Raising Money On-Line

We talked earlier about the dangers of raising money through LinkedIn.  A Massachusetts Supreme Judicial Court decision this week made it even clearer that governments do not want companies to reach potential investors through websites that are open to the public and blind emails.

In Bulldog Investors General Partnership v. Secretary of the Commonwealth, SJC-10756 (Mass. Sept. 22, 2011), three hedge funds tried to find investors through a public website that anyone could could access.  Visitors interested in more information about the hedge funds could sign their names and email address.  Bulldog then followed up with emails that attached pamphlets and other promotionals for the funds. 

Bulldog and the website were all located outside of Massachusetts, and the marketing was not aimed directly at Massachusetts investors.  But in-state investors were by no means excluded from the pitch, and Bulldog was aware that at least one inquiring visitor was from Massachusetts.

The Massachusetts Secretary of State shut the website down, claiming Bulldog had violated. § 301 of G.L. c. 110A of the Massachusetts Uniform Securities Act (Massachusetts act) by offering unregistered securities to a Massachusetts resident through a publicly available Web site and an electronic mail (e-mail) message.

Bulldog sued, claiming among other things, that the Secretary of State impinged on its First Amendment rights to freedom of speech.

Bulldog was represented at the SJC by the eminent Constitutional scholar Laurence Tribe.  Tribe argued in part that the state should not be able to require Bulldog to issue disclosure statements becaue that constitutes forced speech.  The First Amendment argument, however, got exactly nowhere.

The SJC ruled that the state had power to regulate a website because it is commercial speech.  Courts will take a hard look if the state probitis commercial speech completely.  But if the state is only restricting the speech, then courts are much more lenient.

For more than 80 years, the state has had the power to regulate how securities are marketed.  The SJC pointed out that Bulldog was allowed to market its securities to the public, so long as it first registered teh securities with the SEC.  If Bulldog wanted to make a private offering, though, then it could only do that under Regulation D, marketing to accredited investors or a limited number of other investors who read full disclosures of the company first.

Since it was impracticable for Bulldog to give disclosures to potential investors before they got the information on the public website, Bulldog proposed instead disclosing before an actual sale was made. 

The SJC scowled.  That plan, the SJC said, “will likely decrease the quantity of information in the marketplace, will increase the likelihood of securities scams and of unlawful sales of unregistered securities to unsophisticated investors, and will weaken the market’s efficiency overall. Bulldog’s proposal to concentrate enforcement at the point of sale rather than at the offer stage increases the risk that enforcement will come too late to prevent the harm or permit monetary recovery.”

The takeaway is that anyone planning to market securities through internet offerings should proceed carefully.  As the SJC stated, “If any reminder was needed, the financial collapse in the autumn of 2008 that led to our persistent recession illustrates the extent to which unregulated and poorly regulated securities have the potential to become “financial weapons of mass destruction.”

Linked, Out

The other day, a fellow with a startup wanted to know if he could raise money by soliciting investors through a closed LinkedIn, invite-only group and still escape close regulation by the SEC.

Interesting question.

When you sell shares of your company, you are selling a security and you fall under regulation by the SEC and the state.  Usually you have to register the security with the SEC, a process that can burn up some pricey lawyer hours.

Startups are usually strapped for cash, though, so the securities laws (1933 Act Section 4(2) and Rule 502 of Regulation D) exempt small offerings from registration – so long as the startup avoids making general solicitations of its securities.

Fine, you say, this will be easy.  So what’s a “general solicitation”?  And that’s where things get interesting.

The SEC doesn’t say.

Instead of giving a hard and fast defintion of general solicitation, the SEC states that it will evaluate on a case-by-case basis.  See Interpretive Release on Regulation D, Securities Act Release No. 33-6455, 17 C.F.R. Pt. 231, 1983 SEC LEXIS 2288 (March 3, 1983).

But there are some clues as to how the SEC would come out.  For starters, the Supreme Court said in the famous SEC v. Ralton-Purina case, 346 U.S. 119 (1953), that “the focus of inquiry should be on the need of the offerees for the protections afforded by registration”, namely where the offerees ”have access to the kind of information which registration would disclose.”

LinkedIn has the advantage of allowing a startup to be able to see the backgrounds of the people they intend to solicit for investment.  But that does not mean that the solicitees, in turn, will have full access to your information without registration.

Second, if you look at how the SEC comes out in their no-action letters, you can make out the outlines of how they would come out on this idea. It appears the SEC bases its decisions on whether there is already a significant relationship that predates the offering (friends or family, for instance), whether the offerees share a common interest, whether a third-party communication has been made on behalf of the issuer or whether a sale of securities was intended.

Since these are LinkedIn invitations, we can scratch the first category – there is not a pre-existing relationship.  The second category could work, depending on the screening done.  But the common interest cannot be something like “red hair,” or “fellow South End resident.”  The common interest must be enough that it allows the offeror to evaluate the suitability of the security for the offeree.

For that reason, the SEC has granted no-action status to a proposal to hand out questionnaires to potential investors and, based on the outcome, solicit the responder.  The SEC has also allowed an on-line version of this scheme.

So if the LinkedIn scheme allows the startup to gather enough information about the potential investor that they can be screened and evaluated before the pitch, the chances are the SEC would not stand in the way.

But since the SEC says it wants to evaluate on a case-by-case basis, a no-action letter would seem to be the way to go here.