In general, private offerings to accredited investors are exempt from registration requirements under U.S. securities laws.  To take advantage of this exemption, however, the issuer must not engage in a “general solicitation.”  The ban on general solicitation is construed broadly, and in certain instances, even bare “tombstone” ads can result in violations.  In a 1983 SEC No-Action Letter to Alma Securities Corporation, Special Counsel to the SEC stated, “[W]here a sponsor or issuer conducts an ongoing program of private or limited offerings, tombstone announcements for the completion of each individual offering could be used to solicit investors to the program as a whole.”  If a tombstone advertisement, simply stating the name of the issuer, the amount raised, and other bare facts may violate the ban on general solicitation, a press release would fare no better.

Fortunately for our client, there is a narrow exception to this general rule that applies to foreign private issuers.  The SEC has established a safe harbor, Rule 135e, which allows foreign private issuers to provide both foreign and U.S. journalists with access to press conferences held outside the U.S., and to written press-related materials released outside the U.S., so long as four conditions are met:

(1)   The offering is not being conducted solely in the U.S.;

(2)   Access is provided to both U.S. and foreign journalists;

(3)   Any written materials include certain statements that such materials are not an offer of securities for sale in the U.S., that securities may not be offered or sold in the U.S. absent registration or an exemption from registration, and that any public offering of securities to be made in the U.S. will be accompanied by a prospectus; and

(4)   Any written materials must not include any purchase order or coupon that may be returned to indicate interest in the offering.

This rule only applies to press activities and materials provided to journalists, and not to materials or information provided to the general public.  Materials made available on the internet are considered to be provided to the general public and generally would not qualify for this safe harbor.  For a foreign private issuer to take advantage of this safe harbor while using the internet to share materials about such an offering, a system must be established whereby only people outside of the U.S. may access the materials.  Of course, once a journalist publishes an article based upon the press conference or press materials, there is no limit to the extent to which such an article may be shared or forwarded.

In our current social media-driven world, this rule seems archaic.  The distinction between journalist and blogger is increasingly hazy and the proliferation of content-sharing platforms (e.g., Twitter, Facebook, LinkedIn, Digg, etc.) means that information can cross borders instantly.  The latest comprehensive SEC guidance on the use of electronic media by issuers was released in 2000, long before the social media revolution began in earnest.  The SEC is currently revisiting the ban on general solicitation, so updated guidance on these issues may be released in the near future.  In the meantime, we are stuck with rules that often don’t foot with reality. 

Finally, keep in mind that the restriction on press releases and public dissemination of investment information applies only as long as the company or fund is actively raising money in the U.S..   Once the offering is completed in the U.S., the company or fund may announce the good news publicly.

Chris Hurtado wrote this post with some input from Bruce Campbell.  Chris is working with Campbell Law Group as a law clerk during his final year of the JD/MBA program at Yale Law School and Yale School of Management.  Prior to graduate school, he worked at the Bridgespan Group, where he advised private foundations and operating nonprofits on issues related to strategy, management, and organization.  He started his career in corporate finance in the Silicon Valley.

The New Year will bring an increase of 14% in the federal tax rate for many investments – up from a rate of 0% for qualifying investments made on or before December 31, 2011 (yes, that means no federal tax).  You should consider taking advantage of the current exclusion from capital gains taxes before it expires.  And the holiday cheer offered by this potential tax benefit is not limited to outside investors.  Others who may want to consider a change in their end-of-year financial plans include:

(1)   Entrepreneurs – if you were thinking about forming a company or contributing additional capital to your new business at the beginning of 2011, you may want to accelerate your plans.

(2)   Option/warrant holders – if you hold vested options/warrants, you may want to evaluate an early exercise of your rights.

(3)   LLC members – have you been considering a change in form of entity?  Conversion to a corporate form before the end of the year could qualify the stock you receive for tax free treatment on capital gains.

Section 1202 of the Internal Revenue Code includes a number of requirements and limitations for this tax benefit, some of which are summarized below.  As the list below is not exhaustive, you should review the details of any proposed investment with an attorney or tax adviser to ensure that it qualifies. 

(1)   The issuer must be a C corporation.

(2)   The stock must be acquired at original issuance from the issuer (not from a third party or secondary offering).

(3)   The stock must be held for at least five years.

(4)   The aggregate gross assets of the issuer (including majority parents and majority-owned subsidiaries) may not exceed $50 million at issuance.

(5)   The issuer must engage in the active conduct of a “qualified trade or business.”  Examples of businesses that do not qualify include: banking, insurance, financing, leasing, investing, farming, mineral extraction, hospitality businesses, and a variety of service businesses where the principal asset of such trade or business is the reputation or skill of its employees (such as those in health, law, consulting, and financial services).

Note:  This content is provided solely for general informational purposes.  It does not constitute legal advice regarding any specific facts and circumstances, and its dissemination does not create an attorney-client relationship.   If you are interested in learning more or want to discuss a particular situation, you should contact one of us or another attorney or tax adviser.

I’m now 18 hours into a 25 hour sleep-deprived trip to Nairobi – my first time to the African continent.  In the three weeks I will spend in Kenya and Uganda, I hope to start to build the same kind of relationships that have made my experience in India so rewarding.  I’m aware on this trip of how much of a head start I will have because of the powerful network that is arising out of the Unreasonable Institute.

Early in my trip, I will be meeting with clients and Unreasonable graduate ventures Kopo Kopo, One Degree Solar and re:char, and will have the pleasure of connecting with friends at Unreasonable Capital Partners First Light Ventures and Invested Development.  I will complete my trip by going deep on Eco Fuel Africa with Unreasonable fellow extraordinaire Sanga Moses.  Most importantly, I will have the honor of attending Sanga’s wedding!   And sitting across the aisle from me is Rich Hoops, who is also based in Boulder and actively supporting Unreasonable ventures – including Nairobi-based LivelyHoods.

I am grateful to the Unreasonable Institute for bringing these extraordinary people to Boulder, and for helping to forge relationships that have the potential to change the world for the better.

More to come.

Dear Occupy Movement:

 I saw you last weekend in Boulder, and I was mostly saddened by what I experienced.  Yes, it is good to see that you are motivated enough to change things that you will spend a spectacular fall day marching on Pearl Street.  But you seemed so angry, at times almost hateful.  I was glad that none of the “other” 1%, or the people that work at banks and corporations were around, as they seemed particularly detested.

 Then I realized that, being Boulder, those people probably were around.  Boulder is a wealthy community.  All of the big banks have offices here.  And many people I know are employed by corporations.  I wondered, if those people — our neighbors — really deserved to be the subject of such negativity.

 I also imagined the power of your movement if it included some of the “other” 1% and employees of banks and corporations.   What if rather than demonizing millions of people you invited them to join you in speaking out against economic injustice?  What if rather than being against so many things – and people – you were for something positive?

 Both Gandhi and Martin Luther King wrote that successful non violent social movements require internal work among the participants, not just action in the outside world.  The internal work is to develop enough wisdom and compassion so that people do not become the subject of protest, anger and violence.   The focus is always on the condition, the policy, the underlying cause of the injustice.

Martin Luther King, for example, was not against white people, he was for equality under the law.  I seem to remember from the footage of his marches that the very people who benefited from the injustice he was protesting were present.  And as a spiritually evolved person, he knew that the people who did not support the movement suffered from an ignorance that they did not choose.  They, too, were victims.

So, accordingly, I will join you when I feel it is safe to invite my brothers and sisters from the “other” 1% and from banks and corporations (remember, banks and corporations cannot exist without people).  In the mean time, I will occupy myself.  By this, I mean that I will work to transform in myself that which might cause me to be insensitive to the suffering of others, and I will dedicate as much time as I can to helping to provide economic opportunity for those that are in the most need.

 Sincerely yours,

 Bruce Campbell

It is undeniably awesome that entrepreneurs have a choice of not one, but now three different forms of entities that allow for alternative governance structures.  It is important, though, to think critically about the different options, and to understand that the best choice for a particular social business may be none of the new forms.  The details matter, and it does not help anyone if a structure reflects a business’ values but impedes its ability to execute on critical components of its financial plan.

So, I’m glad that the recently adopted California laws creating the Flexible Purpose Corporation and the Benefit Corporation do not take effect until January 1, 2012.  The delayed effectiveness will, hopefully, allow for some of the hype to die down and misinformation to be corrected, so that entrepreneurs make well informed decisions about the form of entity that is appropriate for their particular business.

On the hype:  it is important to remember that there a number of factors that must be considered before choosing a particular corporate form.   It would be a big mistake to think that just because you operate or plan to start a business with social objectives that you must (or should) migrate to one of these new corporate forms.   In a later post, I will provide more details on some of the considerations that go into this decision, but here’s a short starter list:

• Is a corporation the right form for tax purposes?  Keep in mind that limited liability companies and cooperatives have potential tax benefits that are unique to those forms.
   
• How will prospective investors respond?  This question is particularly important for companies that may want to attract capital from more mainstream sources.   
   
• What are the increased costs associated with the reporting and other requirements of these new forms? 
   
• What will be the demands on managements’ time to comply with these new governance standards and procedures?

On the misinformation:  a much tweeted New York Times article that references the Flexible Purpose Corporation contains so many inaccuracies and misleading statements that I may cancel my subscription.  Todd Johnson points out a few of the mistakes in his blog.  I wish I had the time to address the others.

The most misunderstood aspect of this conversation is the potential liability for directors of traditional corporations with social objectives.   In my opinion, the liability concern is overstated – or at least over simplified – by almost everyone who writes on the topic.   For a comprehensive discussion of director fiduciary duties in the context of a business with social objectives, see this law review article.  It is interesting to note that the law professor authors conclude that corporate law did not compel the Ben & Jerry’s founders to sell their company.  The sale of Ben & Jerry’s to Unilever, of course, is the most often cited example of why entrepreneurs with social objectives need to seek out alternative corporate forms.

Before any of these new corporate forms existed, I would sometimes have a client come into my office (I know, old school) and tell me that they wanted me to form a particular kind of entity for them based on advice from their accountant, or a friend or the research they did on the Internet.  Not once did I agree to form an entity without first understanding – and often challenging – the client’s assumptions around why they had decided on that particular form.   Often after such a conversation we agreed that the client’s initial decision was a good one, but a good amount of the time we concluded that a different approach made more sense.

In my opinion, we as social enterprise lawyers have a responsibility to engage in the same kind of rigorous analysis of a client’s decision to use one of the new corporate forms, especially given all of the hype and misinformation that is currently rampant in social and traditional media.  At the end of the day, legal form is just a tool, and what matters most is how the tool is used.  A social business should be defined by its positive impact on society, not by the corporate identifier that comes after its name.

We would not be at this point without the hard work of Greg Berry, Ian Carter, Caryn Capriccioso, Tyler Hartung, Richard Hoops and Corey Kohn.

More details to follow soon.  It’s on!

Fortunately, crowdfunding and the anachronistic restrictions on the public offerings of securities are receiving a lot of attention these days.  After the President mentioned a proposal to exempt crowdfunding from registration requirements during his jobs speech a few weeks ago, the attention reached fever pitch.  It even extended to Congress.  Since the President’s speech, there have already been two Congressional hearings regarding an exemption and one bill has been introduced by a House Republican. The House bill is substantially aligned with the President’s proposal. Such bipartisan support is promising. The SEC is also exploring potential rule changes to exempt crowdfunded offerings that would not require legislative action. 

Despite all the positive signs, however, the future of crowdfunding remains very uncertain.  Three primary risks threaten the potential of crowdfunding to become a significant source of startup capital in the near future.  

Risk 1: The voices opposed to a crowdfunding exemption win the day.

Support for a crowdfunding exemption is not universal.  On September 21, Heath Abshure, a representative of the association of state securities regulators, testified before a House subcommittee regarding small business capital formation.  In his wide-ranging testimony, Abshure made a strong case for investor protection and for the unique role state securities regulators play at the local level.  The crowdfunding bill that was introduced in the House includes a state preemption clause, effectively exempting crowdfunded offerings from state registration requirements.  As Abshure’s testimony indicates, this will likely be met with continued opposition from state securities regulators who have seen their scope of authority recede as federal regulation has increasingly preempted state securities laws.

The SEC also has expressed concerns about investor protection and may be reticent to carve out a significant exemption.  In 1982, the SEC adopted Regulation D, which, among other things, included Rule 504, the “Seed Capital” exemption.  Under Rule 504, small issuers (under $1 million) were allowed to offer and sell securities to an unlimited number of people regardless of sophistication; such issuers were exempted from delivering any specified information to investors; and such issuers were allowed to engage in general solicitation and advertising.  After a number of abuses surfaced (facilitated by burgeoning Internet use), the SEC limited the scope of Rule 504.  This history illustrates why the SEC may be risk averse in adopting a significant exemption regime for crowdfunding.           

Risk 2: The final regulations are too narrow, gutting crowdfunding of its potential.

The SEC has voiced some guarded support for the principle of a de minimis exemption related to crowdfunded offerings.  In a letter, SEC Chairman Mary Schapiro described one conception of crowdfunding as an offering of up to a maximum of $100,000 with individual investments capped at $100.  The current House bill, meanwhile, would exempt crowdfunded offerings of up to $5 million and cap individual investments at $10,000.  Abshure’s Congressional testimony echoed the SEC’s more restricted vision of crowdfunding.   Referring to the limits included in the House bill, he stated that “the caps on these offerings are simply too high.”  In support for this position, he argued that since more than half of households have less than $25,000 in savings and investments, a $10,000 loss would be “crippling” to most investors (but still not significant enough to reasonably pursue a private cause of action).

If legislation or SEC rule changes create a crowdfunding exemption at the $100,000 offering / $100 individual investment level, it will be an unrealistic source of real startup capital for most entrepreneurs.  Most crowdfunding platforms intend to require a minimum commitment level in order for any funds to be invested and spent by the startup.  With such low individual investment caps, very few deals would meet these minimums and actually get done.  Furthermore, if the final exemption did not include state preemption, significant compliance costs would still fall on issuers. These results would relegate crowdfunding to a trivial role as a provider of startup capital for businesses.

The ultimate determination of aggregate offering and individual investment caps is of central importance.  In my view, while a flat $10,000 cap on individual investments may be too high for many investors, it is certainly orthogonal to the policy goal of investor protection.  A cap set as a percentage of income or wealth is more aligned with the goal of protecting a naïve investor from losing his shirt.  It is also more flexible, allowing well-heeled investors to add larger infusions of capital to these markets. In any event, the success of a crowdfunding regime will be tied to these limits.

Risk 3: The process for adopting regulatory changes is slow, significantly delaying any exemption.

Any successful exemption regime, even if it includes the wish list of generous caps, state preemption, and other goodies, will likely take a long time.  During her Congressional testimony on crowdfunding, SEC representative Meredith Cross was questioned as to the timeline for a decision.  While she could not answer directly with respect to crowdfunding, she briefly discussed the timeline for an analogous inquiry that is instructive.  In May of this year, Congressional hearings were first heard regarding potential changes to the 500-investor cap outlined in the Exchange Act’s section 12(g). Cross estimated that no decision would likely be made until “sometime in 2012.”  Final regulations would likely not be released until much later. 

A legislative solution is also likely to take time.  With historic debt levels, continuing high unemployment and upcoming elections, Congress has a full plate. (Even just with respect to proposals related to capital markets).  Nevertheless, it is possible that crowdfunding’s bipartisan appeal could position it for a realistic victory.  But even in this best-case scenario, the clarity provided by final regulations would not come for some time. 

Crowdfunding has a lot of promise, but the final contours of any regulatory regime are still unformed.  These regulations could unleash the wisdom and wallets of the crowd in powerful ways, or could stifle a promising opportunity.  Only time will tell.  What does seem certain is that it will take a while. 

Chris Hurtado wrote this post with some input from Bruce Campbell.  Chris is working with Campbell Law Group as a law clerk during his final year of the JD/MBA program at Yale Law School and Yale School of Management.  Prior to graduate school, he worked at the Bridgespan Group, where he advised private foundations and operating nonprofits on issues related to strategy, management, and organization.  He started his career in corporate finance in the Silicon Valley.

Suppose that you wish to support a particular charitable cause with your business. You will probably
want to identify your brand or a particular product line with the cause and let your customers
know that you will donate some portion of revenue or profits to the cause. In addition to the
social or environmental impact from your donations, recent studies have shown there are some
compelling “business” reasons for a business to pursue such a “cause marketing” campaign. A 2010
study found that 86% of worldwide consumers feel that business needs to place at least equal weight on
societal interests as on business interest and another study that year determined that 90% of consumers
want companies to tell them the ways they are supporting causes. According to a 2008 study of
American consumers, 79% would be likely to switch brands (assuming equivalent price and quality) to a
brand associated with a good cause.

Several of our clients, including Cultivate Wines and Altruette, are making their commitment to
charitable causes and donations a core aspect of their business and their marketing appeal, and we have
had the opportunity to help them understand and comply with numerous state laws applicable to cause
marketing. The bottom line is that “cause marketers” are operating in state-regulated terrain. Nearly
every state has its own laws to deal with the solicitation of funds for charitable causes and in most
states “cause marketing” is to some extent regulated. The key is making a statement to consumers that
some portion of the price they pay will go to a charitable cause. If a business simply wants to donate
some percentage of its revenue or profits to a good cause and does not tell its consumers that it is doing
this as part of its sales solicitation, it is generally free to pursue this path without being subject to the
charitable solicitation regulations (although the business should be aware that there are certain limits
on tax deductability of donations – for instance a maximum of 10% of a C-corporation’s net taxable
income). If a business, however, induces sales with a statement that such sales will benefit a charitable
cause/nonprofit, under many state laws it is considered a “commercial co-venturer.”

The various states each have their own specific requirements and regulations for commercial co-
venturer. Many state commercial co-venturer regulations are relatively easy to comply with – the
most basic requirement in most states is that the business should be very specific in its advertisement/
sales disclosure regarding what dollar amount or percent will benefit the charitable cause. This is, for
instance, the approach in Colorado (and Colorado in fact only actually requires this if a co-venturer
expect that more than 50% of the sales will be in Colorado). A handful of jurisdictions (notably Maine,
Massachusetts, Alabama, D.C. and Illinois) require state registration of co-venturers. In California, a co-
venturer can avoid registration if it ensures that its contracts contain some very specific requirements
(the co-venturer has to ensure, for instance, that it pays the charitable cause every 90 days and must
include very specific written disclosures to its customers). In states that require registration, the fees
tend to be approximately two or three hundred dollars annually, co-venturers generally have to make
certain annual financial disclosures to state regulators, and often have to post a bond. In addition, there
are many states that require co-venturers to have written contracts with the charitable organizations
and require co-venturers to file these contracts with the state attorney general’s office. Numerous states
have particular requirements of what to address in the contracts between co-venturers and
charitable organizations.

The trickiest aspect to state compliance for co-venturers involves cause marketing over the internet.
Suppose a business sells products over the internet and the website indicates that a certain percentage
of sales will be sent to a charitable cause. The business is in theory soliciting customers in every state
(and even worldwide), so is it subject to the regulations of every state? The time and cost of compliance
in every state would not be a significant burden relative to sales for a large company like Proctor &
Gamble, but could potentially be prohibitively costly and burdensome for a small web-based startup.
Stay tuned! We will explore this issue further in a future post.

Daniel Gross, Worldhaus – Unreasonable Climax 2011 Presentation from the Unreasonable Institute.

Episode 6: The Bridge

Episode 6 “The Bridge” from the Unreasonable Institute.