The SEC is getting closer to allowing companies, in particular start-ups, to raise money through so-called "crowdfunding." In crowdfunding, even small, non-accredited investors can make small investments in start-ups or other similar companies without the companies needing to register their securities. The Commission voted last week to send preliminary rules out for comment. Under the proposed rules, investors with incomes and net worth under $100,000 to invest up to 5% of their incomes, and persons with higher incomes up to 10%. Companies would be limited to raising $1,000,000 -- but importantly, companies raising over $500,000 would be required to supply investors with annual audited financials. The new rules require that companies ask investors about income and net worth but no verification is required. While the new rules will open the doors to start-up investing to a much larger segment of the population and allow easier means for companies to raise capital, the new funding mechanism may also provide opportunity for fraud and perhaps rampant litigation when crowdfunded start-ups fail -- as most start-ups ultimately do.
Brown, Neri, Smith & Khan LLP Blog
As we noted recently, the SEC has been looking closely at companies raising money through the EB-5 investor program under which foreign investors can obtain a Visa for residence in the US if the investor makes qualifying investments in the US. We noted here recently that the SEC earlier this year brought its first enforcement action against parties who raised money through the EB-5 program. Anecdotal evidence suggested that the SEC was looking closely at a number of other companies that had used the EB-5 vehicle. Now, the SEC has brought another enforcement action against some individuals and related energy companies in Texas for allegedly perpetrating a scheme to defraud foreign investors through the EB-5 program. This action further evidences that the SEC is here to stay in the EB-5 area. Companies using the EB-5 vehicle to raise funds must comply carefully not only with rules and regulations on the immigration side but also on the securities side. Even very legitimate companies raising EB-5 funds may see some SEC scrutiny to ensure they are in compliance. It is imperative that companies seeking to use EB-5 to raise funds employ qualified transactional counsel at the outset, and, if the SEC comes questioning, be prepared with securities litigation counsel to quickly and accurately respond to the SEC's inquiries.
In August, Phil Falcone, billionaire hedge fund operator of Harbinger Capital Partners, agreed to an $18 million settlement with the U.S. Securities & Exchange Commission. The case isn't so significant for the specific allegations of wrongdoing asserted by the Commission against Falcone. Rather, the case may signal a major change in the SEC's settlement position in high profile cases. In July, Falcone negotiated a settlement with the Staff that called for the same financial remuneration as the August settlement, but did not include an admission of wrongdoing and included only a two year ban from starting a new hedge fund. Commission Chairman Mary Jo While, in an unusual move, rejected the Staff's recommended settlement as too lenient. Historically, recommendations by the Staff are rarely rejected by the Commission. The new settlement, approved by White and the Commission, included an admission of wrongdoing and a broader five year ban on work in the securities industry. The questions raised by the settlement are (1) does the settlement suggest the SEC will demand more in settlement going forward? (2) will admissions now become a deal point that the SEC demands in settlements regularly? (3) if so, when will admissions be required? (4) will longer and broader bans from participation in the securities industry become more common? The admission issue in particular may be a major stumbling block for settlements because it may leave the settling defendant largely defenseless in parallel private civil litigation in many cases.
This week, the Second Circuit issued a very significant ruling regarding the time period during which securities cases must be brought. In Police and Fire Retirement System of the City of Detroit v. IndyMac MBS, Inc. (http://www.ca2.uscourts.gov/decisions/isysquery/2d3ab723-2344-425c-9bf5-139f44ee9197/1/doc/11-2998_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/2d3ab723-2344-425c-9bf5-139f44ee9197/1/hilite/), the Second Circuit held that so-called American Pipe tolling does not apply to the statute of repose for filing claims under the Securities Act of 1933. Specifically, the Securities Act requires that civil claims brought thereunder must be filed within one year of plaintiff's discovery of the claim or within three years of the offering at issue, whichever occurs first. The Second Circuit held that the three year period is a hard limit not subject to a well accepted form of tolling, so-called American Pipe tolling. In American Pipe, the Supreme Court held that statute of limitations for the claims by class members is tolled -- it does not run -- while a class action purporting to advance those claims is pending. Otherwise, putative class members might be forced to file individual claims while waiting for class certification; otherwise, if class certification were denied, it might by then be too late for individual class members to file individual actions. The Second Circuit held that the three year repose period under the Securities Act is so strict that this American Pipe tolling rule does not apply to it.
While technical and perhaps esoteric, the no tolling rule as significant implications. In the IndyMac case itself, plaintiffs failed to include a named plaintiff for each and every one of the over 100 securities offerings at issue. Accordingly, the claims with respect to offerings for which there was no named class representative were dismissed. Absent the statute of repose, this problem would be easily remedied; plaintiffs would simply add class representatives for the additional offerings. But, by the time of the ruling the three year statute of repose had run and the pendency of the class action the Second Circuit held did not extend the time period to file.
More common application of this rule may come in the form of opt outs. Often, institutional and individual plaintiffs will remain part of a putative class action to see how the class action will proceed and how favorable a settlement might be. If unsatisfied, the institutions or individuals can "opt out" of the class and file individual actions. It is now clear that these would-be individual plaintiffs will have to opt out and file an individual action before the three-year statute of repose runs. Accordingly, this new rule will impact opt out decisions and timing.
The rule will also almost certainly not be limited to Securities Act claims. The more common securities claims under Section 10(b) of the Securities-Exchange Act and Rule 10b-5 are subject to a functionally identical five year statute of repose. Therefore, this same rule will apply to Exchange Act claims.
Finally, the rule may also apply to other forms of tolling, possibly even contractual tolling agreements. This ruling calls all forms of tolling into question with respect to the statutes of repose applicable under the Securities and Exchange Acts. Plaintiffs will sometimes agree not to name certain defendants in exchange for a tolling agreement in the event that later discovered facts reveal a compelling reason to add that defendant. Such agreements may be ineffective after the statute of repose date.
In sum, this decision will give defendants opportunities to argue that certain securities cases are time barred. More importantly, perhaps, it will force plaintiffs to make more rapid decisions on class certification, opting out and other critical decisions in the life of securities actions.
In Gabelli v. Securities and Exchange Commission (http://www.metnews.com/sos.cgi?0213//11-1274_aplc), the Supreme Court unanimously applied a hard five year statute of limitations to the SEC's ability to impose civil penalties on defendants. The SEC tried to apply the so-called "discovery rule" to toll the limitations period until the wrongdoing was discovered. The SEC contended that the discovery rule should be applied in cases of fraud. The Supreme Court rejected that view, holding that the limitations runs from the date of the act constituting the wrongdoing without exception or extension. This result is beneficial to defendants because it precludes the SEC from seeking to impose civil penalties to any conduct occurring more than five years before the SEC files suit.