A few months ago we posted an article entitled “Financing Your Startup: How to Sell Stock without Going to Jail.” Among other things, the post described a series of legal restrictions associated with raising funds legally. Although there have been many widely publicized calls to relax these restrictions over the past decade (such as this 2006 Report of the SEC’s Advisory Committee on Smaller Public Companies or this 2007 SEC Release), most of these efforts fizzled with no action. However, in connection with the Dodd-Frank Act reforms, there has recently been a notable resurgence of pressure to simplify rules regarding private company capital raising. This pressure has come from a variety of sources, most notably Congressman Darrell Issa (R-CA), Chairman of the House Oversight and Government Reform Committee. Recently, SEC Chairman Mary L. Schapiro, and Director of the SEC’s Division of Corporation Finance Meredith Cross, testified before the House Oversight and Government Reform Committee to discuss some of these topics. A transcript of their testimony can be found here.
The two issues that appear to be center stage are (1) relaxing the general solicitation prohibitions in private offerings and (2) increasing the 500-shareholder threshold for triggering reporting obligations under the Securities Exchange Act of 1934, as amended (the “1934 Act”).
Most private companies raise funds through “private offerings” that do not require the relatively long and expensive registration processes proscribed by Section 5 (e.g. an initial public offering) of the Securities Act of 1933, as amended (the “1933 Act”). One of the most commonly-used exemptions is Section 4(2) of the 1933 Act, which exempts transactions by an issuer “not involving any public offering.” Currently, an issuer relying on Section 4(2) or its safe harbor, Rule 506 of Regulation D under the 1933 Act (“Rule 506”), is prohibited from using general solicitation or advertising to attract investors for its offering. The ban was designed to ensure that companies do not solicit investors not capable of fending for themselves – i.e. those who would benefit from the safeguards of the registration process.
With respect to potentially relaxing or removing the general solicitation prohibition in private offerings, Schapiro stated that:
I recognize that some continue to identify the general solicitation ban as a significant impediment to capital raising for small businesses. I also understand that some believe that the ban may be unnecessary because those who do not purchase the offered security would not be harmed by the solicitation that occurs. At the same time, the general solicitation ban is supported by others on the grounds that it helps prevent securities fraud by making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market. We need to balance these considerations as we move forward in analyzing this issue.
Cross has also indicated that the staff wants to be confident that, if the ban is eliminated and private offerings are allowed through publicity and advertising, the groups to whom the securities are sold via such general solicitations are not in need of the protections provided by the federal securities laws – i.e. that they are, in fact, accredited investors.
When discussing the need to reexamine the 500-shareholder threshold for triggering 1934 Act reporting Schapiro noted that “both the question of how holders are counted and how many holders should trigger registration need to be examined.” Specifically, Cross stated that the staff would consider whether accredited investors and employees of the issuer should be eliminated from the count entirely.
Schapiro concluded her testimony by outline the SEC’s next steps, noting that she has:
asked the staff to take a fresh look at [its] offering rules in light of changes in the operation of the markets, advances in technology and the acceleration in the pace of communications.
Schapiro also requested that the SEC staff “think creatively about what the SEC can do to encourage capital formation, particularly for small businesses, while maintaining important investor protections.” The particular areas of focus that Schapiro outline for the staff include:
- the restrictions on communications in initial public offerings;
- whether the general solicitation ban should be revisited in light of current technologies, capital-raising trends and our mandates to protect investors and facilitate capital formation; the number of shareholders that trigger public reporting, including questions surrounding the use of special purpose vehicles that hold securities of a private company for groups of investors; and
- regulatory questions posed by new capital raising strategies.
If implemented, increasing the 500 shareholder threshold would probably have limited impact on how very early-stage startups seek and obtain private financing. However, for larger and more well known private companies, like Facebook, Twitter and Zynga, relaxation of the 500-shareholder threshold would likely further fuel secondary market activity for private stock sales through platforms like SecondMarket. While increased secondary market activity could add much needed liquidity for private company investors (and their otherwise illiquid private company securities), such transactions do not typically result in any direct proceeds to the company itself. That said, an added alternative for liquidity could increase the appetite for investments in startups and private offerings.
On the general solicitation issue, I suspect that the SEC may propose a new exemption under Section 18 of the 1933 Act (e.g., state preemption) that resembles Rule 506 but without the prohibition on general solicitation if all purchasers are “accredited” – or perhaps “super-accredited.” Unlike a change to the 500 shareholder threshold, such change to the general solicitation restrictions would certainly impact how private companies seek and obtain private financing.
The specifics of any changes to either of the above rules would almost certainly require the SEC to go through the rulemaking process, so we are unlikely to see rapid implementation of any of the above changes. However, the renewed focus on these issues, and the potential boon to private company capital formation, make them extremely interesting issues to monitor.