SEC Warns of SAFE Investment Instrument Popular in Equity Crowdfunding Campaigns

The SEC issued a bulletin warning investors about SAFE securities used in equity crowdfunding offerings.

Issuers in equity crowdfunding campaigns have offered various types of securities since it became legal to do so, such as various classes of stock, notes and instruments known as SAFE instruments.  ‘SAFE’ stands for ‘Simple Agreement for Future Equity.’

SAFEs were originally designed to be an alternative to convertible notes for early-stage technology investments.  The idea was that they would become simple, standardized vehicles for investing in very young companies without dealing with a lot the terms needed to make a convertible note or stock investment.

As the SEC points out, a SAFE is not like investing in common stock.  It is an agreement that converts into issuer securities in the event of future triggering events, such as a future investment round, an IPO, a change of control or a liquidation.

Some people seem to think of them like convertible notes.  However, convertible notes have maturity dates, among other terms.  SAFEs do not and may never convert.  SAFEs are more like derivative contracts with springing conversion based on listed events.

SAFEs have been increasing in use in the venture capital and angel investing worlds, and more recently other investors have gained some exposure and comfort with them.  However, the SEC wants investors to know that:

  • SAFEs do not represent a current equity stake in the company in which you are investing.
  • SAFEs may only convert to equity if certain triggering events occur.
  • Depending on its terms, a SAFE may not be triggered.

To the people who have seen them before, none of this is a surprise.  To a new investor, the SEC is concerned that these terms may be unexpected.  As the SEC said:

SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail.  Oftentimes, for the venture capital investor, it was more important to get the investment opportunity, and possible future opportunities, with the startup than it was to protect the relatively small investment represented by the SAFE.  In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, were designed to best operate in the context of a fast growing startup likely to need and attract additional capital from sophisticated venture capital investors.  This may or may not be the case with the crowdfunding investment opportunity you are exploring.

SAFEs can make a lot of sense to particular parties in particular deals, but investors such as crowdfunding investors should make sure to understand exactly what rights they have in what they are purchasing.

SEC issues warning about SAFE instruments in equity crowdfunding campaigns.
SEC issues warning about SAFE instruments in equity crowdfunding campaigns.

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

Insider Trading Law Tightens Up for Tippers and Tippees

The Supreme Court speaks about insider trading, and it is not good for tippers and tippees.

I’m still going through the backlog of recent stuff.  Here’s an important update on insider trading.

For the first time in a long time, the Supreme Court provided new guidance on insider trading laws. The government had suffered a few high-profile defeats in this area over the last few years, but Salman v. United States provided more insight into indirect liabilities for insider trading while providing more ammunition to the government to go after indirect (tippee) insider trading defendants.

In Salman, A was an investment banker in Citigroup’s healthcare investment banking group. Over time, he regularly tipped off B, his brother. B also provided the information to other people, including C, B’s friend who was also A’s brother-in-law. A tangled web and all that . . .

In the classic Dirks case, a tippee, in this case C, is exposed to liability to insider trading if the tippee participates in a breach of the tipper’s fiduciary duty. The test is whether the insider will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, a close, personal relationship can create an inference of benefit.

In 2014, the Second Circuit in Newman, a case involving a more distant relationship between the traders and the insider information, did not permit the inference without proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.

The Ninth Circuit and the Supreme Court disagreed.

The Supreme Court said that the test is whether the insider personally will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, the benefit can be inferred from objective facts and circumstances such as a relationship between the parties that suggests a quid or quo or intention to benefit the tippee.

The takeaway is that insider trading is not worth it. If caught, it is not that difficult to convict.* It just got easier. If the prosecution can show that there is a close enough relationship between the tipper and tippee, a jury can infer a benefit assuming that the transaction is no different than the tipper doing the trading and gifting the proceeds to the tippee.

*Sort of.  There are some pending articles about some more difficult cases for the SEC and prosecutors.

M&A Broker vs. Broker-Dealer

SEC issues M&A Advisor interpretations.

Securities and Exchange Commission
SEC issues M&A Advisor interpretations.

I have written in the past about the challenges of people looking to facilitate deals without a broker-dealer license. Short answer: You probably can’t get paid.

However, there is an entire industry of business brokers and M&A advisors that seem to get close to the line. In January 2014, the SEC outlined when an M&A advisor could assist in the sale of a privately held company without registering as a broker-dealer. Its been hanging out there for a while, but I figured this was a good enough time to write about it.

First, it defined “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.”

In addition, a “privately-held company” is not an SEC filing company

The SEC provided a list of several conditions:

  • The M&A Broker will not have the ability to bind a party to an M&A Transaction.
  • An M&A Broker will not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction.
  • The M&A Broker may not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
  • No M&A Transaction will involve a public offering.
  • Any offering or sale of securities will be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933.
  • No party to any M&A Transaction may be a shell company, other than a business combination related shell company.
  • To the extent an M&A Broker represents both buyers and sellers, it will provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation.
  • An M&A Broker will facilitate an M&A Transaction with a group of buyers only if the group is formed without the assistance ofthe M&A Broker.
  • The buyer, or group of buyers, in any M&A Transaction will, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.
  • Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act.

There are more details in the SEC’s letter, which we may cover in another post. It will be interesting over time to see if the SEC focuses on one or more elements of the interpretation.

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

 

 

 

 

 

 

 

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.

SEC Rolls Out Market Structure Website

It is actually a part of their sec.gov website, but it is a new part.

MIDAS Website here.
SEC Press Release here.

The SEC released its new MIDAS site to “promote better understanding of our equity markets and equity market structure through the use of data and analytics.”  This is a fancy way of saying that you can make charts of market info that you usually don’t see in traditional stock tickers rolling across your t.v. screen.

I am still combing through it to see what it does and how it can be useful.  It seems to provide some very detailed information relating to trading activity.  We are not talking about mere buy-sell-bid-ask information for stocks, but information that generates pretty charts purporting to show how the market functions.

It seems aimed at understanding (or providing the premise for going after) the high frequency trading (HFT) crowd and flash crashes.

The SEC believes it will help it to monitor and understand mini-flash crashes, reconstruct market events, and develop a better understanding of long-term trends.  To this end, MIDAS collects:

  • posted orders and quotes on national exchanges;
  • modifications/cancellations of those orders;
  • trade executions against those orders; and
  • off-exchange trade executions.

The SEC’s new website will be making available broadly:

  • ratios related to the number and volume of orders that are canceled instead of traded;
  • percentage of on-exchange trades and volume that are not disseminated on the public tape (odd-lot trades);
  • percentage of on-exchange trades and volume that are the result of hidden orders; and
  • quarterly distributions analyzing the lifetime of quotes ranging from one millionth of a second to one day.

The website can be used to:

  • compare and contrast data series according to the type of security, market capitalization, volatility, price, and turnover; and
  • explore detailed quote-life distributions, and download data series and quote-life distributions.

It is not immediately clear to me how this will be used as a policy-making tool, but you can expect charts generated from MIDAS to be displayed in some very exciting Congressional hearings.

SEC To Remain Open During Government “Shutdown”

The SEC has assured the markets that it “will remain open and operational in the event the federal government undergoes a lapse in appropriations on October 1.”

Any changes to the SEC’s operational status after October 1 will be announced on www.sec.gov.

If you want more juicy details of the SEC’s operational plan in the event of a government shutdown, enjoy this link:

Plan of Operations During an SEC Shutdown

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.