Well, in most business dealings, your business counterpart does not owe you any kind of duty. Your counterpart is free to exploit whatever you reveal to her, subject only to her sense of fair play and good conscience. You can change this dynamic, however, if you and your counterpart sign an NDA. At that point her commitment becomes more than a mere matter of conscience; it becomes a binding contractual obligation.

But engaging an attorney is entirely different. Unlike most business dealings, attorneys already owe you a duty not to disclose your confidential information — even if you don’t hire them. The Rules of Professional Conduct that govern our dealings with prospective clients commands it:

(b) Even when no client-lawyer relationship ensues, a lawyer who has had discussions with a prospective client shall not use or reveal information learned in the consultation, except as Rule 1.9 would permit with respect to information of a former client or except as provided in paragraph (e).
….
(e) A lawyer may condition conversations with a prospective client on the person’s informed consent that no information disclosed during the consultation will prohibit the lawyer from representing a different client in the matter. The prospective client may also expressly consent to the lawyer’s subsequent use of information received from the prospective client.

RPC 1.18. I never ask a potential client to agree in advance that I may use the information I receive from them.

And when I am hired, the Rule becomes even clearer:

A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b).

RPC 1.6.

In my standard terms of engagement, I make the commitment to you that I will perform work at a level “you would expect of a reasonably prudent and competent attorney providing legal services in the State of Washington under similar circumstances and time constraints.” This commitment necessarily includes complying with ethical obligations, the duty of confidentiality chief among them.

Beyond this, when you hire me, you are entitled to the benefits of the attorney-client privilege. This means that, by the Rules of Evidence, I cannot even be compelled by a court to disclose your secrets, so long as they are secrets that only you and I share during the course of our engagement.

I choose not to sign an NDA, therefore, because it doesn’t give you anything you don’t already have. It does, however, potentially matter to me. I do not want to set myself up where my contractual obligation to you potentially alters my ethical obligation to you or to any of my other clients. I will not allow other clients, past or future, to place me in a position by contract where I cannot zealously pursue your best interest. And I will not allow you to do the same to them.

A brief explanation: Reg A provides an exemption to the registration requirements for offerings of up to $5 million, if pursued in compliance with a number of conditions. Among these is a requirement to file an abbreviated form of offering circular with the SEC and each state in which the offering is made. As Reg A does not preempt state blue sky laws, some states, including Washington, conduct a “merit review” of any Reg A offering made within its borders.

Because of these requirements, Reg A is not, shall we say, “highly trafficked.” The regulatory hurdles make the $5 million “bang for the buck” difficult to pencil; particularly when its far easier to complete a “Reg D” offering (for accredited investors only) in an unlimited amount. It is not surprising, then, to learn that there were only 24 Reg A filings in each of 2009 and 2010, and that only three of those in each year were ultimately qualified.

In recommending to the Commission that it pursue a ten-fold increase to the Reg A limit, the Advisory Board touched on various impediments and, generalizing, voiced strong doubt that any increase in the offering amount alone would be sufficient to invigorate Reg A’s use. Presumably most members (although certainly not the one there on behalf of NASAA) would like to see a preemption of State law for Reg A offerings as well.

But as David Feldman wrote recently on his blog, there is another missing piece that also requires attention. A company that relies on Reg A to issue shares is not a “reporting company,” and therefore its shares cannot be listed on an exchange, much less the OTC Bulletin Board. Without a listing, investors who buy Reg A stock suffer an illiquidity problem due to the absence of an immediately viable secondary market. While their shares can trade on lower-tier over-the-counter markets (and remain subject to state blue sky laws for secondary trading), Mr. Feldman advocates the implementation of a “fast track” system that would smooth the path to full reporting and consequent “uplisting” for these companies.

Manny members of the Advisory Board must have quietly thought so, too.

I confess that until recently I shared their view.

Those of us who are “old school” are more than a little familiar with boiler room operators who hawk fictional investments to those members of our society who are least suspecting and least able to afford the loss. So when we hear about “crowdfunding” on the Internet, we imagine Nigerian princes peppering our email inbox with too-good-to-be-true investment opportunities. And because we’re so close to the professional investment community, we also can’t imagine that any truly worthwhile idea is not somehow going to find its backer.

The reality, though, is that many ideas in our new economy can be conceived, designed, developed, and tested for tens, not hundreds, of thousands of dollars. Funding this “conceptual phase” is not the strength of any venture capital firm (especially those with billion dollar funds), or even the vast majority of angel groups. How many great ideas die an early death due to lack of funding during this conceptual phase? Who really knows, but certainly the number is less than trivial.

It can’t be a bad thing if crowdfunding fills this gap, so long as it can be done without, as Professor John Coffee of Columbia University might say, creating a “Boiler Room Full Employment Act.” For one thing, funding the low cost “conceptual phase” of a greater number of ideas will necessarily result in a greater number of viable opportunities for follow-on professional investment. At the same time, ideas will be proven valid, or not, earlier, meaning those who support a losing idea will move on to different, and potentially more worthwhile, pursuits sooner. And finally, crowdfunding will spread the risks and the rewards of venture finance to those who heretofore have been excluded — albeit on a very, very small scale.

So why aren’t the “old schoolers” willing even to give it a try? I identify three key issues, all solvable. First, the amount of the exemption for all the proposals currently under consideration is way higher than the need requires. The crowdfunding proponents are bringing an elephant gun to a rabbit hunt. If proponents dramatically lower the maximum amount of the exemption, the old schoolers will stop focusing on the size of the gun and start looking at the pipeline for opportunity.

Second, “old schoolers” want to know that these deals will be in the hands of a responsible professional. This likely means accepting at least modest regulatory oversight of intermediaries; and a requirement that deals not close without involving them. Knowing that money cannot change hands in a dimly lit back room (or, more likely, a temporary url) will make crowdfunding seem normal, not sordid. NASAA’s proposal for regulating intermediaries as “broker-dealer light” may not ultimately be the right answer, but it certainly moves the debate in a direction that old schoolers can understand.

Third, “old schoolers” can’t see how these investments will work after the deal closes. And frankly, I think this is the most difficult proposition that crowdfunding proponents face — but have completely failed to address. As venture firms will tell you, they don’t want to buy into a company that has a complex cap table. What then, to do with the crowdfunded shareholders? One solution might be for crowdfunded companies to retain the right to redeem investor shares upon attaining a “qualified financing,” but at what multiple? And if redemption is not the answer, how to handle secondary trading in shares or, for that matter, even something as simple as annual shareholder meetings?

These practical issues are ones that the securities regulators may not need to answer in order to craft a viable exemption. But the absence of thoughtful analysis on these issues is nevertheless causing “old schoolers” to question the value of crowdfunding, and therefore to not invest much time in creating an exemption in the first place. Which leads, as we’ve seen today, to a potentially influential group deeming the concept entirely unworthy.

Many argue that the thresh hold is too low and thus forces many smaller, privately-held companies to begin reporting too early in their development. Others argue that, because the rule is tied to holders “of record,” larger companies are able to game the system (by holding “street securities” and using special investment vehicles) to avoid reporting obligations entirely.

Today, the SEC’s Advisory Committee on Small and Emerging Companies met to discuss this issue, among others. The discussion focused on whether the rule should be changed from holders “of record” to beneficial holders. That change would catch the larger companies that game the system.

The discussion also focused on increasing the triggering number to something significantly greater. That change would bring relief to smaller companies who run up against the 500 stockholder limit.

Many committee members also supported the idea that, whatever the triggering number, employee-shareholders should be excluded from the count. Had such a rule been in place, Facebook reportedly would have stayed private even longer than it has.

In the end, the Advisory Committee determined that a move to a different system (“beneficial owners” instead of “holders of record”) requires study and feedback. But the Advisory Committee also agreed on the need for immediate interim relief.

In the end, the Advisory Committee passed a resolution (with only 2 dissenting votes) recommending to the Commission that it immediately increase the 1960s rule from 500 to 1000 holders “of record.” The Committee also recommended that any Company that becomes a reporting Company should not be able to end reporting until it falls below 600 shareholders of record, a number that is double the current 300.

I thought it might be worth sharing my observations about the major issues — highlighting both the areas of general consensus and the areas of significant difference. My aim here is not only to inform readers, but also to refine my own thinking.

The Idea Behind Crowdfunding

The general idea of crowdfunding is for a “sponsor” to raise funds by obtaining small contributions from a large number of sources. By this definition, charities and political campaigns are effectively crowdfunded, and have been so for many years. We just didn’t call it that.

One should not be surprised to learn that entrepreneurs have ported this traditional notion of “crowdfunding” to the Internet. They have given it a name, expanded its uses, and encouraged its growth through social media.

Thus, there are now sites for crowdfunding charities (e.g., globalgiving), crowdfunding loans (e.g., kiva), crowdfunding creative projects (e.g., kickstarter), and, soon, crowdfunding business opportunities (e.g., wefounder).

The business models for these sites vary.

For some, the contributors make a pure donation to the sponsor. For others, the contributors receive a “reward,” such as a pre-purchase discount on whatever the sponsor proposes to develop with the proceeds. But so far, in the United States at least, none currently allow contributors to receive an “equity stake” in the sponsored project.

Our securities laws stand as an obstacle.

The Securities Laws

State and federal securities laws tightly regulate the “offer or sale” of securities. A “security” is broadly defined to include any investment opportunity whose outcome depends on the efforts of others. See SEC v. Howey Co, 328 U.S. 293, 298-299 (1946). Crowdfunding in exchange for an equity interest in a sponsored project plainly runs afoul of this definition, and is therefore subject to regulation.

These regulations, as constructed now, do not permit an easy path (any path?) for crowdfunding investment opportunities. The alternative of “registering” each deal with the SEC ahead of time is plainly cost-prohibitive — running in the tens if not hundreds of thousands of dollars. And because crowdfunding involves a large number of investors (many not “sophisticated,” much less “accredited”) who likely have no pre-existing relationship to the sponsor, the existing regulatory exemptions for deals involving accredited investors and a limited number of fairly sophisticated investors, all with pre-existing relationships to the sponsor, simply do not apply.

As if that were not enough, the securities laws would also trigger fairly onerous licensing requirements for the sites acting as deal intermediaries, as the securities laws would likely require their registration as a broker-dealer. And finally, because the deals would involve a large number of investors once completed, any company closing a crowdfunding deal could be deemed “public” and thereafter be subject to onerous periodic reporting requirements.

So, what to do?

Agency Rulemaking

On the federal level, the SEC regulates the securities market, including “issuers” and “broker-dealers.” The SEC has, within its existing authority, the ability to exempt crowdfunding from the registration requirements of the Securities Act. It could do so, for example, under Section 3(b) of the Securities Act, which permits the SEC to exempt offerings of less than $5 million if it finds that “enforcement … is not necessary in the public interest and for the protection of investors by reason of the small amount involved or the limited character of the public offering.” The SEC has similar authority to exempt brokers under Section 36(a) of the Exchange Act, which authorizes the SEC to create such an exemption by finding that it “is necessary or appropriate in the public interest, and … consistent with the protection of investors.”

While the SEC has such authority, thus far it has not exercised it. It presently has before it at least one petition formally seeking rule making on the issue — in respect of which the SEC has already received dozens of comments. In her testimony before Congress on May 11 2011, SEC Chairman Mary Schapiro confirmed that the SEC is studying the issue. And since then, the SEC created an Advisory Committee on Small and Emerging Committees that is tasked with making recommendations on a number of issues involving small companies, including crowdfunding.

Still, it is difficult to say whether any of this will yield a viable crowdfunding exemption anytime soon.

The Legislative Proposals

The initiative to create a crowdfunding exemption enjoys significant bipartisan support. In September 2011, even President Obama weighed in on the concept, advocating its adoption among many of his proposed job-creating measures. And Congress listened.

In the House, Congressman Patrick McHenry introduced H.R. 2930 — the Entrepreneur Access to Capital Act. H.R. 2930 proposes an exemption for offerings of up to $1 million (or, with audited financial statements, up to $2 million) in any 12-month period where each individual investor invests no more than the lesser of $10,000 or ten percent of such individual’s annual income. H.R. 2930 passed the House with an overwhelming 407-to-17 vote, but has not yet been acted on in the Senate.

Meanwhile, Senator Scott Brown introduced a crowdfunding bill of his own, which he calls the “Democratizing Access to Capital Act of 2011.” His bill, S. 1791, proposes an exemption for offerings of up to $1 million in any 12-month period where each individual investor invests no more than “an aggregate annual amount of $1,000.” Also in the Senate, Senator John Merkley introduced S. 1970, a bill whose ridiculous title is far too long to mention but whose acronym spells “CROWDFUND.” S. 1970 proposes an exemption for offerings of up to $1 million in any 12-month period where each individual investor invests no more than $500 or, if greater, no more than either one or two percent of the individual’s annual income depending on whether such income is more or less than $100,000. To date, neither Senate bill has advanced for consideration beyond a one-day committee hearing on S. 1791.

NASAA Rulemaking

The hearing on S. 1791 brought out its opponents, with Professor John Coffee of Columbia University leading the charge. He declared that the Bill should be “called the Boiler Room Legalization Act of 2011,” warning that the worst kind of fraudsters will begin hawking fictional investments to those in our society least able to understand or afford them.

Jack Herstein, President of the North American Securities Administrators Association (the “NASAA”), joined in. NASAA is an organization composed of state securities regulators. For years NASAA has waged a back-and-forth battle in opposition to the increasing federalization of securities regulation. Not unexpectedly, then, Mr. Herstein insisted in his testimony that regulating “small offerings” is ideally left to the states. He declared that his organization had the capacity and desire to implement a workable regulatory regime of its own.

Late last week, NASAA made good on its promise by circulating an early draft to its members. Besides retaining state oversight, NASAA’s proposed “Model Crowdunding Exemption” contemplates a coordinated exemption for securities sold in any participating state where the offering amount does not exceed $500,000 in any 12-month period and no single investor buys more than $1000 worth of the offered securities.

The Key Issues

So where does this leave us?

Well, we have four different concrete proposals: HR 2930, S. 1791, S. 1970, and NASAA’s “Model Crowdfunding Exemption.” We do not yet have any proposed rule making from the SEC — which is indeed unfortunate, for the SEC itself is probably best positioned to craft a truly workable crowdfunding solution. In its absence, however, we might benefit by reviewing the existing proposals against the following key areas of concern:

• maximum offering amount;
• maximum individual investment amount;
• restrictions on advertising and general solicitation;
• required disclosure documents and warnings;
• required use of an intermediary;
• escrows and closing conditions;
• restricted securities and holding period;
• disqualifying circumstances;
• notice filings and fees; and
• preemption of state law.

I’ll take these up in Part 2.

One of the Obama provisions would increase the amount of money that can be raised through small public offerings that don’t require companies to undergo an extensive Securities and Exchange Commission registration process. The limit for such “mini public offerings” would increase from $5 million a year to $50 million.

via Obama to ask Congress for small business tax breaks, investment incentives.

This move is not surprising, as Reg A’s existing limit has been the subject of much prior discussion. President Obama’s suggested upward revision to $50 million, however, is aggressive on the upward side, and will likely be welcomed by a Congress anxious to help out ailing small businesses.

NASAA claims that its proposal represents a “compromise” between the competing federal proposals. Highlights of an early draft being circulated among NASAA members include the following key points:

• A limit on the aggregate offering amount of $500,000 over any 12-month period;
• A $1000 cap on the amount of investment raised from any single investor;
• The use of an intermediary that, in turn, is registered as a broker-dealer (albeit one freed of certain restrictions);
• A notice to be filed prior to the offering with the securities regulator of the issuer’s home state;
• A disclosure document that informs investors about the issuer, the offering, and various risk factors; and
• A ban on general advertising and investor communications, apart from reference to, and use of, an intermediary’s web site.

NASAA’s proposal, obviously, advocates retaining state authority to regulate securities offerings made pursuant to its proposed exemption. This is a significant difference between it and both H.R. 2930 and S. 1791, and will no doubt generate significant debate. But, as the proposal itself acknowledges, it is not viable without federal implementing legislation of some kind. A significant question therefore remains whether any such federal legislation will carve out an exemption that allows states to retain the control that NASAA’s proposal contemplates.

The short answer: Absolutely, but the Company will need to (1) put the option contracts into writing, (2) provide copies to securities regulators in the State of Washington 30 days ahead of time, and (3) ensure that there are enough shares authorized in its Articles to fulfill the options when exercised.

Expanding on this a bit, the grant of a stock option is deemed an “offer or sale” of securities and is thus subject to regulation under both state and federal securities laws. On the federal level, SEC Rule 701 provides guidance. There, you’ll find various restrictions on the amount that can be “sold” during any one year and to whom grants can be made. But this is the operative language for our purposes here:

This section exempts offers and sales of securities . . . under a written compensatory benefit plan (or written compensation contract) established by the issuer, . . . , for the participation of their employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders.

(Emphasis mine.) In other words, a “plan” is not required under Rule 701 so long as there is a written compensation contract.

On the State level, RCW 21.20.310 permits an “offer or sale” of:

Any security issued in connection with an employee’s stock purchase, savings, pension, profit-sharing, or similar benefit plan if: … the director is notified in writing with a copy of the plan thirty days before offering the plan to employees in this state.

Importantly, the Securities Administrator in the State of Washington has issued an “interpretative release” that makes clear that a “plan” under RCW 21.20.310 includes written compensation contracts, just the same as Rule 701. According to the release:

“The term “employee benefit plan” means any written purchase, savings, option, bonus, appreciation, profit sharing, thrift, incentive, pension or similar plan, or written compensation contract, solely for employees, directors, general partners, trustees (where the registrant is a business trust), officers, or consultants or advisors, provided that bona fide services shall be rendered by consultants or advisors and such services must not be in connection with the offer or sale of securities in a capital-raising transaction.” (emphasis added).

Securities Act Interpretative Statement -06 (emphasis in original).

So, recapping, a Washington state company can grant options to its employees (among others) who work in our State without adopting a grandiose stock option plan. Any company doing so, however, must:

• include the grant in a written compensation contract;
• share the written compensation contract with  state regulators; and
• ensure there’s enough authorized but unissued shares to honor the options.

Note: The astute reader might notice that I’ve omitted provisions from the Washington state law that would allow a company to bypass the requirement of notifying securities regulators in advance. In doing so, I’m assuming that the company granting one-off stock options like that addressed here would not go the extra mile of including provisions that would make the stock option agreement qualify for treatment as an “incentive stock option” plan.

[E]liminating the ban would reduce the cost of capital for private funds and lead to greater efficiency in private offerings, said the MFA, which in turn would facilitate the allocation of capital and investment by private funds throughout the financial markets. Private fund managers face significant costs in seeking to comply with the ban due to its broad application, the limited scope of existing guidance, and the severe consequences of an inadvertent violation. Managers expend considerable time and resources when making any sort of communications or participating in industry events, and often take a conservative approach and refrain from such activity. These effects impose administrative burdens for managers and unnecessarily limit communications with potential investors, increasing the cost of obtaining capital for private funds.

via Jim Hamilton

The Petition is in addition to pending House and Senate legislation that seeks, in effect, to achieve the same outcome, albeit by legislation rather than by agency rule making. Interestingly, however, today’s petition is made only on behalf of private investment funds (i.e., hedge funds), and apparently is not intended for application beyond “private funds.” By comparison, the proposed legislation, if passed, would have far more comprehensive effect.

To begin, the most important thing anyone needs to know about making the election is that Section 83(b) is unforgiving in the extreme: An election not made on time is the same thing as not making the election at all. There are no exceptions.

(As an aside, because of the severe consequences of missing the filing deadline, I highly recommend to my client companies that they implement a system for obtaining from those to whom they grant restricted stock a written and signed acknowledgment of having been informed about the need to make an 83(b) election, if at all, within a short time period.)

So, how is this election actually made? Well, while the IRS is a forms-oriented agency, it does not have any special form for effecting an election under Section 83(b). Instead, in Publication 525, the IRS instructs taxpayers simply to prepare a “written statement” that contains the following information: