Bar News - December 16, 2011
Business Law & Business Litigation: Wall Street Reform Act: New Challenges to Raising Capital?
By: Matthew H. Benson
Today’s tight capital markets are making it difficult for start-ups and other entrepreneurial ventures to raise capital. While there is some evidence that the capital markets are slowly becoming more accessible, there is still a long way to go to before more vibrant capital markets open up to provide necessary funding for more rapid business growth and expansion.
Tightening the Rules: Proposed Changes to Rule 506
As if the tight markets themselves were not enough of a concern, at least one important tool used by companies to raise capital may soon become more difficult to access. Many start-ups and entrepreneurial ventures rely on the so-called Federal Rule 506 exemption when raising capital. The benefits to relying upon Rule 506 are many, including the ability to raise capital from an unlimited number of so-called "accredited investors" (i.e., investors that satisfy certain financial criteria) with limited disclosure requirements and pre-emption of state blue sky laws. In short, Rule 506 provides an efficient (and relatively cost-effective) way for companies to raise capital from certain well-heeled investors with minimal federal and state filing requirements.
Section 926 of the recently enacted Wall Street Reform Act (i.e., the Dodd-Frank Act) is likely to have the effect of making it more difficult for companies to raise funds by relying on the exemption provided by Rule 506. This section of the Dodd-Frank Act required the Securities and Exchange Commission (SEC) to adopt rules by July 21, 2011, which disqualify felons and certain other "bad actors" from being involved in Regulation D offerings (i.e., offerings relying on Rule 506). While there are in effect "bad actor" rules that pertain to other exemptions, these rules currently do not apply to Rule 506 transactions. Among other reasons is the premise that in a transaction consummated in accordance with Rule 506, sales may be made only to accredited investors (i.e., investors that meet certain stringent financial guidelines) who the law presumes are sufficiently sophisticated and financially secure so do not require a heightened level of legal protection, and to a limited number of non-accredited investors (i.e., not more than 35) to whom significant legal and other disclosures have been provided. However, the new proposed rules turn this presumption on its head and actually impose greater restrictions than those that apply to other securities law exemptions.
Although the SEC missed the July 21 deadline and has not yet adopted final rules, the SEC did release proposed rules on May 25, 2011 that are largely based on current rules applicable to other exemptions. According to the proposed rules, if certain "covered persons" (including the company issuing securities, any director, officer or general partner of the issuer, any beneficial owner of 10 percent or more of any class of the issuer’s equity securities, any promoter of the issuer, or any person that has been or will be paid remuneration for solicitation of purchasers in connection with sales of the securities to be offered) have engaged in certain "disqualifying events", then the company raising capital cannot rely on the exemption provided pursuant to Rule 506.
"Disqualifying events" include the following: the issuer had filed a registration statement which is the subject of a pending proceeding or examination, any covered person had been convicted within 10 years (or 5 years if the covered person is the issuer) prior to the first proposed sale of securities of any felony or misdemeanor in connection with the purchase or sale of any security, or a covered person is enjoined from engaging in any conduct in connection with the purchase or sale of a security.
In addition to these disqualifying events which are derived from existing rules, the proposed rules include additional categories of disqualifying events that include a covered person being subject to a final order of a state securities commission or other agency that regulates banks, savings associations or credit unions that bar the covered person from engaging in the business of securities, insurance, or banking.
According to the proposed rule, if a covered person subject to a disqualifying event is involved in a transaction in which the issuer relied on the Rule 506 exemption, then the exemption would be unavailable and the transaction would not be exempt. In other words, the issuer would have issued unregistered securities without an applicable exemption, which becomes an enormous problem for the company that issued the securities.
So what does this mean? If the new rules become final, then companies seeking to raise funds will have to engage in a significantly greater level of diligence regarding its directors, officers, brokers, existing and potential investors and others to ensure that no bad actor who is subject to a disqualifying event is involved in the company or in the sale of the securities. The upside of such a rule arguably is that this added level of diligence would provide additional protection for investors. However, the downside is that it will substantially increase the costs (and risks) of relying on Rule 506 for companies seeking to raise capital and perhaps make this useful tool unavailable to a large number of start-up companies – not because they have bad actors involved, but simply because they do not have the resources to satisfy the new diligence requirements imposed by the proposed rules.
Loosening the Rules: Proposed Changes to Rule 506
The tightening of Rule 506 requirements is particularly interesting in light of other securities law changes being considered by Congress to loosen regulations and make raising capital easier. Among other proposals is a bill that was passed by the US House of Representatives (HR 2930) that would permit crowdfunding. This new legislation (if enacted) would permit a company to raise up to $2,000,000 but not more than $10,000 from any investor, and the investors would not have to be accredited (i.e., the investors would not have to meet any financial criteria as required pursuant to Rule 506). Thus, while the requirements under Rule 506 are becoming more stringent, Congress is considering other proposals that reduce regulatory restrictions (including for those that have far less by way of financial resources) in an attempt to make capital more accessible. Thus, while at the same time regulations are being tightened regarding Rule 506 transactions (even though those investors are generally considered less in need of legal protection), other regulations may be loosened for crowdsource funding (although investors in such a transaction do not have to meet any financial or other standards and arguably are more in need of regulatory safeguards).
The forces at work make this a very interesting time for companies seeking to raise capital. On one hand, the financial crisis has sparked a push for more regulation; while on the other hand, the dearth of capital that has resulted from the crisis has created a push for less regulation to make capital more accessible. The regulatory schemes that result from these forces will have a significant and lasting impact on the ability of start-up and other companies to raise much needed capital to fuel their growth.
Matthew H. Benson is an attorney at Cook Little Rosenblatt & Manson in Manchester, where his practice focuses on representing start-up and other entrepreneurial companies with various business and commercial matters. He can be reached at firstname.lastname@example.org and followed on Twitter @matt_benson.