Equity Crowdfunding Risks and Liabilities – Yes, They Do Exist

Sorry startups, you actually have to be careful with equity crowdfunding disclosures. There is substantial risk of liability for securities fraud.

Based on discussions with the equity crowdfunding-curious, people seem to believe that equity crowdfunding is the wild west where anything goes.  Raise lots of money and do it cheaply! Do what you want, say what you want and the SEC does not care!  Look at the Form C’s, there were probably no lawyers anywhere near them.  Think of the savings!!!!

None of that is true.

Done correctly, an equity crowdfunding offering should be done with as much care as any private placement.  The actual information requirements are more extensive than a typical Rule 506 offering.  Most importantly, crowdfunding issuers are subject to the same liability as any other securities selling issuer.

Securities Act Section 4A(c) provides that an issuer will be liable to a purchaser of its securities in a transaction exempted by Section 4(a)(6) if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading . . .

Sound familiar?  What is the difference between this liability and private placements?  Equity crowdfunding is done publicly to more people who are potential claimants.

What does this mean for issuers?  It means the Form C and the offering page on the platform site need to be done carefully and in compliance with SEC rules.  Those rules sound a lot like watered down Regulation S-K rules for MD&A, description of securities, related party transactions, etc…  If you have never complied with them, good luck doing this without experienced help.

Well, at least the platforms are safe, right?  They are just dumb pipes for crowdfunding deals and have no responsibility for what the issuers do on their site, right?

Well, no.  While the SEC did not impose issuer liability on the platforms, it specifically declined to exempt the platforms from liability under Section 4A(c).  Why?  So investors could bring suits against the platforms to make sure that the platforms take steps to keep from becoming conduits of fraud.

The SEC believes that the platforms should take steps to protect themselves.  Congress provided them a defense if they could not have known of an untruth or omission in the exercise of reasonable care.  In other words, the “head in the sand” defense will not work.  In addition, I have seen them provide and even require standard language and provisions in their issuers Form Cs and offering pages.  I doubt the SEC will ignore this if this becomes misleading.

As the SEC stated:

These steps may include establishing policies and procedure that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.

We are coming up on the one year anniversary of equity crowdfunding.  It is still very early in the equity crowdfunding world to see where the liability issues will shake out.  However, it is clear that the SEC and the state securities regulators take these liability issues seriously, and the issuers and platforms should too.

Equity Crowdfunding. Missing Category: Liability
Equity Crowdfunding. Missing Category: Liability

Equity Crowdfunding Publicity, Or What Not To Do

Rules on marketing and advertising your equity crowdfunding campaign are more restrictive than you think.  Startups accostomed to blogging your every thoughts and feelings beware.

When the SEC adopted the crowdfunding rules under Regulation CF, it included severe restraints on a company’s ability to publicize its crowdfunding campaign.  Many people think the SEC allows general solicitation and it applies to everything.  Wrong.  It does not apply to crowdfunding.

You know those cool tombstone ads in the Wall Street Journal showing off an IPO?  That shows the type of information that your crowdfunding notices can include.

A crowdfunding advertising is limited to:

  • a statement that the issuer is conducting a crowdfunding offering in reliance on section 4(a)(6) of the Securities Act of 1933
  • the name of the platform
  • a link directing the investor to the intermediary’s platform;
  • the terms of the offering; and
  • factual information about the legal identity and business location of the issuer, limited to:
    • the name of the issuer of the security
    • the address of the issuer
    • phone number of the issuer
    • website of the issuer
    • the e-mail address of a representative of the issuer and
    • a brief description of the business of the issuer.

The description of the terms of the offering must be limited to:

  • the amount of securities offered;
  • the nature of the securities;
  • the price of the securities; and
  • the closing date of the offering period.

That’s it.  Some short bullet-pointy info dots.

There’s no “this is the Internet and I can say whatever I want.”  There’s no “This is the new world and old rules don’t apply.”

Is it limiting?  Yes.

Is there a reason?  Yes.

As with public offerings, there is a required disclosure document, in this case Form C.  The SEC wants to make sure you have access to it before you make an investment decision.  The SEC does not want a hyped-up ad to entice you to purchase before you have the ability to review 50 to 100 pages of required disclosure.

Any good news?  Well, the company does not have to file the notices with the SEC.  The company is not limited to newspapers.  The notices can go anywhere, such as social media or the company’s website.

Also, the company can communicate with investors through the crowdfunding platform.  The SEC believes that this ability will facilitate the wisdom of the “crowd” in crowdfunding.  The company must identify itself as the company and not as “Random Guy Who Believes Company Will Be the Next UBER x Google.”

Old timey Ford tombstone. Crowdfunding companies need to get used to this.
Old timey Ford tombstone. Crowdfunding companies need to get used to this.

Do Startups and Other Private Companies Have to Provide Info to Employees?

If the employee is a stockholder, private companies, including secretive tech startups and other private emerging growth companies, must provide some company information, as confirmed by old law and new case.

Some ink is being spilled regarding the Biederman v. Domo case about a former employee and current stockholder suing Domo for financial information.  Some of the ink tells the story, but some get it wrong.  Let’s take a look.

I’m using news reports since I could not find an opinion or ruling, so accuracy may vary as we will see.

Domo usually keeps its financial information secret, like most companies.  Domo also pays its employees in stock and options, like many tech and startup companies.  Domo was richly valued in VC rounds, like many tech and startup companies.  Domo’s value may have declined, like many tech and startup companies that were richly valued in VC rounds.

Biederman wanted information about Domo’s financial condition, Domo wanted a confidentiality agreement.  Biederman refused.  According to the Information, this

“highlighted an obscure Delaware law that gives investors the right to financial information of private tech firms in which they hold stock.”

The San Francisco Business Times (the “SFBT“) misreports the Information by stating that

The Information reports that a Delaware law applies to any privately held company that has issued more than $5 million in stock awards in a year and is incorporated in the state. The rule allows employees of any U.S. private company a right to detailed financial information — even if they work for the famously opaque and sometimes secretive tech sector.”

Let’s unpack this a bit.

First, Section 220 of the Delaware General Corporation Law is not obscure.  It is commonly invoked by stockholders who demand information.  The universe of documents available to the stockholder is limited and related to the stockholder’s purpose for requesting the information.

Second, with respect to the SFBT, Delaware law cannot apply “to any privately held company,” only those subject to Delaware’s jurisdiction.  The $5 million figure refers to SEC Rule 701, which exempts certain compensation benefit plans from SEC registration requirements and has nothing to do with Delaware law.  Basically, certain disclosure requirements are triggered if the value of equity awards in a 12-month period exceeds $5 million.

None of this is new.  There are those, particularly in the tech world, who don’t understand that old rules apply to them.  You can’t force a stockholder to sign an agreement as a condition to exercising statutory rights.  I suppose you can try, but a court may disagree.  In some states, a company may be subject to penalties for refusing access to books and records.

Generally speaking, private companies do not have to make disclosures to stockholders (employee or otherwise).  However, there are circumstances where statutes and regs require opening up, such as:

  • pursuant to a proper books and records inspection request (most states have statutes requiring this, and the request has to be in proper form);
  • while there are usually no specific disclosure requirements for stockholder meetings, fiduciary considerations apply when asking for stockholder vote, such as M&A transactions; and
  • state and federal antifraud and registration/exemption rules apply when securities are involved.
Probably a different Domo, but Domo wants his stockholder books and records information.
Probably a different Domo, but Domo wants his Biederman stockholder books and records information.

Penny Stock Fraud – Why Penny Stock Email Promotions Are Bad For You

SEC Logo
SEC cracks down on microcap securities fraud.

Like me, you may get bombarded with long email ads for some penny stock.  They always tout how the stock is about to break out from $0.01/share to $0.05 or $10.00/share.

Did you ever get the sense that these may be scams.  Gadzooks!  Say it ain’t so!

The SEC today announced fraud charges and an asset freeze against the promoter of AwesomePennyStocks.com, a frequent trash dumper into my email accounts.

It charges that John Babikian used his sites for a “scalping” scam with the stock of America West Resources Inc. (AWSRQ).  AWSRQ was low priced and thinly traded.  Babikian fired off about 700,000 emails touting the stock.  However, he failed to disclose that he owned 1.4 million shares of AWSRQ and was ready to sell them through a Swiss bank.  The stock took off, and he made “ill-gotten” gains of more than $1.9 million.

The Babikian case is another example of the SEC’s focus on microcap stock fraud.

“The Enforcement Division, including its Microcap Fraud Task Force, is intensely focused on the scourge of microcap fraud and is aggressively working to root out microcap fraudsters who make their living by preying on unwitting investors,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

Proving that the SEC has some teeth when it needs them,

The court’s order, among other things, freezes Babikian’s assets, temporarily restrains him from further similar misconduct, requires an accounting, prohibits document alteration or destruction, and expedites discovery.  Pursuant to the order, the SEC has taken immediate action to freeze Babikian’s U.S. assets, which include the proceeds of the sale of a fractional interest in an airplane that Babikian had been attempting to have wired to an offshore bank, two homes in the Los Angeles area, and agricultural property in Oregon.

 

SEC Due Diligence Alert Released For Investment Advisers

SEC due diligence alert regarding processes for selecting alternative investments is released.



Link: SEC Risk Alert – Investment Advisor Due Diligence Processes for Selecting Alternative Investment and their Respective Managers

The SEC has been reviewing due diligence processes for investment advisers for alternative investments and is getting concerned. After all, assets under management, or “AUM” in industry talk, reached $6.5 trillion for alternative investments. The SEC issued an alert reminding advisers to perform due dilience to determine whether the investment:

  • Meets the clients’ investment needs; and
  • Is consistent with disclosed investment strategies.

According to the SEC, “alternative investments” include hedge funds, private equity, venture capital, real estate and funds of private funds.

The SEC conducted examinations of registered advisers and noted the following trends in alternative investment due diligence to identify risk indicators:

  1. Advisers are seekeing more information directly from alternative investment managers
  2. Advisers are using third parties to supplement their analyses and verify data
  3. Advisers are performing additional quantitative analysis of performance returns and risk measures
  4. Advisers are expanding their due diligence processes and focus areas

The SEC then used the alert to remind advisers about their obligations to adopt and review their compliance programs and codes of ethics.

 

SEC Logo
SEC Office of Compliance Inspections and Examinations issues risk alert for due diligence processes by investment advisers

 

 

 

 

 

 

 

Microcap Fraud Crackdown Continues At SEC

SEC’s efforts to combat microcap fraud continue as it suspends trading in dormant shell companies. Commence Operation Shell-Expel!

One favorite technique of microcap fraud operators is to use shell companies as vehicles for pump-and-dump schemes. The SEC has tried over the years to clamp down on operators who take advantage of unsuspecting investors through these types of companies. For example, the SEC recently announced a microcap fraud task force to deal with fraud involving microcap securities.

Securities and Exchange Commission
Securities and Exchange Commission cracks down on Microcap Fraud.

In this regard, the SEC has also announced that it has taken a proactive step in its shell company enforcement. It has suspended trading in 255 dormant shell companies of the type it describes as “ripe for abuse in the over-the-counter market.”

“A frequent element in pump-and-dump schemes has been the use of dormant shells,” said Andrew J. Ceresney, director of the SEC Enforcement Division. “Because these shells all too often are used by those looking to manipulate stock prices, we will continue to protect unwary investors by suspending trading in shells.”

Operation Shell-Expel has been in effect since 2012. The SEC has been scrutinizing penny stocks and looking for inactive companies. Trading is then suspended until updated financials are provided. Since this is generally unlikely, the trading suspension ends the value of the dormant company to scammers.

Due to the number and low profile of dormant companies, enforcement this sector can be a challenge.

“Policing this sector of the markets can be a challenge,” said Margaret Cain, a microcap specialist in the Office of Market Intelligence. “There is often little or no reliable information about a microcap issuer, and the sheer number of these companies stretches law enforcement resources thin and makes this sector particularly dangerous for investors. The approach we take with Operation Shell-Expel is both economical and efficient as the SEC continues its commitment to preventing microcap fraud.”

 

 

New Twist On Old SEC Enforcement Tool: Deferred Prosecution Agreements for Individuals

The SEC announced that it entered into a deferred prosecution agreement with an individual, a first for the agency.

Enforcement officials often use DPAs to encourage targets to come forward with information about illegal activities and to cooperate with investigations.  The agency agrees not to prosecute, and the target agrees to behave.

In this case, the deferree, a hedge fund administrator, spilled the beans about his boss regarding misuse of about $1.5 million and lying to investors about the fund’s performance.  The DPA discusses overstatements of fund returns and discrepancies in the net asset value, or NAV, used for internal and external purposes.

The SEC froze the fund’s and the boss’ assets and is preparing to distribute about $6 million to injured investors.

Do Section 10(b) and Rule 10b-5 Apply Outside of the U.S.?

Spoiler Alert: No, and this applies to civil and criminal matters, according to the Second Circuit.

Link:  U.S. v. Vilar 

Amid a selection of evidentiary and litigation-y claims, the recent 2nd Circuit case of U.S. v. Vilar did have some interesting nuggets for securities professionals.  Looking at an open issue following the U.S. Supreme Court case of Morrison v. National Australia Bank Ltd., the court looked at whether criminal liability under the Securities Exchange Act of 1934 extended to conduct outside the U.S.

Morrison was a civil case that limited Exchange Act Section 10(b) and Rule 10b-5 to domestic transactions in securities.

Background

The defendants were investment managers and advisers managing up to $9 billion before the tech bubble burst.  They offered select clients the opportunity to invest in securities that paid a high, fixed rate of interest, which were backed primarily by high quality, short-term deposits.  However a portion was invested in publicly traded emerging growth stocks.  See where this is going?

The bubble burst and the defendants were not able to meet the interest payments.  They created another investment vehicle and sold it to an investor, using the proceeds to settle a portion of the previous securities and for various personal expenses.  This investor complained to the SEC after demands to return her funds were met with questionable responses.

The defendants were convicted on a variety of securities, mail and wire fraud counts.

The Argument

Relying on Morrison, he defendants argued that their convictions should be reversed since their conduct was extraterritorial, or outside the U.S.

The court agreed and quoted Morrison for the proposition that when a statute gives no clear indication of an extraterritorial application, it has none.  Although Section 10(b) clearly forbids a variety of fraud, its purpose is to prohibit crimes against private individuals or their property, which is the sort of statutory provision for which the presumption against extraterritoriality applies (responding to the government’s examples of cases broadly applying statutes extraterritorially where the victims were government actors).  A statute either applies exterritorially or it does not, and once it is determined that  a statute does not apply extraterritorially, the only relevant question is whether the conduct occurred in the territory of a foreign sovereign.  In such a case, the court’s test is:

A securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.  More specifically, a domestic transaction has occurred when the purchaser has incurred irrevocable liability within the United States to take and pay for a security, or the seller has incurred irrevocable liability within the United States to deliver a security.

The Upshot

The conviction stands.  The conduct at issue was conducted in the United States, with ties to New York and Puerto Rico, which counts for the court’s purposes.

The defendants claimed that they structured the transaction carefully to avoid U.S. jurisdiction.  However, the court declined to “rescue fraudsters when they complain that their perfect scheme to avoid getting caught has failed.”

The Takeaway

The court summarized its conclusion on the relevant (to us) point as follows:

  • Section 10(b) and Rule 10b-5 do not apply to extraterritorial conduct, regardless of whether liability is sought criminally or civilly.
  • A defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with:
    1. a securities listed on a U.S. exchange; or
    2. a security purchased or sold in the United States.

SEC Issues Alert and Addresses Weaknesses of Investment Advisor Plans in Disruptions Caused By Weather

Following Hurricane Sandy, the SEC contacted investment advisors in the Northeast to try to understand how they were impacted by the storm.*  The SEC just released its findings, which it believes will help improve responses and reduce recovery time after “significant large scale events.”

Among the weaknesses noted by the SEC in certain advisors’ “business continuity plans,” or BCPs, were:

  • Some BCPs that did not adequately address and anticipate widespread events, such as adequate plans addressing situations where key personnel were unable to work from home or other remote locations.
  • Some advisers did not have geographically diverse office locations, and many smaller advisers had fewer geographically dispersed staff.
  • Some advisers did not evaluate the BCPs of their service providers.
  • Some advisers did not engage service providers to ensure that back-up servers functioned properly and relied solely on self-maintenance.
  • Some advisers did not adequately plan how to contact and deploy employees during a crisis, and inconsistently maintained communications with clients and employees.
  • Some advisers inadequately tested their BCPs relative to their advisory businesses.
  • Some advisers opted not to conduct certain critical tests because vendors provided disincentives or charged for testing.

The alert did not distinguish between large and small advisors or how appropriate BCP provisions addressing these weaknesses would be for smaller firms.  Geographic diversity is the most obvious example in that case.

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*Investment advisors are required to implement these types of BCPs under the SEC’s interpretation of Rule 206(4)-7.

 

Whether Investment Notes Are(n’t) Securities Is Kinda Important To A Jury Verdict For Securities Fraud

Apprarently, the question about whether something is or is not a security has become a hot issue, judging by two consecutive blog entries.

Link:  U.S. v. McKye

I noticed a case that primarily involves procedural issues for trial, a subject to which I have not paid much attention since law school.  However, the substance of the appeal involved securities fraud and whether or not the instruments in question were securities.

McKye was convicted of securities fraud and conspiracy to commit money laundering.  As it turns out the McKey case provides an interesting take for transactional lawyers on how this issue may come up at trial.

Background

McKye prepared revocable trusts for clients and financed the costs with loans for those who could not pay.  Promissory notes represented the loans, and in some cases, there would be a lien on the client’s house.  He also sold “investment notes” that offered a guaranteed annual return of 6.5% to 19.275%.  There was some documentation showing a pledge of collateral supporting the investment notes, which turned out to be from the persons who financed the costs of the revocable trust services.

McKye and his salesmen told people that the instruments were backed by real estate notes and mortgages and that they were not securities.

McKye received about $5.9 million in proceeds from the sales of investment notes, which he used to pay other investors (you may know this structure as a “Ponzi scheme”) and to pay his own expenses.

At trial, McKye requested a jury instruction to determine whether the investment notes were securities.  The court said that the notes are presumed to be securities and that McKye failed to present evidence overcoming that presumption.  A jury instruction indicated that the notes were securities.

The Upshot

After a discussion about the analysis of whether a note is a security, the appeals court determined that the question of whether a note is a security is a mixed qustion of fact and law.  Mixed questions of fact and law must be submitted to a jury if they implicate an element of the offense.  In this case, securities fraud requires . . . the offer or sale of any security . . .”  Because the government was required to prove that the investment notes were securities as an element of its case, the trial court erred when it instructed the jury that the notes are securities.

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For those interested, here are some excerpts regarding the ‘note as security’ analysis, discussing the U.S. Supreme Court case of Reves v. Ernst & Young, the primary case in this area:
“Although 15 U.S.C. § 77b(a)(1) defines a security to include “any note,” the Supreme Court held in Reves that “the phrase ‘any note’ should not be interpreted to mean literally ‘any note,’ but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.””

 

“The Court then identified a list of notes falling “without the ‘security’ category,” to include (1) a note delivered in consumer financing, (2) a note secured by a mortgage on a home, (3) a short-term note secured by a lien on a small business or some of its assets, (4) a note evidencing a character loan to a bank customer, (5) a short-term note secured by an assignment of accounts receivable, (6) a note which simply formalizes an open-account debt incurred in the ordinary course of business and (7) notes evidencing loans by commercial banks for current operations.”

 

“The Court further explained that any note bearing a “family resemblance” to the enumerated notes also does not fall within the Act’s definition of a security. Id. at 65-67. It adopted a four-part test to determine whether a note meets the family resemblance test. Id. at 66-67. The four factors are: (1) “the motivations that would prompt a reasonable seller and buyer to enter into it,” (2) “the ‘plan of distribution’ of the instrument,” (3) the “reasonable expectations of the investing public,” and (4) “whether some factors such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.