Private Placements After the JOBS Act

The Seminar Group Conference

“Crowdfunding, the JOBS Act and Private/Angel Investments in 2013”

March 13, 2013 Charles D. Vaughn Co-Chair, Securities Practice Group Nelson Mullins Riley & Scarborough LLP Atlantic Station 201 17th Street NW / Suite 1700 Atlanta, GA 30363 404.322.6189 charles.vaughn@nelsonmullins.com

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Private Placements After the JOBS Act

March 13, 2013

Prepared by: Charles D. Vaughn, Partner Nelson Mullins Riley & Scarborough LLP, Atlanta, Georgia (1)

A. Introduction – Topics Covered

Exemptions under the JOBS Act

The Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) became law on April 5, 2012. The JOBS Act affects both exempt and registered offerings. Almost all of the parts of the JOBS Act that I will talk about today are not yet effective because the SEC has not yet adopted the final rules that are required. This memorandum summarizes and analyzes the following provisions of the JOBS Act that relate to private offerings:

• The elimination of the prohibition on general solicitation and general advertising in

Rule 506 offerings when sales are made only to accredited investors, along with comparable changes to Rule 144A (Title II of the JOBS Act) – the SEC has proposed rules but has not yet adopted them, although its deadline was 90 days after the JOBS Act was enacted.

• The exemption from broker/dealer registration solely because the person or entity is providing a “platform or mechanism” for Rule 506 offerings (Title II of the JOBS Act) – the SEC has recently provided FAQs about the exemption, which is technically in effect but practically of no use until Rule 506(c) becomes effective.

• The small offering exemption for crowdfunding, including funding portals (Title III

of the JOBS Act) – the SEC has not yet proposed rules although its deadline was 270 days after the JOBS Act was enacted.

• The exemption for offerings of up to $50 million (Title IV of the JOBS Act),

commonly referred to as “Regulation A Plus” – the SEC has not yet proposed rules, and there is no deadline for proposed or final rules.

(1) This memorandum reflects my personal views on these matters, which are not necessarily those of my law firm or our clients. This memorandum is for educational and informational purposes only and is not intended and should not be construed as legal advice. I gratefully acknowledge the help of my partner Steve B. Park and my associate Andrew C. Nielsen in preparing this memorandum.

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Disclosing Projections in Private Offerings

This memorandum suggests some of the things that a securities lawyer should consider in advising a client about disclosing projections in private offerings. Drafting Disclosure Materials for Private Offerings

This memorandum explains how to approach drafting disclosure materials for private

offerings, including determining the appropriate level of disclosure and using plain English to make the disclosures easier to understand. Drafting Risk Factors for Private Offerings

This memorandum explains how to draft risk factors in private offering materials using (a) the SEC’s guidance for risk factors in public offerings and (b) analogous risk factors that public companies in the same industry use. Offering Terms Will Not Be Covered

Although the agenda lists “offering terms” as my final topic, I will defer to the able and experienced investment bankers, investors, accountants, and lawyers who are speaking today (including my partner Doug Spear) regarding recent trends in offering terms.

B. Proposed Rule 506(c) and Related Amendments Overview

Rule 506 of Regulation D is a commonly used exemption from registration under the securities laws due to its unlimited offering amount, ease of filing, and preemption of state blue sky laws. The JOBS Act expanded Regulation D to give issuers the ability to engage in general solicitation and general advertising for certain Rule 506 offerings. Note, however, that the implementing rule is not yet effective, so general advertisement and general solicitation are not yet permitted. I first summarize proposed amendment to Rule 506 as if it will be adopted as proposed, and then I describe a change to the proposed rule that various commentators and groups are advocating.

Section 201(a) of the JOBS Act instructs the SEC to remove the prohibition against

general solicitation and general advertising for offers and sales under Regulation D’s Rule 506. Currently, given that the changes mandated by the JOBS Act have not yet become effective, Rule 506 exempts the sale of securities only if the issuer does not engage in any general solicitation or advertising, and issuers can legally sell to a purchaser based a “reasonable belief” that the purchaser is an accredited investor without extensive verification of that belief. In the JOBS Act, Congress conditioned the remarkable change to Regulation D on the conditions that the modified Rule require the issuer (a) to sell the securities only to “accredited investors” and (b) to take “reasonable steps to verify” that all purchasers are indeed “accredited investors.”

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Summary of Proposed Rule 506(c)

In response to Congress’s mandate, the SEC proposed modifications to Rule 506 on August 29, 2012 that, if adopted, would provide an additional Rule 506 exemption as Rule 506(c). This new exemption would allow issuers to take advantage of the most appealing aspects of Rule 506 – the ability to raise unlimited amounts of capital and preemption of state securities laws – while using general advertising and general solicitation.

As required by the JOBS Act, proposed Rule 506(c) requires the issuer:

• to satisfy all the conditions of Rule 501 (definitions, including “accredited investor”), Rule 502(a) (integration), and Rule 502(d) (limitations on resale);

• to sell only to “accredited investors”; and • to take reasonable steps to verify that purchasers are in fact accredited investors.

“Reasonable Steps” to Verify Accredited Investor Status Under Proposed Regulation 506(c)

In the proposing release for proposed Rule 506(c), the SEC explained that the new legal structure would enable a flexible approach for verification. It explained that taking “reasonable steps” entails an objective determination based on the particular facts and circumstances of each transaction, which would necessarily require different procedures depending on the situation. (I refer to the SEC’s proposing release No. 33-9354, issued on August 29, 2012, as the “Proposing Release.”) The SEC gave the following examples of factors to consider, all of which should be considered together to tailor the “reasonable steps” required for the specific transaction:

• the nature of the 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, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The “nature of the purchaser” factor references the categories of “accredited investor” as

defined in Rule 501(a). For instance, different steps would be reasonable to determine whether (a) an individual’s net worth exceeds accredited investor thresholds and (b) a broker-dealer is properly registered under Section 15 of the Securities Exchange Act of 1934.

The SEC deliberately elected not to prescribe a “one size fits all” set of “reasonable

steps.” Instead, the SEC stated in the Proposing Release that the “more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.” For example, a purchaser who is an executive officer or director of the issuer requires no additional steps to verify accredited investor status. On the other hand,

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verification of a private individual’s net worth may require asking the individual to complete a questionnaire or provide financial documents. The source of the information is also integral to this factor. Publicly disclosed information subject to securities fraud liability, such as an executive’s salary published in the proxy statement of a public company, will require fewer steps than determining if the trustee of a purchaser is a “sophisticated person.”

The way the securities are offered and the relationship of the issuer with the potential

purchaser can substantially change the steps required to verify the potential purchaser’s status as an accredited investor. At one extreme end of the spectrum, solicitations made only to investors that have been prescreened for accredited investor status by a reliable third party (such as a registered broker/dealer) would require very few, if any, additional steps to verify the status of the purchaser before selling the securities. At the opposite extreme, general solicitation to the public by way of general advertising or posting information on the issuer’s website would require multiple additional steps for proper verification. A “check the applicable box” feature in the securities purchase documents enabling the investor to claim accredited investor status would be insufficient “reasonable steps” for an offering conducted through general solicitation.

The SEC does not require the issuer to take all of these varying “reasonable steps” itself.

In fact, the SEC has a favorable view of issuers depending on reliable third parties to substantiate purchasers’ accredited investor status.

Accredited Investors and “Reasonable Belief”

The lead-in language in Rule 501(a) provides: “Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person: . . . .” (Emphasis added.)

Section 201(a)(1) of the JOBS Act states:

“[T]he [SEC] shall revise its rules issued in [Rule 506], to provide that the prohibition against general solicitation or general advertising contained in [Rule] 502(c) . . . shall not apply to offers and sales of securities made pursuant to [Rule] 506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the [SEC].” (Emphasis added.)

In response to concerns expressed by commentators that the above language in the JOBS Act could be interpreted as precluding the use of the “reasonable belief” standard in Rule 501(a) in determining whether a purchaser is an accredited investor, the SEC stated in the Proposing Release that in the SEC’s view, the language “does not represent a Congressional intent to eliminate the existing reasonable belief standard in Rule 501(a) or for Rule 506 offerings.” In support of this position, the SEC noted that the JOBS Act did not change the definition of “accredited investor,” which as noted above does allow for “reasonable belief.” The SEC also observed:

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“If a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, we believe that the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.”

Proposing Release at p. 29. The Future of Rule 506 Offerings

If proposed Rule 506(c) is adopted as proposed, issuers will have a choice between

traditional Rule 506 offerings and the new 506(c) offerings, and Form D will have a new box to check for Rule 506(c) offerings. The decision will in some cases require cost-benefit analysis of verification versus solicitation. If an issuer decides to use general solicitation for the offering, the issuer will have no choice but to check the Rule 506(c) box. An issuer that intends to make a traditional Rule 506 private offering, however, may elect not to check the Rule 506(c) box and thus not have to worry about the extra verification steps (or the attention that the SEC may focus on Rule 506(c) offerings). Rule 506(c) may help issuers who initially intend to make a traditional Rule 506 private offering but have some circumstance arise that might be construed as a general solicitation. The Proposing Release did not say that checking the Rule 506(c) box is an exclusive election, so presumably an issuer will continue to be able to check multiple boxes if the issuer believes it meets the requirements for the specific exemption. Cautious issuers may be reluctant to use the new 506(c) because the required verification would be based on facts and circumstances rather than a bright line test. In its currently proposed form, Rule 506(c) does not include a verification safe harbor.

As a practical matter, if Rule 506(c) is adopted as proposed and issuers elect to use

general advertising and general solicitation:

• Issuers and their counsel will have to implement much more detailed verification standards than the more or less customary “check the box” forms.

• Purchaser questionnaires will be much more detailed than those used currently.

• If verification measures include copies of detailed financial statements, tax returns, or pay stubs, for example, issuers will have to maintain procedures to guard the privacy of those materials and to reassure subscribers that they have done so. The more general the solicitation and the weaker the pre-offering connection between the issuer and the investor, the more difficult it will be to persuade investors to provide the appropriate data to verify their status as an accredited investor.

• Alternatively, issuers will have to rely more heavily on reliable third parties like

registered broker/dealers, attorneys, and accountants. Over time, banks, accountants, and even specialized verification providers may develop routine procedures for these types of verification services.

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Possible Amendments to Proposed Rule 506(c)

Like everything else in Washington, D.C., proposed Rule 506(c) has gotten caught up in

the political climate since its proposal in August 2012. Free market advocates and some in the Republican Party are frustrated at the delay in adopting the rule. Democrats, investor and consumer advocates, the North American Securities Administrators Association (NASAA), and at least one SEC Commissioner are arguing strenuously that the rule should be amended, perhaps with a complete re-proposal, to strengthen investor protection measures, including updating the definition of “accredited investor” to increase the income and net worth thresholds, and to add a verification “safe harbor.”

With respect to NASAA in particular, on March 5, 2013 NASAA released its Legislative

Agenda for the 113th Congress. A section of that agenda is entitled “Congress Must Strengthen Investor Protections that Were Weakened by the JOBS Act to Minimize the Act’s Enormous Potential for Abuse.” NASAA asserts that the removal of the ban on “general solicitation” in Rule 506 “dismantles an important investor protection” that “warrants a corresponding increase in dollar thresholds in the accredited investor definition.” NASA also urged Congress to ensure that the SEC adopts a verification safe harbor, that a Form D should be filed before the use of any general solicitation, and that reasonable restrictions should be placed on advertising, including performance advertising for private funds.

Further complicating the adoption of a final rule are the following:

• the SEC currently has only four commissioners, who are evenly split by party; • new SEC Chair nominee Mary Jo White has yet not been confirmed and has an

enforcement, not a corporate finance, background; • the Division of Corporation Finance has an Acting Director, Lona Nallengara; • the SEC is behind schedule on a number of Dodd-Frank rules; and • the SEC is aware that the Court of Appeals for the District of Columbia is likely

to require a rigorous cost-benefit analysis to support any rule that the SEC adopts that is challenged in the courts.

I believe that the most likely amendment is a verification safe harbor that would include, for example, a provision stating that obtaining copies of tax returns is an appropriate method of verification of income. Absent Congress intervening, I do not believe that the SEC believes it has the authority to increase the dollar thresholds in the accredited investor definition. Rule 506(c) seems to be first in line for the JOBS Act rules at the SEC, but I cannot predict when it will be adopted or whether it will be re-proposed.

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Broker/Dealer “Platform or Mechanism” for Rule 506 Offerings

Section 201(c) of the JOBS Act adds new paragraph (b) to Section 4 of the Securities Act that provides:

“(1) With respect to securities offered and sold in compliance with Rule 506 of Regulation D under [the Securities Act], no person who meets the conditions set forth in paragraph (2) shall be subject to registration as a broker or dealer . . . solely because—

“(A) that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitation, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through other means;

“(B) that person or any person associated with that person co-invests in such securities; or

“(C) that person or any person associated with that person provides ancillary services with respect to such securities.”

“(2) The exemption provided in paragraph (1) shall apply to any person described in such paragraph if—

“(A) such person and each person associated with that person receives no compensation in connection the purchase or sale of such security;

“(B) such person and each person associated with that person does not have possession of customer funds or securities in connection with the purchase or sale of such security; and

“(C) such person is not subject to a statutory disqualification as defined in section 3(a)(39) of this title and does not have any person associated with that person to such a statutory disqualification.

“(3) For the purposes of this subsection, the term ‘ancillary services’ means—

“(A) the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and

“(B) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.”

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As a practical matter, who would use a platform or mechanism? The answer is: a venture capital fund. The SEC stated in a recent FAQ:

“Question 6.

“May an entity, such as a venture capital fund or its adviser, operate an Internet website where it lists offerings of securities by potential portfolio companies (in compliance with Rule 506), co-invest in those securities with other investors, and provide standardized documents for use by issuers and investors, rely on Securities Act Section 4(b) to not register as a broker-dealer? “Answer.

“Yes. These activities are permitted under Section 4(b), subject to the conditions set forth in Section 4(b)(2), including the prohibition on receiving compensation in connection with the purchase or sale of securities. As a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration. (Emphasis added.)

See the SEC FAQs on this part of the JOBS Act at: http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm. JOBS Act Amendment to Rule 144A

Rule 144A provides a safe harbor from registration for resales of certain securities to purchasers the seller reasonably believes are “qualified institutional buyers,” or “QIBs” (pronounced “kwibs”). Resales that comply with Rule 144A are exempt from Securities Act registration. Rule 144A permits an investment banking firm or other financial intermediary to buy securities from an issuer and resell them immediately to an unlimited number of QIBs if those sales comply with Rule 144A. Those QIBs can then trade the securities among themselves in transactions that comply with Rule 144A.

As required by the JOBS Act, the SEC proposed an amendment to Rule 144A(d)(1) that

provides that securities may be offered under Rule 144A to persons other than QIBs, including through general solicitation or advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs. The amended rule itself does not mention “general solicitation or general advertising,” but the Proposing Release is entitled “Eliminating the Prohibition against General Solicitation and General Advertising in Rule 506 and Rule 144a Offerings.” SEC Clarification that Private Funds Can Use Rule 506(c)

On pages 31-32 of the Proposing Release, the SEC noted that privately offered funds, such as hedge funds, venture capital funds, and private equity funds, typically rely on Section

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4(a)(2) and the Rule 506 safe harbor to offer and sell their interests without registration under the Securities Act. These funds generally rely on one of two exclusions from the definition of “investment company” under the Investment Company Act. These exclusions are not available if a fund makes a public offering of its securities. Providing comfort to these funds, the SEC advised that “[w]e believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.”

C. The New Section 4(a)(6) Crowdfunding Exemption Overview

Title III of the JOBS Act created the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or the “CROWDFUND Act” and added Section 4(a)(6) to the Securities Act. This crowdfunding exemption, when effective once mandatory SEC rules are adopted, allows companies to leverage the Internet to sell securities to a large group of investors who purchase in small amounts without a registered offering. Although Congress instructed the SEC to create specific regulations to give effect to this provision by the end of December 2012, the SEC has yet to release proposed rules. Given that we do not have proposed rules to analyze, the following section of this memorandum focuses on the text of the law, on which the SEC must elaborate before we will know the complete legal framework for crowdfunding. No General Solicitation and Advertising

The crowdfunding exemption does not permit general solicitation and advertising. An issuer may only direct prospective purchasers to the funding portal or broker, as the case may be. The SEC will likely provide specific guidance in this regard, which may be similar to tombstone ads. Furthermore, issuers may not compensate third parties for promoting the offering unless both comply with SEC disclosure requirements regarding compensation.

Eligibility

Only non-reporting companies can use the crowdfunding exemption. Additionally, investment companies and companies excluded from the definition of “investment company” by Sections 3(b) or 3(c) of the Investment Company Act of 1940 cannot take advantage of the crowdfunding exemption. Lastly, the SEC is instructed to exclude “bad actors,” which it is free to define in the final rule as long as the definition is substantially similar to Rule 262 of Regulation A. Issuer Offering Amount Limitation

The crowdfunding exemption has significant limits on the capital an issuer can raise under the exemption. The aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding

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the date of the sale, cannot exceed $1,000,000. Given this limit, if an issuer has previously raised $500,000 from its founders, then it cannot sell more than another $500,000 under the crowdfunding exemption.

Purchaser Amount Limitation

Each investor’s purchase is also limited so that the aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the sale, cannot exceed the following amounts: If either the annual income or the net worth of the investor is less than $100,000, the investor can invest no more than the greater of $2,000 or 5% of the investor’s annual income or net worth. If either the annual income or net worth of the investor is equal to or more than $100,000, the investor can invest no more than the lesser of $100,000 or 10% of the investor’s annual income or net worth. The income and net worth of a natural person under must be calculated in accordance with SEC rules regarding the calculation of the income and net worth, respectively, of an accredited investor.

As described below, an intermediary broker or funding portal must ensure that no

investor in a 12-month period has purchased securities offered under the crowdfunding exemption that, in the aggregate from all issuers, exceed the investment limits described above. Funding Portals

To qualify for the Section 4(a)(6) crowdfunding exemption, issuers must conduct all offerings through an intermediary broker or funding portal. See Section D – Crowdfunding Portals below for an analysis of that aspect of crowdfunding. Issuer Disclosure Requirements for a Crowdfunding Offering

The issuer must file with the SEC information about itself and the offering.

Disclosures About the Issuer Subject to additional clarification by the SEC, the issuer must file with the SEC, and

provide to investors and the relevant broker or funding portal, information that includes:

• the issuer’s name, legal status, physical address, and website address; • the names of the issuer’s directors, officers, and 20% stockholders; • a description of the issuer’s business and anticipated business plan; and • a description of the issuer’s financial condition.

The level of detail of the required disclosure varies depending on the issuer’s previous use of the crowdfunding exemption within the previous 12 months. For offerings that, together with all other crowdfunding offerings of the issuer within the preceding 12-month period:

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• have “target offering amounts” of $100,000 or less, the issuer must provide income tax returns for its most recently completed year (if any) and financial statements certified by the principal executive officer to be true and complete in all material respects;

• have “target offering amounts” of more than $100,000 but not more than $500,000, the issuer must provide financial statements reviewed by a public accountant who is independent of the issuer, using professional standards and procedures for such review or standards and procedures established by the SEC for that purpose; and

• have “target offering amounts” of more than $500,000 (or such other amount as the SEC may establish), the issuer must provide audited financial statements.

Disclosures About the Offering

The issuer must also file with the SEC, and provide to investors and the relevant broker

or funding portal, the following:

• a description of the stated purpose and intended use of the proceeds; • the target offering amount; • a deadline to reach the target offering amount; • regular updates regarding the progress towards meeting the target offering

amount; and • the price to the public of the securities or the method for determining the price.

The issuer must also describe in detail the ownership and capital structure of the issuer,

including:

• the terms of the offered securities and of each other class of the issuer’s securities not involved in the offering;

• the potential negative effect on the offered securities if the principal shareholders exercise their rights;

• the identity of all shareholders who hold more than 20% of any class of the issuer’s securities;

• the methods used to value the offered securities and examples of how the issuer may value its securities in the future, “including during subsequent corporate actions”; and

• the risks to purchasers of the securities relating to minority ownership in the issuer, the risks associated with corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties.

Ongoing Reporting Requirements for Issuers Who Conduct a Crowdfunding Offering

At least annually, issuers will be required to file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer, as the SEC determines are appropriate.

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Blue Sky Preemption

Crowdfunding securities will be “covered securities,” which will preempt states’ enforcement of their blue sky laws with respect to the securities for reasons other than fraud. Restrictions on Transfer

The securities obtained through crowdfunding offerings are subject to restrictions for one year after issuance but are not “restricted securities.” During that period, investors that purchase securities in a crowdfunding offering can transfer those securities only to the issuer, an accredited investor, as part of an SEC-registered offering, or to a family member in connection with the death or divorce of the purchaser. The SEC has the authority to limit these transfer rights further.

D. Crowdfunding Portals Overview

As noted above, issuers must sell securities through crowdfunding intermediaries for the offering to satisfy the Section 4(a)(6) crowdfunding exemption. The JOBS Act added Section 4A(a) to the Securities Act to describe the role of these intermediaries in crowdfunding offerings. Both brokers and the newly defined “funding portals” may qualify as intermediaries.

Under the JOBS Act, a “funding portal” is:

“[A]ny person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to [the crowdfunding exemption], that does not—

“(A) offer investment advice or recommendations; “(B) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;

“(C) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;

“(D) hold, manage, possess, or otherwise handle investor funds or securities; or “(E) engage in such other activities as the [SEC], by rule, determines appropriate.”

Crowdfunding portals will be subject to the examination and enforcement rules of both

the SEC and a member of a national securities association that is registered under Section 15A of the Securities Exchange Act. The Financial Industry Regulatory Authority (FINRA) has issued

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an interim form for funding portals to complete and file with FINRA now. This form is not an official filing until the SEC has promulgated specific crowdfunding regulations, but FINRA has asked funding portals to complete and submit the form now so that it may “better understand the funding portal community” and “develop rules specific to funding portals.”

Investor Protection Responsibilities

Crowdfunding lies between private and public offerings. Unlike Rule 506 offerings, securities are available to all types of investors, whether accredited or not, and unlike public offerings, investors will not receive the full set of disclosure documents required for securities registration. One of the primary purposes of intermediaries in crowdfunding offerings is to provide protection for investors to make up for the absence of disclosure and the assumed sophistication of investors.

Crowdfunding intermediaries are required to engage in the following investor education

programs and procedures:

• provide such disclosures, including disclosures related to risks and other investor education materials, as the SEC determines are appropriate; and

• ensure that each investor: reviews investor-education information; positively affirms that the investor understands that the investor is risking the

loss of the entire investment; and answers questions demonstrating: an understanding of the level of risk generally applicable to investments in

startups, emerging businesses, and small issuers; an understanding of the risk of illiquidity; and an understanding of other matters that the SEC determines to be

appropriate.

In addition, crowdfunding intermediaries must:

• take measures to reduce the risk of fraud with respect to crowdfunding transactions, including obtaining a background and securities enforcement regulatory history check on each officer, director, and 20% shareholder of the issuer;

• not later than 21 days before the first day on which securities are sold to any investor (or such other period as the SEC establishes), make available to the SEC and to potential investors any information the issuer provides to comply with the crowdfunding exemption;

• ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount;

• allow all investors to cancel their commitments to invest, as the SEC determines is appropriate;

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• ensure that no investor in a 12-month period has purchased securities offered under the crowdfunding exemption that, in the aggregate from all issuers, exceed the investment limits for investors described above;

• take such steps to protect the privacy of information collected from investors as the SEC determines is appropriate;

• not compensate promoters, finders, or lead generators for providing the broker or funding portal with the personal identifying information of any potential investor;

• prohibit their directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using their services; and

• meet such other requirements as the SEC prescribes for the protection of investors and in the public interest.

Effect of Intermediary’s Violation of Crowdfunding Rules

Whether an intermediary’s violation of crowdfunding rules will result in a loss of the offering’s exempt status or result in a separate action directly against the intermediary are currently open issues. State Enforcement

Except as provided in the following sentence, no state may enforce any law, rule, regulation, or other administrative action (“State law”) against a registered funding portal with respect to its business as such. The preceding sentence does not apply with respect to the examination and enforcement of any State law of a state where the principal place of business of a registered funding portal is located, provided that the State law is not in addition to or different from the requirements for registered funding portals established by the SEC.

In NASAA’s Legislative Agenda for the 113th Congress, NASAA said the following about the crowdfunding provisions generally:

“Given the potential for huge numbers of unsophisticated investors to participate in crowdfunded offerings, and in view of the anticipated lack of regulatory oversight these public offerings will receive, NASAA believes that high standards must be in place for issuers and funding portals or intermediaries.”

E. The New Section 3(b) Exemption – “Regulation A Plus” Overview

Regulation A was designed as a less onerous means for smaller companies to sell securities to the public. Since the late 1990s, however, Regulation A has steadily lost appeal to issuers, who have increasingly decided to use Regulation D instead. Commentators generally agree that Regulation A’s low dollar threshold and lack of state law preemption are the primary reasons that issuers do not use it. Title IV of the JOBS Act directed the SEC to add a type of

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offering very similar to Regulation A, but with some differences that could make it more desirable to issuers.

The SEC is currently working on a rule to implement what many call “Regulation A

Plus,” and Congress did not impose a deadline to pass the final rule. I believe that it is third in line among the JOBS Act rules, behind both Rule 506(c) and the crowdfunding rules. The JOBS Act does lay out the basic structure analyzed below.

JOBS Act Provisions for Regulation A Plus Offerings

Regulation A Plus allows issuers to sell up to $50 million in securities within a 12-month

period, representing a significant increase over Regulation A’s $5 million cap. The SEC is instructed to review this cap every two years and increase it as it deems proper. The issuer may sell equity, debt, and convertible debt securities as well as guarantees of those securities. In addition, the issuer may “test the waters” before filing any documents with the SEC to determine the level of interest for its securities.

Unlike current Regulation D, Regulation A Plus allows public solicitation, and securities

sold under Regulation A Plus will not be “restricted securities,” thus permitting unrestricted resales by any unaffiliated investor. Unlike Rule 506, Regulation A Plus will also allow sales to non-accredited investors. Members of the SEC staff have noted, however, that Exchange Act Rule 15c2-11 and Rule 144 under the Securities Act could be amended to impose current information requirements for offerings under Regulation A Plus for resales. SEC Speaks 2013 Conference Notes, by Stephanie Bignon, Nishchay Maskay and Keir Gumbs, Covington & Burling LLP (“Covington Notes”).

Securities sold under Regulation A Plus are “covered securities,” which means that state

blue sky laws are preempted, so long as (a) the securities are offered and sold on a national securities exchange, or (b) the securities are offered or sold only to “qualified purchasers” as defined under the Securities Act. This provision may not be as helpful as it might appear at first glance. First, whether any national securities exchange will permit the listing of shares offered and sold under Regulation A Plus, and whether merely listing the shares on the exchange means that “the securities are offered and sold on a national securities exchange,” are open questions. Second, the SEC has yet to define “qualified purchaser” for purposes of Regulation A Plus. As any securities lawyer who practiced before NSMIA preempted blue sky regulation for Rule 506 offerings can attest, complying with state blue sky laws can be complicated, unpredictable, expensive, and time-consuming. Particularly frustrating are additional disclosures mandated by individual states.

To be eligible for a Regulation A Plus offering, neither the issuer nor its predecessors,

affiliates, officers, directors, underwriters, or other related persons can be felons or “bad actors,” as the SEC will define it in the final rule, which will be substantially similar to Rule 506’s requirements. The SEC may also place additional requirements and limits on Regulation A Plus offerings. These provisions may include requiring an offering memorandum for each offering or may limit how an issuer may “test the waters” before making its first filing with the SEC.

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The SEC has the authority to require the issuer to prepare and electronically file with the SEC and distribute to prospective investors an offering statement and any related documents. The SEC has the flexibility to prescribe the form and content of those materials, including audited financial statements, a description of the issuer’s business operations, its financial condition, its corporate governance principles, its use of investor funds, and other appropriate matters.

Issuers will also be required to file reports annually with the SEC, including audited

financial statements. Members of the SEC staff have recently stated that it “will be interesting to see how we address this ongoing disclosure question.” Covington Notes. The Future of Regulation A Plus

Proponents of Regulation A Plus hope it will be an attractive alternative to both initial

public offerings and Regulation D. I believe that the utility of Regulation A Plus will largely depend on (a) how the SEC defines “qualified purchaser,” and (b) whether the securities exchanges create a way to accommodate Regulation A Plus offerings. If state blue sky laws are preempted for the types of offerings that issuers desire to conduct, Regulation A Plus has a bright future. If blue sky laws are not preempted, however, I do not believe that Regulation A Plus will offer compelling advantages over proposed Rule 506(c).

F. Disclosing Projections in Private Offerings Overview

Projections or financial forecasts are an essential element of many private placements. Although no federal law provides a safe harbor for forward-looking statements by private companies in the same way that Section 27A of the Securities Act provides a safe harbor for certain offerings under the Securities Act, private companies can and should use cautionary language surrounding their projections and forecasts. The “Bespeaks Caution” Doctrine

Cautionary language surrounding projections or forecasts can benefit from the judicially created “bespeaks caution” doctrine, which several federal courts of appeal, including the Eleventh Circuit, have embraced. The U.S. District Court for the Northern District of Georgia summarized it in this manner in 2001:

“‘Forward-looking representations are also considered immaterial when the

defendant has provided the investing public with sufficiently specific risk disclosures or other cautionary statements concerning the subject matter of the statements at issue to nullify any potentially misleading effect.’ This doctrine, which is called the ‘bespeaks caution’ doctrine, ‘provides a mechanism by which a court can rule as a matter of law ... that defendants’ forward-looking representations contained enough cautionary language or risk disclosure to protect the defendant against claims of securities fraud.’ However,

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not every risk disclosure will be sufficient to immunize statements relating to the disclosure; rather, ‘the cautionary statements must be substantive and tailored to the specific future projections, estimates or opinions . . . which the plaintiffs challenge.’ General statements that fail to disclose specific underlying material information fail to trigger the protection of the bespeaks caution doctrine. Likewise, boilerplate warnings merely reminding an investor that the investment holds risk are not sufficient. On the other hand, acceptable cautionary language includes warnings that are specific and are linked to the projections at issue. At bottom, the ‘bespeaks caution’ doctrine stands for the ‘unremarkable proposition that statements must be analyzed in context’ when determining whether or not they are materially misleading.”

In re S1 Corp. Sec. Litig., 173 F. Supp. 2d 1334, 1351-52 (N.D. Ga. 2001). [Citations omitted.] Using Disclosure Requirements for Accountants

To bolster the likelihood that its projections will receive the benefit of the “bespeaks caution” doctrine, an issuer should consider including the disclosures that accountants generally use if they are associated with projections. The following three matters are usually disclosed in prospective financial statements:

1. a description of what the issuer intends for the projections to present; 2. a summary of significant assumptions; and 3. a summary of significant accounting policies.

Each page of the prospective financial statements should direct the reader’s attention to

the summaries of significant assumptions and accounting policies. A legend such as “The accompanying summaries of significant assumptions and accounting policies are an integral part of the financial forecast” or “See accompanying summaries of significant assumptions and accounting policies” is often used. The accounting guidance includes more detailed requirements that may apply if an accountant is involved, and the client should consider having its accountant informally review and comment on the projections even if the accountant is not officially reviewing them and is not named in the private offering materials or accompanying materials. Sample Cautionary Language for Projections

Sample cautionary language for projections is attached as Appendix A.

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G. Drafting Disclosure Materials for Private Offerings Overview

This section of the memorandum explains how to approach drafting disclosure materials

for private offerings, including determining the appropriate level of disclosure, and using plain English to make the disclosures easier to understand. Determining the Appropriate Level of Disclosure

This task is more art than science, and experienced, reasonable securities lawyers can differ on the level of disclosure that is appropriate. In a Rule 506 offering made solely to accredited investors, the analysis starts with Rule 502(b)(2):

“(2) Type of information to be furnished. (i) If the issuer is not [a public

company], at a reasonable time prior to the sale of securities the issuer shall furnish to the purchaser, to the extent material to an understanding of the issuer, its business and the securities being offered:” (Emphasis added.)

The rule goes on to list various types of information, depending in part on the size of the offering. Because an issuer must disclose all of the required information if it sells securities to “any purchaser that is not an accredited investor,” it is rare in my experience for issuers to sell to unaccredited investors in private offerings.

In evaluating materiality, lawyers can consider the following factors, among many others, and balance them as appropriate. Strictly speaking, one could read the language quoted above as an absolute standard of materiality, but in the real world, securities lawyers and issuers make judgment calls regarding the level of disclosure required. The factors to consider include the size of the offering; the anticipated number, type (institutional or individual), and sophistication of the investors; the perceived level of risk associated with the offering; the experience of management; and whether the issuer will use general advertising and general solicitation (after Rule 506(c) becomes effective).

Sometimes an important practical consideration is the amount of legal fees the client can

afford to pay its counsel to draft the offering memorandum. On rare occasions, if the amount of legal fees that will be required to enable the lawyer to draft adequate disclosure materials is outside the client’s ability or willingness to pay, the lawyer may have to decline the representation. Using Plain English

A private offering memorandum should be an effective method of communication between the issuer and its potential investors. In addition, as the securities lawyer and the issuer go through the drafting process, the issuer often focuses its business on what is critical rather than on what is desirable, identifies and addresses risks, and improves its strategy and business

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plan. The likelihood of gaining these benefits will be higher if the lawyer follows plain English principles in drafting the private offering memorandum.

The SEC’s “A Plain English Handbook: How to Create Clear SEC Disclosure Documents” is available in PDF format at this link:

http://www.sec.gov/news/extra/handbook.htm

I believe that these are the most important plain English practices:

• write in simple, concise sentences; • avoid defined terms and acronyms, although using well-known acronyms like

SEC and FDA is helpful; • avoid industry jargon; • write in the active voice, not the passive voice; • avoid embedded lists – use bulleted or numbered lists instead; • use tables, charts, and graphs; • don’t “write like a lawyer” using big words like “hereinafter”; • instead, use plain English words (see Appendix B for words to substitute); • avoid using “romanettes” – (i), (ii), (iii), etc.; • use letters instead – (a), (b), (c), etc.; • use white space effectively; • use a jagged right edge instead of a justified right edge; and • use bold type rather than uppercase type for emphasis.

H. Drafting Risk Factors Overview

The risk factors section of a private placement memorandum can be the one that protects the issuer the most, even if the negative tone of the language may shock the officers of the issuer if they have no previous experience with risk factors in a securities offering document. In public documents, risk factors must be in plain English; see Rule 421(d). Risk factors in a private offering memorandum should be in plain English, too. They can serve as a counterbalance to “puffing” by overly enthusiastic officers of the issuer and support the issuer’s later claim that it is entitled to the protection of the “bespeaks caution” doctrine. Item 503(c) of Regulation S-K

Although Item 503(c) of Regulation S-K does not directly apply to risk factors in a private offering memorandum, it provides useful guidance:

“(c) Risk factors. Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make the offering speculative or risky. This discussion must be concise and organized logically. Do not present risks that

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could apply to any company or any offering. Explain how the risk affects the company or the securities being offered. Set forth each risk factor under a subcaption that adequately describes the risk. The risk factor discussion must immediately follow the summary section. If you do not include a summary section, the risk factor section must immediately follow the cover page of the prospectus or the pricing information section that immediately follows the cover page. Pricing information means price and price-related information that you may omit from the prospectus in an effective registration statement based on §230.430A(a) of this chapter. The risk factors may include, among other things, the following:

“(1) Your lack of an operating history; “(2) Your lack of profitable operations in recent periods; “(3) Your financial position; “(4) Your business or proposed business; or “(5) The lack of a market for your common equity securities or securities

convertible into or exercisable for common equity securities.” Other SEC Guidance about Risk Factors

In the “Staff Observations in the Review of Smaller Reporting Company IPOs” issued by

the SEC’s Division of Corporation Finance and posted on its website (Modified: 03/04/2009), the SEC staff gave the following advice about risk factors:

“Item 503 of Regulation S-K requires a company to discuss the most significant

facts that make its offering speculative or risky. A company should limit each risk factor to one or two short paragraphs in which it identifies the risk and explains, in plain English, why it applies to the company.

“We issued a substantial volume of comments on risk factors. In our comments,

we made the following suggestions:

• Clearly and concisely identify a risk in each risk factor subheading; • Limit each risk subheading to one risk. Instead of discussing multiple

risks under one caption, break the discussion into separate, appropriately captioned, risk factors;

• Generic risk factor discussions that do not describe how a specific risk applies to the company or to an investment in the offering are not helpful to an understanding of the risk; and,

• Set out the extent of each risk plainly and directly. It is rarely helpful to state that there is or can be no assurance of a particular outcome. Further, generally avoid mitigating language in risk factor discussions, such as clauses that begin with ‘while,’ ‘although’ or ‘however.’”

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For some issuers, the SEC’s 2011 cybersecurity risk disclosure guidance (CF Disclosure Guidance: Topic No. 2 “Cybersecurity”) can be helpful:

http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic2.htm

Using Sample Risk Factors of Public Companies in the Same Industry

Risk factors should not be generic; they must be tailored to the particular issuer. After learning about the issuer’s business and asking management “what keeps you up at night,” the lawyer should use the SEC’s EDGAR website, and perhaps other tools such as Intelligize, to find risk factors of public companies in the same industry. While some of those risk factors will not apply to a private company, others will. You can easily edit those risk factors to fit the issuer’s circumstances.

Appendix A

Sample Cautionary Language for Projections

Certain Cautions Regarding Projections

This presentation, including the following Exhibits, includes forecasted, projected or other types of forward-looking information, including information relating to [the Company’s] future business prospects, sales, number and timing of new stores, new hires, store level data, store-level economics, financial performance, pro forma financial data, liquidity, capital expenditures, capital needs, costs, income and EBITDA (the “Projections”). You should not regard the Projections as an indication that [the Company], its directors, officers and members, their financial or legal advisors, or any other person considered, or now considers, the Projections to be material or necessarily predictive of actual future results. The Projections are subjective in many respects and are thus subject to interpretation. While presented with numerical specificity, the Projections reflect numerous estimates and assumptions made by management with respect to industry performance and competition, general business, economic, market and financial conditions and matters specific to [the Company’s] business, all of which are difficult to predict and many of which are beyond [the Company’s] control. We cannot assure you that the Projections will be realized or that actual results will not be significantly higher or lower than budgeted. As a result, you should not rely on the Projections as necessarily predictive of actual future events.

No one has made or makes any representation regarding the information included

in the Projections. [The Company] does not intend to update or otherwise revise the Projections to reflect circumstances existing after the date when made or to reflect the occurrence of future events, even if any or all of the assumptions on which the Projections were based are shown to be in error. [Add summary of significant assumptions]

Appendix B

Plain English Tips

Examples of Words and Phrases That Are Not “Plain English” and How They Can Be Replaced

Word or Phrase Replace with

certain some hereby by this [name of document] in accordance with under respectively state each item separately* the year ended December 31, 2012 2012 or fiscal 2012 in order to to in the event that if at or prior to at or before subsequent to after in lieu of instead consummation closing herein in this [name of document or section] pursuant to under upon on such the, this, that, those, or these set forth provided, described, or shown prior to before including, among other things including third parties others the Commission the SEC

* Replace “the cumulative losses for the years ended December 31, 2012, December 31, 2011, and December 31, 2010 were $2.6 million, $2.8 million, and $1.5 million, respectively” with “the cumulative loss for 2012 was $2.6 million, the cumulative loss for 2011 was $2.8 million, and the cumulative loss for 2010 was $1.5 million.”