Securities Regulation Archives

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.

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 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.

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.

Nasdaq Launches Market for Private Companies

Nasdaq debutes market for private companies, taking aim at SecondMarket and others.

Nasdaq launches marketplace for private companies.

Most people are familiar with Nasdaq as a stock exchange for many well known public companies. Most people would like to forget Nasdaq for its handling of the Facebook IPO, but that’s another story.

For private companies, even those with shares held by many people, it is difficult for their shareholders to find a buyer for their shares. Buyers often have a difficult time finding a way to invest in those companies if the Company is not offering directly to them on a private basis.

Nasdaq has launched a new capital marketplace for private companies that it claims will provide “qualifying” companies the tools and resources “to efficiently raise capital, control secondary transactions, and manage their equity-related functions.” Nasdaq refers to it as a “platform for controlled liquidity.”

To qualify, a company must have one of the following:

funding of $30 million within the last 2 years and an enterprise value of $50 million, based on the most recent financing round
Total assets of $50 million and annual revenue of $50 million in the latest fiscal year or 2 of the last 3 fiscal years
shareholders’ equity of $5 million and a two-year operating history
backing by a recognized financial investor with a track record of successful venture investments

The qualifying company will be subject to governance and reporting requirements.

Nasdaq is taking aim at SecondMarket and the burgeoning market for secondary transactions and the coming deluge of crowdfunding and other platforms for private company finance that people have been predicting since the passage of the JOBS Act. For their sake, I hope it goes better than the PORTAL market did way back when.

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

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:

Advisers are seekeing more information directly from alternative investment managers
Advisers are using third parties to supplement their analyses and verify data
Advisers are performing additional quantitative analysis of performance returns and risk measures
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 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 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.”

Bitcoin Regulatory Risk Begins In India

Bitcoin under attack in India. First a warning, then a raid.

I have previously discussed the risks involved in dealing with Bitcoins, which are primarily regulatory.

Bitcoin regulatory risks become reality in India.

I must be psychic, or at least recognize that regulators do what they do: shut down what they cannot understand or control. The Bitcoin risk is becoming real. First, The Reserve Bank of India issued a warning to people dealing in Bitcoin about the risks involved in dealing in Bitcoin. Were they just being helpful?

The warning did not explictly say that dealing in Bitcoin was illegal, but it offered this bit of foreshadowing:

“The Reserve Bank has also stated that it is presently examining the issues associated with the usage, holding and trading of VCs under the extant legal and regulatory framework of the country, including Foreign Exchange and Payment Systems laws and regulations.”

A couple of days later, Indian authorities raided a Bitcoin trading platform, buysellbit.com.in. The Enforcement Directorate conducted the raid since the central bank does not provide permission to indulge in such transactions [Ed.: We assume something was lost in translation here, but you get the idea.]

“’We are gathering the data of the transactions, name of the people who have transacted in the virtual currency from Gupta’s server that is hired in the US. At present, we believe that this is a violation of foreign exchange regulations of the country. If we are able to establish money laundering aspect then he can be arrested,’ said a top ED official.”

Coming soon to a U.S. regulator near you? An arrest of another Dread Pirate Roberts in the next Silk Road-type incident could be the catalyst for a crackdown, but I doubt it would take that much. We can all watch in 2014 whether Bitcoin goes mainstream enough to avoid a government response. However, that didn’t work for e-gold or PayPal in the 90’s or online poker in 2011.

Insider Trading – A Contrarian Take From CNBC

Should insider trading be illegal?

John Carney at CNBC posted an interesting article posing the question about whether insider trading should be a crime. In light of Michael Steinberg’s conviction for securities fraud due to his activities at SAC Capital, Carney asks who were the victims and what was the harm?

SAC Capital has been under fire for alleged insider trading. One trader was recently convicted.

In Steinberg’s case, part of the facts involved trading on early access to Dell’s earnings. Why is this a big deal?

But it’s hard to see how Steinberg’s acquisition of Dell’s earnings a day early hurt the company in any way. His trading may or may not have moved the stock price a bit but the actual release of the earnings moved it more.

Does Dell have an intellectual property right in its earnings? We don’t really recognize all corporate secrets or corporate information as protected intellectual property, much less property whose unauthorized use gives rise to criminal sanctions. There are certain categories—trade secrets, trademarks, copyrights—that are protected. But earnings aren’t trade secrets. Dell released them the very next day.

It is important to remember that Steinberg’s trading did not involve face-to-face arm’s length transactions with the counterparties. They were nameless and faceless people who never met Steinberg, knew Steinberg was in the market to buy or sell Dell shares or placed their orders with any knowledge of Steinberg and what he may have known or not known, disclosed or not disclosed. As Carney points out, regardless of what Steinberg did, each one of them would have acted in the exact same way.

What about the people who bought the shares of Dell on the day Steinberg was selling? Again, they would have been in exactly the same position regardless of whether Steinberg traded or not. Arguably, they were able to buy at a slightly better price because Steinberg’s trades would have pushed the stock slightly in the direction the stock actually moved when the earnings became public.

You’ll sometimes hear it said that the people on the other side of Steinberg’s trades were harmed because they wouldn’t have bought the shares if they had the same information he had. But that’s precisely the wrong test. The question isn’t what would they have done if they also had inside information. It’s what would they have done if Steinberg hadn’t had his information? The answer is: exactly what they did anyway. Steinberg’s possession of inside information didn’t affect them one bit.

Carney comes to a similar conclusion that I have always believed. This type of insider trading is not about protecting people. It is about (1) punishing success and profit [Ed. This is more me than Carney], and (2) a gut reaction that this behavior is wrong and should be punished. It is about addressing moral qualms, not about stopping harm.

In this respect, Carney compares this type of insider trading to blue laws.

In other words, our ban on insider trading isn’t really about protecting investors or making markets function better. It’s about expressing a moral view, much like we do with Blue Laws that ban the sale of alcohol on Sundays.

Here it is important to note that there is a school of thought that suggests insider trading should be encouraged since it makes the market more efficient by sending information about the insiders’ views of the company into the market. There are entire schools of trading based on insider transactions and Section 16 filings.

And here is where he loses me:

There’s nothing necessarily wrong with encoding morality into securities laws.

Yes, there is. We see it everyday in garbage like the ridiculous executive compensation disclosure now imposed on companies. We see it in required environmental disclosure, cybersecurity disclosure and blood minerals disclosure that probably don’t apply to most companies.

We see it every time some activist jumps up to demand that the SEC impose disclosure requirements on all companies that comport with the activists’ agenda, regardless of whether it furthers the mission of the disclosure regime for SEC reporting companies: Do investors have the information they need to make an informed investment decision? End of story.

If those issues are material to the disclosing company, they will have to be discussed. If not, this is nothing more than an extra tax (by way of time and money spent to assess and produce this nonsense) on reporting companies to pay for the whims of some vocal activists, be they outside agitators or Congressmen (who were (and probably still are) able to trade on inside information illegally in a way that would send you or I to prison).