Jay Parkhill March 30th, 2010
There has been a lot of news recently about Senator Christopher Dodd’s banking reform bill, which was introduced in the Senate a couple of weeks ago. I dug into the details relevant to startup and private company financing transactions (with help from the comments on avc.com and an insightful piece on TechFlash), and thought a bit about how it would likely affect my client base.
The entire bill runs 1036 pages, of which about 6 are relevant to angel and VC financings.
First, the proposal requires that the accredited investor dollar threshold be increased regularly to adjust for inflation. The current requirement (which dates from 1996) is that an investor earn at least $200,000 per year or have a net worth of at least $1,000,000. The Dodd bill requires that a retroactive inflation adjustment be applied to those figures and that they continue to be adjusted at least every 5 year going forward. I haven’t tried to do the math, but pundits say this would increase the threshold to $450,000/$2,300,000.
Second, the bill kicks oversight of Regulation D transactions (the principal exemption from public offering registration requirements used by private companies) largely to state authorities. The bill would (i) set a dollar threshold below which the SEC would not even try to regulate, saying that small transactions are exclusively overseen by state agencies, and (ii) for larger transactions provide a 120 day SEC review period, following which state authorities could also choose to review if the SEC did not.
Where This Comes From
The president of NASAA is also a Texas state securities regulator and in testimony to Congress explained NASAA’s belief that (i) fraud is most effectively prevented when SEC and state authorities can review/investigate problem cases, (ii) NSMIA prevents state authorities from preemptively investigating cases and only allows them to investigate after fraud has occurred, and (iii) lack of Reg D oversight contributed to the financial meltdown.
It looks to me as though NASAA is concerned about the Bernie Madoffs of the world and sees increased regulation over private securities transactions as the best way to reign in this type of fraud. Clearly NASAA also does not believe the SEC is up to the job of policing this environment.
Things I Don’t Understand
I don’t understand how the 120 day rule would work and I would love to ask Sen. Dodd the following questions:
-Will private companies be required to wait 120 days before closing financing transactions?
-If not formally required to wait, will investors have a rescission right if the SEC or state authorities find noncompliance with procedural or substantive requirements?
-How would this rescission right be enforced? Brokers are subject to bonding requirements so there is the possibility of recovery in a fraudulent sale by a stock broker, but seemingly none with early stage companies in particular. Six months after closing an angel financing a company may have already spent a decent chunk of the financing proceeds.
-Will state pre-closing notice requirements apply even prior to the SEC’s review period, so that e.g. a company would need to file a notice (and forms!) in NY, file an SEC notice 2 weeks later and then wait 6 months to see if NY would be able to pick up again?
What I Will Probably End Up Telling My Clients
In the most practical terms as a California lawyer, if this bill passes I will probably tell my clients that there is a sliding scale for transaction costs and timing that depends on where investors reside. My gut tells me neither the SEC nor the CA Department of Corporations wants to begin scrutinizing early stage investments, so my advice to clients will be to keep all their investors in CA, and if they have investors in XYZ other states then the cost of completing the transaction will be dramatically higher and riskier. This will be unfortunate.
What I Plan to Do
I am going to write a letter to both of my senators raising the questions above and asking them to look carefully at how this language will affect companies in California, and also how the concepts might be revised to avoid penalizing startup companies for the sins of hedge fund managers and unscrupulous securities brokers. I have also added my name to the online petition here: http://gopetition.com/online/32354.html Apart from that, I plan to watch this closely to see how it plays out.