The Deal: SEC Rule on Advertising May Be Too Tough for Startups

NEW YORK ( TheStreet) - The Securities and Exchange Commission's proposed rule that would require private placement issuers to file general solicitation and advertising materials with the commission could lead small companies to raise less capital, rather than more, under the common securities law provision that many currently use.

That is the opinion of numerous entrepreneurs and advocates for startup companies, expressed in interviews and in letters filed with the SEC as comments on the proposal.

Sara Hanks, co-founder and CEO of CrowdCheck Inc., said in a lengthy, July 6 letter to the SEC that the commission is unlikely to receive all the solicitation materials it is expecting because many small securities issuers don't understand the nuances of the securities laws. CrowdCheck, based in Alexandria, Va., provides due diligence and disclosure services in small, online securities offerings.

"This imposes a significant burden on the founders of small issuers, whose focus should be on running their companies and making sure that their communications are complete and accurate, not on uploading large, continually changing files to the commission," Hanks wrote.

Proposed Rule 510T was published for public comment on July 10. It would require private placement issuers relying on Rule 506(c) of the Securities Act to file written general solicitation materials with the SEC.

The filings would be made through an intake page on the SEC website no later than the date of the first use of the materials. The filing requirement does not apply to oral communications. Filings would not be available to the general public and would expire after two years, under the proposal.

The SEC made the proposal on the same day that it approved a rule to eliminate the ban against general solicitation and advertising of private placement offerings.

Congress had required the SEC to end the general solicitation ban under the Jumpstart Our Business Startups Act, which was signed into law in April 2012. Ending the ban was one of numerous provisions of the JOBS Act that was meant to make it easier for small companies to raise capital. The SEC wants the 510T filings in order to gather information about how general solicitation and advertising develops in the private placement market. The commission plans to use the information to make any necessary changes to protect investors from market abuses.

To be sure, many in the industry fear such information may lead to enforcement actions.

Hanks said that many small securities issuers do not hire experienced attorneys and, as a result, may not understand that proposed Rule 510T would require them to submit written communications following the guidelines of Rule 405 under the Securities Act. Rule 405 defines graphic and broadcast material as written communications.

"It will not occur to people not steeped in the technicalities of securities law that a video is 'written,'" Hanks stated in her letter. As a result, she said many common forms of general solicitation and advertising will "remain innocently unsubmitted."

Hanks also asserted that because there is no way for the SEC to determine whether all materials have been submitted, there may be a built-in incentive to undersubmit.

"There is every incentive for issuers to submit whatever materials they find easiest to submit and deliberately withhold materials they least want the SEC to see or which present challenges to uploading," she wrote.The withheld materials are most likely to include innovative approaches to fundraising, Hanks said, while the submitted materials are most likely to include traditional, text-heavy disclosures such as private placement memoranda.

Materials such as slide-decks, videos, legal documents, platforms that allow for due diligence or information calls between issuers and investors will present challenges to issuers in terms of their filing requirements.

For the SEC, building a system that can handle the potential volume and different types of data will be "difficult and expensive," Hanks wrote.In addition, the SEC's possible use of information gathered from such filings in enforcement actions may create incentives for issuers to feign compliance and withhold materials that might raise concerns with regulators.

Hanks said the SEC would be better served in its efforts to be informed about the small-cap financing market by relying on the existing array of advisory bodies and working groups on small business and investor protections.

Many of Hanks' concerns were echoed by Scott Purcell, the founder and CEO of Arctic Island LLC, in a July 22 letter to the SEC. San Francisco-based Arctic Island plans to offer software and services to help small businesses raise private placement financing.

"These businesses and their related parties, including owners and employees, may be very good at operating their companies but are certainly not steeped in securities laws," Purcell wrote.

Requiring them to prefile "every Facebook like, every Tweet, every Pinterest, every mention in a post or comment on a LinkedIn forum, or every handwritten sign they may place in the reception area of their businesses is simply not practical," he stated. "Even with the best of intentions, it is not reasonable to expect that the rule will be complied with by these small issuers.

And even if it were, the millions of postings would likely overwhelm any database that the SEC creates for such a purpose."Purcell said that the SEC should provide an exemption from the rule for offerings by business issuers raising less than $5 million, or it should create a separate standard for funds, differentiated from businesses capital raising directly to grow and create jobs.

"There's no way a startup can digest all this," said Jason Crawford, the 33-year-old co-founder of tech startup Kima Labs. It raised $770,000 from angel and seed investors including his parents in 2010 before selling itself to Groupon Inc. in 2012 for an undisclosed amount.Kima Labs made iPhone apps, including one called Barcode Hero, which allowed users to scan the barcodes of products, comment on them and view other users' comments.

"The securities laws are so complex," Crawford said. "No one understands them except the experts. I'm lucky because I work with good lawyers," he continued. "It's probably going to lead to extra legal expenses, but I'll be able to avoid penalties and major problems. I worry about the guys who can't afford a good lawyer. Good luck trying to do it yourself."

Crawford said he supports an exemption for the smallest tech startups to allow them to avoid the filing requirements. "There are a lot of areas where the filing requirements could be lessened," he said.Mitchell Littman, a partner with the law firm of Littman Krooks LLP in New York, said he was surprised people are so concerned about the new filing requirements because it is premature to say for sure how the new rules will affect raising capital.

"If they're feeling queasy about their offering documents, maybe that should tell them something," he said. "Either be confident in your work or don't file."

Littman said the concern is probably confined to the smallest and least sophisticated issuers who are not as knowledgeable about securities laws.The good news for the unsophisticated issuers is that if they're overwhelmed by the filing requirements for general solicitation and advertising, they can opt to raise capital the old-fashioned way, without solicitation and advertising, he said.

"Just like one-size-fits-all doesn't work with capital raising, no one size fits all for exemptions," Littman said. "If you don't like the rules, you can still issue shares without general solicitation. The variations have actually expanded and not shrunk."

The SEC staff is unlikely to be receptive to the concerns that startup advocates are expressing, said David Pankey, a partner in the Washington office of law firm McGuireWoods LLP.

"They're basically saying people will try to figure out ways not to comply with the filing requirement," Pankey said. "I don't think the staff will be persuaded by that argument."

Pankey said that small companies already face filing requirements with the SEC for acquisitions and other kinds of transactions. Trade groups and deal advisers have developed standard forms to help small companies deal with those requirements.

"There is already in place a very similar requirement when you're doing a proxy solicitation or an M&A deal," Pankey said. "It's been in place for over a decade." Industry groups "very quickly figured out how to put out pro-forma filings with the SEC," he said. "If there is industry guidance out there, and there will be fast, I wouldn't see it as a potential problem. People who are intermediaries and members of trade associations would put them together and their members could use them."

Pankey noted, however, that it also remains to be seen whether state securities regulators will put out their own similar requirements.Asked whether securities issuers should be worried about such filing requirements being used against them in enforcement actions, Pankey was circumspect.

"It depends entirely on each individual situation," he said. "Some presence exams of fund managers are leading to enforcement cases, but the vast majority are leading to situations where the SEC says, 'You need to fix this or that.' It depends on the personalities of the examiners, the profile of the people involved and mostly on the extent of the alleged wrongdoing."

Written by Dan Lonkevich in New York

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