A few weeks ago, I blogged about whether the SEC’s new rules making Form D filings publicly available will actually (and counter-intuitively) made it easier for a company to stay in stealth mode. In response to that post, I was asked whether, if there is some piece of information that you would be required to disclose in the new Form D that is just too sensitive — for example, if your lead founder is a name personality in your field and their mere involvement with the project will set off bells in the blogosphere — can you just skip the Form D filing entirely and find some other exemption from the registration requirements of securities laws. The answer to this question is tricky because failure to file this form is more than a mere administrative defect and such failure can have real consequences. I will explore this in more detail below the break. As I mentioned previously, all offerings and sales of securities must be either registered with the SEC (i.e a public offering) or exempt from registration with the SEC. The easiest way to ensure that your private offering is exempt from registration is to comply with the SEC’s safe harbor under Reg. D. Unfortunately for stealth mode companies, a central component of the Reg. D safe harbor is the requirement that a company file with the SEC a Form D. Beginning March 16, 2009, all Form D filings will be publicly available online at the SEC’s website. Use of a Form D is only a “safe harbor.” This means that, if you can meet the Form’s requirements, you are assured that you have a valid exemption from registration. One of the basic requirements is that you file your Form D within 15 days after the first stock sale in the offering you need the exemption for. So what happens if you intentionally choose not to file?

SEC 2020

While the rules are not explicit, the SEC has stated that if you fail to file your Form D, you do not automatically lose your safe harbor and your exemption. Regardless, it is one thing to miss a deadline or mistakenly think someone else made the filing and quite another to intentionally choose not to file. For other sections of Reg. D, the SEC allows you to make insignificant deviations from the rules so long as you made a good faith and reasonable effort to comply. Willfully deciding not to file is not a “good faith reasonable effort” to comply with the rules. Also, the SEC has the power to ban you from using Reg. D in the future if you fail to file a Form D. If the SEC believes you are doing this willfully, it is likely to increase the chance that they will impose this ban. In addition, without the safe harbor, you will have to rely on the general “4(2)” exemption from registration. 4(2) seems very broad — it exempts any offering “not involving any public offering.” Unfortunately, it is so broad that it is very hard to know exactly what it means. The SEC refuses to give clear guidance on how to apply the test. In fact, this is precisely one of the reasons Reg. D was created. Moreover, the courts that have looked at this issue have come out all over the map — the US Supreme Court even ruled that an offering to one or two people could be a public offering. Consequently, it is often difficult for a lawyer to give his opinion that you made a successful 4(2) offering. Whether or not you are getting a legal opinion, it is still very important that the company itself feel good that it has a valid 4(2) exemption. This can be exceptionally difficult, especially when there is a large number of investors or when any of these investors are inexperienced in investing or do not have that much money to invest. These are precisely the sorts of people that the courts try to protect — and these are also precisely the sorts of people most start-ups rely on in their friends and family or seed rounds. If your company ends up not working out, these are the people that may seek protection from a court and in hindsight, the court may determine that your offering was not sufficiently private to meet the vague 4(2) standards. Further, it is your responsibility in the lawsuit to prove that you met the terms of this vague standard. In addition, when looking at a 4(2) offering, the court will examine every single person that you made an offer to. This is different than a Reg. D offering where the rules only look at who actually purchased shares. If you made an offer to one illegal person, even if that person did not buy stock, you lose your exemption for everyone in the deal. Also, in a 4(2) offering, some courts require that you give the equivalent of an IPO prospectus to every person you offer shares to. It can be very difficult to prove that every person you made an offer to received sufficient information. So, the next question is, what does it mean if I blow the 4(2) exemption and can’t use Reg. D or some other exemption? The main penalty is called “rescission.” This means that you have to give every investor the right to take his money back. In good times, this is not such a bad thing as most investors will want to leave their money in your company. However, in bad times, this can be a company killer. Further, it is usually when you are having bad times that your investors start bringing suits that claim you did not have a valid exemption for the offering. Even if your company is gone, the unhappy investor may be able to recover his investment directly from the old officers and directors. All of this is in addition to whatever fines and legal penalties the government may be able to bring against you. In conclusion, choosing to stay in stealth mode while also raising capital can be a very tricky choice to make. Prior to the revisions to Form D, there may have been some justification for using a 4(2) exemption instead of Reg. D. However, now that the Form has been revised, in the majority of cases a company in stealth mode will now want to file their Form D and arrange it so that they make the minimum possible disclosures.

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