BILL ANALYSIS �
SENATE BANKING & FINANCIAL INSTITUTIONS COMMITTEE
Senator Juan Vargas, Chair
AB 2081 (Allen) Hearing Date: June 27,
2012
As Amended: April 11, 2012
Fiscal: Yes
Urgency: No
SUMMARY Would authorize a new securities law permitting
exemption for persons seeking to offer or sell securities using
any form of general solicitation, general advertising, or
unsolicited telephone calls to a person's residence or cellular
telephone, provided that sales of the securities are made only
to persons who the issuer reasonably believes, after reasonable
inquiry, are accredited investors.
DESCRIPTION
1. Would provide that an issuer who offers or sells a
security, using any form of general solicitation or general
advertising, or using a telephone call to a person's
residence or cellular telephone, does not require a permit
from the California Department of Corporations for those
solicitation or sales activities, as long as the transaction
meets all of the following requirements:
a. If solicitation is made via a telephone call, the
issuer and the caller must reasonably believe, after
reasonable inquiry, prior to the phone call, that the
person being solicited is an accredited investor, defined
pursuant to specified federal law.
b. Regardless of how the solicitation is made (i.e.,
whether via general solicitation, general advertising, or
a telephone call), sales of securities may be made only
to persons who are, or whom the issuer reasonably
believes to be, accredited investors immediately prior to
the sale.
c. The issuer must reasonably believe that, immediately
prior to the sale, the offering is suitable for the
person being solicited, based on the person's financial
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status, objective, investment experience, time horizon,
risk tolerance, and any other information the issuer
deems relevant.
d. If the person being solicited is a natural person,
the amount paid by that person may not exceed 10% of his
or her net worth, or joint net worth with his or her
spouse, immediately prior to the investment.
Furthermore, each investor's investment in the offering,
together with that investor's investment in all previous
offerings made under this new permitting exemption during
the previous 12 months, may not exceed 10% of that
investor's net worth.
e. The issuer must be able to reasonably assume that
the person being solicited has the capacity to protect
his or her interests in connection with the offering, due
to his or her business or financial experience, or the
business or financial experience of his or her
professional adviser, who is unaffiliated with and not
compensated, directly or indirectly, by the issuer or any
affiliate or selling agent of the issuer.
f. The issuer must specify on the cover page of each
disclosure document, and in all advertisements,
communications, sales literature, and other information
that is disseminated in connection with the offering,
that the securities will be sold only to accredited
investors. Dissemination of information regarding the
proposed offering to a person who is not an accredited
investor does not disqualify the offering from the
exemption.
g. The issuer may not be an investment company or a
development stage company, as those terms are defined
under federal law. The exemption is also unavailable to
any issuer, if that issuer or its predecessors,
affiliates, directors, officers, general partners,
beneficial owners of 10% or more of any class of its
equity securities, promoters presently connected with the
issuer, any underwriter of the securities to be offered,
or any of the underwriter's partners, directors, or
officers has committed one or more of a series of bad
acts involving securities, which are specified in the
statute (the so-called "bad boy" provisions, which are
intended to ensure that known bad actors aren't involved
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in the offer or sale of securities).
2. Requires each issuer utilizing the exemption provided for
pursuant to this bill to file a notice with the Commissioner
of Corporations and pay a specified fee within 15 days after
its first sale of securities in the state.
3. Provides that a person who purchases securities in an
offering that fails to meet all of the terms and conditions
of the bill may bring an action to rescind his or her
purchase pursuant to specified sections of the Corporations
Code, and directs a court to award attorney's fees and costs
to a prevailing purchaser in any such action.
EXISTING FEDERAL LAW AND REGULATION
1. Provides for the Securities Act of 1933, and for its
implementing regulation, Regulation D, which provide a
regulatory framework for the qualification and sale of
securities and for the protection of investors that purchase
those securities. Generally speaking, the Securities Act of
1933 and Regulation D require the sale of all securities to be
registered with the Securities and Exchange Commission (SEC) and
to be structured as prescribed in federal law and regulation.
They also require those who offer (i.e., market) and sell
securities to be licensed as investment advisers or
broker-dealers, unless either the transaction or the activity
being undertaken is exempt.
2. Contains several exemptions from the requirement for securities
issuers to register the sale of their securities with the SEC,
and includes among those exemptions the sale of securities in
accordance with Regulation D, Rules 501 through 508. Key
elements of those rules, which are relevant for this analysis,
include the following:
a. Rule 501 of Regulation D defines accredited investors
as, among other things, financial institutions, securities
broker-dealers, large pension plans, corporate entities with
assets in excess of $5 million, and other large, financially
sophisticated entities. It also includes:
i. Any natural person whose individual net
worth, or joint net worth with that person's spouse,
exceeds $1 million at the time of his purchase,
exclusive of their primary residence; or
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ii. Any natural person with an individual income
in excess of $200,000 in each of the two most recent
years, or joint income with that person's spouse in
excess of $300,000 in each of those years, together with
a reasonable expectation of reaching the same income
level in the current year.
b. Rule 504 of Regulation D authorizes the offer and sale
of securities that are made exclusively according to state
law exemptions that permit general solicitation and general
advertising, as long as sales are made only to accredited
investors, as defined in Rule 501. Thus, under Rule 504, the
offer and sale of securities is exempt from both federal and
state qualification, as long as the offer and sale are
covered by a specified state law exemption.
EXISTING STATE LAW
1. Provides that it is unlawful for any person to offer or
sell any security in this state, unless such sale has been
qualified by the Commissioner of Corporations, as specified,
or unless the sale is covered by an express exemption
(Corporations Code Section 25110.
2. Contains several exemptions from the requirement
immediately above. While the number of exemptions is too
numerous to list, two of the most relevant exemptions for
purposes of this bill include Corporations Code Sections
25102(f) and 25102(n).
a. 25102(f) provides an exemption for any offer or sale
of any security in a transaction that meets all of the
following criteria: i) sales of the security are made to
an unlimited number of accredited investors and up to 35
other persons, who are not accredited investors; ii) all
purchasers either have a pre-existing personal or
business relationship with the offeror, or can reasonably
be assumed to have the capacity to protect their own
interests in connection with the transaction, by reason
of their business or financial experience, or the
business or financial experience of their professional
advisers; iii) each purchaser represents that he or she
is purchasing for his or her own account, and not with a
view to or for sale in connection with any distribution
of the security; and iv) the offer and sale of the
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security is not accomplished through the publication of
any advertisement.
According to the Department of Corporations, approximately
20,000 to 35,000 people file forms with DOC annually,
claiming exemptions pursuant to Section 25102(f).
b. 25102(n) provides an exemption for any offer or sale
of any security in a transaction that meets all of the
following criteria: i) the issuer is not a blind pool
issuer, as that term is defined by the Commissioner of
Corporations; ii) sales of securities are made only to
qualified purchasers or other persons the issuer
reasonably believes to be qualified purchasers; iii) each
purchaser represents that he or she is purchasing for his
or her own account, and not with a view to or for sale in
connection with any distribution of the security; iv)
each natural person purchaser is provided with a
disclosure statement that meets the disclosure
requirements of federal Regulation D, at least five
business days before they purchase or commit to purchase
the security; v) the offer and sale of the security is
made by way of a general announcement, whose content is
strictly limited; and vi) telephone solicitation by the
issuer is not permitted, until and unless the issuer
determines that the prospective purchaser being solicited
is a qualified purchaser.
Qualified purchasers are those who meet one or more of
several criteria listed in subdivision (n). Generally
speaking, these criteria describe persons with some
degree of financial sophistication, though the qualified
purchaser bar is lower than the accredited investor bar.
As an example, an individual is a qualified purchaser if
they individually, or jointly with their spouse, either
have a minimum net worth of $250,000 and had, during the
immediately preceding tax year, gross income in excess of
$100,000, and reasonably expect gross income in excess of
$100,000 during the current tax year. Alternately, the
term applies to individuals who have a minimum net worth
of $500,000, exclusive of their home, home furnishings,
and automobiles. Natural persons are limited to
investing no more than 10% of their net worth in any
25012(n) investment.
According to DOC, between 20 and 50 people file forms with
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DOC annually, claiming exemptions pursuant to Section
25102(n).
COMMENTS
1. Purpose: This bill is sponsored by Small Business
California, to allow small businesses and start-ups to more
readily access capital. The author contends that existing
state and federal statutes authorizing the solicitation of
investors are inaccessible to small businesses, because
existing law requires companies to personally know the
accredited investors from whom they solicit funds or hire a
financial adviser, who can bridge that relationship gap.
2. Background and Discussion:
Why Is Existing Law Inadequate For This Bill's Proponents?: To
address this topic, it is necessary to boil down the lengthy
summaries of Sections 25102(f) and 25102(n) above into a few
simple concepts. These simplifications are not intended to
be legal interpretations of either section; they are,
instead, an attempt to look past the legalese in hopes of
better explaining the logic behind the bill.
The author and sponsor of this bill would like to help small
businesses and start-ups raise capital. These businesses
typically lack pre-existing personal and business
relationships with wealthy people, so they are looking for
ways to reach out to people they don't know, either via
telephone or via enticing advertising which pitches their
business model to wealthy people who might be interested in
investing.
Section 25102(f) does not appeal to these small businesses and
start-ups, because it requires the business that is
soliciting funds (i.e., the issuer) to either have a
pre-existing personal or business relationship with the
investors who are being solicited, or requires the business
to hire a financial adviser, who can bridge that
relationship gap by reaching out to the wealthy individuals
or to their financial advisers. 25102(f) is also
unattractive to these businesses, because it does not allow
the use of advertising.
Section 25102(n) is also unappealing to these businesses, though
for different reasons. This section authorizes the use of
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very limited advertising - too limited to be of much use to
a business seeking to raise funds from investors it does not
know or investors who are unfamiliar with the business or
its business model. The advertising authorized by Section
25102(n) is known as tombstone advertising. To be allowable
under 25102(n), a tombstone ad must include the name of the
securities issuer; the full title of the security to be
issued; the anticipated suitability standards for
prospective purchasers; a statement that no money or other
consideration is being solicited or will be accepted, that
an indication of interest made by a prospective purchaser
involves no obligation or commitment of any kind, and that,
if the issuer is required to deliver a disclosure statement
to the prospective purchaser, no sales will be made or
commitment to purchase accepted until five business days
after delivering the disclosure document and subscription
information to the prospective purchaser; and a statement
that, "For more complete information about (name of issuer)
and (full title of security), send for additional
information from (name and address) by sending this coupon
or calling (telephone number)." The advertising may
additionally include a brief description of the business of
the issuer, its geographic location, and the price of the
security to be issued. No other information is allowed in
the advertisement.
Section 25102(n) also allows telephone solicitations, but
provides that the issuer (or someone calling on its behalf)
may not call the prospective purchaser until that issuer
knows that the prospective purchaser meets the definition of
a qualified purchaser. A call made pursuant to Section
25102(n) may cover any topic, as long as the caller does not
make any misrepresentations or material omissions (i.e., a
telephone solicitation made pursuant to Section 25102(n) is
not limited to information that may be included in a
tombstone ad).
This bill proposes to add Section 25102(r), to do two things:
1) authorize the use of general solicitation and general
advertising, which is not limited in the same way as the
tombstone ads authorized under 25102(n), and 2) allow
unsolicited telephone calls (to both residences and cell
phones) to individuals that "the issuer and the caller
reasonably believe, after reasonable inquiry, prior to the
unsolicited telephone call," to be accredited investors (a
lower standard of knowledge than 25102(n) contains for the
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calls it authorizes).
Although sales of securities may be made only to accredited
investors if an issuer uses proposed Section 25102(r) to
solicit funds, issuers may advertise widely and in great
detail about their securities, and issuers may utilize lists
of accredited investors (available for a fee from companies
that market these lists) as their call lists for unsolicited
telephone calls pitching their investments. Although the
standard of knowledge about the person being called is lower
under 25102(r) than under 25102(n), the two sections are
similar in that, once the call is initiated, the topics
discussed on a call are not limited in any way, as long as
the caller does not make any misrepresentations or material
omissions.
3. The Jumpstart Our Business Startups Act (JOBS Act): On
April 5, 2012, President Obama signed the JOBS Act into law.
The JOBS Act was intended to make it easier and less
burdensome for companies to raise capital through securities
offerings. Some of the JOBS Act's provisions became
effective immediately, while other provisions require
rulemakings by the SEC under deadlines that vary from 90 to
270 days following enactment of the law.
The provision of the JOBS Act that is most relevant for purposes
of this bill is Title II of the Act, which requires the SEC
to eliminate the prohibition against general solicitation
and general advertising when issuers conduct private
placements under Rule 144A and Rule 506 of Regulation D.
These rules provide a safe harbor from registration
requirements, under which a company can conduct a private
placement with no dollar amount limitation. Until enactment
of the JOBS Act, an issuer wishing to rely on Rule 506 in
connection with the sale of securities could not offer such
securities for sale by any form of general solicitation or
general advertising. Rule 144A is a similar safe harbor,
which covers the resale of securities to qualified
institutional buyers (generally large institutions with over
$100 million in assets under management)
The changes made by Title II of the JOBS Act will allow
companies to advertise broadly when conducting private
placements, as long as securities are purchased by
accredited investors (in the case of Rule 506) or qualified
institutional buyers (in the case of Rule 144A). The SEC is
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required to promulgate regulations implementing this change
within 90 days of the Act's enactment (i.e., by July 3rd).
Is AB 2081 Still Necessary, Given the JOBS Act? There is no
question that this bill and Title II of the JOBS Act are
focused on the same goal (help small businesses and
start-ups raise capital from accredited investor), and use
similar means to accomplish that goal (authorize the use of
general solicitation and advertising). Yet, because the
regulations implementing Title II have not yet been issued,
it remains unclear precisely how this bill and the SEC rules
will differ.
Some have suggested that AB 2081 is unnecessary, given enactment
of the JOBS Act. A corporate attorney advising the author
(Lee Petillon, the same individual who advised the authors
of the prior legislation listed in the Prior and Related
Legislation section below) believes that the bill is
necessary, despite the existence of the JOBS Act. First, he
asserts that we cannot know what regulations the SEC will
issue to implement Title II of the JOBS Act, nor can we be
sure that those regulations will be issued on time (many SEC
regulations are not). He also asserts that AB 2081 has more
investor safeguards than the related JOBS Act provision,
because AB 2081 imposes a variety of suitability
requirements, including a limit on each 25102(r) investment
to 10% of the investor's net worth, and a requirement that
the issuer reasonably assume that the person being solicited
has the capacity to protect his or her interest in
connection with the offering; the JOBS Act is silent on all
of these topics. He also observes that Section 25102(r)
limits the amount that can be raised to $1 million annually,
while the JOBS Act does not have such a limitation.
As this bill is proposed to be amended by the author (see
Amendments section below), it tracks the language in Section
201 of the JOBS Act, and requires the use of an investor
questionnaire to help in evaluating the suitability of
investments for potential investors. It also contains
suitability requirements, a limit on each investment to 10%
of an investor's net worth, and the investor capacity
requirements summarized above. Although it will be
impossible to definitively compare this bill with the new
federal rule until federal regulations are issued by the
SEC, it appears that, as proposed to be amended, AB 2081
will be at least as protective of investors, and possibly
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more protective than the related JOBS Act provision.
4. Summary of Arguments in Support: Small Business California,
sponsor of this bill, writes that "California small
businesses, especially women- and minority-owned businesses
as well as disabled veteran business enterprises have modest
funding needs, typically less than $500,000 and no more than
$1 million. The average small business owner is not likely
to have a broad circle of high net worth relationships
(business or personal), nor is the business owner likely to
attract an investment banker who has such relationships and
would be willing to engage in raising such modest amounts.
This bill will remove the barrier of small business access
to capital...and provide small businesses with the
opportunity to access a capital source that is not currently
available."
Small Business California also believes that this bill is more
important than ever, given the current financial crisis and
credit crunch. Prior to the economic downturn, small
businesses traditionally relied on bank financing and credit
card debt to fund their working capital requirements, and
were able to tap into their home equity for additional
liquidity. In the current financial crisis, small
businesses face declining business income, reduction in
credit lines, cancellation of credit cards, and loss of home
equity.
5. Summary of Arguments in Opposition:
a. AARP opposes the bill, because it "places seniors
who have saved over a lifetime at significant risk of
losing their retirement savings at the hands of promoters
of risky securities, which would be exempted from the
normal oversight of the Department of Corporations. We
are not at all comforted by the fact that it would apply
to investors with significant assets, as this simply
means that persons who have saved over a lifetime would
be targeted. Successful savers are not necessarily
sophisticated investors. Entities that cannot raise
capital from lending institutions or venture capital
sources should not be turned loose on an unwary public
without the oversight and restrictions that apply under
current law."
b. The Public Investors Arbitration Bar Association
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(PIABA) is a national association of over 400 attorneys
who represent victims of investment fraud and stockbroker
and financial planner misconduct. "On a daily basis in
our practices, we see devastating losses resulting from
violations of investor protection laws and regulations
that govern the securities industry and issuers of
securities. Disproportionately, these losses fall on
elderly and vulnerable savers and investors."
PIABA believes that the proposed exemption eliminates the
proper regulatory oversight necessary to prevent
financial disaster and assure basic fairness to
investors. The organization believes that it is critical
for the types of offerings contemplated by 25102(r) be
qualified with the Commissioner of Corporations to ensure
that what is being advertised is in fact delivered to
investors.
PIABA asserts that enterprises raising capital pursuant to
the proposed new Section 25102(r) will fall into one of
two molds: 1) small or start-up companies that may be
making good faith attempts at building new, growing
enterprises, but which are too risky for investment by
traditional sources of capital; or 2) companies whose key
personnel believe that the real money is made by putting
investment deals together, not by putting years of hard
work into growing the companies after the capital is
raised. "With respect to the former, while finding
capital for those risky but potentially promising
businesses might seem a laudable goal, one might well
question whether business should be permitted to target
the life savings of senior citizens and retirees who
cannot replace the savings they lose. The latter group
are often repeat purveyors of cookie-cutter investment
programs with no societal value. There simply is no
justification for exposing California's seniors, retirees
or anyone else to their sales efforts."
While PIABA takes issue with the entire proposed
subdivision, the bulk of the organization's concerns
hinge on the subdivision's requirement to use general
solicitation and general advertising (a requirement that
PIABA observes is drafted in a very misleading way,
because it seems to suggest that this form of advertising
is authorized pursuant to SEC Regulation D, when in fact
that regulation currently prohibits use of such
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advertising). PIABA's concerns with this provision,
however, do not hinge on the way in which it is
referenced in the bill, but instead on the potential
abuse of such advertising, which includes print, radio,
television, and in-person seminar advertising.
PIABA notes that aggressive advertising is very effective
when directed at nonprofessional investors, who will be
the vast majority of persons solicited using the proposed
exemption. "One's status as an accredited investor is
based primarily on an outdated computation of net worth.
Status as an accredited investor offers no guarantee or
even likelihood of investment sophistication or the
ability to evaluate risky but legitimate startup
ventures, let alone the highly speculative capital
formation programs that will no doubt spring up to take
advantage of the new exemption...Money lost by investors
in these deals as a result of wrongdoing is likely never
to be recovered."
6. Amendments:
a. The following amendments have been agreed to by the
author and sponsor of this bill, to address concerns
about its potential to harm unsophisticated and/or
elderly investors. As noted above, these amendments are
likely to result in a bill that is at least as protective
of investors as the related JOBS Act provision, and which
may be somewhat more protective of investors than the
federal provision (though a definitive comparison of the
two will be impossible until the SEC issues its
regulations). Only the provisions of the bill that are
proposed to be amended are reproduced below:
(r) (1) (A) Any offer or sale of a security by an issuer
using any form of general solicitation or general
advertising as specified in Rule 502(c) of Regulation D
under the Securities Act of 1933 (17 C.F.R. 230.502(c)),
except as provided in paragraph (B).
(B) Any offer of a security made by means of an unsolicited
telephone calls call to a person's residence or cellular
telephone, unless the issuer and the caller take
reasonable steps , reasonably believe, after reasonable
inquiry , prior to the unsolicited telephone call, to
verify that the person is an accredited investor, as
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defined in Rule 501 of Regulation D promulgated under the
Securities Act of 1933, as amended (17 C.F.R. 230.501),
and the transaction meets all the requirements of this
subdivision.
(2) Prior to selling any security to a person solicited
pursuant to this subdivision, an issuer shall obtain from
that person a completed offeree questionnaire in a form
adopted by the Commissioner of Corporations.
Renumber all subsequent paragraphs to reflect the addition
of paragraph 2.
(2) (3) Sales of securities shall be made only to a person
who is, or who whom the issuer takes reasonable steps to
verify is reasonably believes, after reasonable inquiry,
to be an accredited investor immediately prior to the
sale.
(3) (4) The issuer takes reasonable steps to verify
reasonably believes, after reasonable inquiry, that
immediately prior to the sale the offering is suitable
for the person, based on the person's financial status,
objectives, investment experience, time horizon, risk
tolerance, and any other information the issuer deems
relevant to determine whether the offering is suitable to
the person. The issuer shall maintain, for a period of
four years, documentation sufficient to establish the
basis for its determination of suitability.
b. Staff also observes that this bill and SB 978
(Vargas) make different amendments to the same code
section. Double-jointing amendments are necessary, to
minimize the possibility that one bill will chapter out
the changes made by the other.
7. Prior and Related Legislation:
a. SB 875 (Price), 2009-10 Legislative Session:
Substantially similar to this bill. Never taken up by
the author in the Senate Banking, Finance & Insurance
Committee.
b. AB 1644 (J. Campbell), 2001-02 Legislative Session:
Failed passage in the Assembly Banking and Finance
Committee.
AB 2081 (Allen), Page 14
LIST OF REGISTERED SUPPORT/OPPOSITION
Support
Small Business California (sponsor)
Opposition
AARP
Public Investors Arbitration Bar Association
Consultant: Eileen Newhall (916) 651-4102