May 26, 2012
Below is an article that I wrote for Business Law Today, a publication for the American Bar Association’s Business Law Section.
Crowdfunding: Its Practical Effect May Be Unclear Until SEC Rulemaking is Complete
President Obama signed the Jumpstart Our Business Startups Act (known as the JOBS Act) into law on April 5, 2012. One highly anticipated provision of the JOBS Act, Title III, is entitled ”Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or the ”CROWDFUND Act.” Title III enables “crowdfunding,” or the ability to sell securities in small amounts to a large number of investors.
Whether or not the crowdfunding provisions will have a significant impact on small business fundraising is yet to be determined. Despite the buzz among entrepreneur communities, various restrictions may make crowdfunding impractical for companies raising money and the intermediaries that facilitate the process. Most importantly, the crowdfunding provisions of the JOBS Act are not yet effective. On April 23, 2012, the SEC published guidance reminding issuers that “any offers or sale of securities purporting to rely on the crowdfunding exemption would be unlawful under federal securities laws” until the SEC adopts new rules.
Crowdfunding Prior to the JOBS Act
Crowdfunding is not a new concept. The Internet has made it easier for individuals and organizations to raise money for charitable purposes, political campaigns, artists seeking support from fans and various other projects. In 2005, Kiva launched a micro-finance platform that allows people to lend small amounts of money to entrepreneurs in developing areas. This lending model was further refined, and peer-to-peer lending companies like Prosper emerged in 2006 and Lending Club emerged in 2007. More recently, companies like Kickstarter have emerged to enable the public to fund creative projects ranging from independent films, video games, and food projects.
Prior to the JOBS Act, crowdfunding suffered from some several legal limitations. First, crowdfunding involving the sale of securities triggers the prohibitively expensive registration requirements of the Securities Act of 1933, as generally no exemptions are available in many crowdfunding models. Second, websites that facilitate crowdfunding may be subject to regulation as brokers.
As a result, current crowdfunding platforms have generally developed business models designed to avoid characterization as a sale of a security. Some companies utilize pure donation models. Companies like Kiva that provide micro-loans without interest and do not take commissions are arguably not offering securities because there is no expectation of profit on the part of the investors. Other companies like Kickstarter offer rewards or facilitate the pre-purchase of products. At the other extreme, because the SEC has taken the position that interest-bearing notes are securities, companies like Prosper and Lending Club have registered their offerings with the SEC.
Under pressure from Congress, the SEC agreed to review its regulations and their effect on capital formation in spring 2011. Crowdfunding received a boost when the Obama administration endorsed crowdfunding in September 2011. Although the SEC has the authority to exempt crowdfunding from the registration requirements of the Securities Act and to exempt intermediaries from registration as broker-dealers, Congress has forced the SEC to take action. The House of Representatives passed a crowdfunding bill in November 2011 and crowdfunding bills were introduced in the Senate in November 2011 and December 2011 that resulted in the crowdfunding provisions of the JOBS Act.
Crowdfunding Under the JOBS Act
Title III of the JOBS Act amends Section 4 of the Securities Act by adding a new paragraph (6), and requires the SEC to promulgate related rules to create an exemption from registration that permits a private company to sell securities in small amounts to large numbers of investors that are not accredited over a 12-month period.
Under the crowdfunding provisions, the aggregate dollar amount of securities that an issuer can sell in a crowdfunding transaction is limited to $1 million (less the aggregate amount of securities sold under other exemptions) over a 12-month period. In addition, the amount an issuer can sell to an individual investor in any 12-month period is limited to the maximum of:
• the greater of $2,000 or 5 percent of the annual income or net worth of an investor, if either the investor’s net worth or annual income is less than $100,000; and
• 10 percent, not to exceed $100,000, of annual income or net worth of an investor, if either the investor’s annual income or net worth is equal to or greater than $100,000.
Securities sold pursuant to the crowdfunding provisions are not transferable by the purchaser for one-year from the date of purchase, unless the securities are transferred to the issuer, an accredited investor, in a registered offering, or to family of the purchaser. The securities may also be subject to such other limitations as may be determined by the SEC.
Requirements on Intermediaries
An issuer must sell the securities in a crowdfunding offering through a broker or funding portal, which is required to register with the SEC and other applicable self-regulatory organizations.
These intermediaries need to meet a series of specific and restrictive requirements to be determined by the SEC. For example, intermediaries will be required to:
• provide investors with certain information (such as disclosures related to risks and other investor education materials);
• ensure that investors review the investor-education information, affirm their understanding of the risks and answer questions demonstrating an understanding of the risks;
• take measures to reduce the risk of fraud, including conducting background checks on officers, directors, and holders of more than 20 percent of the shares of issuers;
• make available to the SEC and potential investors the disclosure required to be provided by issuers not later than 21 days prior to the first day on with securities are sold;
• ensure that offering proceeds are provided to the issuer only when the target offering amount is reached or exceeded and allow investors to cancel their commitments;
• ensure that no investor in a 12-month period has purchased securities pursuant to the crowdfunding exemption that exceed the per-investor limits in the aggregate;
• take steps to ensure the privacy of information collected from investors;
• not compensate promoters, finders, or lead generators for providing the intermediary with the personal identifying information of any potential investor; and
• prohibit its directors, officers, or partners from having a financial interest in an issuer using its services.
The SEC is directed to establish rules that exempt funding portals from broker-dealer registration as long as they are subject to the authority of the SEC, are a member of a national securities association and are subject to other requirements the SEC may establish.
However, in order to qualify as a funding portal, the intermediary must not offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered on its website; compensate persons for such solicitation based on the sale of securities referenced on its website; hold, manage, possess, or otherwise handle investor funds or securities; or engage in other activities that the SEC determines.
While separate from the crowdfunding provisions, the JOBS Act also clarified that certain intermediaries in the fundraising process, such as web sites like AngelList that facilitate introductions between companies and investors, are not subject to broker-dealer registration. Section 201(c) of the JOBS Act provides that certain trading platforms involved with the sale of securities in a valid Rule 506 private placement are not subject to registration as a broker or dealer as long as certain conditions are met, including that persons receive no compensation in connection with the purchase or sale of securities and that the platform does not have possession of customer funds or securities in connection with the purchase or sale of securities.
Requirements for Issuers
Issuers utilizing crowdfunding must make financial and other information available to both the SEC and investors, both in connection with the offering and on an annual basis. The JOBS Act provides for a tiered disclosure regime based on the size of the offering, including the following:
• $100,000 or less: Income tax returns for the last fiscal year and unaudited financial statements certified as accurate by the principal executive officer.
• $100,000 to $500,000: Financial statements reviewed by an independent public accountant.
• More than $500,000: Audited financial statements.
As a practical matter, many early-stage startup companies that are considering crowdfunding may have only been recently incorporated and have not yet filed tax returns. Furthermore, many startup companies may not yet have engaged independent public accountants, nor have audited financial statements at the time they wish to raise funds.
Among other things, the issuer must file with the SEC and provide to investors and the intermediary and make available to potential investors:
• basic corporate information including name, legal status, address, and website;
• names of officers and directors (and any persons occupying similar status or performing similar functions);
• names of any holder of more than 20 percent of the shares of the issuer;
• description of the business and the anticipated business plan of the issuer;
• description of the stated purpose and intended use of the proceeds of the offering;
• target offering amount, deadline to reach such target amount, and regular updates relating to the issuer’s progress in meeting the target offering amount;
• the price to the public of the securities or the method for determining the price, and written disclosure prior to the sale of the final price and all required disclosures, providing investors with a reasonable opportunity to rescind the commitment to purchase;
• description of the ownership and capital structure of the issuer; and
• such other information as the SEC may prescribe.
Issuers must file annual reports with SEC and provide to investors reports of results of operations and financial statements as the SEC determines. However, many private companies wish to protect such sensitive financial information and may be disinclined from utilizing the exemption for this reason.
Furthermore, issuers may not advertise the terms of the offering except through notices that direct investors to the broker or funding portal. Compensation of intermediaries will be subject to rules designed to ensure that recipients disclose receipt of compensation.
In addition, the JOBS Act specifically authorizes an investor in a crowdfunding transaction to bring a civil action against an issuer for material misstatements or omissions in disclosures provided to investors. Such an action is subject to the provisions of Section 12(b) and Section 13 of the Securities Act.
The crowdfunding exemption will not be available to foreign companies, SEC reporting companies, investment companies, and companies excluded from the definition of investment company by virtue of Section 3(b) or 3(c) of the Investment Company Act of 1940.
The SEC is directed to promulgate disqualification provisions under which an issuer is not eligible to offer securities pursuant to new Section 4(6) of the Securities Act and brokers or funding portals shall not be eligible to effect or participate in crowdfunding transactions.
Coordination with State Law and Other Exemptions
Securities acquired pursuant to the crowdfunding provisions will be exempt from registration or qualification under state blue sky laws. In addition, states may not require a filing or a fee for crowdfunding securities except for the state of the principal place of business of the issuer or the state in which purchasers of 50 percent or greater of the aggregate amount raised are residents. However, the crowdfunding provisions preserve state enforcement authority over unlawful conduct by intermediaries and issuers and with respect to fraud or deceit.
While the JOBS Act specifically states that the crowdfunding amendments to the Securities Act are not to be interpreted as preventing an issuer from raising capital through other methods, it is unclear in practice how this will work. Private placements conducted through Regulation D-the most common type of private offering transaction-may be integrated with other offerings conducted within six months. Absent SEC clarification, significant questions regarding integration may inhibit a crowdfunding transaction at the same time as an angel or venture capital-led transaction with accredited investors is being conducted.
In addition, the SEC is directed to issue a rule to exclude persons holding crowdfunding securities from the shareholder threshold for registration under Section 12(g) of the Securities Exchange Act of 1934.
The crowdfunding provisions of the JOBS Act require significant SEC rulemaking, which is supposed to occur by December 31, 2012. In addition to specific areas that the SEC is supposed to address through rulemaking, the SEC is given wide discretion to prescribe various requirements on intermediaries and issuers for the protection of investors and in the public interest. The SEC has begun accepting public comments on regulatory initiatives under the JOBS Act, including the crowdfunding provisions.
SEC Chairman Mary Schapiro has publicly stated that the proposed rulemaking deadlines in the JOBS Act do not provide sufficient time for the SEC to consider and adopt rules under the act. Given these statements, it is not clear when companies actually will be able to take advantage of all of the provisions of the JOBS Act, including the crowdfunding provisions. Given the extensive SEC rulemaking required by the JOBS Act, and the investor protection issues involved, it is unclear whether the SEC will meet the deadline.
Raising Capital Apart from Crowdfunding
Other provisions of the JOBS Act provide opportunities to enable capital raising other than through crowdfunding. For example, Section 201(a)(1) of the JOBS Act directs the SEC to amend Rule 506 to make the prohibition against general solicitation or general advertising contained in Rule 502(c) inapplicable to offers and sales under Rule 506 provided that all purchasers are accredited investors. Section 201(b) amends Section 4 of the Securities Act to provide that offers and sales exempt under Rule 506 as revised by Section 201 “shall not be deemed public offerings under the Federal securities laws” as a result of general advertising or general solicitation. Section 201(a) requires the SEC to amend both Rule 506 and Rule 144A not later than 90 days after enactment of the JOBS Act. Therefore, after SEC rulemaking is complete, it may be easier for issuers to advertise Rule 506 offerings and raise capital through the sale of securities to accredited investors.
What the Crowdfunding Provisions Mean
First, companies should not try to utilize crowdfunding until the SEC finalizes rulemaking. Doing so would violate the securities laws and, in view of the “bad actor” provisions in the JOBS Act, may preclude a company from subsequently utilizing crowdfunding to raise capital.
Second, crowdfunding will clearly expand the options available to small companies seeking financing. As some early-stage startup companies have used Kickstarter to fund pre-sales of products, some startups may choose to use crowdfunding as an alternative to more conventional sources of funding.
Third, companies seeking to raise capital through crowdfunding will need attorneys involved to ensure that their corporate housekeeping is in order. Companies will need to ensure that an appropriate number and type of shares is authorized and review provisions relating to voting rights, board composition, and other matters that may be affected when the number of stockholders increases. In addition, companies will need to consider whether they will want their stockholders to enter into agreements imposing restrictions on share transfers, such as a company right of first refusal or IPO-related lock-up provisions. Furthermore, with a large number of stockholders, companies may want to review their director and officer indemnification provisions, and consider obtaining director’s and officer’s liability insurance.
Fourth, companies will be required to make filings with the SEC. Although these filings will be less burdensome than the filings required by public companies, they may still impose burdens on the resources of small companies, and may subject the companies and their officers and directors to potential liability if not properly prepared.
Fifth, many companies may be unable to prepare disclosure documents in compliance with the crowdfunding provisions of the JOBS Act. The SEC may use its rulemaking authority to prescribe a format, such as the Form 1-A Regulation A offering statement and the model offering circular contained in the form, which may impose a significant burden to raising a small amount of money.
Sixth, the increase in number of stockholders as a result of crowdfunding may result in increased administrative burdens on issuers. Stockholders may call or e-mail company personnel with questions or request meetings and may seek to avail themselves of rights to attend and participate in stockholder meetings and to inspect corporate books and records. Should litigation arise, it may be more challenging to manage such actions as the number of stockholders increases. In addition, if an issuer is the target of an acquisition, having a large number of stockholders may complicate securities law compliance.
Seventh, companies will need to choose intermediaries carefully. While some intermediaries’ websites have already begun to prepare for crowdfunding, the transaction fees charged by intermediaries have not yet been determined and there is the risk that fees will be excessive or that unscrupulous persons will masquerade as registered intermediaries.
Finally, it is possible that the attention given to crowdfunding may result in more elaborate schemes to defraud the public. Although the SEC will likely establish strict regulations on issuers and intermediaries, the perception that crowdfunding is legitimate may encourage unscrupulous persons to spam the public with various fraudulent crowdfunding opportunities not in compliance with the crowdfunding provisions of the JOBS Act. This may range from fraudsters operating fraudulent intermediaries to directly soliciting investments in fraudulent businesses.
April 15, 2010
(The following is from a WSGR client alert.)
On April 7, 2010, the California Division of Labor Standards Enforcement (DLSE) issued an opinion letter addressing the requirements employers must meet in order to have unpaid interns in compliance with California law. Although widely published news reports, including a recent New York Times article analyzing the DLSE’s April 7th opinion letter, have raised hopes that California is relaxing its position with respect to the permissibility of unpaid internships, such optimism appears to be misplaced and employers must continue to exercise caution in this area.
The DLSE’s guidance is timely, as thousands of college graduates and students prepare to hit the job market in search of employment opportunities. Many employers offer internships for a variety of reasons, including providing useful “real world” experience to students seeking to learn more about a particular industry or profession, and trying to help the children of customers, business colleagues, or friends. However altruistic their reasons, employers must be aware that California and federal law severely limit the circumstances under which such internships can be unpaid.
In response to a letter from an attorney representing Year Up, Inc., (a program aimed at developing fundamental job and technical skills in information technology for 18- to 24-year-olds) about the classification of internships in California, the DLSE concluded that the interns enrolled in the internship program were not employees under California law, and therefore were exempt from coverage under California’s minimum wage law. In reaching its conclusion, the DLSE followed the federal Department of Labor’s (DOL’s) criteria for determining whether the interns were exempt from minimum wage coverage and examined the “totality of the circumstances” surrounding their activities. Ultimately, the DLSE’s opinion letter reiterated its longstanding position that California follows the same stringent federal factors in analyzing the classification of interns, and thus serves as a reminder to employers that improper classification of employees as unpaid interns can be costly.
The DOL has articulated six criteria to determine whether an “intern” or “trainee” is exempt from the Fair Labor Standard Act’s minimum wage coverage. In order to qualify as an unpaid internship, all six factors must be satisfied under state and federal law. The six criteria are as follows:
1. The training, even though it includes actual operation of the employer’s facilities, is similar to that which would be given in a vocational school.
2. The training is for the benefit of the trainees or students.
3. The trainees or students do not displace regular employees, but work under their close observation.
4. The employer derives no immediate advantage from the activities of the trainees or students, and, on occasion, the employer’s operations actually may be impeded.
5. The trainees or students are not necessarily entitled to a job at the conclusion of the training period.
6. The employer and the trainees or students understand that the latter are not entitled to wages for the time spent in training.
The DLSE’s new opinion letter concluded that all six criteria also must be satisfied in California. However, the agency now appears to take a more relaxed approach as to when an employer will meet certain aspects of the six factors. For example, in determining whether regular employees are displaced (i.e., the “non-displacement” criterion), the DLSE now takes the position that occasional or incidental work by an intern should not defeat the exemption provided such work does not intrude into activities that could be performed by regular workers and effectively displace them. As the stringent six criteria must still be satisfied, it will be difficult for companies, particularly for-profit companies, to have properly classified unpaid interns. The recent New York Times article regarding internships quoted Nancy J. Leppink, the acting director of the federal Labor Department’s Wage and Hour Division, as stating, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.”
Many companies have relied upon unpaid interns as a way to minimize costs and provide opportunities to eager workers who are willing to work for free in hopes of ultimately securing a paid position. Such an approach is risky, and employers must understand that the consequences of utilizing unpaid internships that do not comply with applicable law are potentially grave. As with misclassification of an employee as an independent contractor, employers with misclassified unpaid interns face potential liability for unpaid wages and violations relating to failure to pay minimum wage, which could be significant for a full-time intern. In addition to the wages due to unpaid interns, the employer could face potential liability for overtime and missed meal or rest periods. Moreover, the employer could be liable for various penalties under California’s Labor Code (including waiting-time penalties for failing to pay wages on a timely basis), as well as unpaid employment-related taxes owed to governmental agencies.
For more information about legal issues regarding interns, please contact Fred Alvarez, Kristen Dumont, Laura Merritt, Ulrico Rosales, Marina Tsatalis, Alicia Farquhar, or another member of the firm’s employment law practice.
April 3, 2009
Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. In addition, the company must also comply with securities laws in each state where securities are offered.
The Act provides companies with a number of exemptions from federal registration requirements. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as “accredited investors” defined in rule 501 of Regulation D. Offerings to accredited investors are exempt from the registration requirements on the theory that accredited investors are sophisticated enough to protect their own interests.
The following types of individuals are accredited investors:
- a director, executive officer, or general partner of the company selling the securities;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase; or
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
Net worth includes the value of houses and automobiles. Thus, many homeowners are accredited investors due to the value of their houses. The $1 million net worth and $200,000 income standards were established in 1982 and have not increased with inflation.
The following types of entities are accredited investors:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a business in which all the equity owners are accredited investors; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
SEC Proposes Amendments to the Net Worth Standard for Accredited Investor Status
On January 25, 2011, the Securities and Exchange Commission (SEC) voted to propose certain amendments to the net worth standard for determining accredited investor status under the rules promulgated by the Securities Act of 1933. These amendments reflect the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Although Section 413 was effective on July 21, 2010, upon enactment by operation of the Dodd-Frank Act, the SEC is still required to revise the Securities Act rules to reflect the new standard. In addition, the SEC is proposing technical amendments to Form D and a number of rules to conform them to the language of Section 413(a) and to correct cross-references to former Section 4(6) of the Securities Act, which was renumbered Section 4(5) by the Dodd-Frank Act. The proposed rules are available here.
New Net Worth Test
Under proposed Securities Act Rules 215 and 501, the value of a person’s primary residence would be excluded for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the net worth standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth.
The proposed amendments would define an accredited investor, among other things, as:
“Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.”
Neither the Securities Act nor the Securities Act rules define the term “net worth,” so the proposing release states that the purpose of adding the phrase introduced by the words “calculated by” is to clarify that net worth is calculated by excluding only the investor’s net equity in the primary residence. The SEC believes this approach is consistent with and advances the regulatory purposes of Section 413(a) because it reduces the net worth measure by the amount or “value” that the primary residence contributed to the investor’s net worth before enactment of Section 413(a). The SEC also notes that some of its existing rules are similar in approach to the proposed rules. For example, Rule 701 under Regulation R provides for the exclusion of the value of a person’s primary residence in applying a net worth standard and also provides for the exclusion of “associated liabilities,” such as mortgages.
The proposed rules do not define “primary residence,” although they provide that issuers and investors should be able to use the commonly understood meaning of the term—the home where a person lives most of the time.
Effectiveness of the Proposed Rules
There is no transition period for the new accredited investor net worth standards, since these new standards were effective upon enactment of the Dodd-Frank Act. Under the current rules, a company or fund is not permitted to treat an investor as accredited if the investor subsequently loses that status, even if the investor has previously invested in the company or fund at a time when it satisfied the accredited investor standard. Investors must satisfy the applicable accredited investor income or net worth standard in effect at the time of every exempt sale of securities to the investor that is made in reliance upon the investor’s status as such. The proposed amendments would not change this situation. Nevertheless, the SEC is seeking comment on whether some transition and other rules might be appropriate to facilitate subsequent investments by an investor who previously qualified as accredited but was disqualified by the change effected by the Dodd-Frank Act.
Section 413(b) specifically authorizes the SEC to undertake a review of the definition of the term “accredited investor” as it applies to natural persons, and requires the SEC to undertake a review of the definition “in its entirety” every four years, beginning in 2014.
Effect of the New Net Worth Test
Among other things, the changes required by Section 413 of the Dodd-Frank Act impact the legal requirements governing unregistered offers and sales of securities, i.e., “private placement” exemptions from the registration requirements of the Securities Act relied on by companies in raising private capital from individuals. One of the requirements of certain private placement exemptions is for capital to be raised from accredited investors. By excluding the value of an investor’s primary residence in calculating net worth, indebtedness secured by the primary residence would be netted against the value of the primary residence up to the fair market value of the property. This may cause fewer individuals to qualify as accredited investors, thereby reducing available private capital.
Notwithstanding the foregoing, it is still possible for individuals to qualify as accredited investors on other grounds. For example, Rule 501 of the Securities Act provides that an accredited investor shall also mean any person who comes within, or who the issuer reasonably believes comes within, any of the following categories:
- any director, executive officer, or general partner of the issuer of the securities being sold, or
- any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year.
As a result, while the net worth test promulgated pursuant to the requirements of the Dodd-Frank Act may be more restrictive, natural persons may still qualify as accredited investors under one of the other definitions provided in Rule 501.
What You Should Do Now
Because Section 413(a) became effective upon the enactment of the Dodd-Frank Act and it requires the exclusion of the value of a person’s primary residence for purposes of determining whether such person qualifies as an “accredited investor,” all companies that have not already done so should revise their standard forms of accredited investor questionnaire and investor representations and warranties in their standard forms of financing documents to ensure that an individual’s net worth is properly calculated.
November 28, 2008
The SEC publishes a guide titled: Q&A: Small Business and the SEC that provides a simple answer.
In the chaotic securities markets of the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits – without disclosing any meaningful information to investors. These conditions contributed to the disastrous Stock Market Crash of 1929. In response, the U.S. Congress enacted the federal securities laws and created the Securities and Exchange Commission (SEC) to administer them.
Companies selling common stock, preferred stock or issuing options or warrants are issuing “securities.” The Securities Act of 1933 generally requires companies selling securities to give investors full disclosure of all material facts that investors would find important in making an investment decision. The Act also requires companies to file a registration statement (i.e. see the Google IPO registration statement) with the SEC that includes information for investors, unless the security or the type of transaction is exempt from registration.
However, registering a securities offering with the SEC is a very expensive (typically costing over $1,000,000) and time-consuming process. Therefore, sales of securities by companies to private investors or venture capitalists are usually structured to be exempt from the registration requirements of the Act. These exemptions (post to come) are fairly technical and companies need advice from competent securities attorneys to ensure compliance.
Even if a securities offering is exempt from federal registration requirements, the company must also comply with securities laws in each state where securities are offered. States may impose their own registration or qualification requirements that must be complied with unless an exemption is available.
Failure to comply with securities laws allows a purchaser to rescind or undo the purchase of securities and get his or her money back or recover damages. These rescission rights create potential exposure to the company if its stockholders demand their money back.
Generally, the federal statute of limitations for noncompliance with the requirement to register securities under the Securities Act is one year from the date of the violation upon which the action to enforce liability is based. State remedies and statutes of limitations vary and depend upon the state in which the shares were purchased. For example, the California statute of limitations for noncompliance with the requirement to register or qualify securities under the California Corporate Securities Law is the earlier of two years after the noncompliance occurred, or one year after discovery of the facts constituting such noncompliance.
In extreme cases, a company may make a rescission offer (i.e. offer to repurchase the securities plus interest) to stockholders that were sold securities in noncompliance with securities laws in an attempt to eliminate the exposure from rescission rights. The rescission offer itself must comply with all relevant securities laws. For example, Google’s noncompliance with securities laws in connection with option grants required it to file a registration statement with the SEC to make the rescission offer at the time of its IPO and resulted in a cease and desist order by the SEC.
April 27, 2008
There are various factors to consider when reviewing or drafting a confidentiality or non-disclosure agreement (NDA). Obviously, your perspective on the agreement depends on whether you are primarily disclosing or receiving confidential information. The following points should be kept in mind:
- Need for an agreement. Entering into an NDA increases the risk that the recipient may face charges of trade secret misappropriation if it develops similar information in the future or inadvertently discloses or uses the information. This is the primary reason that VCs will not enter into NDAs.
- Mutual versus one-way. Some agreements only cover disclosure of confidential information by one party. Other agreements are mutual and cover disclosures by both parties. Generally speaking, mutual agreements are less likely to have provisions that are one-sided.
- Non-disclosure and non-use. There are two important restrictions in an NDA. The non-disclosure provision prevents the recipient from disclosing the confidential information to third parties. The non-use provision prevents the recipient from using the information other than for a specified purpose. Occasionally, an NDA may not have a non-use provision. This would allow the receiving party to use the information for its own purposes as long as it did not disclose the information
- Definition of confidential information. The discloser will want a broad definition of confidential information and may also want third party confidential information to be deemed confidential. The receiver will want to narrow the definition of confidential information in order to avoid being “tainted” by the information. The definition can be narrowed by (i) limiting it to information disclosed in writing (or oral disclosures reduced to writing within a certain time frame), (ii) specifically marking the information confidential, (iii) specifying the information that is deemed confidential or (iv) specifying the dates of disclosure. The discloser will want to avoid some of the limitations because of the possibility or inadvertent disclosure or over-marking information as confidential, which may impair the ability to enforce the agreement with respect to genuine trade secrets.
- Exceptions to confidential information. The recipient will want broad exceptions to the definition of confidential information. Typical exceptions to the definition of confidential information include (i) information publicly known or in the public domain prior to the time of disclosure, (ii) information publicly known and made generally available after disclosure through no action or inaction of the recipient, (ii) information already in the possession of recipient, without confidentiality restrictions, (iv) information obtained by the receiver from a third party without a breach of confidentiality, and (v) information independently developed by the recipient. The discloser will try to limit the exceptions or add qualifiers such as the discloser must prove the exception with contemporaneous written records. Please note that the typical exception for information required to be disclosed by law should be an exception to the duty to not disclose, as opposed to an exception from the definition of confidential information (which would allow the recipient to disclose the information to anyone).
- Residual information. The recipient will want to include a clause that allows the recipient to use the discloser’s information that is retained in its employees’ memory. The recipient will want to avoid being “tainted” by receiving the information. This is often strongly rejected by the discloser. In the event the residuals clause is included, the discloser may try to limit it to (i) use of general skills and knowledge, (ii) information retained in the unaided memory of employees after a certain amount of time after access to the confidential information, and (iii) explicitly noting that the discloser is not granting any license to the recipient.
- Permitted disclosures. The discloser will want to limit disclosures to employees and contractors on a need to know basis with similar non-disclosure obligations. In addition, if disclosure is required by law, the discloser will want the recipient to notify the discloser in advance and provide the opportunity to obtain a protective order or otherwise maintain the confidentiality of the information.
- Term. NDAs commonly have terms of three to five years. The period of time depends the strategic value of the information to the discloser and how quickly the information may become obsolete.