Hanson Law Gazette - May 21, 2012

The Hanson Law Gazette

May 21, 2012

The Brave New World of Small Scale Corporate Fundraising: The JOBS Act

Part 2: The Frog in the Pot for Companies and their Insurers

Faced with stubbornly high unemployment rates, Congress has enacted new legislation designed to Jumpstart Our Business Startups (The JOBS Act) by easing the administrative and regulatory burden on small companies seeking investment to foster growth.  Proponents of the law hope it will facilitate a burst of job creation by entrepreneurs, but some insurers fear that it will also give rise to a dangerous wave of suits and claims against insured organizations and individuals.

What is the reality likely to be?

To arrive at a useful answer, let us first review in broad terms how the JOBS Act goes about fostering the growth of small businesses.

Prior to the enactment of the two great pillars of federal investment regulation in the 1930’s, the Securities Act of 1933 and the Securities Exchange Act of 1934, securities regulation was largely the province of state authorities.  In the aftermath of the stock market crash of 1929, the 48 state-based regulatory regimes were largely but not entirely replaced with a national scheme of filings, disclosures, and oversight by the Securities Exchange Commission.  While these reforms did much to bring order to the sometimes chaotic world of stock issuance and sales, they added a layer of expense and complexity that effectively made it much more difficult and expensive for entrepreneurs to raise money from a broad range of stranger investors.

The federal securities regulation regime has always allowed for a number of exemptions.  Thus, from the beginning, “Private Offerings” have been exempt from the federal law, as have certain types of insurance, annuity, debt, secured and commercial-paper transactions.  Determining whether a modest offering of shares is an exempt Private Offering or is instead subject to federal law has been the subject of debate, discussion and no small amount of litigation and regulation over the years.

Many small businesses have structured their securities offerings in the past to take advantage of the safe harbor from federal regulatory oversight provided by Regulation D, Rules 504, 505, and 506, by limiting their offering to “accredited investors” (those with high enough income or net worth), or to a limited number of additional investors, and by keeping their offerings below the federal regulatory threshold of $5 million.  But in doing so, business owners seeking a capital infusion have generally been denied access to the broader public as potential investors.  In an era in which so much commerce and information is now shared through the internet, rather than though professional intermediaries, such as stock brokers and financial advisers, these limitations as to the number or nature of investors and the relationships between them and the offering firm are seen to have served as a drag on the entrepreneurial zeal of owners of business startups.

In simplest terms, the JOBS Act allows issuers of securities to reach out to less sophisticated, less wealthy strangers while still avoiding much of the cost and complexity that has been historically associated with a regulated stock offering.  Specifically no formal registration statement is required for the type of stock offering contemplated by the JOBS Act. For a small enough offering, the issuer need only provide last year’s tax return and have its Chief Executive Officer swear that the financial statements are true. Only when the offering reaches six figures must the issuer provide a CPA review, and that review need not be audited until the offering is half a millions dollars. The amount each individual can invest under the JOBS Act crowdfunding provision is capped at $2,000 for typical investors, but the per-investor-and-per-company cap can go up to as much as $100,000 for demonstrably wealthier investors. By complying with these requirements, an issuing firm can avoid the expense and delay associated with filing a formal registration statement with the SEC while still gaining access to investors “in the cloud.”

Importantly, while the JOBS Act eases the front-end burden of expense and delay associated with small scale securities offerings, it does not change the standards of care applicable to issuers (and those that aid them) under either federal or state (“Blue Sky”) laws.

So should we expect a change in either the severity or frequency of securities related suits against modestly sized businesses and their executives, owners and professional advisers once the SEC has issued its implementing regulations (in about January 2013)?  If so, should we prepare for a litigation tsunami, or generally rough seas, or little more than a ripple on the placid waters of securities-based litigation and insurance claims?

From our vantage point, the weather forecast calls not for hurricane warnings, mountainous storm surges and tidal waves, but for gradually rising water levels marked with occasional outbursts of stormy and unpredictable claims weather for issuers, directors and officers, and the occasional accountant, lawyer, broker, financial adviser, or funding-portal operator that gets involved in investment funding facilitated by the JOBS Act.  Think of it as either global warming or the proverbial frog in a pot of slowly warming water.  There will be change, with more frequent and more serious claims involving a number of different insurance coverages and professionals that will build over time, raising exposures, increasing both frequency and severity.  But it will build slowly, at least at first, so much so that many will barely discern the change until, like the frog, they find the water has gone from cool, to tepid, to comfortable, to hot, to perhaps downright dangerous if not intelligently addressed.

And here is why.

The JOBS Act, as mentioned above, does not make securities funding of startup enterprises suddenly and broadly available in some revolutionary fashion as of its passage in April of this year.  Only when the SEC has put into place the regulations detailing the acceptable processes, timetables and definitions contemplated by the legislation will businesses be able to take advantage of the law’s enhanced access to crowdfunding and the like.  Thus it is unlikely there will be many or even any offerings specifically facilitated by the JOBS Act until the first quarter of 2013, or later.  The number of offerings facilitated by the Act seems likely to grow, however, once all the parties involved (entrepreneurs, lawyers, accountants, brokers, financial advisers, and small business owners and managers) become more familiar with the routines associated with a JOBS Act offering.

There are as many as 600,000 new businesses launched every year in the United States,[1] and several times that number in existing businesses may have an interest in taking advantage of the crowdfunding provisions of the JOBS Act.  In a given year, the volatility associated with small businesses will mean that a sizeable proportion of those offerings will lead to disappointment on behalf of the investors.  Small businesses carry with them the potential for great, multiplied rewards, it is true, but by dint of their modest size they are also susceptible to the ravages of market changes, personnel changes, technological obsolescence, increased or unexpected competition, and a host of other risk factors.  As anyone involved with private placements of securities will typically observe, if the investor loses significant amounts of money, lawsuits typically follow – against issuers, executives, intermediaries, and professionals.

There will be important differences between claims brought in connection with private placements or other exempt transactions and those that will be filed in the aftermath of a JOBS Act offering.  Typical private placements involve a relatively modest number of investors each with a fairly significant amount of money at risk.  The small number of investors, coupled with the individual nature of their relationship with the issuer, typically means claims are filed not as class actions but as group filings or even individual cases.  Bear in mind that all of the anti-fraud provisions of state Blue Sky law remain in place for JOBS Act offerings.  Thus, the disparate standards in the 50 different states (as well as the District of Columbia and various off-shore possessions of the United States) will continue to apply.  So while the offering materials required for JOBS Act offerings are considerably less extensive than those usually associated with a formal public offering or even many private placements, issuers are still obliged to be truthful and accurate in their offering materials, even if these primarily consist of tax returns and CPA comments.

If business failure is a key triggering event for claims, is there any reason to believe the failure rate will increase among small businesses once crowdfunding becomes available to them?  Perhaps so.  At present, entrepreneurs seeking funding for business expansion have three general options to pursue: loans and investments from friends and family, bank loans, and traditional private offerings.  There seems to be no reason to believe that reliance on friends and family (and, according to some wags, fools as well) will change next year, unless an entrepreneur decides to seek cloud funding as a means of buying out previous friend and family investors.  Bank financing remains difficult for entrepreneurial organizations, not for lack of available capital, but because federal bank regulations stress bank soundness and safety at the expense of risk and lending to firms with more prospects than customers.  Private placements will remain a viable option after the implementing regulations for the JOBS Act are issued, just as before.

But what will perhaps change (and not for the better) is the vetting process, the disciplines built into the current funding option regime that help weed out good ideas from bad, good managers from bad, good financial prospects from bad.  Even if regulators, public officials, bankers and others can be criticized for making bank loans too hard to get, or for making private securities placements too expensive or slow to orchestrate, it seems likely a lot of overly ambitious schemes and dreams in the minds of less qualified owners and managers never see the light of day in today’s economy for lack of funding.  If the JOBS Act has the impact desired by its drafters, more money will flow into business startups, and it seems inevitably that it will do so with formal review and vetting than would be the case if the business backers were local bankers or serious, sophisticated investors with a big stake in the outcome.

Businesses that obtain their growth capital from banks and successful investors (as through private placements) often receive more than cash through their efforts.  They get selfishly interested supervisors and advisers who both care about the outcome of the business but also have experiences and skills that can help a startup avoid pitfalls and plan intelligently for both success and struggles.  Thus it seem logical to expect that, once armed with new sources of funds but provided with less experienced guidance from investors, there will be a noticeable number of business growth failures funded through JOBS Act investments in the years to come.  With those failures will come suits and claims.

Who will facilitate those claims, and why?

Locally based plaintiffs and business lawyers seem likely to respond to the brave new world of JOBS Act funding with gusto.  The recession of the last four (yes, it is effectively now four years since the country has seen any substantial economic growth) has negatively affected the law business in a way no previous recession for perhaps the last 65 years has done so.  With fewer business clients with sufficient assets to file lawsuits, with commercial transactions at a low ebb or with skimped legal budgets, and with law schools still pumping out thousands and thousands of now unemployed or marginally employed new lawyers each year, there is no shortage of entrepreneurial attorneys ready to find ways to commercialize business failure as much as business success.  They will not have the advantages of some of the well-established rules that now attend the world of national securities class actions filed under Rule 23 and addressing alleged federal securities law violations, but for a small business with limited resources the effect could be even more devastating.  Not only might the cost of defense prove overwhelming, but the distraction of management could prove debilitating as well.

This is not to say that some high profile class actions may not emerge down the road, either.  The JOBS Act requires that crowdfunding efforts involve either a registered broker or a registered funding portal.  Should a number of offerings facilitated by such an organization suffer cataclysmic failure, we can look for creative plaintiffs’ counsel to seek to attack their business practices more broadly, perhaps across multiple offerings as well.

While the scope of crowdfunding through the JOBS Act is necessarily limited (to offerings under $1 million, figures that would be disdained by the well-established plaintiffs’ securities class action bar),  for local lawyers across the country the potential for a million dollar judgment simply does not come along very often.  Moreover, since many such suits may be filed in state court, or pursued in federal court in jurisdictions that have seen fewer securities cases in the past, the novelty of the law and the unfamiliarity of both plaintiffs and defendants counsel and judges could make for slow-moving, expensive-to-defend proceedings.  While SLUSA (the Securities Litigation Uniform Standards Act) may or may not move such class actions into federal court, it would not necessarily change the legal standard from state to federal law.  Thus, the remarkably different standards that apply under our various Blue Sky laws could add a further complication and expense to the defense of such matters.

Similarly, while the National Securities Markets Improvement Act pre-empts some elements of state law with regard to securities transactions, is does not pre-empt state “anti-fraud” law.  Cases thus may turn very much on where they are filed and choice-of law-questions that have not been central to the familiar securities class action regime of the last 35 years.  Moreover, as insurers of publicly traded corporations are by now well aware, there is a considerable awareness among issuers, insurers, defense counsel and especially securities class action plaintiffs’ counsel with regard to the reasonable settlement range associated with most claims.  The smaller, more novel claims that will evolve in the future will not involve the same body of collective wisdom.  As such, those cases are again likely to be harder fought, slower, and more difficult to resolve through settlement.

Perhaps most problematic of the issues currently ascertainable regarding JOBS Act crowdfunding is a numerical and transactional challenge.  Generally speaking, corporations with less than 500 shareholders are not required to register with the Securities Exchange Commission.  Those with 500 or more separate investors take on that burden as soon as they cross that threshold.  The JOBS Act speaks of a $1 million ceiling on investments under the Act.  Given that the typical investor is limited to investing $2,000, a $1 million offering will have 500 investors.  Very importantly, however, absent some creatively and carefully drafted shareholder terms and agreements, an issuing firm could quite easily find itself crossing that threshold.  If, for example, a holder of 10 shares dies leaving the shares to children and grandchildren, the effective number of shareholders will cross the threshold through no fault of involvement of the issuer.  Although the Act (and presumably the regulations that follow) contemplates a 12-month holding period for shares purchased through the crowdfunding arrangement, shares can be sold after that point and push the company into being a Public under the 1934 Act. Companies that do not adequately protect themselves through appropriate shareholder agreements could find themselves suddenly saddled with public company registration and reporting requirements, they can ill afford to meet.

No doubt as the SEC begins to lay out its regulatory framework, and as brokers and funding portals begin to publicize their anticipated approach to hosting crowdfunding efforts, the potential liability picture will become even clearer.  Many additional areas of concern are simply beyond the scope of the available space of this writing.  It seems clear even at this early stage, however, that there will be changes to the claims environment once the impact of the JOBS Act starts to be felt.  Expect the waters to rise, albeit gradually, but the wise investor, the wise insurer, and the wise small-business manager would all be well advised to do their research and carefully watch to see how any frogs in their particular pot might be doing in the months and years ahead.