April 22, 2013
Re: [Release No. 33-9354; File No. S7-07-12]
Who Wants To Be A Startup Investor?
Previous Securities and Exchange Commission rules for investing in startups have created insane market conditions. Only the JOBS Act is currently offering a solution to these problems. Anyone who attacks the JOBS Act on the basis of the belief that it will open the door to massive fraud, particularly the theft of retirement savings from millionaire retirees, must stop making unfounded accusations and instead start to analyze the problems with the current system of capital formation in the United States.
Under the previous rules, startups were not permitted to raise capital from persons with whom they did not have a "pre-existing substantive relationship" regardless of whether those persons were classified as "Accredited" investors. Furthermore, no person was permitted to engage in solicitation or general advertising of unregistered securities Offerings if those actions would result in crossing into Federal jurisdiction. Offerings that do not cross state lines have been, and continue to be, regulated only by State securities law at the option of the issuer (if that makes it easier for the issuer to raise capital) but, strangely, issuers have always had the option of submitting to Federal jurisdiction for Offerings, even if those Offerings only end up selling securities to investors in the issuer's home state. In almost every state there is near-automatic and in many cases cost-free qualification for registration exemption if the issuer submits to Federal jurisdiction, instead of state jurisdiction, by filing a Form D with the SEC and then notifying the state securities regulator of the new Federal jurisdiction securities Offering. When an Offering is conducted pursuant to Federal securities law, state law automatic registration exemptions are afforded priority over state regulation. The core requirement of regulatory compliance is that the issuer not, under any circumstances, solicit or accept funding from anyone with whom the issuer did not already have a "pre-existing substantive relationship"
prior to commencing the securities Offering.
This prohibition on forming relationships with new investors was insane.
It created a system of "road show" introductions where issuers were required to travel to pitch potential new investors in a private and controlled setting, generally with securities lawyers watching over the proceedings. Often times the "road shows" for connecting investors and issuers were hosted by the securities lawyers themselves at their offices. The securities lawyers would then manage the process of qualifying the investors and the issuers for lawful capital formation pursuant to legal loopholes that only they understood. Part of the previous process, a critically-important part, and everyone who has been involved in this old scheme knows this to be true, was for would-be investors to "self-certify" that they are "Accredited" as defined by SEC Rule 501 of Regulation D. For the most part if the would-be investors were not "Accredited" then they weren't allowed to invest, except that in practice nobody paid any attention to this regulation which is why, prior to the IPO of Google, Inc., securities lawyers were required to conduct extensive costly legal procedures to retroactively address the problem of over a thousand early investors who had purchased shares of Google in private offerings without proper qualification, and to remedy the fact that Google had simply ignored the registration requirement of the 1933 Securities Act entirely for years.
"It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things.
Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new. This coolness arises partly from fear of the opponents, who have the laws on their side, and partly from the incredulity of men, who do not readily believe in new things until they have had a long experience of them." – Niccolo Machiavelli
It ought to be remembered that, historically-speaking, compliance with insane laws and regulations has always been optional. Who is the greater fool, I ask you, is it the fool who complies with insane laws and regulations, or the fool who invests in him? Google, Inc. "may have"
violated the Securities Act of 1933 and states' securities laws by, basically, completely ignoring them and doing whatever it wanted.
"Q: Why are we making the rescission offer?
A: Certain shares of common stock issued pursuant to certain of our
stock plans during the period from September 2001 through June 2004 were not registered under federal securities laws and we did not seek to exempt these securities from the registration requirements of these laws. In addition, certain option grants and stock issuances pursuant to certain of our stock plans during this period were not qualified under state securities laws and we did not seek to exempt these securities from the qualification requirements of these laws. Consequently, these option grants and stock issuances may have violated the Securities Act of 1933 and the state securities laws of Arkansas, California, Colorado, Connecticut, the District of Columbia, Georgia, Illinois, Maryland, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Texas, Virginia and Washington. The rescission offer is intended to address these federal and state securities laws compliance issues by allowing the holders of the options and shares covered by the rescission offer to rescind the underlying securities transactions and sell those securities back to us.
The 23,240,668 shares of our common stock subject to the rescission offer are held by 1,105 persons and the outstanding options to purchase
5,592,248 shares of our common stock are held by 301 persons. All of these people are current and former employees and consultants who purchased shares of our common stock pursuant to option agreements or hold outstanding options to purchase our common stock. We granted these options and the options underlying the outstanding common stock subject to the rescission offer between September 2001 and June 2004, at exercise prices ranging from $0.30 to $80.00 per share."
Within the Google, Inc. Rescission Offer is a supplemental note:
"Rescission offers for such potential violations are commonly made by companies in these situations."
In other words, the insane market conditions created by the SEC are so insane that everybody violates the rules and regulations in the normal course of business, and then, if they did not commit fraud and also made enough money so they can afford to do so, pays extra to securities lawyers who commonly file the appropriate paperwork to ask forgiveness.
This process of becoming guilty of offenses and then asking forgiveness for them appears to be the true intended outcome of the 1933 Securities Act politics.
Consider the SEC's previous best effort to create a "seed capital"
exemption to the registration requirement of the 1933 Securities Act:
Rule 504 of Regulation D.
As a former CEO/Chairman of a small California startup that conducted a reverse merger with a fully-reporting, registered, NASDAQ OTCBB-listed "shell company" in order to become publicly-traded as a 1934 Exchange Act-compliant company without the time and expense imposed by the conventional IPO process, I have had the opportunity to work with securities lawyers and investors to form capital in full compliance with all applicable state and Federal regulations. As a result of this experience I am aware that securities lawyers frequently make mistakes.
Many times the mistakes are innocent and a pure result of accident and circumstance. Other times the mistakes are intentional, and the securities lawyer does nothing of value for anyone but nevertheless generates substantial income for themselves by operating an "opinion mill" whereby they churn out baseless legal opinions for countless clients and mislead clients into believing that they are complying with securities law and regulations.
After extensive research, including reading all of the SEC's website content relating to small business capital formation and studying case law and reading legislation including much legislative history to understand the intent behind all the complex rules and regulations, I arrived at the conclusion that the SEC's "seed capital exemption" known as Rule 504 was the appropriate method of raising capital, up to
$1,000,000.00 per year, for a small company issuer. See:
When the SEC was working to amend Rule 504 the "Seed Capital Exemption"
in 1998, I was 24 years old and did not know how important free, unfettered access to seed capital was to a successful business. At the time I was already a somewhat-experienced startup co-founder but my startups had not achieved more than providing me and a couple dozen other people with temporary jobs as freelance tech workers in the midst of a booming hi-tech investing bubble (when all of us would have been better off going to work for Google!). My third ...For Dummies book, "Setting Up An Internet Site For Dummies" had already been published, and I was attempting to raise capital for a variety of valuable new businesses including an Internet payment solution (similar to PayPal) which I called payforit.com and which was providing valuable e-commerce payment processing services to customers. I submitted provisional patent applications and reinvested all of the money that I was earning from my freelance programming and technical services, including computer forensics expert witness services, plus all of the money that I received from writing computer books, for the singular objective of helping my startups grow. When I attempted to grow my startups without capital everyone involved, and my family, simply suffered. The only thing that would have made a difference for me was access to capital. This point is best illustrated by the fact that long before PayPal was launched, my company was being told by Wells Fargo Bank and others that the only way we would be permitted to do what PayPal did as a business model was if we deposited $1,000,000.00 in cash in our merchant account and agreed to leave it there to protect the bank in the event of fraud or chargebacks from our customers. Without capital I was unable to do this. If I had access to capital between 1995 - 2001 then my startups would likely have achieved big things.
By the time I discovered Rule 504, in 2007, and followed the legal advice and the procedural requests of investors and securities lawyers, the "Seed Capital Exemption" had already become the playground of scam artists and pump-and-dump boiler rooms systematically exploiting the ability of market makers and market participants in the secondary markets to manipulate market prices illegally. People told me that only crooks used Rule 504 to raise capital. As any good innovator must, I ignored the naysayers.
What my foray into raising capital with the SEC's "Seed Capital Exemption" showed me was that there were, in fact, a number of professional investors who offered seed capital to literally anybody who was able to bring a company public in the United States. These professional investors have varying degrees of ethics and a range of reputations, and I diligently interviewed and researched and checked references of these investors in an attempt to verify that they were offering a lawful, legitimate path to seed capital formation for a public startup. Not long after raising a small amount of test capital from the best, most reputable of these Rule 504 investors, the independent legal counsel who facilitated the transaction and issued the legal opinions upon which it was based was charged by the SEC with operating an illegal "opinion mill" in which he failed to verify that the investors were complying with regulation.
Specifically, the buyers in a Rule 504 Offering must be purchasing the shares as a true investment, not for the purpose of immediate resale to other investors. The investor must be taking an investment risk by their act of investing, they must not be acting as a hidden underwriter in an initial public offering of unregistered securities. In the instance of the Rule 504 securities offering that we transacted, there was no indication at all that the investor violated the spirit or the letter of Rule 504 and I believe to this day that the investor did not violate Rule 504. The SEC never informed me that the securities lawyer who was involved in our transaction did anything wrong in connection with our particular Offering, though clearly the SEC charged that securities lawyer with violating Rule 504 in connection with numerous other issuers' and investors' transactions.
In studying the "Seed Capital Exemption" and attempting to utilize it in practice another thing that I found was that the SEC apparently did not prohibit, by Rule or by way of interpretive guidance, and no legislation appeared to prohibit, a short-seller from accumulating a short position in an issuers' shares and then contacting the issuer offering to "invest" in the issuer at a substantial discount to the market. By purchasing shares from the issuer to offset the short position held by the short-seller, the investor is able to close out the short position at a much greater profit than they would realize through the market.
Because the "investor" is not distributing the shares in violation of underwriter regulations, these short selling investors apparently believe that there is nothing improper or illegal about their business model.
My extensive research and real-world practical experience with these matters leads me to believe that short selling serves a very important and legitimate business purpose and that it should be possible for short sellers to borrow and sell securities, even securities of non-reporting public issuers, and even of public startup companies, on the condition that they do not violate Regulation SHO. Naked short sales are a much more problematic issue, and it appears to have been naked short sales that were primarily at work in short seller Rule 504 transactions in the past. Not all of that market activity ended when the Regulation SHO provisions made it more difficult to do, legally, perhaps because not all of the buyers and sellers who were exploiting the Rule 504 "Seed Capital Exemption" ever tried to comply with law.
The SEC has, through its insane rules and regulations, created a systemic fraud. The systemic fraud is commonly known as "The United States Securities Market." Instead of being allowed to initiate contact with potential investors with whom an issuer has no pre-existing substantive relationship, issuers are required to jump through insane hoops OR TO IGNORE THE RULES ENTIRELY in order to raise even small amounts of capital from people outside of their immediate friends and family relationships.
It is nice that the SEC does not make it illegal for friends and family investors to invest, although SEC does limit the number of non-Accredited investors who are allowed to invest in a securities offering so that more than a few dozen non-Accredited investors are currently impossible to achieve, legally. But it is absolutely intolerable, outrageous, and unforgivable that the SEC has allowed venture capital firms and other wealthy investors to violate Federal securities law, such as by investing in Google pre-IPO.
When an investor contacts an issuer, unsolicited, as the groups of professional Rule 504 investors were routinely doing prior to Regulation SHO, and still do today maybe to a lesser extent, those professional investors are doing what the SEC expressly wanted: seeking out investing opportunities in companies that are trying to build a loyal investor following through the public markets and offering unsolicited capital to those companies – capital that they may not have had access to otherwise without engaging in active solicitation and general advertising of new share Offerings. Congress wanted to prohibit issuers from general solicitation and advertising of Offerings, preferring that investments be made unsolicited in the case of professional investors and only among friends and family in the case of solicitations, and that is precisely why the 1933 Securities Act was legislated into existence in the first place.
Because the SEC lost sight of its own place, and its purpose, in the system of regulation that was born of the anger and retaliation against securities issuers who "caused" the stock market crash of 1929, the system of market regulation that it has created is being ignored by everyone who succeeds. There is no punishment, other than being forced to pay securities lawyers extra fees to seek forgiveness, when an issuer violates or ignores Federal securities regulations, and everyone (except 24-year-olds who are trying to build successful businesses) knows this.
The SEC has no authority to do anything to people who are not engaged in fraud or deception, even when they have successfully raised capital only by violating securities law such as by engaging in illegal Offerings.
The political power of enforcement of Federal regulations has, historically, been reserved for those whom the Commission wishes to punish after-the-fact for failing to make a profit for investors. Anyone who is smart and wishes to defraud investors knows that the Commission cannot take action against them at all if the proper forms are filed so that Offerings are conducted in reliance upon "Safe Harbors" established by the Commission. Thus, over time (or perhaps by its original intent under the first Chairman Kennedy in 1934) the Rules and Regulations promulgated by the SEC from Federal securities legislation have become a tool that allows the government to remove stupid malicious white collar criminals from the market while empowering the smart malicious white collar criminals to grow wealthy and influential within it.
Short sellers must be protected and permitted to engage in lawful risk-taking within this market. The SEC and the Federal legislators have created a massive systemic fraud, pretending that it is a level playing field and a free market economy when it clearly, obviously is neither.
If the SEC does not allow short sellers to conduct lawful business within the SEC's fraudulent market, then there will be no limit at all to the scale of fraud and abuse that the rest of the market participants engage in with SEC support.
I propose that in addition to allowing anyone to offer to sell securities to anyone else, the SEC must also allow anyone to short-sell securities, issued by anyone else, to anyone who will buy the securities.
The only compliance requirement for such short-sales of third-party unregistered securities should be full compliance with every aspect of Regulation SHO. No short-seller should be allowed to engage in unlimited naked short selling and all "fail to deliver" conditions should be cured in compliance thereof.
Naked short-sales of unregistered securities require strict regulation and oversight, but they should be available to anyone who is willing and able to comply with regulation. This is different from the issue that is raised by fraudulent offerings of "pre-IPO" securities, such as in this case involving Facebook:
Nobody who sells securities with the expectation (and hope) that the market price will fall should be accused of wrongdoing or be lumped in with criminals who sell things that they know to be worthless.
When the Commission implements rules allowing general solicitation and advertising of Rule 506 Offerings, and later implements rules allowing limited public marketing of unregistered securities in crowdfunding transactions pursuant to the JOBS Act, the Commission should acknowledge that it has no choice but to create a "free market" through regulation and that this means "free, as in freedom" not "free, as in price." All natural persons should be free to offer and sell securities, honestly, provided that they are not engaging in fraud or deception thereby. All corporate persons should be less free especially insofar as the corporate persons are already wealthy, powerful, and well-connected. The people who need freedom granted to them by the government, or by the SEC, are the people from whom freedom was removed, by Rule, between 1933 and 2013. The people who already have unfettered freedom to do whatever they want, because they already have an inexhaustible supply of money, should not be given the ability to get more of it, for free. I suggest that this axiom guide the Commission in its Rulemaking.
Co-Founder and CEO
Public Startup Company, Inc.