August 2012


Depending on your perspective, lifting the ban on general solicitation and advertising for private offerings is one of the most anticipated or feared provisions in the JOBS Act.  Consumer protection groups are aghast at the potential of fraud stemming from startup companies hawking their stock to unsophisticated investors.  Pro-business groups are ecstatic that someone finally had listened to their complaints about the trouble entrepreneurs have raising capital once they have exhausted their family and friends.  Well, after today’s Securities and Exchange Commission meeting, it looks like the pro-business groups got a further victory.  Or did they?

This morning, the Commission proposed rules to implement Section 201 of the JOBS Act to remove the prohibition on general solicitation and advertising in private offerings when all purchasers are accredited investors.  While removing a ban seems relatively simple, Congress instructed the Commission to write rules to “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

What constitutes “reasonable steps” is the only difficult interpretation that the SEC had to make. There was some concern that the “reasonable steps” could be as harsh as requiring investors to prove their net worth through bank statements; however, the proposed rulemaking takes a much more flexible approach.  The proposed rules require issuers to make an objective determination based on certain factors:

  • The type of purchaser and the type of accredited investor that the purchaser claims to be;
  • The amount and type of information that the issuer has about the purchaser; and
  • The nature of the offering, including the manner in which the purchaser was solicited to participate in the offering and the terms of the offering such as the minimum investment amount.

The Commission didn’t set forth specific required verification methods because it felt a “one-size-fits-all” approach would be overly burdensome, impractical and ineffective.  At first glance this seems like a very issuer friendly approach.  Continue Reading Elimination of ban on general solicitation and advertising may leave some questions unanswered

California Department of Corporations, One Sansome Street, San Francisco

We previously blogged about the potential liability for Facebook, Inc. directors if the company paid too much for the social media start-up company Instagram. Recall that in April, Facebook agreed to acquire Instagram for, at the time, approximately $1 billion with the consideration payable 30% in cash and 70% in Facebook common stock (now, due to the decrease in Facebook’s share price from the stipulated price of $30 per share, the deal is only worth about $650 million). A recent NY Times Deal Book article points out that if the deal fixed the total purchase price rather than the number of shares to be issued, Instagram would have gotten a much better deal due to the depressed Facebook share price. Given the declining share price of Facebook stock, is Facebook’s reduced consideration still fair to Instagram’s shareholders? This is exactly the question that will be determined by the California Department of Corporations which will be conducting a fairness review of the acquisition this Wednesday.

The purpose of this fairness hearing is to allow Facebook to take advantage of a lesser-known exemption from registration under the Securities Act of 1933 known as the “3(a)(10) exemption.” Because Facebook is issuing securities in connection with the Instagram acquisition, the 23 million shares to be issued are required to either be registered or they must be exempt from the registration requirements of the Securities Act. The 3(a)(10) exemption allows companies to issue securities in an exchange transaction without registration provided that either a court or designated state agency finds that the transaction is fair to the recipients of the new securities. This exemption was popular during the tech boom and has both advantages and disadvantages when compared with the most common exemption provided by Rule 506 of Regulation D promulgated under the Securities Act. 

Most smaller companies tend to offer and sell securities on an exempt basis because of the substantial costs of conducting a registered offering. There are a laundry list of exemptions but only a few are of much practical use. Most exempt offerings are structured to take advantage Continue Reading Is Facebook’s acquisition of Instagram fair to Instagram shareholders?

More interesting times have arrived for holders of Facebook stock. The stock, which has been brutally beaten down from its IPO price, faces new challenges as the “lockup” restrictions (which have been in place since the IPO) began to expire on August 16. This means that a significant number of Facebook shareholders are now able to sell their shares in the open market, and significant numbers of Facebook shares will be freed from these restrictions over the next few months. The sale of a substantial number of Facebook shares could obviously drive the stock price down even more. The big questions now:  Who will or won’t sell their stock as these restrictions lapse?

This situation is also a great lesson for entrepreneurs who are contemplating the possibility of taking their companies public. Most observers thought that Facebook’s IPO was a certain success, but so far it’s been a very tough road. One big concern here is that the problems that Facebook has faced with its transition to public company status will divert management’s attention from the company’s business tactics and strategy at a very critical time. 

Facebook went public at a price of $38 per share. Many observers felt that this price was too high, and the market apparently agreed. The stock has not been back to its IPO price since the first day of trading, and its closing price on August 17 was $19.05 per share (a 49.9% decline from the IPO price). The stock price went below $19.00, but has since rebounded to close at $19.44 today. In any case the company has lost almost half of its market value since the IPO. Even at this reduced price the stock is still trading at about 30 times projected next years’ earnings. It’s interesting to note that Google and Apple currently trade at 12 to 13 multiples, so Facebook’s stock is still very highly valued even after its decline.

Lockup restrictions on stock sales by insiders and other parties are normally demanded by underwriters as part of the IPO process. These restrictions help to reduce volatility in the market price of a newly public company’s stock, and they help to ensure that existing shareholders Continue Reading Significant stock price questions loom as Facebook lockup restrictions begin to lapse

This is the first part of our Securities Law 101 series.   Because capital raising is such a critical function for emerging start-up companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law.  We hope that this series will prevent some of the most common mistakes management teams of start-up companies make.  We will periodically publish posts examining different aspects of securities law. 

Contrary to popular perceptions, securities law is not just for large corporations and conglomerates.  Too many start-up companies make the mistake of thinking securities law does not apply to them, though there is no de minimis exception to regulation. Practically, this means all entities, big and small, are required to comply with the applicable provisions of the Securities Act of 1933 (“1933 Act”).  Each state has its own securities laws with similar requirements.

The general principle of the 1933 Act is that every offer and sale of securities must be registered with the SEC unless an offering exemption exists.  You should keep in mind that a “security” is not limited to a share of stock either.  In fact, securities also include what are known as “investment contracts.”  Thus, courts have also applied the 1933 Act to interests bearing little resemblance to traditional securities transactions, including chinchillas, payphone packages, rare coins, live beavers, silver foxes, whiskey receipts, diamonds, and religious cults.

How is a beaver a security?  Back in 1946, the U.S. Supreme Court in a case called SEC v. W.J. Howey Co. created this test for an investment contract: (1) an investment of money; (2) with the expectation of profits; (3) in a common enterprise; (4) coming mainly from the efforts of others. Under this test, for example, limited partnerships are securities because investors invest money and expect a profit which comes in part from the efforts of others (here, the general partners exercising essential managerial efforts).

What do we mean by the investment of money?  Cash is not the only item that constitutes “money.” For example, Continue Reading Securities Law 101 (Part I): Yes, securities law applies to you

Finally, we have had some recent bipartisanship in Congress.  The only problem, of course, is that the recent bipartisanship further burdened public companies with additional disclosure requirements.  As Broc Romanek noted in his blog last week, Congress overwhelmingly passed the Iran Threat Reduction and Syria Human Rights Act of 2012 requiring public companies to disclose to the SEC its dealings with Iran. 

As we have been blogging about for nearly a year, Congress has picked up a bad habit of burdening public companies in advancing an agenda that has nothing to do with the protection of investors.  These so called “social disclosures” (many of which are really “political” – or politically motivated – disclosures) while arguably related to important issues, burden public companies with specific tasks to compile and disclose certain information.  These same burdens, however, are not placed on private companies.  Yet, Congressman Darrell Issa, the Chairman of the House Committee on Oversight and Government Reform, has been demanding to know why there are fewer public companies today as compared to a decade ago. 

To be fair, I note that the House has recently passed (in bipartisan fashion) HR 4078, Red Tape Reduction and Small Business Job Creation Act, which would limit the ability of the SEC to add more regulatory burden on public companies, but given recent Congressional acts, HR 4078 appears more “Do as I say and not as I do.”  For example, Congress passed the American Jobs Creation Act of 2004, which requires public companies to disclose in its Form 10-K if the company incurs a specific type of tax penalty from the IRS involving abusive or tax avoidance (shelter) transactions.  More recently, as everyone is keenly aware, laws have passed pertaining to conflict minerals, mine safety, and executive compensation pay ratios.  Laws that have been proposed, but have not passed (yet), include Continue Reading You asked for it: Bipartisan agreement in congress

Just when it appeared that small banks and their holding companies could simply go private or “go dark” under the new rules in the Jumpstart Our Business Startups (JOBS) Act, legacy rules are significantly slowing the process for some.  Under the JOBS Act, banks and bank holding companies may now go dark if they have fewer than 1,200 shareholders, but the process can be delayed.  Sometimes the delay can last up to a full year, and during that time, the expenses of remaining a public company continue to add up. 

The main reason for the delay is that the JOBS Act does not expressly provide full relief from reporting obligations.  While banks and bank holding companies can deregister from Section 12(g) of the Securities Exchange Act of 1934 if they have less than 1,200 shareholders, there is only limited relief from Section 15(d).  Section 15(d) contains reporting requirements for issuers that file or update a registration statement during the current fiscal year.  Under this section that was amended by the JOBS Act, a banking company going dark could suspend its reporting obligations, effective as of the beginning of the current fiscal year, provided that it did not update or file a registration statement during its current fiscal year.  If the banking company filed a registration statement or updated one as required by Section 10(a)(3) of the Securities Act of 1933 (updating a registration statement on Form S-3 or Form S-8 can be accomplished by merely filing a Form 10-K), Section 15(d) would then require continued public filings (i.e., all Form 10-Qs and the Form 10-K) for the current fiscal year. 

Recognizing the problem, the SEC is providing some relief.  In recent situations where a public bank has an outstanding registration statement, like a shelf registration or a benefit plan S-8, the SEC has been granting no-action relief and allowing the companies to go dark so long as there are no sales of securities under the registration statement during the current fiscal year.

This relief, however, does not go far enough to help some banking companies.  Particularly, those that have sales under a registration statement will be required to continue reporting for the remainder of the fiscal year.  In the past the SEC has given no action relief allowing companies to suspend their Section 15(d) reporting obligations when the number of shares sold in the fiscal year was nominal; however, the SEC has informed us that its current position is that no relief can be granted.  It is the SEC’s position that any sales in the current fiscal year makes the company ineligible for no action relief from its reporting obligations under Section 15(d).  This apparent change in position causes a significant expense and delay for banking companies that otherwise have been targeted for relief under the JOBS Act.  Considering the intent of the JOBS Act (i.e., to relieve the huge burdens on smaller companies), it would seem that the SEC should provider even greater relief in this area.