Category: Securities Law

Securities and Exchange Commission (SEC) Issues Guidance on Resource Extraction Issuer Rules

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FAQs clarify which entities and payments are subject to the final rules.

On May 30, the Securities and Exchange Commission (SEC) released frequently asked questions (FAQs) providing guidance on certain aspects of its final rules for resource extraction issuers (the Resource Extraction Rules).[1] The Resource Extraction Rules, which were adopted on August 22, 2012 pursuant to section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), require companies that are engaged in the commercial development of oil, natural gas, or minerals and required to file annual reports with the SEC to disclose certain payments made to the U.S. federal government or foreign governments (and related entities) for the purpose of commercial development of oil, natural gas, or minerals.[2] The FAQs provide guidance, among other things, as to which issuers are subject to the reporting requirements, what the meaning of “minerals” is, which payments must be reported and how they should be reported, and the consequences of a failure to timely file a Form SD.

Questions Answered by the FAQs

Which entities are resource extraction issuers?

  • Holding companies may be resource extraction issuers. Question 1 clarifies that a holding company is a resource extraction issuer if a subsidiary or other controlled entity is engaged in the commercial development of oil, natural gas, or minerals.
  • Entities engaged in associated services only are not resource extraction issuers. Questions 2 and 4 clarify that an issuer providing services associated with the exploration, extraction, processing, and export of a resource is not a resource extraction issuer. Only issuers directly engaged in the commercial development of oil, natural gas, or minerals must disclose payments to governments. Issuers providing associated services not covered by the Resource Extraction Rules include the following:
    • Issuers providing hardware and logistics for exploration or extraction
    • Issuers providing hydraulic fracturing or drilling services for an operator
    • Issuers providing transport services, including between countries, so long as the issuer does not have an ownership interest in the transported resources

Question 4 further clarifies that transportation activities are generally not included within the definition of “commercial development” unless they are directly related to the export of a resource. Generally, however, the SEC staff would view the movement of a resource across an international border from one host country to another country by a company with an ownership interest in the resource as export.

  • The term “minerals” has been defined. Question 3 provides clarity as to the definition of “minerals” under the Resource Extraction Rules by stating that “minerals” are any materials commonly understood to be minerals. Materials extracted and gathered by means of mining activity—including any materials for which disclosure would be required under Industry Guide 7, “Description of Property by Issuers Engaged or to Be Engaged in Significant Mining Operations”[3]—are encompassed in the definition and include materials such as metalliferous minerals, coal, oil shale, tar, sands, and limestone.

Which payments are subject to the Resource Extraction Rules?

For payments to be subject to the Resource Extraction Rules, they must be made to further the commercial development of oil, natural gas, or minerals and take the forms of taxes, royalties, fees, production entitlements, bonuses, dividends, or payments for infrastructure improvements.

  • Certain payments are excluded. Questions 5, 6, and 8 clarify that certain payments are not subject to disclosure pursuant to the Resource Extraction Rules. These include the following:
    • Payments made to majority-owned government entities for services or activities that are ancillary or preparatory to the commercial development of oil, natural gas, or minerals, such as payments for providing transportation services to supply people or materials to a job site.
    • Penalties or fines related to resource extraction.
    • Corporate-level income tax payments to governments on income not generated by the commercial development of oil, natural gas, or minerals. (However, a resource extraction issuer is not required to segregate this income and may disclose that the information includes payments made for purposes other than the commercial development of oil, natural gas, or minerals.)
  • The format for payment disclosure has been clarified. Question 7 provides that a resource extraction issuer is to present payment information on an unaudited, cash basis for the year in which the payments are made.

What are the consequences of failing to timely file a Form SD?

Question 9 provides that, if a resource extraction issuer fails to timely file a Form SD, the issuer does not lose eligibility to use Form S-3.

[1]. View the FAQs here.

[2]. For more information on the Resource Extraction Rules and the implications for affected companies, see our September 19, 2012 LawFlash, “SEC Adopts Payment Disclosure Rules for Resource Extraction Issuers,” available here.

[3]. View SEC Industry Guide 7 here.

Financial Services Legislative and Regulatory Update – Week of June 10, 2013

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Leading the Past Week

And the beat goes on… Another week with the White House dealing with another issue, this time news that the national security apparatus is collecting and combing through telephone record metadata.  The widespread revelation about a data mining program that would make any hedge fund quant jealous drowned out more positive news of the week, including that the U.S. recovery continues its sluggish, yet positive pace with 175,000 jobs added in May.

And in an interesting comparison, as noted by the extraordinary team at Davis Polk, while the agencies were silent during the Month of May, and did not announce any new implementations of the Dodd-Frank Act, last week, three major implications of the implementation were announced.  First, the SEC publicly released its much anticipated and long awaited money market mutual fund rules.  Second, the Fed announced an almost equally anticipate interim final “push out” rule that provided significant relief to foreign-based banks with operations in the United States.  Finally, the FSOC made its first round of non-bank systemically important financial institutions (“SIFIs”) designations.

Legislative Branch

Senate

As Administration Announces New Iran Sanctions, Senate Banking Members Skeptical of their Effectiveness

On June 4th, the Senate Banking Committee held a hearing to review sanctions against Iran. Witnesses and lawmakers were split regarding the efficacy of the sanctions, some arguing that their effectiveness has been proved by Iran’s continued inability to fund nuclear enrichment and other arguing that the sanctions have not had the desired result of fundamentally changing the governance of the country. Specifically, Ranking Member Mike Crapo (R-ID) and Senators Bob Corker (R-TN), Bob Menendez (D-NJ), and Chuck Schumer (D-NY) all expressed concerns that the sanctions have not measurably changed Iran’s behavior. Witnesses included: David Cohen, Under Secretary for Terrorism and Financial Intelligence for the Treasury; Wendy Sherman, Under Secretary for Political Affairs with the Department of State; and Eric Hirschhorn, Under Secretary for Industry and Security with the Department of Commerce. The hearing comes as the Administration announced a new set of sanctions against the country. An Executive Order released June 3rd takes aim at Iran’s currency and auto sector in addition to expanding sanctions against private business supporting the government of Iran.

Senate Finance Committee Releases Income and Business Entities Tax Reform Working Paper

On June 6th, the Senate Finance Committee released the latest in a series of options papers outlining tax reform options for individual and business income taxes and payroll taxes. The proposal outlines three options for tackling the integration of individual and corporate taxes, such as making the corporate tax a withholding tax on dividends and adjusting capital gains taxes for businesses to match the individual Code. In addition, the paper discusses ways in which to reach a long-term solution for taxing derivatives.

Senate Banking Approves Nomination to Ex-Im Bank

On June 6th, the Senate Banking Committee voted 20 to 2 in favor of Fred Hochberg to continue to head the Export-Import Bank. Senator Tom Coburn (R-OK) and Senator Patrick Toomey (R-PA) both voted against the nomination. Hochberg’s nomination now moves to the full Senate where, though he is expected to be confirmed, he must be approved before July 20th or else the bank would lose its quorum for voting on items.  During the same executive session, the Committee approved by voice vote the National Association of Registered Agents and Brokers Reform Act of 2013 (S. 534) which would make it easier for insurance agents to sell state-regulated insurance in multiple states.

Senator Brown Calls on CFPB to Target Debt Collectors

On June 4th, Senator Sherrod Brown (D-OH) wrote to the CFPB, urging the Bureau to enact rules to curb customer abuses by debt collectors. In a statement accompanying the letter, Brown, Chairman of the Senate Banking Subcommittee on Financial Institutions and Consumer Protection, said he intends to hold a hearing in the next month which will shine a light on bad practices and consumer abuses in the industry. The Dodd-Frank Act gives the CFPB authority to enforce and enact rules under the Fair Debt Collection Practices Act (FDCPA). Brown’s letter urged Director Cordray to pursue debt collectors as soon as possible, as the Bureau would lose its oversight authority in this space should Cordray’s nomination expire and a director not be in place.

Senate Banking Committee To Consider Flood Insurance As Soon As July

In remarks made on June 6th, Chairman of the Banking Committee Tim Johnson (D-SD) said the panel will hold hearings as soon as July to consider national flood insurance affordability. The announcement comes as a number of lawmakers express concerns that rate increases in the 2012 reauthorization are not affordable.

Senate Banking Subcommittee Looks into the State of the Middle Class

On June 6th, the Senate Banking Subcommittee on Economic Policy held a hearing titled “The State of the American Dream: Economic Policy and the Future of the Middle Class.” It was Senator Jeff Merkley’s first hearing as Chair of the Subcommittee, he said he wanted to feature witnesses whose voices were not normally heard in committee hearings and public policy debates. The witnesses included: Ms. Diedre Melson; Mr. John Cox; and Ms. Pamela Thatcher, who were subjects of the documentary movie American Winter; Dr. Atif Mian, Professor of Economics and Public Policy at Princeton University; Ms. Amy Traub, Senior Policy Analyst for Demos; Mr. Nick Hanauer with Second Avenue Partners; and Mr. Steve Hill, Executive Director of Nevada Governor’s Office of Economic Development.

House of Representatives

House to Consider Multiple Financial Services Bills Next Week

Next week the House is set to consider and vote on four separate bills dealing with the Financial Industry.  Three of the these bills, The Business Risk Mitigation and Price Stabilization Act (H.R. 634), The Reverse Mortgage Stabilization Act (H.R. 2167), the Swap Data Repository and Clearing House Indemnification Correction Act (H.R. 742) will be brought up on the suspension calendar, which is generally used for non-controversial measures.  The other bill, the Swap Jurisdiction Certainty Act (H.R. 1256) will be brought forward under a rule, which may allow for amendments to the bill that directs the SEC and CFTC to issue joint rules on swaps and security-based international swaps.  All are expected to pass the House.

Financial Services Subcommittee Examines Role of Proxy Advisory Firms

On June 5th, the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises met to examine the growing reliance on proxy advisory firms in proxy solicitations and corporate governance. Specifically, the Subcommittee sought to investigate the effect proxy advisory firms have on corporate governance standards, the market power of these firms, potential conflicts of interest, and SEC proposals seeking to modernize corporate governance standards. During the hearing Subcommittee Chairman Scott Garrett (R-NJ) voiced concern that institutions are overly reliant on proxy advisory firms in determining how to cast shareholder votes and questioned whether conflicts of interest and voting recommendations based on one-size-fits all policies affect shareholder value.

Witnesses at the hearing included: former SEC Chairman Harvey Pitt,  Timothy Bartl, President of the Center on Executive Compensation, Niels Holch, Executive Director of Shareholder Communications Coalition, Michael McCauley, Senior Offices for Investment Programs and Governance of the Florida State Board of Administration, Jeffrey Morgan, President and CEO of the National Investor Relations Institute, Darla Stuckey, Senior Vice President of the Society of Corporate Secretaries & Governance Professionals, and Lynn Turner, Managing Director of LitiNomics. The hearing comes as SEC Commission Daniel Gallagher recognized that lawmakers and regulators need to re-examine the role of advisory firms in the corporate governance matters as “no one should be able to outsource their fiduciary duties.”

Lawmakers Introduce Legislation Targeting Foreign Cyber Criminals

On June 6th, House Intelligence Committee Chairman Mike Rogers (R-MI) along with Representative Tim Ryan (D-OH) and Senator Ron Johnson (D-WI) introduced legislation that would impose visa and financial penalties on foreign cyber criminals who target American businesses. Specifically, the measure would deny foreign agents engaged in cybercrime from apply for visas or, if they reside in the U.S., would revoke visas and freeze financial assets. The bill also calls for the Department of Justice to bring more economic espionage criminal cases against offending foreign actors.

Online Gambling Legislation Introduced

On June 6th, Representative Peter King (R-NY) introduced legislation to create broad federal Internet gambling regulations and allow all online gambling with the exception of betting on sports and where Indian tribes opt not to participate. The legislation would also establish an office of Internet gaming housed within the Treasury. Following a 2011 ruling by the Justice Department that the 1961 Wire Act does not ban online gambling, several states, including Delaware, New Jersey, and Nevada, have moved forward with creating intra-state online gaming operations.  The movement at the state level has taken some of the momentum out of federal legalization efforts.

Executive Branch

Treasury

FSOC Selects First Group of Non-Banks to be SIFIs

On June 3rd, the Financial Stability Oversight Council (FSOC) voted on the preliminary list of systemically important financial institutions (SIFIs) which will be subject to additional regulation by the Fed. This additional regulation will include new stress tests to monitor stability, additional capital requirements, and the need to create living wills in the event of resolution. While the Council did not release the names or the number of non-banks that have been selected, several firms have announced that they have received notice from the FSOC regarding their designation, including GE Capital, Prudential Financial, and AIG. Now that designations have been made, companies selected will have 30 days to request a hearing to contest the designation. While Secretary Jack Lew called the designations an “important step forward,” Chairman of the House Financial Services Committee Jeb Hensarling criticized the move, saying perpetuating non-banks as “too big to fail” will only put taxpayers on the hook for another bailout.

Federal Reserve

Fed Approves Final Rule Clarifying Treatment of Foreign Banks Under Push-Out Rule

On June 5th, the Fed approved an interim final rule clarifying the treatment of uninsured U.S. branches of foreign banks under the Dodd-Frank Act swaps push-out measure. Dodd-Frank calls for banks to separate certain swap trading activities from divisions that are backed by federal deposit insurance or which have access to the Fed discount window. Under the clarification, the Fed states uninsured U.S. branches of foreign banks will be treated as insured depository institutions and that entities covered by the rule, including U.S. branches of foreign banks, can apply for a transition period of up to 24 months to comply with the push out provisions. The interim final rule also states that state member banks and uninsured state branches of foreign banks may apply for the transition period. The Institute of International Bankers, which represents international banks operating in the U.S., praised the Fed for offering clarity on a “widely acknowledged drafting error in the original legislation.”

Fed Vice Chairman Appears to Support Stronger Capital Rules for Large Banks

Speaking in Shanghai last week, Fed Vice Chairman Janet Yellen said that it may be necessary for regulators to impose capital requirements even higher than those set forth in the Basel III agreement. Agreeing with Fed Governors Daniel Tarullo and Jeremy Stein, Yellen said “fully offsetting any remaining “too big to fail” subsidies and forcing full internalization of the social costs of a SIFI failure may require either a steeper capital surcharge curve or some other mechanism for requiring that additional capital be held by firms that potentially pose the greatest risks to financial stability.” To that end, Yellen noted that the Fed and FDIC are “considering the merits” of requiring systemically significant firms to hold minimum levels of long-term unsecured debt to absorb losses and support orderly liquidation. Yellen who, is seen by many as the frontrunner for Fed Chairman following Bernanke’s term, is starting to generate a lot more attention as we come closer to the end of Bernanke’s reign.  However, she is not the only member of the Fed espousing this policy.  In a speech later in the week, Philadelphia Fed President Charles Plosser echoed Yellen’s sentiments, saying Dodd-Frank and other efforts to end “too big to fail” may not be “sufficient.” Plosser argued that current capital requirements should be made more stringent but also simpler by relying on a leverage ratio rather than the current practice of risk weighting.

SEC

SEC Proposes Long-Anticipated Money Market Mutual Fund Overhaul

On June 5th, the SEC released a proposal which would change the way the $2.6 trillion money market mutual fund industry is regulated. After months of internal disagreement within the SEC, the Commission voted unanimously to propose the plan. The goal of the proposal is to avoid future runs on the market, like that which occurred during the financial crisis, in tandem with ensuring that the industry still function as a viable investment vehicle. The Commission’s proposal sets out two alternative options for reform which could be enacted alone or in combination. The first would require institutional prime money market funds to operate with a floating net asset value (NAV). Notably, retail and government funds would still be allowed to operate with a fixed-NAV. The second alternative would require nongovernment funds whose liquid assets fell below 15 percent of total assets to impose a 2 percent liquidity fee on all redemptions. If this were to occur, a money market fund’s board would be permitted to suspend redemptions for up to 30 days. The proposal also calls for prompt public disclosure if a fund dips below the 15 percent weekly liquid asset threshold.

Coalition of Investment and Consumer Interests Call for Strong Uniform Fiduciary Standard

In a letter sent to the SEC on June 4th, a coalition of investment and consumer groups called on the Commission to enact a uniform fiduciary standard that would require broker-dealers and investment advisers to act in consumers’ best interest. The letter, signed by organizations such as AARP, the Consumer Federation of America, and the Investment Adviser Association, is in response to an SEC request for information (RFI) requesting input on regarding the possible extension of a fiduciary duty to broker-dealers. The groups assert that, the fiduciary standard set forth in the RFI is weak compared to current law and “seems to contemplate little more than the existing suitability standard supplemented by some conflict of interest disclosures.”

District Court Hears Challenge to SEC Critical Minerals Rule

On June 7th, the Court of Appeals for the D.C. Circuit heard a challenge brought on behalf of the American Petroleum Institute, the Chamber of Commerce, and others to the SEC’s critical minerals rule which requires companies to disclose payments made to foreign governments. Industry argues that the rule is overly burdensome and could result in proprietary information being shared with competitors. However, supporters of the rule, including Oxfam America, assert that the measure will increase transparency and help combat human rights abuses.

FDIC

FDIC Approves Non-Bank Resolution Final Rule

On June 4th, the FDIC approved a final rule establishing the criteria which will be used to determine which non-bank financial firms will be required to comply with the FDIC’s authority to liquidate large failing companies. The rule, which lays out factors used to determine if a company is “predominately engaged in financial activity,” requires companies where at least 85 percent of revenues are classified as financial in nature by the Bank Holding Company Act to comply. The FDIC’s rule closely resembles a final proposal by the Fed which established criteria for non-banks to be flagged for additional supervision under Dodd-Frank.

CFPB

CFPB Finalizes Ability-to-Repay Rule Amendments

On May 29th, the CFPB finalized rules designed to increase access to credit through exemptions and modifications to the Bureau’s ability-to-repay rule. The ability-to-repay rule, which was finalized in January 2013, requires that new mortgages comply with basic consumer protection requirements that are meant to ensure consumers do not take out loans they cannot pay back through Qualified Mortgages (QMs). In response to public and Congressional concerns about the scope of the rule, the Bureau’s finalized rules exempt certain nonprofit creditors and community-based lenders who service low- and moderate-income borrowers, facilitate lending by small creditors, banks and credit unions with less than $2 billion in assets and which make 500 or fewer mortgages loans per year, and establish how to calculate loan origination compensation. In announcing the amendments, the CFPB also delayed the effective date of provisions prohibiting creditors from financing certain credit insurance premiums in connection with certain mortgage loans. Currently, the effective date is January 10, 2014; however, the Bureau plans to solicit comment on an appropriate effective date for proposed credit insurance clarifications.

Bureau Issues Mortgage Rule Exam Guidelines

On June 4th, the CFPB issued an update to its exam procedures based on the new Truth in Lending Act (TILA) and the Equal Credit Opportunity Act (ECOA) mortgage regulations finalized in January. The guidance addresses questions about how mortgage companies will be examined such as for: setting qualification and screening standards for loan originators; prohibiting steering incentives; prohibiting “dual compensation,” protecting borrowers of higher-priced loans; prohibiting the waiver of consumer rights; prohibiting mandatory arbitration; requiring lenders to provide appraisal reports and valuations; and prohibiting single premium credit insurance.

CFPB Announced Further Study on Pre-Dispute Arbitration in Financial Products

In a notice and request for comment published on June 7th, the CFPB announced it will conduct phone surveys of credit card holders as part of its study of mandatory pre-dispute arbitration agreements. While Dodd-Frank gave the CFPB authority to ban the use of arbitration in mortgages, Section 1028(a) of the Dodd-Frank Act requires the Bureau to conduct a study before taking additional action to limit arbitration in other financial products. According to the notice, the survey will investigate “the extent of consumer awareness of dispute resolution provisions in their agreements with credit card providers” and consumers’ assessments of these tools.

International

IMF Working Paper Calls for Taxes on Large Banks to Level Playing Field, End “Too Big to Fail”

In a working paper published at the end of May, the International Monetary Fund (IMF), suggesting that large banks in advanced economies have more incentive to take risks due to cheaper funding sources, proposed taxing large banks to “extract their unfair competitive advantage.” The authors of the paper argue that such as tax would level the playing field from the perspective of competitive policy and reduce excess incentives of banks to grow, reducing the problem of “too big to fail” and increasing financial stability. Specifically, the paper found that the implicit guarantee that “too big to fail” banks will be bailed out in the event of failure or crisis can lead to a funding advantage of up to 0.8 percent a year. In related news, On June 5th, Representative Michael Capuano (D-MA) introduced legislation (H.R. 2266) which would require certain systemically important institutions to account for the financial benefit they receive as a result of the expectations on the part of shareholders, creditors, and counterparties that the government will bail them out in the event of failure.

Upcoming Hearings

On Wednesday, June 12th at 10am, in 1100 Longworth, the Trade Subcommittee of House Ways and Means Committee will hold a hearing titled “U.S.-Brazil Trade and Investment Relationship: Opportunities and Challenges.”

On Wednesday, June 12th at 10am, in 2128 Rayburn, the House Financial Services Committee will hold a hearing titled “Beyond GSEs: Examples of Successful Housing Finance Models without Explicit Government Guarantees.”

On Wednesday, June 12th at 2pm, in 2128 Rayburn, the Capital Markets and Government Sponsored Enterprises Subcommittee of House Financial Services Committee will hold a hearing on proposals intended to support capital formation.

On Thursday, June 13th at 10am, in 538 Dirksen, the Senate Banking, Housing, and Urban Affairs Committee will hold a hearing titled “Lessons Learned From the Financial Crisis Regarding Community Banks.”

On Thursday, June 13th at 10am, in 2128 Rayburn, the Monetary Policy and Trade Subcommittee of House Financial Services Committee will hold a hearing on changes to the Export-Import Bank.

On Thursday, June 13th at 1pm, in 2128 Rayburn, the Housing and Insurance Subcommittee of House Financial Services Committee will hold a hearing on international insurance issues.

SEC Money Market Reform

Katten Muchin

On June 5, the Securities and Exchange Commission proposed major reforms to money market regulations that would significantly alter the way money market funds (MMFs) operate. The proposal sets forth two main alternative reforms, which may be adopted alone or in combination in a single reform package. The first proposed alternative would require all institutional prime MMFs to transition from operating with a stable share price to operating with a floating net asset value. The second generally would require every non-government MMF to impose a 2% redemption fee if its level of weekly liquid assets falls below 15% of its total assets, unless its board determines that the MMF’s best interest would be served by eliminating the fee or having a lower fee. The two proposed reforms are intended to, among other things, improve risk transparency in MMFs and reduce the impact of substantial redemptions upon MMFs during times of stress. The proposal also includes reforms designed to enhance MMFs’ disclosure, reporting, stress testing, and diversification practices.

For additional information, read more.

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Total Settles Foreign Corrupt Practices Act (FCPA) Bribery Claims for $398M

Katten Muchin

On May 29, French oil and gas company, Total SA, agreed to pay $398 million to settle US civil and criminal allegations that it paid bribes to win oil and gas contracts in Iran in violation of the Foreign Corrupt Practices Act (FCPA). Notably, the criminal penalty is the fourth-largest under the FCPA and the case marks the first coordinated action by French and US law enforcement agencies in a major foreign bribery case.

In a scheme that allegedly began nearly 20 years ago in 1995 and continued until 2004, Total allegedly paid approximately $60 million in bribes to induce an intermediary, designated by an Iranian government official, to help the company win contracts with National Iranian Oil Co. The contracts gave Total the right to develop three oil and gas fields and included a portion of South Parys, the world’s largest gas field. Total allegedly characterized the bribes as “business development expenses” in its books and records.

The DOJ filed a three-count criminal investigation charging Total with FCPA conspiracy and internal controls and books-and-records violations. Total agreed to resolve the FCPA charges by paying a $245.2 million criminal penalty, which was at the bottom of the $235.2 to $470.4 million range of fines available under the US Sentencing Guidelines. The company also settled a related civil case with the US Securities and Exchange Commission for $153 million in disgorgement of its profits in the scheme. The criminal case will be dismissed after three years if Total complies with the deferred prosecution agreement, which requires Total to (i) retain a corporate compliance monitor, who will conduct annual reviews; (ii) cooperate with authorities and (iii) implement an enhanced compliance program designed to prevent and detect FCPA violations. The compliance program requires, among other things, that Total’s Board of Directors and senior management “provide, strong, explicit and visible support and commitment” to the company’s anti-corruption policy and that they appoint a senior executive to oversee the program and report directly to an independent authority, such as internal audit, the Board or a committee thereof. Total’s problems, however, are not over. French prosecutors have recommended that the company and its chief executive officer be brought to trial on violations of French law, including France’s foreign bribery law.

U.S. v. Total SA, 13-cr-239 (E.D. VA. May 29, 2013).

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The Jobs Act: Improving Access to Capital Markets for Smaller Companies

GT Law

On April 5, 2012, the Jumpstart Our Business Startups Act or “Jobs Act” was signed into law by President Obama with the stated purpose of increasing American job creation and economic growth by improving access to the public capital markets for emerging growth companies. Specifically, the Jobs Act:

  • creates a new category of “emerging growth company” under the securities laws and reduces certain financial reporting and disclosure obligations on these companies for up to 5 years after their initial public offering;
  • directs the Securities and Exchange Commission to eliminate the prohibition on general solicitations for private offerings under Rule 506 of Regulation D and resales under Rule 144A;
  • legalizes crowdfunding through brokers and “funding portals”;
  • authorizes the SEC to increase the maximum amount permitted to be raised in a Regulation A offering from $5 million to $50 million in any 12-month period; and
  • increases the number of shareholders of record that a company may have before it becomes obligated to file SEC reports.

Creation of the ‘Emerging Growth Company’ Designation

The Jobs Act creates the “emerging growth company” as a new category of issuer under both the Securities Act and the Securities Exchange Act.

Definition of “Emerging Growth Company”

An “emerging growth company” is an issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year. The issuer would continue to be an “emerging growth company” until the earlier of:

  • the last day of the fiscal year during which it had total annual gross revenues of $1 billion or more;
  • the last day of the fiscal year of the issuer following the fifth anniversary of its initial public offering;
  • the date on which the issuer has, during the previous 3-year period, issued more than $1 billion in non-convertible debt; and
  • the date on which it is deemed a “large accelerated filer.”

Notwithstanding the foregoing, an issuer that consummated an IPO on or prior to December 8, 2011 will not be eligible to be deemed an emerging growth company. The relief provided to emerging growth companies is available immediately.

Benefits for Emerging Growth Companies

Emerging growth companies will have more lenient disclosure and compliance obligations with respect to executive compensation, financial disclosures and certain new accounting rules. Specifically, an emerging growth company will not be required to:

  • comply with “say on pay” proposals or pay versus performance disclosures;
  • include more than two years of financial statements in the registration statement for its IPO;
  • include selected financial data for any period prior to the earliest audited period presented in connection with its IPO; or
  • comply with new or revised accounting standards that are only applicable to public reporting companies.

In addition, emerging growth companies will be exempt from the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, or SOX, and be given a longer transition period for compliance with new audit standards. Further, SOX has been amended to provide that any rules of the Public Company Accounting Oversight Board, or PCAOB, requiring mandatory audit firm rotation or auditor discussion and analysis will not apply to an emerging growth company. In addition, any future rules adopted by the PCAOB would not apply to audits of emerging growth companies unless the SEC determines otherwise.

The Jobs Act provides that emerging growth companies may start the IPO process by confidentially submitting draft registration statements to the SEC for nonpublic review. Confidentially submitted registration statements would need to be publicly available at least 21 days prior to beginning the road show for the IPO. Emerging growth companies would also be free to “test the waters” with qualified institutional buyers and institutional accredited investors before and during the registration process.

Analyst Reports for Initial Public Offerings of Emerging Growth Companies

The Jobs Act removes some of the restrictions on investment banks underwriting public offerings while simultaneously providing analyst research reports on a particular issuer that was designated as an “emerging growth company.”

Elimination of Prohibition on General Solicitation For Accredited Investors and Qualified Institutional Buyers

The Jobs Act directs the SEC to revise its rules to:

  • provide that the prohibition against general solicitation or general advertising will not apply to offers and sales of securities made pursuant to Rule 506, provided all purchasers of the securities are accredited investors, and
  • provide that the prohibition against general solicitation or general advertising will not apply to offers and sales made under Rule 144A, provided that the seller reasonably believes that all purchasers of the securities are qualified institutional buyers.

It is currently unclear whether these exemptions will apply to offerings exempt from registration under Section 4(2) of the Securities Act to the extent they do not satisfy all of the conditions of Rule 506. The SEC has 90 days from the date of enactment of the Jobs Act to promulgate rules to effect elimination of the specified prohibitions on general solicitation and general advertising.

Creation of a ‘Crowdfunding’ Exemption

Crowdfunding refers to the recent (often internet facilitated) technique of seeking financing for a business through small investments from a relatively large pool of individual investors. Under current securities laws, crowdfunding raises a number of problematic registration exemption issues. The Jobs Act attempts to remedy this by creating a new crowdfunding exemption from the registration requirements of the Securities Act for transactions involving the issuance of securities through a broker or SEC-registered “funding portal,” for which:

  • the aggregate amount of securities sold in the previous 12 months to all investors by the issuer is not more than $1 million; and
  • individual investments by any investor in the securities during any 12-month period are limited to:
    • the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
    • 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.

Such securities would be considered restricted securities subject to a one-year holding period, with certain exceptions, such as sales to accredited investors or family members. The Jobs Act also provides express securities fraud remedies against the issuer of securities sold under the crowdfunding exemption, which includes extending liability to directors, partners and certain senior officers of the issuer.

Disclosure Requirements

The issuer must file with the SEC, provide to the broker or funding portal, and make available to potential investors at least 21 days prior to the first sale, certain information about the issuer. This information is similar to what many companies currently use in offering memoranda in private offerings and includes:

  • the name, legal status, physical address and website of the issuer;
  • the names of officers, directors and greater than 20% shareholders;
  • a description of the issuer’s current and anticipated business;
  • a description of the financial condition of the issuer, including, for offerings where the aggregate amounts sold under the crowdfunding exemption are:
    • $100,000 or less, income tax returns for the most recently completed fiscal year and financial statements, certified by the principal executive officer of the issuer;
    • more than $100,000, but less than $500,000, financial statements reviewed by an independent public accountant; or
    • more than $500,000, audited financial statements;
  • a description of the intended use of proceeds;
  • the target offering amount and the deadline to raise such amount;
  • the price to the public of the securities, or method to determine the price;
  • a description of the ownership and capital structure of the issuer, including the terms of the offered security and each other security of the issuer and how such terms may be modified, limited, diluted or qualified;
  • risks to purchasers of minority ownership and corporate actions, including issuances of shares, sales of the issuer or its assets or transactions with related parties; and
  • such other information as the SEC may prescribe.

The issuer must also annually file with the SEC and provide to investors its results of operations and financial statements.

‘Blue Sky’ Pre-emption

Securities sold pursuant to the crowdfunding exemption are “covered securities” for purposes of the National Securities Markets Improvement Act, or NSMIA, and, therefore, are exempt from state securities registration requirements, or “Blue Sky,” laws. This preemption does not prohibit state enforcement actions based on alleged fraud, deceit, or unlawful conduct.

Creation of ‘Funding Portals’

A person acting as an intermediary in an offer or sale of securities under this new crowdfunding exemption will have to register with the SEC as a broker or funding portal and will also need to register with any applicable self-regulatory organizations. Such intermediary will also have to comply with a number of requirements designed to ensure that investors are informed of the possible risks associated with a new venture, including conducting background checks on each officer, director and greater than 20% shareholders of the issuer. Additionally, the Jobs Act instructs the SEC to promulgate rules or regulations under which an issuer, broker or funding portal would not be eligible, based on its disciplinary history, to utilize the exemption.

SEC Rulemaking

The SEC is directed to issue rules as may be necessary or appropriate for the protection of investors to implement the crowdfunding exemption within 270 days after the enactment of the Jobs Act. In addition, the dollar amounts are to be indexed for inflation at least every five years for changes in the consumer price index.

Raising the Regulation A Limit to $50 million

The Jobs Act amends Section 3(b) of the Securities Act to direct the SEC to amend Regulation A so as to increase the aggregate offering amount that may be offered and sold within the prior 12-month period in reliance on Regulation A from $5 million to $50 million. The SEC is required to review the limit every two years and to increase the amount as it determines appropriate or explain to Congress its reasons for not increasing the limit on Regulation A offerings.

No ‘Blue Sky’ Pre-emption

Predecessor bills would have made the Regulation A exemption more appealing by making Regulation A offered securities exempt from “Blue Sky” laws. Although the Jobs Act does not provide that securities offered under Regulation A are explicitly exempt, it does have a provision requiring the Comptroller General to conduct a study on the impact of Blue Sky laws on offerings made under Regulation A. Securities offered and sold to “qualified purchasers,” to be defined under NSMIA, or on a national securities exchange would be “covered securities” and exempt from Blue Sky laws.

Modifying Registration Thresholds

Currently, Section 12(g) of the Exchange Act requires an issuer with assets in excess of $1 million and a class of security held by more than 500 shareholders of record to register such security with the SEC and, therefore, become subject to the reporting requirements of the Exchange Act. The Jobs Act amends the registration thresholds to require registration only when an issuer has:

  • either 2,000 or more shareholders of record, or 500 shareholders of record who are not accredited investors, and
  • assets in excess of $10 million.

Exceptions to “Held of Record” Definition

Further, the Jobs Act amends the definition of “held of record” to exclude securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of the Securities Act. It also directs the SEC to adopt rules providing that securities acquired under the crowdfunding exemption are similarly excluded.

Increased Thresholds for Community Banks

The Jobs Act amends Section 12(g) of the Exchange Act by increasing the shareholder registration threshold in the case of an issuer that is a bank or a bank holding company to 2,000 persons. The bill also makes it easier for banks and bank holding companies to deregister and cease public company compliance requirements by increasing the threshold for deregistration for those entities from 300 persons to 1,200 persons.

Implementation of the Jobs Act

SEC Rulemaking and Studies

The Jobs Act directs the SEC to adopt rules implementing certain provisions of the act as well as to conduct a number of studies and report back to Congress.

SEC Concerns

A number of SEC Commissioners, including Chairman Mary Schapiro, have publicly expressed concerns on the balance between enhancing capital formation and the reduction in investor protections. The Jobs Act does not affect Rule 10b-5 of the Securities Act and adds some additional securities fraud remedies, so issuers should continue to be scrupulous about compliance with their disclosure obligations.

Full Text of the Jobs Act

The Jobs Act was enacted on April 5, 2012. The text of the act is currently available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf.

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California Requires Many Foreign Corporations To Send Annual Financial Statements To Shareholders

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California is a net exporter of corporate charters, but it remains home to many corporations. As a result, the California Corporations Code has a preternatural concern with foreign corporations.

One example is Section 1501(a) which requires the board to cause an annual report to be sent to shareholders.  This report must include a balance sheet as of year end and an income statement and statement of cash flows for the year.  The statute doesn’t require that the statements be audited, but if an independent accountant has issued a report, then that report must be sent along as well.  If there is no report, then the report must include a certificate of an authorized officer that the statements were prepared without audit from the books and records of the corporation.  If the corporation has fewer than 100 holders of record (determined in accordance with Section 605), the financial statements need not be prepared in conformity with generally accepted accounting principles if the statements reasonably set forth the assets and liabilities and income and expense of the corporation and disclose the accounting basis used in their preparation.

The report must be sent not later than 120 days after the close of the fiscal year and must be sent at least 15 days (or, if sent by third class mail, 35 days) prior to the annual meeting of shareholders held during the following fiscal year.  Cal. Corp. § 1501(a)(1) & (2).

This requirement applies to domestic corporations, a term that embraces any corporation formed under the laws of California.  Cal. Corp. § 1501(g).  Thus, it includes corporations not formed under the General Corporation Law. See Cal. Corp. Code § 167.  However, a corporation with less than 100 holders of record (determined in accordance with Section 605) may include a bylaw provision that waives the annual report requirement.

The statute also applies to any foreign corporation if the corporation has its principal executive offices in California or it customarily holds meetings of its board in California.  Cal. Corp. § 1501(g).

Publicly traded companies are not exempted per se from this requirement.  However, corporations with an outstanding class of securities registered under Section 12 of the Securities and Exchange Act of 1934 will satisfy the annual report requirement if they comply with Rule 14a-16 (17 C.F.R. § 240.14a-16).  Cal. Corp. § 1501(a)(4).  [Note that this statute purports to include future amendments and this may give rise to a constitutional problem, see Why Incorporation May Be Unconstitutional.]

Here is a flow-chart describing the application of the statute.  This is probably a good time to remind readers that this blog does not provide legal advice.  There are other requirements in Section 1501 (including possible quarterly reporting requirements) that are not covered in today’s post.  Moreover, there are other nuances that I’ve not mentioned.

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U.S. Citizenship and Immigration Services (USCIS) EB-5 Engagement with Securities and Exchange Commission

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On April 3, 2013, representatives from the Staff of the Securities and Exchange Commission (SEC) participated with the U.S. Citizenship and Immigration Services (USCIS) in an EB-5 stakeholder conference call opened by Rob Silvers, counsel to the USCIS Director Mayorkas.  Present from the Staff were representatives from four Divisions – Corporation Finance, Trading and Markets, Investment Management and Enforcement.  The call was intended to provide general information to stakeholders.

In general, the Staff members confirmed the application of various securities laws to EB-5 programs.  For many in the EB-5 industry, the views expressed will be unwelcome news, as many have been operating under the assumption that some or all of the securities laws that apply to other investment programs do not apply to EB-5 programs.  For experienced securities lawyers working on EB-5 programs, however, the call broke no new ground but did serve as a confirmation of the advice we have been giving our clients.

Some notes about SEC Staff Interpretations

The Staff members on the call provided the standard disclaimer given in every public talk — that the views expressed represented their own and not necessarily those of the Commission as a whole.  Despite this disclaimer, Staff members are careful in their public speaking, and generally speak only considered views that have been adopted by the senior leadership of the SEC.

When considering Staff interpretations, it is important to note the structure of United States securities laws.  Federal securities laws represent various statutes passed by Congress and amended from time to time.[1] These laws frequently call upon the SEC to adopt formal implementing regulations.  In addition, the SEC Staff routinely provides informal interpretations of the securities laws and the regulations through various means.  In addition, all fifty states have their own securities laws, known as blue sky laws, and except in limited instances of federal preemption, these blue sky laws apply in addition to the federal laws.  Experienced securities lawyers will advise clients based on all of these sources of law.  However, not all of these sources of law have the same legal weight, and in particular, the views of the Staff do not necessarily represent positions that would ultimately prevail in a civil lawsuit brought by the SEC or a private plaintiff, or in a criminal action brought by the Department of Justice.  Nonetheless, the Staff’s views are often persuasive in court, and at a minimum, one can expect substantial legal expenses and regulatory entanglement from operating in a manner contrary to Staff interpretations.

Various speaker notes

The Division of Corporate Finance representative confirmed that federal securities laws apply to transactions in securities.  The SEC noted that the definition of “securities” is very broad, and likely includes most if not all of the investment vehicles used in the EB‑5 program.  The Securities Act of 1933 provides that all offers and sales of securities must be registered with the SEC unless an exemption from registration applies.  EB-5 offerings are frequently conducted in accordance with two exemptions — Regulation D, applicable to private placements of securities, and/or Regulation S, applicable to sales to non-U.S. persons.[2] Each of these exemptions has a number of requirements that must be satisfied.  The representative discussed an important condition of Regulation D – the prohibition on general solicitation (for example, advertising, publicly accessible web sites or conducting seminars where the general public is invited).  The representative noted that the SEC has proposed regulations under the JOBS Act to lift the ban on general solicitation in certain circumstances, but until such regulations are adopted, general solicitation will disqualify an offering from Regulation D.  The representative could not predict when such regulations will be adopted.  The representative noted an important caveat that an exemption from registration requirements does not mean that the offering is exempt from other provisions of the securities laws.  In particular, exempt offerings are subject to the anti-fraud provisions of the securities laws.

The Trading and Market Division representative focused on the laws requiring persons engaged in the business of engaged in the business of effecting transactions in securities for the account of others to register as broker-dealers.  The representative expressed a broad view of the types of conduct that trigger the requirement to register as a broker-dealer.  The representatives stated that in general, if someone is involved in the sale and offering of EB-5 investments and is compensated based on the success of the offering – a “salesman’s interest” in the program – that person is most likely engaging in brokerage activities which trigger the obligation to register as a broker-dealer under the Securities Exchange Act of 1934 (1934 Act).  The representative also provided a very broad view of the jurisdiction of the SEC to enforce broker-dealer requirements for persons soliciting foreign investments.  In the view of the SEC Staff, any activities using United States means of commerce, such as telephone calls made from the U.S., are likely sufficient to invoke U.S. jurisdiction for activities that require broker-dealer registration, regardless of whether the investors are foreign persons.  In response to questions, the Staff representatives noted that:

  • the Staff does not believe that the Supreme Court’s decision in Morrison v. National Australia Bank, Ltd. limiting the extra-territorial application of another section of the 1934 Act is an impediment to their enforcement activities, and
  • the broker-deal registration laws apply equally to solicitation of issuers (as opposed to investors) from within the United States.

The Trading and Market Division representative also discussed the applicability of broker-dealer registration laws to persons employed by Regional Centers to conduct offerings for the account of the Regional Center, and the availability of Rule 3a4-1 as a non-exclusive exemption from registration requirements for such persons.

The Investment Management Division representative addressed applicability of the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to EB-5 programs.  The representative noted that individuals and entities that do not fall into the broker-dealer category will often be required to register under the Investment Advisers Act if they provide investment advice for compensation.  The representative noted that anti-fraud provisions apply to investment advisors, and investment advisers have fiduciary duties to their clients, including the duty to disclose all conflicts of interest.

The representative also stated that Regional Centers which pool investments for third parties and that hold securities likely are investment companies that need to register under the Investment Company Act absent an available exemption.  The representative discussed three exemptions that might be available to Regional Centers:

  • the 3(c)(1) exemption for an investment company with no more than 100 investors that is not making a public offering;
  • the 3(c)(7) exemption for qualified purchases, who must meet a significantly higher net worth standard than accredited investors; and
  • the 3(a)(2) exemption for government securities, which may apply if the Regional Center is sponsored by a governmental agency.

The Division of Enforcement representative discussed the February 2013 enforcement action brought against the Chicago Convention Center project.  The representative focused on the allegations in that case that the defendants made false representations to USCIS as part of a scheme to defraud investors.  He noted that false statements about the ability of a project to create jobs may be fraudulent under the securities laws.  He also noted that anti-fraud provisions apply not only to misstatements but also to omissions of material information.

[1] Examples of amendments include the Sarbanes-Oxley Act of 2002, the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Jumpstart Our Business Startups (JOBS) Act.

[2] The SEC did not speak about state blue sky laws, as those are outside the SEC’s jurisdiction.  However, we note that some states do not have any exemption for programs that are excluded from federal registration requirements under Regulation S.  This is currently a significant issue for programs that do not comply with Regulation D, such as by employing general solicitation in the offer and sale of the securities.

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The Legal Challenge to the SEC’s Conflict Minerals Reporting Regulations

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In the 2010 Dodd-Frank Act, the United States Congress required, inter alia, the SEC to promulgate regulations requiring certain manufacturers to trace the sources of tin, tantalum, tungsten and gold that are contained in products they manufacture or contract to manufacture to allow them to report yearly to the SEC whether the products are “not DRC [Democratic Republic of the Congo] conflict free.” Conflict free was defined by Congress as meaning the products do not contain minerals that finance or benefit violent armed groups in the DRC or adjoining countries. Congress required the SEC action because “it [was] the sense of Congress” that the exploitation of conflict minerals from that region was financing armed groups that engaged in “extreme levels of violence” creating “an emergency humanitarian situation.”

Various industry groups lobbied heavily against the passage of the Dodd-Frank Act and later submitted comments during the SEC’s rulemaking challenging the proposed regulations’ due diligence and reporting obligations as unduly burdensome and costly. After considering the comments, the SEC, where it would not run afoul of the Congressional mandate, did reduce some of the burdens that would be imposed on industry. However, the SEC acknowledged that compliance with Congress’s intent precluded reduction of other burdensome aspects of the regulations. The SEC promulgated the regulations in August 2012.

In October, 2012, the National Association of Manufacturers, along with the U.S. Chamber of Commerce, commenced a legal challenge to the conflict minerals regulations. Since then, voluminous briefs have been filed by NAM and the SEC along with briefs by numerous interested groups. These briefs outline the parameters of the dispute and suggest that NAM faces an uphill battle.

The crux of the industry’s challenge is that the SEC failed to properly quantify the benefits and costs associated with the regulations and thereby acted arbitrarily and capriciously in promulgating them. NAM claims the reporting requirements will not aid the DRC and could cripple the region economically. It also claims that the SEC failed to agree to certain revisions that would have lessened the burdens and costs on business, like carving out a de minimus exemption for manufacturers whose products used only trace amounts of conflict minerals and predicating a burdensome due diligence requirement on whether a manufacturer had “reason to believe” that their products contained conflict minerals that may have originated in the DRC as opposed to whether the products “did originate” there. NAM asks the court to strike the entire regulation and send the SEC back to square one.

The SEC responds that it was not its responsibility to quantify the benefits of the regulations, noting that Congress had made that calculation and had determined that the benefits justified the reporting requirement Congress mandated. In fact, the SEC admitted it could not quantify the benefits because it lacked data to do so. Rather it performed a qualitative analysis. It also defends its rejection of NAM’s proposed revisions that would have reduced the costs of compliance. The SEC noted, and various members of Congress agreed, that Congress had considered and rejected the de minimus exemption because it would defeat the purpose of the rule. Congress concluded that thousands or millions of trace amounts can add up to a significant amount, the trade in which would undercut the rule’s purpose of stopping the flow of money to armed insurgents in the region. The second NAM proposal was rejected because in the SEC’s view, it would encourage willful blindness by industry. That is, if a business encountered a red flag suggesting the sources of its minerals were not conflict-free, it would investigate no further, so as to avoid a determination that they did originate there.

An interesting issue concerns the regulation’s imposition of the reporting requirements not just on manufacturers but also to those who contract for the manufacture of goods. NAM believes that this extension of the reporting requirements is contrary to the express language of Dodd-Frank. It supports its position through application of rules of construction routinely used in interpreting statutes and its argument is logical. However, former and current members of Congress came to the SEC’s aid on this issue claiming in their brief that they intended to include those who contract for the manufacturer of goods, again to prevent exemptions that would significantly undercut what the regulations sought to achieve.

Oral arguments are scheduled for May 15, 2013. It will be very interesting to see how receptive the panel from the DC Circuit is to NAM’s arguments. Asking the court to scuttle the entire regulation, the parameters of which Congress as a matter of policy framed, makes NAM’s challenge all the more difficult.

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District Court Grants Motion to Compel Against Securities & Exchange Commission (SEC), Holding that “Facts” Are Not Work Product In SEC Confidential Witness Interviews

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In a recent Securities & Exchange Commission (“SEC”) investigation, the SEC interviewed three persons who had proffer agreements with the SEC and United States Attorney. In a subsequent SEC enforcement action, a defendant served interrogatories asking the SEC to identify the factual information disclosed in those proffer sessions. The SEC objected, and the defendant moved to compel. The SEC opposed the motion to compel, arguing that defendant sought information protected by the attorney work product doctrine, had not shown substantial need and unavailability, and had not deposed any of the witnesses, despite their identification in Rule 26 disclosures more than a year before. The magistrate judge granted defendant’s motion to compel, and the United States District Court for the Northern District of California confirmed the ruling. SEC v. Sells, No. C 11-4941 CW, 2013 WL 1411247 (N.D. Cal. Apr. 8, 2013).

There had already been an order in the case directing the SEC to answer identical interrogatories about another third-party witness. The SEC had acknowledged it was relying upon that witness’s statements as a basis for the allegations against the same defendant. The court rejected the SEC’s attorney work product objection because the interrogatories sought factual information, and not an attorney’s strategies or mental impressions. The court relied on an earlier decision, In re Convergent Technologies, 122 F.R.D. 555, 558 (N.D. Cal. 1988), in which the court reiterated the well-established principle that “the law does not permit counsel or litigants to use the work product doctrine to hide the facts themselves.” Nor does it shield from discovery the identities of the persons from whom an attorney learned such facts or the existence or non-existence of documents.

An interesting side note about the three witnesses is that their interviews were not recorded, unlike the other fourteen witnesses in this case. Because of this, any inconsistencies, disclosures of motives for their proffers or other potential impeachment evidence were not “otherwise available” to defense counsel. The SEC also advised the court that the three witnesses might testify at trial.

The lesson of this case is not to underestimate the value to defendants in SEC enforcement proceedings of specific, simply stated interrogatories. The SEC was not ordered to turn over its attorneys’ notes. Instead, it was ordered to answer interrogatories. This case also reminds lawyers not to give up, even when your adversary is far more powerful. In the words of the magistrate judge who handled “every possible objection” that the SEC had asserted to avoid answering, “Sunshine is ordinarily the best medicine for a party that is keeping discoverable information hidden in the dark. But where, as here, one party is repeatedly withholding relevant information, stronger medicine may be required.”

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The Good Angel Investor (Part 1): Doing the Deal

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At a time when lean startups often require considerably less than $1 million dollars to develop the proverbial minimum viable product and even validate the same with some customers, angel investors are playing an increasingly important role in startup financings.  And that’s a good thing, particularly in places outside of the major venture capital centers, where institutional venture capital is scarce.

Most startups successfully launched with angel capital will want to tap deeper pools of capital later on, often from traditional venture capital investors.  That being the case, entrepreneurs and their angel investors should make sure that the structure and terms of angel investments are compatible with the likely needs of downstream institutional investors.  Herewith, some of the issues entrepreneurs and angels should keep in mind when they sit down and negotiate that first round of seed investment.

  1. Don’t get hung up on valuation.  Seed stage opportunities are difficult to put a value on, particularly where the entrepreneur and/or the investor have limited experience.  Seriously mispricing a deal – whether too high or too low – can strain future entrepreneur/investor relationships and even jeopardize downstream funding.  If you and your seed investor are having trouble settling in on the “right” price for your deal, consider structuring the seed round as convertible debt, with a modest (10%-30%) equity kicker.  Convertible debt generally works where the seed round is less than one-half the size of the subsequent “A” round and the A round is likely to occur within 12 months of the seed round based on the accomplishment of some well-defined milestone.
  1. Don’t look for a perfect fit in an off-the-shelf world.  In the high impact startup world, probably 95% of seed deals take the form either of convertible debt (or it’s more recent twin convertible equity) or “Series Seed/Series AA” convertible preferred stock (a much simplified version of the classic Series A convertible preferred stock venture capital financing).  Unless you can easily explain why your deal is so out of the ordinary that the conventional wisdom shouldn’t apply, pick one of the two common structures and live with the fact that a faster, cheaper, “good enough” financing is usually also the best financing at the seed stage.
  1. On the other hand, keeping it simple should not be confused with dumbing it down.  If the deal is not memorialized in a mutually executed writing containing all the material elements of the deal, it is not a “good enough” financing.  The best intentioned, highest integrity entrepreneurs and seed investors will more often than not recall key elements of their deal differently when it comes time to paper their deal – which it will at the A round, if not before.  And the better the deal is looking at that stage, the bigger those differences will likely be.
  1. Get good legal advice.  By “good” I mean “experienced in high impact startup financing.”  Outside Silicon Valley, the vast majority of reputable business lawyers have little or no experience representing high impact entrepreneurs and their investors in financing transactions.  When these “good but out of their element” lawyers get involved in a high impact startup financing the best likely outcome is a deal that takes twice as long, and costs twice as much, to close.  More likely outcomes include unconventional deals that complicate or even torpedo downstream financing.  This suggestion is even more important if your deal is perchance one of those few that for some reason does need some custom fitting.
  1. Finally, a pet peeve.  If you think your startup’s future includes investments by well regarded institutional venture capital funds, skip the LLC tax mirage and just set your company up as a Delaware “C” corporation.  If you want to know why, ask one of those “experienced high impact startup lawyers” mentioned in point 4 above.
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