Below is a copy of the letter I just emailed to Senator Dodd’s office with respect to his new financial regulatory reform bill and its material adverse effect on angel investments.
March 31, 2010
Senator Christopher J. Dodd, Chairman
Committee on Banking, Housing and Urban Affairs
534 Dirksen Senate Office Building
Washington, DC 20510-4605
Re: The Restoring American Financial Stability Act of 2010 (the “Reform Bill”)
Dear Senator Dodd:
As a corporate lawyer for entrepreneurs, I would like to get a few things off my chest with respect to the Reform Bill. Indeed, I do not understand why a 1,336-page bill designed to address our recent financial crisis includes two major changes to the federal securities laws that could destroy angel investing.
As you may recall (and as I discuss in detail in my recent blog post on VentureBeat), the first change relates to the definition of “accredited investor” and increases the qualification thresholds for an individual from $1 million of net worth to $2.3 million and from $200,000 of annual income to $449,000 (or from $300,000 of joint annual income with a spouse to $674,000).
According to Business Week, this change would lower the number of individual accredited investors by 77%. Should I repeat that? 77%! Over two-thirds, amigo!
If that weren’t bad enough, here comes the second change – which provides that even if all the investors are “accredited” under your new definition (and despite SEC Rule 506, discussed below), a filing must be made with the SEC, and the SEC will have 120 days to review it; and if the SEC does not review the filing within such 120-day period, then the applicable State securities commissions would have the right to review the merits of the angel investment.
In case you or your staff haven’t done the math: 120 days equal four months. Thus, under your bill, we will have 77% less angel investors and then startups will have to wait up to four months (or longer) while the SEC and/or State securities commissions review the merits of their angel investment. With all due respect, Senator, this is fucking nuts!
And, sadly, it gets even worse: Alternatively, the SEC can designate that certain financings under Rule 506 are too small in size or scope to warrant SEC review and push such review to the State securities commissions altogether. This is exactly what the National Securities Markets Improvement Act of 1996 (“NSMIA”) was designed to prevent. Why are we moving fucking backwards?
As you know, the beauty of NSMIA has been that startups could rely on Rule 506 if all of their investors were “accredited” – and thereby preempt state law and no longer have to deal with the excessive cost, delay and onerous disclosure requirements of State securities commissions (which was a significant problem pre-1996). Indeed, NSMIA has facilitated the extraordinary growth of angel investing for the past nearly 15 years, which has contributed to the success of companies such as Google, Facebook, Twitter and many others (not to mention the concomitant job creation).
Let’s take a simple example and see how this plays out in the real world:
On April 26th, I will be co-sponsoring an Open Angel Forum event in Los Angeles, which will provide each of five startups with the opportunity to pitch 15-20 angel investors for an investment of approximately $500,000 to $1 million. All of the angel investors are “accredited investors” under the SEC’s current definition and your new definition; in fact, some have a net worth in excess of $100 million.
Under current law pursuant to SEC Rule 506, if an angel investor decided to invest in one of the startups, a deal could be closed and the investment funds could be wired to the startup within 24 to 48 hours – particularly if the deal were structured as a convertible note (as opposed to preferred stock) due to the simplified paperwork.
Why? Because under Rule 506, there is no written disclosure requirement (such as a private placement memorandum) if the investors are accredited; and, as a result of the enactment of NSMIA, Rule 506 preempts State law and thus the startup would not have to comply with any disclosure or other requirements under applicable State securities laws, other than filing a Form D notice (which is also filed with the SEC) within 15 days after the sale.
Now let’s see what happens if your bill were enacted.
First, instead of money being wired to the startup within 48 hours, it would presumably be put into escrow for up to four months pending the SEC’s review of the startup’s filing. If the SEC did not review the filing within four months, the startup would then need to comply with all applicable State securities laws — which presumably would mean any State in which part of the offer and/or sale takes place (i.e., California and any other State implicated as a result of subsequent emails, telephone calls, delivery of the notes/stock certificates, etc.). Again, fucking nuts!
Alternatively, as noted above, the SEC could require the startup, due to the small size or scope of the investment, immediately to comply with applicable State securities laws even though all of its investors were “accredited” and may have net worth in excess of $100 million. In other words, NSMIA would be thrown out the window, and we would be back to the pre-1996 days where counsel must work his way through the maze of State securities laws, including dealing with State regulators for weeks and weeks (and perhaps months and months), and legal fees mount, and investors walk away in frustration.
The bottom line, Senator, is that not a lot of thought has gone into this aspect of the Reform Bill. Clearly, you and your staff have been heavily lobbied by the North American Securities Administrators Association, who are anxious to repeal NSMIA and restore their power; it’s a classic regulatory turf battle. The problem, however, is that you are about to destroy angel investing and job creation in the process.
Scott Edward Walker