California Senate Bill No. 978 was recently introduced by Senators Juan Vargas (D) (District 40, San Diego) and Curren D. Price, Jr. (D) (District 26, Los Angeles) and is apparently threading its way through the legislative process. SB 978 is lawmaking at its worst, IMHO, at least as far as the venture capital and legal industries are concerned.
1 - What It Does. SB 978 would change two longstanding securities law exemptions used in venture capital financings – Sections 25102(e) and 25102(f) of the California Securities Law – to say that failure to timely file a notice of transaction with the state Commissioner of Corporations would result in loss of the exemption. Under current law failure to file this form can result in penalties but not loss of the exemption. Why is that bad? Because the proposed new law converts a ministerial failure to make a one-page “notice” filing into a material violation of California Securities Law that (a) triggers the full panoply of enforcement horribles, most notably, rescission rights, and (b) will inevitably result in claims against lawyers for legal malpractice and/or invalid third party closing opinions. In short, it’s a “file-or-die” rule and an ugly victory of form (no pun intended) over substance.
2 – Technically Speaking. In purely technical terms, venture financings that rely on Rule 506 should be unaffected by SB 978 by virtue of the continuing preemption by the National Securities Markets Improvement Act of 1996 (“NSMIA”). By its terms, NSMIA applies to Rule 506 transactions, but not to transactions effected under Rule 504, Rule 505 or Section 4(2) of the Securities Act of 1933. Thus, only financings done in reliance on any of the latter exemptions would feel the wrath of SB 978.
3 – In Practical Terms. So, what does all of that mean, exactly, in the real world? Well, not much as far as Rule 504 is concerned. Rule 504 has never been a significant exemption for venture capital financing purposes because of its $1M aggregate offering limit. Ditto Rule 505 with its $5M aggregate offering limit. Rule 506 and Section 4(2), on the other hand, are the workhorses of nearly all venture capital financings and the impact here is significant for issuers, investors and their respective lawyers alike.
» 506 Traps. As noted, SB 978 should be irrelevant to valid Rule 506 transactions by operation of NSMIA. However, the key word here is “valid.” I’ve seen more than a few venture financings done with a hand wave toward that rule and the filing of a Form D. What sometimes gets lost is that lurking in Rule 506 is a trap for the unwary. As the SEC itself says:
Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. (emphasis added).
So, Rule 506 transactions that involve only accredited investors … all good. But, Rule 506 transactions with a handful of the proverbial non-accredited “friends and family” … not so much. Why? Because the information and financial statement requirements are rarely met or even practicable to meet by a start-up comprised of the proverbial two engineers, an idea, a dog and no money. The point: A lot of “Rule 506” transactions are technically not for failure to comply with the information delivery requirements.
» The Final Frontier. That leads us to Section 4(2) – the longstanding private offering exemption with the wonderfully vague guidelines as to purchaser sophistication, the number of purchasers, dollar amount of stock sold, and information provided. Whether used as the primary exemption for a securities offering or as the “back up” for an invalid Rule 506offering, Section 4(2) has been a backbone of Silicon Valley capital raising for decades on end. With respect to SB 978, this is where the rubber meets the road. The California Commissioner of Corporations has long called out the fact that Section 4(2) transactions are not preempted by NSMIA – see Release 103-C. Thus, Section 4(2)transactions are subject to regulation by the State of California, and would be expressly affected by SB 978. In real world terms, here’s how things go bad … . Classic bootstrapped start-up does a “friends and family” round of financing in reliance on Section 4(2) and therefore California Section 25102(f). Oops, accidently miss that one page notice filing, even by one day? Sorry, no exemption, the entire offering is unlawful for lack of a valid California exemption, the purchasers have recission rights, and the issuer is, at least potentially, a “bad boy” (aka a “disqualified bad actor”). Welcome to California.
4 - Bad Timing. Putting aside the wisdom of complicating the capital raising process in the current economic environment, the timing of SB 978 is also unfortunate vis-à-vis two other recent legislative developments: First, it is “harder” to be an “accredited investor” today. As a result of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), the value of one’s primary residence does not count as an asset for purposes of calculating “net worth” to determine “accredited investor” status. Second, under a still proposed rule driven by Dodd-Frank, “bad boys” would be barred from participation in any Rule 506 offerings. Barred forever? I don’t know. It’s a proposed rule, so stay tuned. Notably, the existing federal “bad boy” rules are triggered by federal bad acts (e.g., acts before the SEC) and not by state-level misconduct. At least theoretically, the proposed Rule 506(c) sweeps in the “final orders of certain state regulators” as a “disqualifying event.” The broad point is that, juxtaposed against concurrent federal rulemaking, SB 978 comes at a time when (a) the pool of accredited investors is smaller and issuers are more likely to rely on Section 4(2) as a primary exemption, and (b) the federal consequence of being a state-level “bad boy” is in flux.
5- Ignoring History. One of the remarkable things about SB 978 is that we’ve been down this path before with unhappy results. Section 25102(o) of the California Securities Law articulates the standard exemption for sales of securities pursuant to a compensatory benefit plan (i.e., the issuance of stock and options to employees and consultants). When Section 25102(o) was first enacted, failure to make a similar “notice filing” was fatal to the availability of the exemption. This led to a host of problems, and the simple fact that many start-ups engaged in expensive (and largely pointless) employee rescission offers on the eve of their initial public offering in order to cure a ministerial dysfunction. In recognition of the “undue burden on businesses creating jobs … in California” imposed by Section 25102(o) generally, a wave of changes in 2007 brought it into line with corresponding federal securities law. Among those changes was the elimination of the “file-or-die” element … . “The failure to file the notice of transaction within the time specified in this subdivision [Section 25102(o)] shall not affect the availability of this exemption” (emphasis added). Precisely the language to be deleted from Sections 25102(e) and 25102(f) by the backward looking SB 978.
6– Risk Management. If SB 978 actually becomes law, then failure to timely file Section 25102(f) notices would be material and legal malpractice claims inevitable. For knowledgeable start-up lawyers, think Section 83(b) elections. Under SB 978, the stakes would be similar. Failure to file, even by one day … . Investors with buyers’ remorse will have a rescission right that the issuer will look to the lawyers to make good on. Company unable to raise additional capital because it is a “bad boy” with a documented unlawful issuance? Try on the consequential damages for size. Ditto lawyers who render third party legal opinions to the investors at the closing of venture financings. The customary opinion regarding the availability of an exemption? Suddenly much riskier to give. Expect a good deal of hand-wringing, theorizing and negotiated exceptions on that stead.
Net: SB 978 – as proposed - is the worst sort of regulatory sausage … . (1) a punishment vastly out of context for the violation, (2) guaranteed to generate a wave of socially useless litigation in order to sort out the debris field that such punishment will leave in its wake, all for (3) zero actual benefit to the investing public it is presumably intended to aid.
Here’s to hoping that cooler heads prevail.
© david jargiello 2012 all rights reserved
First Posted February 23, 2012, Re-Posted March 7, 2012