One of the changes Congress introduced in the Jumpstart our Business Startups (JOBS) Act of 2012 was the creation of a new securities offering exemption for smaller companies. In March 2015, the SEC introduced rules implementing this provision, known as Regulation A+. The track record for Reg. A+ offerings has been mixed, as discussed further below. Recent events involving Longfin Financial, a blockchain fintech company that just completed a Reg. A+ offering in December 2017 highlights many of the questions and concerns about Reg. A+ offerings. Longfin’s share price plunged over 80% after the company announced on Monday that its offering and a subsequent acquisition are the subject of an SEC investigation. Now the company has been hit with a securities class action lawsuit. As discussed below, these recent developments have a number of implications.
In the JOBS Act, Congress sought to implement a number of measures intended to make it easier for smaller companies to raise capital. The Reg. A+ offering exemption was intended to allow smaller companies to raise up to $50 million without having to incur many of the costs and burdens associated with a traditional IPO. The provisions also allow qualifying companies to bypass some accounting and disclosure requirements. Because companies Reg. A+ offering companies meeting certain specifications can list their shares on securities exchanges, Reg. A+ offerings are sometimes called “mini-IPOs.” The basics of Reg. A+ offering were well-described in a recent guest post on this blog, here. For a good description of the difference between a Reg. A+ offering and other types of capital raising processes, refer here.
Longfin represents itself as in the business of operating computer trading platforms on the Singapore and other stock exchanges. On December 12, 2017, Longfin completed a Reg. A+ offering, raising $5.7 million at a price of $5 per share. The company was able to list its shares on NASDAQ. Almost immediately after the offering, the company plunged into tumult of events that caused its share price to swing dramatically, rising 13-fold in a matter of weeks and then plunging 80% in a matter of days. At its peak, the company’s market capitalization was over $5 billion.
Just two days after the December offering, the company disclosed that its chief financial officer and its chief operating officer had resigned just before the offering. But the same day, the company also announced that it had acquired Ziddu.com, a blockchain technology company providing microfinancing services. Longfin acquired Ziddu.com from a company controlled by Longfin’s founder, CEO, and largest shareholder, Venkat Meenavalli. Over the next two trading sessions after this announcement, the company’s share price rose more than 1,200%, to a high of over $72 a share.
For eight trading days in March, Longfin was included in the Russell 2000 small-company stock index. Short-sellers said the company’s inclusion in the index was a mistake because only 1.5% of Longfin’s shares are traded, below the 5% minimum. Russell removed the company from the index on March 26, 2018.
On April 2, 2018, Longfin disclosed in its 10-K that on March 5, 2018 the SEC’s enforcement division informed the company that it had launched an investigation of the company and requested documents “related to our IPO and other financings and the acquisition of Ziddu.com.” The company said that “We are in the process of responding to this document request and will cooperate with the SEC in connection with its investigation. While the SEC is trying to determine whether there have been any violations of the federal securities laws, the investigation does not mean that the SEC has concluded that anyone has violated the law.”
The company also reported an independent public accounting firm’s audit revealed material weaknesses in its internal control over financial reporting. The auditor cited the company’s lack of qualified personnel who understand generally acceptable accounting principles and defects in the company’s accounting procedures.
In an April 3, 2014 article entitled “Up-and-Down Longfin Is Facing an SEC Probe” (here), the Wall Street Journal reported that “in the run-up to the IPO … failed to disclose important facts” and “left a trail of misstatements behind.” The discrepancies the Journal noted included things as basic as Meenavalli’s age and the number of company employees. Individuals listed in company documents as officers or directors denied that they served in those roles. In one company document, Meenavalli is said to have a computer-science degree from Australia’s Sheffield University, while is Longfin biography lists a diploma in international trade from Middlesex University in the U.K. The Journal article also noted that the company’s sole U.S. office is “a small room with three desks and no computers in a shared-office building in downtown Manhattan that was deserted at 9:30 a.m. on a recent weekday morning.”
On April 3, 2018, a Longfin shareholder filed a securities class action lawsuit in the Southern District of New York against the company and Meenavalli. A copy of the complaint in the lawsuit can be found here.
The complaint purports to be filed on behalf of a class of persons who purchased Longfin shares between December 15, 2017 and April 2, 2018. In an April 3, 2018 press release (here), plaintiff’s counsel said that the complaint alleges that the defendants misrepresented or omitted to disclose “that: (i) Longfin had material weaknesses in its operations and internal controls that hindered the Company’s profitability; (ii) Longfin did not meet the requirements for inclusion in the Russell 2000 and 3000 indices; and (iii) as a result of the foregoing, the Defendants’ public statements were materially false and misleading at all relevant times.”
There are a lot of noteworthy aspects to this brief but eventful sequence at Longfin, but from my perspective the most significant is that a Reg. A+ offering company has been hit with a securities class action lawsuit.
Of course, even though companies completing a Reg. A+ offering are permitted to bypass some of the requirements for IPO companies, they are still subject to the liability provisions of the federal securities laws. For all of us who have found ourselves working with Reg. A+ since the new regulations were put in place, it is important to keep this significant consideration in mind. (Indeed, it really should come as no surprise to anyone that the liability provisions apply to Reg. A+ companies; as I pointed out in a recent post, the securities laws’ liability provisions apply even to private companies.)
The sequence of events at Longfin also may reinforce the concern others have raised about Reg. A+ companies, which is that companies able to raise capital while relieved of some accounting and disclosure requirements may make Reg. A+ companies even more susceptible to securities liability claims than companies completing a full-blown IPO. An April 4, 2018 Wall Street Journal article, entitled “Longfin Collapse Puts Focus on Lax IPO Rules” (here) raises this very question. Among other things, the Journal article states that Longfin’s “rapid rise and epic collapse highlights flaws in how gatekeepers such as the SEC, stock exchanges and index providers are policing the fast-track method used by Longfin to sell shares to the public.”
Among the concerns the Journal article raised about the process by which the SEC signed off on Longfin’s offering is that the agency allowed the company to sell shares base on one month’s audited financial statement showing that 96% of company expenses were paid to a company that Meenavalli owns. The Journal noted that Reg. A+ offerings are meant to be available only to U.S. and Canadian companies; despite the Company’s minimal office presence in New York described above, 100% of the company’s net sales are outside the U.S. The SEC apparently accepted the company’s assurances that it intends to expand its presence in the U.S.
The Journal’s articles contain a number of details and statistics about Reg. A+ offerings. Among other things, the Journal reports that since the SEC instituted the offering rules in 2015, companies have raised over $400 million through Reg. A+ offerings. However, only 40 of the more than 290 companies that filed for Reg. A+ offerings actually completed their offerings. Only ten companies (including Longfin) have gone on to list their shares on an exchange or over-the counter.
The Journal quotes the Massachusetts securities regulator as saying that if the SEC is “going to rubber stamp even the minimum requirements … it opens the door to scams and fraud.” These kinds of offerings are more dangerous that private offerings because they are not limited just to accredited investors; the Massachusetts regulator said that “what you’re opening the door for here is a log of unaccredited investors getting caught up in the buzz of the moment and victimized.” One of the Journal articles quotes Duke Law School Professor James Cox as saying “We’re going to look back on Reg. A+ and think this was an experiment that didn’t get managed very well.”
The Massachusetts regulator’s reference to the buzz of the moment definitely applies to Longfin. The company’s share price rocketed after it announced that it had acquired a blockchain technology company. This fact is noteworthy in and of itself, above and beyond the fact that Longfin is a Reg. A+ company, in that it makes the company yet another firm trying to participate in the cryptocurrency craze that has been hit with a securities lawsuit. By my count, since October, there have now been a total of eleven ICO or blockchain companies hit with securities class action lawsuits.
One aspect of Longfin’s blockchain technology identity is that the company only jumped on the blockchain bandwagon after it completed its offering. I don’t know whether or not Longfin has D&O insurance, but if it does, in all likelihood, coverage under any public company D&O insurance it purchased incepted on the offering date, and the coverage was underwritten based on information available before the offering. The company only became a blockchain technology company after the coverage incepted, meaning that the carrier or carriers likely took on the risk without knowing about company’s blockchain play. This sequence underscores the point that I made in a recent post, which is that even D&O insurers that declare to themselves and the world that they are staying away from cryptocurrency and blockchain companies could find themselves with companies in their portfolio that are deeply involved with this new digital technologies.
The Journal’s statement that since 2015 Reg. A+ offering companies have raised a total of $400 million is interesting. By way of contrast, as I discussed in a post last week, ICO companies have raised as much as $6 billion just since the beginning of December 2017. The fact that so many companies trying to complete Reg. A+ offerings fail to complete the offering is also interesting; it suggest that while Congress and the SEC intended to make it easier for start-up and smaller companies to raise capital, they didn’t succeed in making it easy enough for many smaller firms. At the same time, however, as the Journal article emphasizes, even the slightly lower barriers to entry that the SEC’s implementing regulations arguably may be susceptible to abuse.