The SEC recently gave its blessing to a marriage of old and new:  traditional private placements conducted via the Internet. In doing so it lifted the veil on how VC firms can create “pre-existing, substantive relationships” with initially anonymous web-based investors.

Copyright: karenr / 123RF Stock Photo
Copyright: karenr / 123RF Stock Photo

Something Old:  Three years ago the JOBS Act lifted the long-standing prohibition on “advertising or broadly soliciting interests in privately held securities.” However, for a variety of reasons firms and issuers generally prefer the tried and true approach, a private sale of securities known as a 506(b) offering. To qualify for the 506(b) safe harbor, the offering cannot include a general solicitation and general advertising. But if issuers can show a “pre-existing, substantive relationship” with the prospective investor, the offering is not considered a general solicitation or advertisement.

Something New:  Enter the modern, “Add to Cart, Click” anonymity of the Internet. Potential investors from around the world are just a Google search away from a VC firm’s web-based portfolio, creating opportunity…and risk. How does a VC firm take advantage of an online platform and still establish a pre-existing, substantive relationship with prospects?

Catch Me a Catch…But How?:  In a recent no-action letter, Citizen VC, the SEC’s Division of Corporation Finance helped bridge the gap. Citizen VC, Inc. is an online venture capital firm that facilitates through its website indirect investment in private companies from seed to late-stage. In a letter to the SEC, Citizen VC outlined its procedures for developing pre-existing, substantive relationships with its online investors, and the SEC did not disagree with its methods.

Citizen VC set forth a two-step process for establishing pre-existing, substantive relationships. First, visitors to Citizen VC’s password-protected site must register and be accepted for membership. Prospects complete a generic online “accredited investor” questionnaire.  Depending on its evaluation of the questionnaire, Citizen VC will initiate the “relationship establishment period,” which is not limited to a specific time period.  According to Citizen VC, this period is a “process based on specific written policies and procedures created to ensure that the offering of Interests is suitable for each prospective investor.” (Citizen VC, Inc., Incoming Letter p.2). Citizen VC connects with and collects information from prospects in a variety of ways, assessing each prospect’s sophistication, financial circumstances, and ability to comprehend investments and their risks. Citizen VC’s relationship-building activities include:

  1. offline telephone introductions and conversations to discuss investing experience, goals and strategies, financial suitability, awareness of risks and other matters;
  2. an introductory email;
  3. online interaction to answer questions about Citizen VC, its website and its investments;
  4. confirming a prospect’s identity and gathering financial information and credit history using third party services;
  5. encouraging the prospect to review the website and ask questions regarding investment strategy, philosophy and objectives; and
  6. fostering online and offline contacts between the prospect and Citizen VC.

Prospects are finally admitted as members when Citizen VC determines that “(i) the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the [website], and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor.” (Citizen VC, Inc., Incoming Letter p.3)

Specifically, the SEC agreed with Citizen VC that the most important factor when determining whether a “substantive” relationship exists is the “quality” of the relationship between the issuer and the investor. It also agreed that issuers cannot rely on a specific duration of time or particular short form accreditation questionnaire to establish such a substantive relationship.

Citizen VC shows that building the right relationship between issuer and investor is a process of communication and evaluation at multiple steps. Matchmakers looking to bring investors and portfolio companies together online now have greater certainty of how to structure their activities to satisfy the 506(b) safe harbor.

Sandra Romaszewski writes:

Although not a new issue or requirement, many U.S. companies, including emerging companies and their parent companies, affiliates and investors, may not be aware of certain reporting requirements required by the International Investment and Trade in Services Survey Act (the Act).  In general terms, the Act governs the reporting of investments made in the U.S. by foreign persons and investments made by U.S. persons abroad. (Note that there are other specific filing requirements for airline operators, ocean and freight carriers, insurance companies, and financial service providers.) The Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce is tasked with collecting the data and reporting the statistics.

Copyright: ymgerman / 123RF Stock Photo
Copyright: ymgerman / 123RF Stock Photo

U.S. Direct Investment Abroad

All U.S. persons (in the broad sense, including individuals or business enterprises) who own, directly or indirectly, 10% or more of the voting securities or equivalent interest in a foreign business enterprise, are subject to the BEA’s reporting requirements.  This includes U.S. private equity funds that own foreign affiliates directly or through U.S. portfolio companies that they control.

Foreign Direct Investment in the U.S.

All U.S. business enterprises in which a foreign person (again, in the broad sense, including an individual or business enterprise) owns, directly or indirectly, 10% or more of the voting securities or equivalent interest in a U.S. business enterprise, are also subject to the BEA’s reporting requirements.  This includes foreign ownership of any real estate in the U.S. except residential real estate held exclusively for personal use and not for profit-making purposes.

Reporting is Mandatory But Information is Kept Confidential

Reporting to the BEA is mandatory whether or not companies are contacted by the BEA.  Reporting requirements include quarterly surveys, annual surveys, and benchmark surveys that must be completed every 5 years.  Also, for new foreign direct investment in the U.S., an initial report must be filed no later than 45 days after the date a foreign direct investment in the U.S. is made.  Foreign direct investment includes any of the following by a foreign person:  (1) the establishment of a new U.S. legal entity, (2) the expansion of U.S. operations, or (3) the acquisition of a U.S. business enterprise.

Types of data collected by the BEA may include balance sheets, income statements, sales figures, taxes, employment information, research and development expenditures, capital expenditures, and exports and imports.  The Act protects the confidentiality of the data reported to the BEA, and the survey data can only be used for analytical and statistical purposes.  Exemptions from filing are available if any of the exemption criteria is met, but a Claim for Exemption from filing must still be filed with the BEA for each survey.

Penalties for Non-Compliance

What happens if companies do not file the mandatory BEA surveys?  Companies may be subject to fines and penalties and may be subject to governmental orders directing compliance.  Even worse, a company’s willful failure to report may lead to a more significant fine and an individual’s willful failure to report may lead to a fine, imprisonment for not more than 1 year, or both.  To top it off, any officer, director, employee or agent of any company who or which knowingly participates in such violations may be punished by fines, imprisonment, or both, upon conviction.

It goes without saying that all companies, including emerging companies which rely heavily on their Boards of Directors and management teams, should adhere to the BEA’s filing requirements and seek advice from their legal and tax professionals to avoid fines and/or imprisonment for non-compliance.

Sandra A. Romaszewski is an associate in the firm’s Warrington, PA office.

JR Lanis writes:

The Securities and Exchange Commission has issued new rules, termed Regulation A+, which were promulgated under Section 401 of the 2012 Jumpstart Our Business Startups Act, also known as the JOBS Act, which expand upon the previous Regulation A. The new rules ease securities laws to allow smaller and independent investors to engage in the rapidly expanding equity crowdfunding market. These equity-based crowdfunding platforms are different from other “social’ crowdfunding websites, such as Kickstarter, which offer backers non-equity based incentives to participate.

Copyright: qingwa / 123RF Stock Photo
Copyright: qingwa / 123RF Stock Photo

Previously, only accredited investors—generally defined as individuals who earn over $200,000 in income or who have $1 million in assets (excluding their primary residence)—were permitted to purchase shares in private companies through equity crowdfunding. Accredited investors make up less than 1% of the U.S. population, severely limiting those who could invest.  Traditionally, the other 99% of investors had to wait for a company’s initial public offering to purchase its stock. This protected less sophisticated investors from the risks inherent in early stage investments, but it also meant that most Americans were prevented from getting in “on the ground floor” of the next Facebook or Google.

Regulation A+ creates two new tiers of exempted filings for issuers that would have been ineligible under the previous Regulation A rules. Tier 1 provides an exemption for securities offerings of $20 million or less, annually. These offerings will be available to accredited and unaccredited investors without restriction. Tier 2 provides an exemption for securities offerings of $50 million or less, annually. Accredited investors may purchase securities in Tier 2 offerings without limit. However, unaccredited investors are limited to 10% of the greater of their annual revenue or net assets.

As the SEC democratizes the equity crowdfunding market with Regulation A+, it is also implementing new regulations to increase protections for these new investors. Most notably, an issuer in Tier 2 will be required to submit audited two-year financial statements to the SEC.  Tier 1 filers generally need only provide an unaudited balance sheet and income statement for two years. Some experts believe that Regulation A+ will primarily help startups that have exhausted their ability to raise “seed” money.

Regulation A+ affords the general public the opportunity for outsized gains previously only available to accredited investors. It also means that early stage companies have additional sources of capital available to them. However, first-time investors should remember that returns are not guaranteed. For every Uber and Snapchat, there are countless companies that do not survive.

Alan A. “JR” Lanis, Jr., is a partner in Fox Rothschild’s Los Angeles (Century City) office.

JR Lanis writes:

The Securities and Exchange Commission has announced new Lesbian, Gay, Bisexual, and Transgender (LGBT) inclusive interpretations of the terms “spouse” and “marriage.”  This update brings SEC regulations into compliance with the Supreme Court’s decision in United States v. Windsor, which struck down the Defense of Marriage Act’s exclusion of lawfully wedded same-sex couples from federal recognition.

Copyright: tonobalaguer / 123RF Stock Photo
Copyright: tonobalaguer / 123RF Stock Photo

The succinct SEC order states that the Commission will read the term “spouse” to include “an individual married to a person of the same sex if the couple is lawfully married under state law, regardless of the individual’s domicile,” and the term “marriage” to include “a marriage between individuals of the same sex.”  These new definitions apply to the federal securities statutes administered by the SEC, the rules and regulations promulgated under those statutes, releases, orders, and any guidance issued by the staff or the SEC.  Full text of the order can be found here.

The SEC has lagged almost two years behind numerous other federal agencies that updated their regulations after the Windsor decision was announced on June 26, 2013.  In August 2013, the Treasury Department and the Internal Revenue Service issued orders recognizing legally married same-sex couples as married for federal tax purposes.

The SEC made this announcement one week before the Supreme Court decided in Obergefell v. Hodges that the 14th Amendment requires all states to issue marriage licenses to same-sex couples.  This landmark ruling only strengthens the Windsor ruling and will likely precipitate similar decisions from other agencies to make their regulations more LGBT-inclusive.

Alan A. “JR” Lanis, Jr., is a partner in Fox Rothschild’s Los Angeles (Century City) office.

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Investors typically do not finance an early stage or middle market company with the intent to ultimately call for a redemption of the preferred shares that it receives from the company in connection with the original financing.  Such a situation signals a failed investment, as the return of the original purchase price for the investor’s preferred shares represents zero appreciation on the original investment.  However, there are circumstances where redemption is appropriate as a last option.

A recent Delaware Chancery Court decision in TCV v. TradingScreen provided some insights into Delaware’s approach to determining the circumstances under which a corporation is legally permitted to fulfill a demand for redemption, meshing the statutory concept of “surplus”, as such term is used in the Delaware General Corporation Law, and the common law concept of “funds legally available.”  The Delaware courts had previously left unanswered the question of whether the statutory standard of “surplus” was somehow different than the common law standard of “funds legally available.”  According to the Chancery Court in TCV v. TradingScreen, there is a difference.  While a calculation of “surplus” basically consists of net assets in excess of capital, “funds legally available” is to be determined on the basis of a “going concern/insolvency” analysis (i.e., would the company’s payment of the redemption amount to the investor impair the company’s ability to continue as a going concern and pay its debts when due?).  The risk to investors is that the viability of a contractual redemption right with respect to its preferred shares may be closely tied to the timing of the demand for redemption of those shares.

Final word on the matter will be provided by the Delaware Supreme Court, as the Chancery Court decision in TCV v. TradingScreen has been appealed.  In the meantime, companies and investors should be cognizant of the implications of the Chancery Court’s decision when negotiating the terms of a redemption provision and the remedies available to the preferred stockholders if the company is not able to satisfy a mandatory right of redemption.

Big and small dogs.
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At an open meeting on March 25, 2015, the SEC adopted final rules to facilitate smaller companies’ access to capital via update and expansion of Regulation A, summarized in this press release.

A Two-Tier Approach

One core feature of the new rules is the establishment of a tiered system for these so-called “mini-IPO” style offerings, which will allow non-accredited investors to participate in two types of offerings:

  • Tier 1, for offerings that raise up to $20 million in proceeds in a 12-month period, including no more than $6 million of securities sold on behalf of selling securityholders; and
  • Tier 2, for offerings that raise up to $50 million in proceeds, including no more than $15 million of securities sold on behalf of selling securityholders.

Eligibility Requirements and Offering Restrictions

Although the new rules provide companies and investors with a powerful option for fundraises alongside Regulation D / Rule 506 offerings (see here for a helpful Reg. A / Reg. D comparison chart by Kiran Lingam of SeedInvest), there are various restrictions to the regime, including:

  • The final rule will include a limitation on the overall amount of securities that may be sold on behalf of selling securityholders.
  • The exemption will not be available to certain bad actors and to other entities, such as investment companies.
  • Tier 2 will require the issuer to provide audited financial statements, file regular and special event reports, and limit the amount of securities non-accredited investors can purchase in a Tier 2 offering.

Industry response has been generally positive, recognizing that the new rule will permit smaller and emerging companies to have an opportunity to raise substantial capital.

The new rules should be effective 60 days after publication in the Federal Register.



The North American Securities Administrators Association (NASAA) recently unveiled a new online Electronic Filing Depository that will allow an issuer of securities to submit a Form D for a Regulation D, Rule 506 offering to state securities regulators and pay related fees.

This system will be available 24 hours a day, 7 days a week. In addition to the filing fees required by the states, there is a one-time $150 system use fee for each offering making its filings through the system, which fee will cover any required amendment and renewal filings.

This system is initially limited to Form D filings for Regulation D, Rule 506 offerings, but NASAA expects the system to be expanded to include additional state securities registration and notice filing materials.

Currently, 37 states plus the District of Columbia, Puerto Rico and the U.S. Virgin Islands are participating and accepting Form D filings through the Electronic Filing Depository.

Click here for a link to the Electronic Filing Depository. As always, please be sure to consult with your attorney and other professional advisors regarding federal and state securities offering requirements.

Effective as of January 1, 2015, issuers of securities filing Form D Notice Filings with Delaware will be required to pay a fee with their submission based on the amount of the offering in Delaware. Specifically, the fee is equal to one-half of one percent of the maximum aggregate offering price of securities to be offered in Delaware during the initial registration period, but not less than $200.00 or more than $1,000.00.

Under Delaware blue sky rules, an issuer is required to file a notice on Form D no later than 15 days after the first sale of securities in Delaware. The new fee would now be due at the same time as this notice filing.

Since many investment vehicles are formed as Delaware entities, many issuers of securities (including many startup and emerging companies raising capital) will likely find themselves needing to pay this fee in their next offering. Please be sure to consult with your attorney and other professional advisors regarding this new filing fee and securities offering requirements in general.