Letter from the Editor
Dear clients and friends,
Jeff Beck’s Quarterly Tidbit of Interest:
Quote from James Doty, Chairman of the Public Company Accounting Oversight Board (February 6, 2014) suggesting that mandatory auditor rotation in the United States is dead for the time being.
"We don't have an active project or work going on within the Board to move forward on a term limit for auditors."
In this issue of the Corporate Communicator we bring you two short articles on important developments from the SEC relating to private securities offerings and private M&A transactions. In the first article, we discuss the SEC’s recent rule changes that allow, subject to some rigorous conditions, general solicitation activities in private securities offerings. Our second article discusses a recent SEC no-action letter that relaxes in important ways the SEC’s prior restrictions on the involvement of unlicensed “M&A brokers” in private M&A transactions.
Very truly yours,
Snell & Wilmer
Business & Finance Group
General Solicitation Yet to Be Generally Embraced
For all the hype leading up to the SEC’s recent lifting of the prohibition against general solicitation, the first several months under the new regime have been noticeably anti-climactic. While lawyers have been fielding calls left and right from clients that often start with “What’s this I hear about being able to talk to anyone about investing in my company,” their enthusiasm fades quickly after counsel provides a brief reality check. There are, in fact, many reasons a startup company may not want to be one of the first to test the waters under the new solicitation regime.
Historical Restrictions on General Solicitation
The modern era of securities regulation in the United States stems back to the adoption of the Securities Act of 1933 and the Securities and Exchange Act of 1934 and the related establishment of the Securities and Exchange Commission. Prior to 1934, it was not uncommon to see advertisements for securities in newspapers or to learn of “the next best” stock through a well-orchestrated word-of-mouth campaign. In the aftermath of the stock market crash of 1929 and the Great Depression, where fortunes were lost overnight through investments stemming from these unregulated marketing campaigns, Congress stepped in and regulated the manner and means of offering and selling securities in interstate commerce. While the laws adopted by Congress and the rules promulgated thereunder by the SEC have been modified over time, the ban on general solicitation and advertising remained intact and a significant feature of the regulatory scheme for nearly a century. That feature of securities regulation came to an end on September 23, 2013 when the new Regulation D Rule 506(c) took effect.
The New Era
Under Rule 506(c), issuers are allowed to use general solicitation and advertising to raise unlimited amounts of capital from an unlimited number of investors so long as all of those investors are accredited investors. Under the new Rule 506(c), however, the issuer must take “reasonable steps” to verify that each purchaser of securities meets the standard for an accredited investor. Under the old version of Rule 506 (which is now contained in Rule 506(b)), issuers often got comfortable relying on a subscription agreement from investors representing to such matters as their status as an accredited investor. In its adopting release for Rule 506(c), however, the SEC made clear that this historical practice would not be sufficient for a valid Rule 506(c) offering. As the SEC stated in its release, “we do not believe that an issuer will have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.”
Instead, as suggested by the nonexclusive means for verifying an accredited investor’s status as provided for in Rule 506(c), at a minimum, it appears that “reasonable steps” require some type of third party documentation or documentation filed under penalty of perjury to meet the requisite standard. Under the new Rule, if a non-accredited investor slips through the cracks, the issuer will be held accountable unless the issuer can establish that it satisfied the “reasonable steps” standard or that the investor provided false or misleading information.
Rationale for Reluctance to Engage in General Solicitation
The requirement that issuers take reasonable steps to verify that all purchasers in the offering are accredited, and the significant risks that come along with not taking adequate steps and letting a non-accredited investor slip through, is one of the primary reasons issuers have thus far been tepid when it comes to engaging in general solicitation activities. As every startup lawyer is constantly reminding his clients, ignoring securities laws or blowing your intended exemption has some pretty drastic consequences, most notably rescission with interest or damages. In light of this, issuers’ unease with the “reasonable steps” requirement was heightened, to some extent, when the SEC issued its first set of Compliance and Disclosure Interpretations related to the new rule. In the C&DIs, the Staff clarified that “The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.” In essence, if you “generally solicit,” you’ve locked yourself into the burdens of satisfying the “reasonable steps” standard with each investor, regardless of how certain you are that the investor is accredited.
A second significant reason lawyers have been reluctant to advise clients to embrace general solicitation is that an issuer that engages in general solicitation but fails to satisfy the standards of Rule 506(c) will not be able to fall back on another exemption under Regulation D or the exemption in Section 4(a)(2), and so will likely be unable to proceed with an even more limited offering. As the SEC stated in its November C&DIs, an issuer that commences an offering under Rule 506(c) and engages in general solicitation, subsequently cannot rely on Rule 506(b). If the issuer cannot complete the offering under Rule 506(c), it will be stuck waiting on the sidelines for at least six months (the period during which the SEC can determine that two offerings should be integrated and viewed as a single offering) before utilizing a different exemption under Regulation D. In addition, while an issuer that fails to satisfy the technical requirements of the Rule 506(b) safe harbor (i.e. old Rule 506) might still get comfortable that its offering meets the more generic standard in Rule 4(a)(2) (which provides that the securities registration requirements shall not apply to transactions by an issuer not involving any public offering), an offering that has been tainted with general solicitation will automatically violate Rule 4(a)(2).
Yet an even more fundamental reason there hasn’t been a torrent of issuers in the market relying on general solicitation is that the primary beneficiaries of the new rule are those who lack the resources to comply with it. Rule 506(c) was not adopted to help those companies that already have significant revenues and resources access the capital markets. Absent unusual market conditions such as the global recession of 2009, larger companies with reasonable revenues and several years of operations have generally not encountered significant difficulties raising capital in reliance on the old formulation of Regulation D. Instead, Rule 506(c) was adopted to benefit the smaller issuers, who often are unable to catch the eye of angel investors and venture capital funds. It is these small business issuers who need to cast a wider net when looking for capital, and who may not be able to complete an offering absent the ability to advertise and solicit from those with whom they do not have a preexisting relationship. Yet smaller companies don’t have the resources to engage in a fundraising advertising campaign. They also may not have the resources to undertake the “reasonable steps” that are required to verify accredited investor status. Smaller businesses likely lack the capacity, and in many cases the sophistication, to correctly verify accredited investor status, and they may lack the financial resources to engage a third party professional to fill that void.
A fourth reason many potential issuers are yet to test the waters with general solicitation is fear over the type of investors who are likely to respond to general solicitation. An issuer desperate for cash may not hesitate to take money from anyone willing to invest. However, for those who can be even mildly selective, they prefer investors who are likely to be business minded, easy to work with, rational decision makers, and possibly who have industry experience that may be useful to the Company. General solicitation is just that – “general”. Anyone can see the message and anyone can respond. The business minded, easy going, rational and experienced investors are not the type that typically invest based off an advertisement, and even if they do respond to the advertisement, it may be difficult to identify them among the crowd of unsophisticated, demanding, irrational and inexperienced investors who also respond. Just because someone meets the financial standard to be an “accredited investor” does not mean they are a desirable investor.
Another factor in issuers’ reluctance to embrace general solicitation stems from issuers’ understandable desire to safeguard their proprietary information. Founders of many new companies looking to raise capital are convinced that their company has a competitive advantage of some sort – be it because they have developed a new technology, a new product, a new service, a new take on an old product or a more efficient way to deliver an existing service. The bottom line is, the company has something unique, and it is looking to raise capital to further develop that unique product or service before marketing its product to its consumer base. Companies such as this usually take great strides to keep their confidential information confidential, and so they are very reluctant to make the recipe for the secret sauce public ever, let alone to unknown investors responding to an early round general solicitation. That said, when an issuer raises capital through the sale of stock or debt, it is selling a security, and therefore is subject to the antifraud laws that require disclosure of material information. A company considering engaging in general solicitation is faced with the dilemma of finding the right balance between adequate disclosure for anti-fraud purposes while at the same time protecting information so as to prevent a competitor from gleaning sensitive information that can be used to undermine the potential success of the issuer’s business.
Finally, given that the prohibition on general solicitation was such a fundamental component of securities law for nearly 80 years, the SEC is likely to be particularly interested in the market’s response to the new regulatory scheme, especially since the new rules did not originate from an SEC initiative. Those actively involved in the securities industry generally expect the SEC to take a keen interest in the first batch of issuers to test the waters on general solicitation. Companies often hire lawyers to help keep them off the SEC’s radar, so the prospect of waiving a flag and asking the SEC to “scrutinize me” is fairly unappealing to issuers. Rather, most companies seem perfectly content to let the more adventuresome early adopters of general solicitation forge the way. To date, there seem to be relatively few volunteers for that pioneering role.
When evaluating a potential offering involving general solicitation, entrepreneurs who learn of the cost of complying with the rules, and the risks of failing to satisfy the standards, often come to the logical conclusion that they are better off sticking to the more traditional methods of capital raising. Those entrepreneurs who choose to be trailblazers in the realm of general solicitation should seek appropriate counsel to ensure they are complying with the new rules and to understand the benefits and limitations of utilizing the new rules in the context of a particular offering.
M&A Brokers Find Relief from Federal Broker-Dealer Registration
On January 31, 2014, the SEC issued an important no-action letter permitting the involvement of certain “M&A Brokers” in business acquisition transactions involving privately held companies without the need for federal broker-dealer registration under Section 15(b) of the Securities Exchange Act of 1934. Historically, the involvement of intermediaries, such as “finders,” in facilitating private company sale transactions created uncertainty because the SEC has taken an expansive view of the definition of “broker” and the SEC’s safe harbor from broker registration is fairly narrow in its application. The failure of such an intermediary to comply with broker-dealer laws could give other parties a right of rescission and expose the intermediary to regulatory actions and penalties. As a result, the SEC’s no-action letter provides a welcome clarification for certain financial advisors providing M&A transaction services.
What Is an “M&A Broker”?
The SEC’s no-action letter provides relief on behalf of “M&A Brokers” without regard to the size of the transaction. The letter defines “M&A Broker” as:
[A] person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (as defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company.
A privately held company is any company that does not have any securities registered or required to be registered, or any company not required to file public reports, with the SEC. A buyer will be deemed to operate the company if, among other actions, the buyer elects executive officers, approves the annual budget or serves as an executive or other executive manager of the company. Further, control will be presumed if, upon completion of the transaction, the buyer (or group of buyers) has the right to vote 25% or more of a class of voting securities, has the power to sell or direct the sale of 25% or more of a class of voting securities, or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital.
In addition, M&A Brokers must limit their activities as follows:
The M&A Broker cannot have the ability to bind a party to the “M&A Transaction,” which is defined as any merger, acquisition, business sale or business combination.
An M&A Broker cannot directly or indirectly provide financing for the M&A Transaction. If the M&A broker assists in securing financing from unaffiliated third party lenders, it must follow all applicable laws and disclose any compensation in writing to the client.
An M&A Broker cannot have custody, control or possession of or otherwise handle funds or securities issued or exchanged in connection with the M&A Transaction or other securities transaction for the account of others.
The M&A Transaction must not involve a public offering of securities, must be conducted under an applicable exemption from registration under the Securities Act of 1933 and may not involve a “shell company” except for a “business combination shell company” defined under Rule 405 of the Securities Act.
To the extent the M&A Broker represents both buyers and sellers, it must provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation.
The M&A Broker may facilitate the M&A Transaction with a group of buyers only if the group is formed without assistance from the M&A Broker.
The M&A Transaction will not result in the transfer of interests to a passive buyer or group of passive buyers.
Any securities received by the buyer or the M&A Broker will be restricted securities as defined in SEC Rule 144(a)(3) of the Securities Act because the securities would have been issued in a private offering.
The M&A Broker, along with any officer, director or employee of the M&A Broker, must not be barred from association with a broker-dealer by the SEC, any state or any self-regulatory organization, and must not be suspended from association with a broker-dealer (e.g., a “bad actor”).
Welcome Relief, but Issues Remain
The SEC’s no-action letter provides welcome clarification, although M&A Brokers should be mindful of the limited scope of the letter. The no-action letter does not affect broker and finder requirements under applicable state laws. In other words, there is no federal pre-emption of state laws in this area. Whether and to what extent the states follow the lead of the SEC on this issue remains to be seen. In addition, the no-action letter is intended to apply on a transaction-by-transaction basis and not to provide a broad exemption.
Finally, the no-action letter does not seem to provide much relief for many advisors to private equity funds when brokering a transaction for a portfolio company. For example, in many cases such advisors may not qualify as an M&A Broker as they may have custody, control, possession of, or handle securities issued in the transaction, or they may have the ability to bind a party to the transaction, or they may plan to provide financing for the transaction. Accordingly, M&A Brokers should proceed with caution and seek independent legal analysis of the facts and circumstances of a particular transaction.