEC has indicated they will constitute safe harbors for compliance absent any actual knowledge of the issuer that the particular investor is not in fact accredited. In addition, in light of the burden imposed on issuers to prove reasonable steps to verify accreditation have been taken, issuers should ensure proper recordkeeping of all documents germane to such analysis (e.g., copies of the PPM, solicitation materials, copies of investor qualification documents, documents demonstrating reasonable steps to verify were taken, copies of completed subscription documents, participating broker certification statements, etc.). Finally, it is important to remember that the verification prong is a separate and independent condition from that requiring that the issuer has reasonable belief that all investors meet Rule 501 s definition of an accredited investor both prongs must be satisfied when relying on Rule 506(c). Accordingly, if all of the purchasers actually constitute accredited investors, the safe harbor will not be available if the issuer does not take reasonable steps to verify the same (unless the issuer has actual knowledge of accredited investor status). On the other hand, an issuer who does not engage in general solicitation efforts will only need to demonstrate the issuer had a reasonable belief that the purchaser is accredited. 3. Proposed Form D Amendments In an effort to mitigate the potential for greater fraud that could result in light of the relaxed solicitation rules, the SEC proposed amendments to the Form D filing requirements in connection with offerings conducted pursuant to Rule 506(c). While other Regulation D offerings require that the issuer file a Form D electronically within 15 days of the first sale of securities, in SEC Release No (issued on July 10, 2013), the SEC proposed amendments to Form D that would require Regulation D issuers to: (i) submit the document no later than 15 days prior to the commencement of any general solicitation; 80 (ii) file amendments to the Form D filing within 15 calendar days after the date of the first sale of securities to disclose any additional information in the event all information required by Form D was not provided during the initial filing; (iii) file an additional closing Form D within 30 calendar days after the termination of the offering; and (iv) provide additional information pertaining to the issuer s website, the methods of general solicitation utilized and the steps taken to verify accredited investor status of its purchasers. 80 No advanced filing would be required for offerings made under Rule 504, Rule 505 and Rule 506(b). 43

44 Note the SEC has requested additional comments with respect to how inadvertent general solicitations should be handled with respect to the Form D filing requirements. Further, the proposed amendments would require that all issuers relying on Rule 506 file a closing Form D within 30 days of the offering s termination, irrespective of whether the issuer engaged in general solicitation. In addition, the SEC Release proposed adoption of a new Rule 507, which would preclude an issuer from conducting a Rule 506 offering for one year if the issuer did not comply with the Form D filing requirements at any time within the previous five years. Should these new rules become effective, it will be critically important for issuers to adhere to the Form D filing requirements in connection with a Rule 506 offering whereas currently, failure to timely file the Form D will not automatically result in forfeiture of the safe harbor exemption. However, the SEC stressed that it purposefully chose not to make the availability of the 506 safe harbor contingent on the proper filing of Form D in connection with that particular offering since the substantial costs of losing the registration exemption (loss of federal preemption over state blue sky laws and rescission rights to investors) would outweigh the benefits. Instead, failure to comply with the Form D filing requirements within the previous five years would preclude the issuer s reliance upon Rule 506 for future offerings conducted over the next year. In addition, the SEC s proposed rules would permit issues to cure filing deficiencies for a period of thirty (30) calendar days, but only with respect to the issuer s initial failure to timely file the Form D and any subsequent amendments to the filing. Finally, the proposed rules would disqualify an issuer from relying on the Rule 506 exemption with respect to future offerings if the issuer (or any of its affiliates or predecessors) has been the subject of an order, judgment or court decree enjoining such issuer due to failure to (i) include the prescribed legends, or (ii) submit the written general solicitation materials. The SEC also proposed a rule allowing the Commission to waive any disqualification by demonstrating good cause for noncompliance. Regardless of what form the proposed Form D amendments may ultimately take, the SEC release implementing Rule 506(c) did in fact amend Form D to require the issuer to (i) indicate whether it is relying on Rule 506(b) or 506(c), and (ii) certify that the issuer is not precluded from relying on Rule 506 due to the bad actor disqualifications under new Rule 506(d) (see below). The issuer is not allowed to check both the 506(b) box and the 506(c) box with respect to the same offering. 4. Disclosure Documents in a Rule 506(c) Offering Although not technically required under Rule 506 with respect to sales of securities to accredited investors, most issuers prepare disclosure documents for delivery to potential investors in order to comply with the antifraud provisions of the securities laws - which essentially require full, fair and complete disclosure of all material information related to the issuer, its finances, business, operations and management. The disclosure documents typically 44

45 take the form of a private placement memorandum (PPM) with the objective of satisfying the disclosure of material information requirements contained in Rule 502(b)(2) of Regulation D. In addition to fulfilling its disclosure obligations, issuer agents and advisors generally prepare the PPM in order to establish a defense against potential accusations from future investors of antifraud violations under the federal securities laws. However, any oral or written representations by issuer representatives or associated placement agents will significantly diminish the value of the PPM and undermine the efforts to satisfy disclosure requirements and minimize the likelihood of antifraud claims. Accordingly, issuers relying on Rule 506(c) should be diligent to ensure all sales, solicitation, advertisement and other promotional materials are consistent with the terms of the PPM. If not, prompt updates to the PPM should be made to rectify the inconsistency and/or reflect any material changes and delivered to all recipients of the previous PPM. Further, while the SEC does not require the filing of the PPM with its office, FINRA members participating in a Regulation D private offering are now required to file the PPM disclosure documents with FINRA within 15 days of the first sale of securities following the recent adoption of Rule 5123 by FINRA. Rule 5123 provides that the filing is for notice purposes only and will not be subject to substantive review by that department. 81 Although Rule 506(c) now permits general solicitation through various channels such as communications, radio and television advertisements, social media platforms, print circulations, etc., issuers must be cognizant that such communications will be subject to the antifraud provisions of Rule 10b-5 of the 1934 Exchange Act, Section 17(a) of the 1933 Securities Act, and Section 206 of the Investment Advisors Act of 1940, and consequently must avoid misleading statements and other fraudulent behavior. Whereas issuers relying on Rule 506(b) must take care to ensure delivery of the PPM and related disclosure documents is limited to prospective investors with whom they (or participating brokers) have a preexisting and substantial relationship, Rule 506(c) permits distribution of the placement documents to any prospective investor, irrespective of the lack any knowledge about, or preexisting relationship with, such investors. However, any subscription documents delivered in connection with a 506(c) offering should contain more extensive representations and requests for documentation evidencing accredited investor status so as to comply with the verification requirements associated with such placements. Further, subsequent requests for additional information from prospective investors will likely be necessitated for the issue to establish the reasonable steps prong of the 506(c) compliance determination. 5. Comparing the Rule 506 Exemptions Note that issuers who do not intend to undertake general solicitation or advertising measures in conducting a private offering can still rely on Rule 506(b) as an available exemption option. Those relying on Rule 506(b) are not required to take reasonable steps to verify 81 FINRA 5123 became effective on December 3,

46 accredited investor status as is required with respect to Rule 506(c) offerings. As long as either (i) the security purchasers are actually accredited or (ii) the issuer has reasonable belief that such investors are accredited, no further verification process is required in connection with Rule 506(b) offerings. Despite the advantages presented by lifting the ban on general solicitation, the availability of new Rule 506(c) will not signal the death of 506(b) as many issuers will continue to rely on the less burdensome 506(b) exemption (e.g., no need to undertake accredited investor verification measures) where circumstances don t require more expansive investor communications. CHART COMPARING RULE 506(b) to RULE 506(c) Rule 506(b) Private Placements No general solicitations or advertising allowed Issuer only required to establish good faith for accreditation purposes Less regulatory burdens and reporting requirements; more simple and less expensive alternative Form D filed within 15 days after the first sale of securities Issuer can choose to engage in general solicitation if the private offering is not effective (must then comply with Rule 506(c)) Rule 506(c) Private Placements General solicitation and advertising allowed Issuer must take reasonable steps to determine each investor is accredited Costs associated with undertaking accredited investor verification measures makes this alternative more expensive Form D filed within 15 days before the first sale of securities Once an issuer generally solicits, it may not change course and seek shelter under Rule 506(b) 6. Associated New Rules Yet to be Adopted by SEC Shortly after the release of the general solicitation implementing rules, the SEC issued a separate release on July 10, 2013 (SEC Release No ), which proposed additional new rules that may ultimately apply to 506(c) offerings. One such proposal was Rule 509 which, if adopted, would require issuers to include prescribed legends on all general solicitation materials used in a 506(c) placement. In addition, the SEC proposed new temporary Rule 510T which would mandate the submission to the SEC of all written general solicitation materials to be used in a 506(c) offering prior the distribution of such materials. This temporary rule would be effective for two years from the date of adoption. 46

47 According to the SEC Release, the objective of the proposed rules is to improve the SEC s ability to observe and analyze the market effects of 506(c) offerings so as to ensure meaningful levels of investor protection are maintained. However, if adopted, the proposed rules may reduce issuer reliance on new Rule 506(c) due to the significant verification burdens associated with such submission requirements. F. Bad Actor Disqualification under New Rules 506(d) and 506(e) 1. New Bad Actor Disqualification and Disclosure Rules In connection with the lift on the ban on general solicitation, the SEC adopted new Rules 506(d) and 506(e) which materially limit the involvement of certain bad actors in all Rule 506 offerings. In SEC Release No , the Commission prohibited issuers from relying on Rule 506(b) or 506(c) if certain bad actors are involved in the offering with its promulgation of Rule 506(d), which was a requirement established by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ). The disqualification provisions apply to certain covered persons of the issuer including: (i) the issuer, its general partner, directors or managing member; (ii) any person owning at least 20% of the issuer s voting securities; (iii) executive officers of the issuer and other officers that participate in the offering; and (iv) any associated person compensated for soliciting investments on behalf of the issuer. As detailed below, the disqualifying events include certain criminal convictions, securities-related injunctions and restraining orders, and other SEC disciplinary orders. However, under new Rule 506(d), the new disqualification rules apply only to triggering events occurring after the effective date (September 23, 2013), provided that disclosure of any such events occurring prior to the effective date must be disclosed to prospective investors. Specifically, new Rule 506(e) requires that, within a reasonable period of time prior to the sale, the issuer provide each prospective purchaser with a written description of the events that would have triggered disqualification had they occurred after the September 23, 2013 effective date. As such, it may behoove the issuer to identify all covered persons and request information relevant to the Rule 506(e) disclosure requirements prior to undertaking a private offering. 2. Who Qualifies as Covered Persons subject to Rules 506(d) and (e)? The SEC provides the following additional information with respect to the definition of Covered Persons : (a) Executive officers and participating officers of the issuer: Certain executive officers and other officers of the issuer whom participate in the offering will be Covered Persons subject to the new disqualification and disclosure requirements. 82 The term executive officer means a company s president, any vice president in charge 82 See SEC Release No

48 of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function or any other person who performs similar policy-making functions. The term officer means a president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, as well as any person who routinely performs corresponding functions. Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants. (b) 20 percent beneficial owners of the issuer: The class of Covered Persons also includes beneficial owners of 20% or more of the issuer s outstanding equity securities, calculated on the basis of total voting power rather than on the basis of ownership of any single class of securities. 83 (c) Promoters: The category of promoter as a Covered Person can be very broad. Securities Act Rule 405 defines a promoter as any person individual or legal entity that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities (other than securities received solely as underwriting commissions or solely in exchange for property). 84 (d) Investment managers and principals of pooled investment fund issuers: For issuers that are pooled investment funds, the rule covers investment advisers and other investment managers of the fund; the directors, general partners, managing members, executive officers and other officers participating in the offering of such investment managers; and the directors, executive officers and other officers participating in the offering of the investment managers general partners or managing members. (e) Compensated solicitors: Persons compensated for soliciting investors, as well as their directors, general partners, managing members, executive officers and officers participating in the offering, are Covered Persons under new Rule 506(d). This category covers any persons compensated for soliciting investors but will typically involve broker-dealers and other intermediaries. 83 Whether securities are voting securities depends on whether security holders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. For example, the Commission would consider that securities that confer to security holders the right to elect or remove the directors or equivalent controlling persons of the issuer, or to approve significant transactions such as acquisitions, dispositions or financings, would be considered voting securities for purposes of the rule. Conversely, securities that confer voting rights limited solely to approval or changes to the rights and preferences of the class would not be considered voting securities for purposes of the rule. 84 The test considers activities alone or together with others, directly or indirectly ; therefore, the result does not change if there are other legal entities (which may themselves be promoters) in the chain between that person and the issuer. 48

49 3. What are Disqualifying Events under Rules 506(d) and (e)? In addition, the Commission provided detailed information related to the different categories of disqualifying events subject to the new bad actor disqualification and disclosure regime: (a) Criminal convictions: Disqualification is triggered by criminal convictions in connection with: (i) the purchase or sale of a security, (ii) making a false filing with the SEC, or (iii) the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. The criminal conviction must have occurred within ten years of the proposed sale of securities, or five years in the case of the issuer and its predecessors and affiliated issuers. (b) Court injunctions and restraining orders: Disqualification under Rule 506(d) is triggered by court injunctions and restraining orders in connection with: (i) the purchase or sale of a security, (ii) making a false filing with the SEC, or (iii) the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. Disqualification only applies for injunctions and restraining orders that are in effect at the time of the proposed sale of securities and were entered within the preceding five years. 85 (c) Final orders of certain state and federal regulators: Disqualification is triggered by final orders 86 of state regulators of securities, insurance, banking, savings associations or credit unions, federal banking agencies, the Commodity Futures Trading Commission and the National Credit Union Administration, that: (i) bar the covered person from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities; or (ii) are based on fraudulent, manipulative, or deceptive conduct 87 and were issued within 10 years of the proposed sale of securities. 88 Bars are orders issued by one of the specified regulatory authorities that have the effect of barring a person from association with an entity that is regulated by that authority; from 85 Injunctions and court orders that have expired or are otherwise no longer in effect are not disqualifying, even if they were issued within the five-year look-back period. For example, an injunction that was issued four years before the proposed offering but lifted before the offering occurred would not be disqualifying. 86 A final order is a written directive or declaratory statement issued by one of the federal or state regulatory agencies listed above, under applicable statutory authority that provides for notice and an opportunity for hearing, which constitutes a final disposition or action by that federal or state agency. 87 The final rules do not provide a specific definition of fraudulent, manipulative or deceptive conduct, and in particular do not limit it to matters involving knowing misconduct or scienter. 88 Note, that an order does not have to be non-appealable to be a final order under the bad actor rules. In addition, there are no procedural requirements beyond the basic requirement that notice and opportunity for hearing be provided for in the statutes, rules and regulations under which an order is issued. No hearing need have occurred. For example, a settlement is considered to have been made after an opportunity for hearing. 49

50 engaging in the business of securities, insurance or banking; or from engaging in savings association or credit union activities. Any final order that has one of those effects is a bar, regardless of whether it uses the term bar. 89 (d) SEC disciplinary orders: Disqualification is triggered under new Rule 506(d) by SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons under Section 15(b) or 15B(c) of the Securities Exchange Act, or Section 203(e) or (f) of the Investment Advisers Act that: (i) suspend or revoke the person s registration as a broker, dealer, municipal securities dealer or investment adviser, (ii) place limitations on the person s activities, functions or operations, or (iii) bar the person from being associated with any entity or from participating in the offering of any penny stock. 90 (e) SEC cease-and-desist orders: Disqualifying events also include SEC orders to cease and desist from violations and future violations of the scienter-based anti-fraud provisions of the federal securities laws, 91 that were issued within five years before the proposed sale of securities and remain in effect. (f) SEC stop orders: An offering is disqualified if any covered person has filed a registration statement or Regulation A offering statement that was the subject of a Commission refusal order, stop order or order suspending the Regulation A exemption within the last five years, or is the subject of a pending proceeding to determine whether such an order should be issued. (g) Suspension or expulsion from membership in an SRO or from association with an SRO member: Under the rule, an offering is disqualified if any covered person is suspended or expelled from membership in, or suspended or barred from association with a member of, a securities self-regulatory organization for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade. (h) U.S. Postal Service false representation orders: An offering is disqualified if the issuer or another covered person is subject to a U.S. Postal Service false representation order entered within the preceding five years, or to a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail. 89 A bar is disqualifying only for as long as it has continuing effect. Thus, for example, a person who was barred indefinitely, with the right to apply to reassociate after three years, would be disqualified until such time as he or she is permitted to reassociate, assuming that the bar had no continuing effect after reassociation. 90 Disqualification continues only for as long as some act is prohibited or required to be performed pursuant to the order. 91 For example, Section 17(a)(1) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 15(c)(1) of the Securities Exchange Act, Section 206(1) of the Investment Advisers Act. 50

51 (4) Reasonable Care Exception The final rule provides an exception from disqualification when the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The steps an issuer should take to exercise reasonable care will vary according to particular facts and circumstances. The instruction to the rule states that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualification exists. G. Advantages of New Rule 506(c) The creation of a new registration exemption under Rule 506(c) obviously has many advantages for issuers who wish to engage in general solicitations and advertising in order to attract investment capital from a larger pool of potential purchasers. Obviously, the ability to broaden the potential investment base by advertising to prospective investors whom otherwise would not have known about the issuer will be very attractive to issuers. In addition, similar to Rule 506(b) offerings, private offerings made pursuant to new Rule 506(c) require only notice filings to SEC and the states no requirement to file private placement memoranda and other offering materials with the SEC or the state (pursuant to NSMIA). 92 Further, no specific disclosures from the issuer will be required if the offering is limited to accredited investors - which is required to engage in general solicitations under 506(c) anyway. This flexibility leaves the decision to the issuer s discretion as to what information to disclose in order to provide full disclosure and avoid anti-fraud liability. 93 Significantly, disgruntled investors cannot sue for negligent misrepresentation (i.e., lack of due care) under federal securities laws due to the Supreme Court decision in Gustafson v. Alloyd, 94 which held that the Section 12(a)(2) liability provisions of the 1933 Act do not apply to private securities sales. Investors can only assert federal claims under Section 10(b) and Rule 10b-5 of the 1934 Act which requires that actual intent to defraud (scienter) or reckless indifference to the accuracy of the representations made in the offering must be proven by the plaintiff. Practically speaking, it is very difficult to meet that standard since it is based on intent. While dissatisfied investors can still assert various state law claims, the Gustafson decision made it extremely difficult for investors to win in a properly conducted Rule 506 offering. See the discussion below regarding the public private offerings for more examples of the degree to which the new Rule 506(c) offering exemption could impact the private placement of securities in the near future. 92 Note FINRA requires participating broker-dealers to file copies of PPMs within 15 days of the date of sale, but these filings are only notice filings 93 SEC Rule 502(b)(1) U.S. 561 (1995) 51

52 H. Changes to Exchange Act Registration Requirements. Historically, the Exchange Act of 1934 required securities registration with the SEC with respect to companies with asset values in excess of $10 million if any class of securities was held by 500 or more persons. 95 The JOBS Act has relaxed this requirement by increasing the threshold from 500 to 2,000 holders of record. The increased threshold for triggering securities registration should allow many more private companies to avoid transitioning into public company status, thereby avoiding the costs and public scrutiny typically incurred by public reporting companies. I. Finding Investors in the New JOBS Act Securities Regime. Under Rule 506(b), issuers could use intermediaries or finders to identify potential investors provided that the intermediary limited its involvement and had a substantial and preexisting relationship with the prospective investor sufficient to allow the intermediary to understand the financial sophistication of such investor. Thus, an issuer s decision as to whether to conduct an offering under Rule 506(b) or 506(c) may depend in part on the extent of such preexisting relationships with potential investors. To the extent the issuer has substantial and preexisting relationships with a sufficient number of potential investors, it may choose to rely on Rule 506(b) so as to avoid the burdensome accredited investor verification requirements. In addition, unlike under a 506(c) offering, the issuer could sell securities to up to 35 non-accredited investors if it so chose. In contrast, under a 506(c) offering, intermediaries need not have a substantial or preexisting relationship with a prospective investor in order to conduct general solicitations or general advertising. The SEC has recently increased its efforts to identify and sanction unregistered finders who engage in broker like activities and receive compensation in connection with the procurement of investors for the issuer without being registered under the 1934 Act. See In the Matter of Ram Capital Resources, LLC, SEC Release No (June 19, 2009) and In the Matter of Jeffrey M. Zamorsky, SEC Release No (October 29, 2010). However, concurrently with the SEC s increased focus on the activities of unregistered finders, there has been growing support for the establishment of a form of broker-dealer lite registration. In fact, the American Bar Association Task Force issued a report in April of 2010 championing the adoption of a broker-dealer lite registration for intermediaries whose activities go beyond simply identifying potential investors. The Task Force suggested exempting any securities intermediaries from federal registration, provided such persons are registered with the applicable states. The SEC met with the Task Force in 2012 to discuss this proposal and indications suggest the SEC was receptive to the idea of adopting a federal exemption for finders so stay tuned. 95 See Id. 52

53 J. Effect of Increased SEC Finder Scrutiny on Securities Trading Platforms. An unresolved question debated by securities market players is how the increased SEC scrutiny of finder activities will affect the involvement of securities trading platforms. One of the stated objectives of the JOBS Act was to encourage the engagement of intermediary platforms that could assist accredited investors invest in startups and other private companies. In fact, the JOBS Act includes a specific exemption from broker-dealer registration for these platforms provided certain conditions are satisfied, one of which prohibits the platform s receipt of compensation in connection with the purchase or sale of a security. Despite the restriction on the receipt by the platform of compensation tied to the purchase or sale of securities, the JOBS Act permits such trading platforms to charge user fees to those who wish to access the platform. However, substantial doubt exists within the securities industry as to the practical significance and ultimate use of this fee allowance. Accordingly, the current issue is to ascertain what fee packages that fall between these two ends of the compensation spectrum will be permitted by the SEC. In March of 2013, the SEC issued two no action letters that provide additional guidance as to what forms of platform compensation will not constitute transaction based compensation and thus will be allowed. In AngelList LLC and AngelList Advisors LLC (SEC No-Action Letter, March 28, 2013) and FundersClub Inc. and FundersClub Management LLC (SEC No-Action Letter, March 26, 2013), the SEC granted no-action relief allowing venture fund advisors to receive carried interests for providing passive advisory and consulting services to facilitate investments and to be reimbursed for documented expenses. The SEC indicated the platforms may receive expressions of investment interest from accredited investors with respect to a particular start-up, and once the investment interest becomes appreciable, a platform-affiliated advisor may then establish a transaction vehicle (such as a limited liability company) that can accept funds from accredited investors and subsequently invests in the subject issuer. The model contemplates compensating the advisor with a carried interest to be realized upon the sale of the investment based on the profitability of the issuer. The carried interests were not deemed to be transaction based compensation tied to the success of security sales, but instead were distinguished as incentive fees predicated on the future performance of the fund. Note, however, neither the advisor nor the platform may actually handle investor funds or issuer securities, as all investment funds and securities must be handled by a bank or other financial institution. In addition, the platforms must register as investment advisors with the federal and applicable state security commissions. Irrespective of these restrictions, the recent SEC no-action letters suggest the facilitation of capital formation by such platforms and similar intermediaries not registered as brokers will increase in the future, especially given the relaxation of general solicitation prohibitions in private offerings. Further, the SEC s decisions in these two no-action letters suggest other compensation arrangements tied to the performance of the underlying security (as opposed to the sale of a security) may be permissible. Significantly, similar incentive compensatory packages based on the performance of the security may be implemented by issuers when engaging finders 53

54 and other third party intermediaries assisting with the solicitation of investors, provided other broker-related activities are limited. K. The Real Crowdfunding Exemption Public Private Offerings. As mentioned above, two critical elements of the JOBS Act likely to have an immediate and substantial impact in the private placement environment are: (1) the lift on the ban against general solicitation and advertising in Rule 506(c) offerings; and (2) increasing the holder-ofrecord threshold with respect to the number of investors to whom securities can be sold without registration under the 1934 Act. The synergistic effect of these two changes will likely usher in a new wave of offerings by capital-seeking enterprises colloquially referred to as publicly offered private offerings. The allowance of general solicitation of accredited investors in connection with Rule 506(c) offerings will undoubtedly have a substantial impact on the securities markets. At a minimum, the new 506(c) rules will open up many securities offerings to expansive forms of solicitation and advertising, including: Internet ads; Cable network advertising; Solicitations to a company s customer base; Catalogue ads; Facebook and Twitter ads; Offers to magazine subscribers or credit card account holders; and University alumni offers. Significantly, securities offered under new Rule 506(c) of Regulation D qualify as covered securities and thus will generally avoid substantive federal and state regulation. Rule 506 offerings can be sold to an unlimited number of investors, subject to 1934 Act registration requirement for issuers with more than a certain number holders of record. Significantly, the JOBS Act raised the holder-of-record limit for purposes of 1934 Act registration from 500 to 2, As a result, issuers can conduct a Rule 506(c) offering through general solicitation and widespread advertising, without registration under the Exchange Act of 1934, so long as: (i) all purchasers are accredited investors (or the issuer has reasonable belief they are); (ii) the issuer takes reasonable steps to verify accredited status of its investors; and (iii) the issuer has less than 2,000 holders of record following the offering. Consequently, the securities landscape is likely to experience a wave of crowdfunding placements, however not in the form contemplated by Congress when it created the crowdfunding exemption under Title III of the JOBS Act. Instead, the real crowdfunding exemption is likely to take the shape of an accredited investor crowdfunding mechanism, as private issuers will be inclined to attract investment capital through general solicitations and advertisements targeted at accredited investors so as to fall within the safe harbor of new Rule 506(c). 96 Title V of the JOBS Act amended Section 12(g)(1)(A) of the Securities Act of 1934 to increase the holder-ofrecord threshold to 2,

55 Part of the reason the markets are more likely to see a proliferation of accredited investor crowdfunding under Rule 506(c), as opposed to the new crowdfunding exemption created under Title III of the JOBS Act, is due to the significant expenses, burdens and limitations associated with undergoing a Title III crowdfunding offering. For example, the maximum aggregate offering in a Title III crowdfunding offering is limited to $1,000,000 and the potential capital an issuer can receive from an individual investor is capped at relatively low ceilings. 97 Another limiting attribute of the new crowdfunding exemption stems from the requirement that the offering must be conducted through a regulated intermediary (broker-dealer of funding portal). Intermediaries and issuers must comply with extensive reporting and disclosure requirements to participate in crowdfunding offerings, which will require substantial legal, accounting and intermediary fees for offerings limited to $1,000,000 in the aggregate. In addition, both issuers and intermediaries are subject to ongoing reporting obligations under Title III of the JOBS Act, which will further drive up the costs associated with such offerings. In addition, even though the new crowdfunding exemption is not limited to accredited investors, or subject to the 2000 record holder limitations applicable to Rule 506 offerings, most issuers will (consistent with historical trends) limit securities sales to accredited investors in order to minimize disclosure requirements since accredited investors are assumed to be sophisticated and in less need of detailed disclosures. In summary, issuers relying on Rule 506(c) can raise an unlimited amount capital, from an unlimited number of accredited investors (subject to registration under the 1934 Act if there are more than 2,000 equity owners), without incurring the additional expense likely to be assumed by crowdfunding issuers as a result of ongoing SEC reporting requirements, continuing dealings with funding portal intermediaries, heightened scrutiny with respect to disclosures to non-accredited investors, and the need to compensate professional advisors to ensure compliance with the cumbersome Title III crowdfunding rules. Accordingly, the marked relaxation of investor solicitation allowed under new Rule 506(c), coupled with the flexibility to have up to 2,000 investors, will arguably make 506(c) offerings the preferred vehicle for issuers planning to undertake a private offering of its securities. 97 As mentioned above, investments by investors with less than $100,000 of annual income or net worth are limited to the greater of 5% of annual income or $2,000. With respect to investors with annual incomes exceeding $100,000, the maximum investment amount is limited to 10% of annual income with a cap of $100,

56 VIII. Conclusion. Access to readily available capital is often the lifeline for many Main Street businesses. Under the current regulatory landscape, companies seeking to attract outside capital through the sale of securities to unrelated investors essentially have two choices: (i) register the securities with the SEC and the applicable state security administrations, or (ii) find an exemption from registration under the federal and state securities laws. Due to the burdensome requirements associated with securities registration, which is often prohibitively expensive for many small businesses, exemption qualification is almost always the more attractive option. Given the difficult economic environment currently limiting the ability of private companies to secure institutional financing on reasonable terms, lawmakers have taken legislative measures to stimulate the capital markets by encouraging private investment in small businesses. Congressional initiatives to foster capital formation and spur job growth took shape with the passage of the Jumpstart Our Business Startups Act (JOBS Act) which President Obama signed into law on April 5, The legislation was designed to loosen regulatory reporting requirements and increase access to capital for small and emerging companies in order to stimulate growth in these markets and create additional jobs. While the passage of the JOBS Act is certainly a landmark event in the evolution of securities regulation, its ultimate effect on capital formation for small businesses will largely hinge on how the securities markets react to the substantial rulemaking and guidance that was recently adopted by the SEC to realize full implementation of the various JOBS Act provisions. Given this uncertainty surrounding the ultimate effects of the JOBS Act implementing rules (including the development of intermediary platforms and verification procedures to be undertaken in connection with general solicitation offerings), coupled with the already complicated nature of securities regulation framework, it would be prudent for capital-seeking businesses to seek qualified legal and accounting advice before navigating through the securities regulation labyrinth. 56

57 EXHIBIT A COMPARISON OF NORTH CAROLINA REGISTRATION EXEMPTIONS

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59 EXHIBIT B SUMMARY OF CROWDFUNDING EXEMPTION

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