Crowdfunding Update- SEC Adopts New Rules for Investments under Reg A+

Crowdfunding is going to continue to explode in the near future. On March 25, 2015, the SEC adopted new rules to implement the provisions of the JOBS Act and Regulation A surrounding raising capital up to $50 million by smaller companies and, most likely, raise that money online on their websites or through social media. (The rules don’t go into effect until 60 days after they are published in the Federal Register and here is a copy of the rules and the SEC Press Release).  The new changes have been called “Regulation A+” and hailed by many as significant improvements in giving smaller companies more access to capital.

There are requirements for certain disclosures and filings with the SEC as well as registration of the websites with the SEC as funding portals like a securities “broker-dealer.”  There are also tiers for the companies that depend upon factors like the amount of money raised and state what the requirements will be for each tier.  The end result is that you are going to see much more investment opportunities on the internet and social media geared towards everyday consumers without the requirement that they be classified by higher wealth or income as “accredited investors”, so caveat emptor and let the buyer beware!

For those who aren’t sure, what exactly is “Crowdfunding”?  Most of the discussion in this area involves securities laws.  When a company needs to raise money, they may offer an investment in the company by way of stock, LLC units, convertible debt, or other investments.  These are all securities covered by US and State law and regulated primarily by the US Securities and Exchange Commission.  The company does not need to be a publicly traded stock like a Facebook or Microsoft to worry about the SEC and state regulators.  Any company or person offering or selling stock or other “security” can be subject to regulation.  When companies want to raise capital without the expense of registering their stock with the SEC, they rely upon exemptions from registration.  Most of those exemptions limit companies to seeking investors who meet the definition of “accredited investors.”  These are basically people with over a $1 million net worth or whose income is over $200,000.  Smaller investors are often kept out of these investments by rules designed to protect them assuming that they don’t have the financial savvy to protect themselves.  Crowdfunding is an effort to raise money for a company or a cause from a large number of investors each investing a small amount of money.  It was difficult to use crowdfunding to seek investors for a company if you were limited to only finding “accredited investors” and fall under an exemption from registration.  The provisions of the JOBS Act and the rules that the SEC is issuing are meant to expand access to capital for smaller companies.  Part of the provisions of the JOBS Act were to allow and expand the use of crowdfunding.  Instead of a company raising $250,000 by seeking $25,000 each from 10 accredited investors, the company will now try to raise $250 each from 1,000 regular investors.

It is hard to know the future impact of crowdfunding and the JOBS Act’s attempts to increase access to capital due to many possible areas for possible fraud or misleading of investors.  It looks like the SEC is going to keep a close eye on this topic and they are taking years to be sure the rules implementing the JOBS Act from 2012 cover all possible problems.  We will have to wait and see the impact, but it seems like many smaller companies will be able to gain access to previously difficult to obtain capital.

Business Owners Beware: Document Loans to Your Company or Else- Trends in Debt vs. Equity

Asset Protection Attorney Alert:

Have you ever loaned money to your own company?  Have you ever loaned money from one company to another?  Do you have written loan agreements in place?  Do your accounting records properly document the amount owed, transfers made, regular payments, and accruals of interest? Courts are coming down on these types of arrangements.

It is all too familiar to see when it comes to small and closely held businesses.  The owner puts some of his or her own personal funds into a company or transfers money from one company to the other to cover expenses for that company.  Most owners don’t think twice about it since they don’t have many other shareholders to consider or seek approval from.   Rarely do we see clients who come in who have entered into those kinds of deals that present documented loan agreements or any kind of records, but they think “it’s my company, so it doesn’t really matter” or “I am not publicly traded with the SEC or a big board of directors watching, so who cares.”  What they may not realize is that it can end up hurting the company or the shareholder down the road and, in some cases, in a pretty drastic fashion.

Several recent court cases have emphasized just how much not documenting loans can hurt a company.  Most of these arise in the bankruptcy context, but can be applied to regular state law claims related to loans, which can affect nearly anyone.  Even a minority shareholder could try to use these principles to his or her advantage to avoid loans the company owes to a majority shareholder.

The cases involve an extension of the bankruptcy court’s powers when it comes to debts.  A bankruptcy court has broad equitable powers under Section 105 of the Bankruptcy Code to make changes to carry out a bankruptcy.  On March 4, 2014, the US Supreme Court in Law v. Siegel issued an opinion that put a few restrictions on the recent expansion of those powers, but the concerns for business owners are still there and it is clear that the bankruptcy court’s use of those powers is still valid.

Since this ruling, a bankruptcy appeals panel has held that Law v. Siegel does not go so far as to ban a bankruptcy judge from recharacterizing debt as equity, which is more relevant for business owners.  The case of In Re: Alternate Fuels, Inc. was decided by the 10th Circuit Bankruptcy Appellate Panel on March 18, 2014 finding that loans by a shareholder to the company were equity and not a loan, despite the ruling in Law v. Siegel.

The facts of other recent cases are similar in that the court eventually converted what was claimed to be debts owed by the company to a shareholder/owner into equity.  The shareholder would put money into a company and then claim the company was required to pay it back and make a claim in the bankruptcy court to get paid back.  The courts have found that some of these so-called “debts” were really equity investments by the owner into the company with little to no value.  In a bankruptcy liquidation, if there are assets available, the assets are distributed according to priority to certain liabilities and if all liabilities are paid, then what remains gets distributed to equity holders/owners.  In a bankruptcy repayment or reorganization, such as is common in Chapter 11, the debt holders get paid off over time, but the equity holders do not receive payments.  When the court says that someone with a debt really invested equity and converts it into equity, they are saying that in most cases, that person is out of luck and will probably not get anything.

The cases look to the elements reviewed by state courts when analyzing whether a transfer of an asset could be considered a fraudulent transfer to avoid creditors.  If there is no transfer for something of reasonably equivalent value and there is no real obligation to pay the loan back, it could be considered fraudulent resulting in the loan not being allowed as a legitimate claim and an unwinding of the transaction.  This could result in a company or shareholder loaning money to another company he or she owns and losing that money.

Additionally, these loans have an impact in the context of asset protection planning.  For example, say John Q. Shareholder owns 2 LLCs: Bad Credit, LLC and Money Maker, LLC.  Bad Credit, LLC defaults on some loans and gets sued by a bank.  The bank gets a judgment against Bad Credit, LLC, but learns that Bad Credit, LLC would frequently pay for expenses of Money Maker, LLC.  Mr. Shareholder saw nothing wrong with this and even used one bank account to receive income and pay expenses for both LLCs.  The bank will go to court and try to collect against Money Maker, LLC and Bad Credit, LLC arguing that they are really not different companies due to the commingling (sharing) of assets.  Mr. Shareholder will try to claim the expenses paid by Money Maker, LLC were just loans to Bad Credit, LLC, but when it comes time to prove they are loans, he fails.  The court decides that the two LLCs with common ownership, similar bank account, and shared expenses are really just one company and the bank can go over both LLCs for the debt.  Or even worse, the bank says that both LLCs are really nothing more than Shareholder’s alter ego and the bank can now collect against Shareholder personally.

So what can be done?

A court is more likely to find a valid and enforceable loan when there is a well drafted written loan agreement in place and it is actually treated like a real loan.  This could be an inter-company loan agreement, promissory note, revolving credit line agreement, or other debt document.  The loan has to be for reasonably equivalent value to what is being provided and actually have terms that could be enforced.  If there are regular payments due, those must be paid and documented.  If there is interest due (which there should be at least some minimum amount provided for), it should be regularly accrued and put on the company’s books or accounting records.  These are just some of the actions that need to be taken to protect those dollars you lent to the company.  The more a court would view the arrangement as similar to what a bank or some other outsider lending money would put into place, the more likely the court would enforce the loan or keep liabilities separated from the owner or other companies.  It is also highly recommended to avoid commingling (sharing) funds or bank accounts between companies or owners, but I realize that the day to day needs of a company may not allow that kind of requirement to be kept.  If you have an LLC or corporation, be sure you have a separate bank account in that company’s name and try not to run any personal expenses through it.

A little planning can avoid courts turning your loan into worthless equity or making your personal assets vulnerable to creditors. Avoid these situations altogether with valid legal loan agreements, documented accounting, and segregated accounts and funds, so business owner beware!