June 29, 2014

Crowdfunding Law Made Simple

photo by Twose
One of the topics I am often asked about these days, and one of the subjects that even smart, well-informed people seem to be most confused about, is "crowdfunding."  It seems appropriate, therefore, to offer a basic, high-level summary of the topic here on the N.C. Business & Banking Law Blog.   

Is crowdfunding just a bunch of hype?

Crowdfunding is a Really Big Deal.  Entrepreneurs and owners of businesses with growth potential have historically found it somewhat difficult to access the money that individuals and institutions have accumulated and want to invest without going through traditional gatekeepers (i.e., Wall Street).  This is largely because federal and state securities laws have limited their ability to raise investment capital from anyone other than well-to-do people in their immediate sphere of influence (in SEC-speak, "nonpublic offerings" to "accredited investors").  Most inventors and entrepreneurs do not have enough high net worth friends and business associates to raise large amounts of capital.  The securities rules were designed to protect investors that Congress or the SEC deemed vulnerable, but they had the unfortunate consequence of hampering the efficient flow of investment dollars.  However, recent changes to securities laws (including crowdfunding) are making it much less burdensome to borrow money or raise equity capital.   Crowdfunding will make it possible to raise investment money from virtually anyone.

What does the JOBS Act of 2012 have to do with crowdfunding?

The federal JOBS Act (Jumpstart Our Business Startups Act), enacted on April 5, 2012, required the SEC to write regulations to implement many of its various provisions.  More than two years later, the SEC has not yet finalized rules to implement Title III of the JOBS Act, known as the "crowdfunding" section of the law.  The JOBS Act also called for a new Rule 506(c) to allow a similar method of raising capital, but with important distinctions, which are covered below.

So what exactly is crowdfunding?

Many (perhaps most) of the media and many others who are unfamiliar with the JOBS Act have been referring to multiple methods of soliciting and raising investment as "crowdfunding."  This is often incorrect.  People are using the term to describe a number of different capital-raising methods, only two of which are actually crowdfunding.

Most people are familiar with websites like kickstarter.com and indiegogo.com that allow inventors and entrepreneurs to raise money for new products and services.   These sites existed before the JOBS Act and are unaffected by securities law because no equity or debt is being offered or sold.   People who contribute to campaigns on these websites usually have some personal affinity for the cause or an expectation of receiving the product or service if a sufficient amount of funds are pledged to enable the project to be completed.  Basically, this is not crowdfunding. The important thing to know about these websites, however, is that they demonstrate how popular actual crowdfunding sites are are likely to be, and they are probably the models on which crowdfunding sites will be designed.

Crowdfunding is offering and selling securities to the crowd, by which I mean both accredited and non-accredited investors.  (Accredited investors are essentially those who have $1,000,000 in assets, excluding equity in their primary residences, or $200,000 in annual individual income. Congress and the SEC think that accredited investors are less vulnerable to fraud.)   The crowdfunding rules the SEC proposed in July 2013 (in response to the JOBS Act mandate, but which are not yet final nor effective) will allow people to sell up to $10,000 of debt or equity to each individual as long as they do not raise more than one million dollars in a 12-month period. The SEC's leadership and staff are widely believed to be philosophically opposed to the idea of crowdfunding, and they seem to be attempting (i) to delay finalizing rules and (ii) to make the process difficult.  (The SEC believes that crowdfunding will result in widespread fraud and that the victims will be among society's most vulnerable.)

What is a Rule 506(c) public/private placement?

Another new legal avenue for fundraising that is not actually "crowdfunding" involves the process allowed by new SEC Rule 506(c), which--as mentioned above--the SEC was required to create by the JOBS Act.  Rule 506(c) allows businesses to offer securities to the general public and raise unlimited investment with relatively low compliance costs, provided they sell only to "accredited investors" who have been reasonably verified as such.  Rule 506(c) is very attractive because of the ability to publicly advertise the offering using social media, investing websites, newspapers, magazines, television, radio, and--someday soon--crowdfunding websites.  In the months since Rule 506(c) became effective in October of 2013, billions have already been raised using its provisions. 

What about single-state crowdfunding?

Largely due to frustration at the SEC's foot-dragging, some states have enacted crowdfunding laws to permit limited offerings to investors in certain states without complying with the SEC's more burdensome rules.

A bill (the NC JOBS Act, or House Bill 680) was introduced in the North Carolina House of Representatives in April 2013 to permit intra-state crowdfunding.  After a couple of rounds of amendments, it was passed by the House in June 2013 by a 103-to-1 margin.  The bill now sits in the Senate Commerce Committee, which along with the Senate Finance Committee, must approve it before the full Senate can vote.

The NC JOBS Act would create an exemption from North Carolina's securities registration requirements for offers and sales of securities (also known as the Blue Sky Law) that meet certain criteria.   The requirements of the current version of the proposed crowdfunding provisions include the following:

  • The offering must meet the requirements of the federal exemption for intrastate offerings under Section 3(a)(11) of the Securities Act of 1933.
  • The issuing entity must be organized under the laws of North Carolina (no out-of-state entities).
  • All purchasers must be residents of North Carolina.
  • No more than one million dollars can be raised in 12 months, unless prospective investors have been given audited financial statements, in which case the limit is two million dollars.
  • No more than two thousand dollars can be received from a non-accredited investor.
  • A notice filing with the Securities Division of the Secretary of State's office.
  • An offering circular must be provided to prospective investors and to the Securities Division.
  • Risk disclosures and certifications.
  • Website registration requirements.
  • A bank must act as escrow agent for investment funds collected during the offering period.
  • Officers and directors of the issuing entity cannot receive commissions on sales of securities unless they register themselves as a "dealer" or "salesman."
  • Quarterly reporting to investors.
As you can see, the North Carolina crowdfunding proposal is more restrictive than the SEC's proposal. 

(To better understand the interplay between federal securities laws and state securities laws, see my article here, which was first published in 2008 by WRALTechWire.com, but note that it is now out-of-date.)

More information is available.

This has been a brief summary of some key points relating to crowdfunding, but there is much more that I have not covered in this article.  I have done a little bit of speaking, writing, and tweeting about crowdfunding, but my law partner Jim Verdonik knows more about it than anyone I know.  He has written about it on his blog, Entrepreneur Intersection, and in the Triangle Business Journal.  If you're interested in hearing more about crowdfunding, or have a group that might be interested in having me or Jim speak, please let me know.

June 25, 2014

It's Getting Easier to Borrow from a Bank

It's getting easier to borrow money from a bank, according to reports from the Office of the Comptroller of the Currency, the North Carolina Bankers Association, and the American Bankers Association

Banks are easing loan terms to stay competitive as creditworthy borrowers are becoming more common. Here are seven ways bankers are loosening credit criteria, according to the cognoscenti:
 - Longer Amortization: Banks are extending the term of loans to as much as 25 years, thereby lowering borrowers’ monthly payments.  This increases the lender's exposure to risk and ties up capital.

 - Limited Guarantees: Some banks are the amount subject to a personal guarantee.

 - Extending the Duration of Fixed-Rate Loans: Some banks are extending the term of fixed-rate loans, especially on commercial equipment. (Of course, longer terms at today's low rates could spell trouble for banks if the Fed raises rates quickly, as noted below.)

 - Higher Leverage Ratios: Lenders are tolerating higher loan-to-value ratios, in some cases up to 80%.

 - Lower Debt-Service Coverage Ratios: Some banks are reducing the debt-service coverage ratio, though regulators would like to see them raised.  (One bank lost out on the opportunity to make a seven-figure commercial loan because another lender was willing to waive all debt service coverage requirements.)  The OCC reported today that the average total-debt-to-EBITDA ratio rose to 4.7, the highest since 2007. The OCC believes that covenants should be imposed on companies in most industries that limit this ratio to six times EBITDA.

 - Relaxed Collateral Requirements: Some lenders are lowering collateral requirements on commercial real estate loans by lowering the required cap rate.

 - Fee Waivers: Banks are reportedly more willing to waive or lower fees.

The relaxation in lending standards prompted the Office of the Comptroller of Currency to issue a report today warning of an "erosion in underwriting standards."  The OCC is concerned that banks have taken on more risk than is prudent.  Key conclusions in the report include the following:
  • Competition for lending opportunities is intensifying.
  • Lenders are loosening underwriting standards, particularly in indirect auto, leveraged lending, and other commercial loans.
  • Banks that extend loan maturities could face significant problems depending on the severity and timing of interest rate moves by the Federal Reserve Board. 
The Wall Street Journal reported today that "so-called covenant-lite leveraged loans, which have fewer protections for lenders, totaled $258 billion in 2013, nearly equal to the total amount issued between 1997 and 2012." 

Conclusion:  This is good news for borrowers, but may signal an escalation in already-intense competition among lenders and further regulatory scrutiny for banks.

Sources: American Banker, NC Bankers Association, WSJ, and OCC.

June 22, 2014

Is Bank Account Applicant Screening the Next Target?

For obvious reasons, banks are reluctant to do business with customers who are more likely that most to commit fraud or fail to pay their bills. In fact, federal banking statutes and regulations require banks to perform due diligence on new customers. (These are often referred to as the "Know Your Customer" rules, among other terms.) Many banks use background screening services to review potential customers’ history of fraudulent activity, writing worthless checks, and similar activities that banks prefer to avoid. When banks learn that a prospective customer appears to present a heightened credit risk or fraud risk, the bank often denies the account application. ChexSystems, a subsidiary of FIS, is one of the major providers of these background screening services, as are Early Warning Services, Certegy, and Telecheck.

Some government officials are now complaining that these screening measures disproportionately affect low-income customers, penalizing them for relatively minor mistakes and forcing them to resort to high-cost "shadow banking" financial services rather than more affordable traditional banking services.

Last week, New York's Attorney General announced a voluntary agreement with Capital One under which Capital One will continue to use ChexSystems to screen customers for fraud, but will not use it to evaluate whether the customer would pose a credit risk. The Attorney General said the agreement is part of an ongoing investigation by its Division of Social Justice in the Civil Rights Bureau and the Division of Economic Justice in its Consumer Fraud Bureau into banks’ use of customer history databases. As part of the agreement, Capital One also agreed to "donate" $50,000 to the Office of Financial Empowerment, a New York City agency that provides financial education and counseling to low-income residents. The changes to Capital One’s policies will be implemented nationwide.

The Consumer Financial Protection Bureau has also investigated these services (and further action may be coming).

One takeaway from these developments is that some powerful government officials view a bank account as a civil right, and they have enough power to pressure even a large institution like Capital One into submission. 

(c) photo of New York City by Matt Cordell

Remarks on the 60th Anniversary of the Young Lawyers Division of the North Carolina Bar Association

By request, below is a copy of the remarks I delivered at the North Carolina Bar Association's 2014 Annual Meeting to commemorate the 60th anniversary of the Young Lawyers Division:

Matt Cordell speaks about the history and values of the NCBA YLD
while outgoing chair Clark Walton awaits the passing of the gavel.
Photo by Cabell Clay

Remarks on the 60th Anniversary of the Young Lawyers Division of the North Carolina Bar Association

by Matthew A. (Matt) Cordell

This Annual Meeting of the North Carolina Bar Association marks the 60th anniversary of the Young Lawyers Division, which is an occasion worthy of taking a brief moment to commemorate. 
The YLD was established in 1954 as the "Junior Bar Section" under the leadership of Charles Blanchard.  Its membership was small—only 5 lawyers, as best we can tell from the available records.  In the beginning, it was primarily composed of male lawyers in their twenties returning from military service overseas.  Its original mission was "to promote and carry out the programs of the Association and to improve the administration of justice."  Over time, the Junior Bar Section grew, and became known as the Young Lawyers Division in 1981.  The YLD has continued to grow in the 33 years since, and we now number 6,451.
From its inception, the YLD has been recognized as "the service arm of the Bar Association." It is the source of many of the Association's service initiatives, and has provided an enthusiastic workforce to carry out virtually all of the Association's service projects. 
In addition, the YLD is where the future leaders of the Association, the State, and the nation gain valuable leadership experience. This is evident from a brief summary of the accomplishments of the prior YLD chairs:
  • Six prior YLD chairs have become presidents of this Association.
  • One became president of the ABA. 
  • Seven became NCBA Section Chairs.
  • Seven chaired NCBA committees.
  • Two became president of the State Bar. 
  • Two more took the helm of Legal Aid. 
  • A significant number went on to hold public office. 
To underscore the point, note that these accomplishments reflect only the Division Chairs--one person each year. Scores of other YLD officers and committee chairs honed leadership skills in the YLD that enabled them to accomlish great things later in life. 
Today we honor all of the current and former members of the Young Lawyers Division for their dedication to the YLD's values of Service to the Public, Service to the Profession, and Leadership Training, and we thank each of you for your continuing support of the YLD.



June 19, 2014

Important* New Rule From HUD

*You just can't make this stuff up, folks.

The federal Department of Housing and Urban Development has published a rulemaking notice in the Federal Register titled "Amendments To Reflect Change of Office Name From Office of Healthy Homes and Lead Hazard Control to Office of Lead Hazard Control and Healthy Home."  
Here's the agency's explanation: 


"Because HUD has changed the name of the Office of Healthy Homes and Lead Hazard Control to the Office of Lead Hazard Control and Healthy Homes, this final rule conforms HUD regulations to reference this new name.  This final rule also provides a savings provision that preserves under the Office of Lead Hazard Control and Healthy Homes all actions taken under the Office of Healthy Homes and Lead Hazard Control."

An excerpt from the Federal Register is below.  The rule becomes effective July 21, 2014.

You're welcome.