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The startup community in Philadelphia is abuzz over a provision in Senate Banking Committee Chairman Chris Dodd’s (D-Conn.) draft financial reform bill that could impose significant costs and uncertainties on angel investing.

Angel investors are wealthy individuals who purchase equity or convertible debt securities to contribute much-needed seed capital to startup businesses. Angel investors are different from venture capitalists (VC’s) in that they are individuals rather than professionally managed investment funds and typically invest much smaller sums of money (usually a couple of million dollars or less) than would interest VC’s. (Angels are also less demanding in terms of the economic and participatory rights of ownership, such as liquidation preferences, vesting of entrepreneurs’ equity stakes, seats on the board, etc.) With VC funding virtually non-existent due to the Great Recession, angel investments are the lifeblood for many struggling startups.

Sales of securities to wealthy angel investors normally come under the private placement exemptions to the Securities Act of 1933, which as a general matter requires filing of a registration statement with the Securities and Exchange Commission (SEC) prior to sale (a costly and onerous process). Under the safe harbor granted in Rule 506 of the SEC’s Regulation D (give yourself a pinch if your eyes start to glaze over at this point!), a company can sell securities in a private placement (i.e., without a general solicitation) to accredited investors and certain sophisticated non-accredited investors without filing a registration statement. Compliance with Rule 506 also enables the company to take advantage of exemptions from state securities laws (also known as “blue sky laws”), which otherwise can impose requirements in addition to those in the federal securities laws.

In the context of angels, an “accredited investor” is an individual with more than $1 million net worth or joint net worth with the individual’s spouse (alternatively, there are income tests for determining whether or not someone is an accredited investor). This makes sense in view of the overall purpose of securities regulation – angels are wealthy, savvy individuals who are used to investing, can afford good lawyers and business advisors, and frequently have a prior relationship with the founders of the companies in which they invest. For these reasons, they need less formal disclosure and regulatory protection than, say, a teacher who wants to put the money in her savings account into equities to get a higher rate of return.

Sections 926 and 412-13 of the proposed “Restoring American Financial Stability Act of 2010” would gut the current Rule 506 exemption by opening the door to greater SEC and state regulatory involvement in angel offerings:

• first, the rules would allow the SEC to designate certain securities offerings as not being “covered securities” under the 1933 Securities Act due to their small size (this would have the effect the effect of negating the Rule 506 exemptions from state blue sky laws and forcing companies to comply with differing requirements of individual states – e.g., filing and obtaining state review of a lengthy registration statement).

• third, the bill proposes to roughly double the net worth and income thresholds for accredited investors, meaning that fewer angel investments would qualify for the private placement exemption from SEC registration.

Needless to say, these requirements, if enacted into law, could have a huge impact on the flow of angel funds to cash-starved startups, disqualifying many transactions from favorable securities treatment and vastly increasing transaction time and costs (including legal fees). They could drive a stake through America’s still-beating entrepreneurial heart.

No one has a clear idea exactly how these provisions got into the financial reform bill, the ostensible purpose of which is to address the root causes of the financial collapse of 2008. While these causes are undoubtedly complex, I can safely say that angels run amok is not among them. From conversations with Senator Dodd’s staff, the best that inquirers have been able to discern is that the provisions were intended to deal with Bernie Madoff-type situations and hedge fund abuses. No one appears to have seriously considered the implications for angel investors and startups. Of course, this is an expected problem when, in the name of reform-at-any-cost, you ram through sweeping regulatory overhauls whose drafts consume legions of trees and no has the time to peruse in depth.

Fortunately, the entrepreneurial and angel community, especially the Angel Capital Association, was very much on the ball here, and, as we speak, their representatives are working with Senator Dodd and Senator Richard Shelby (R-Ala.) to make fixes. Hopefully we will have some good news to report on this blog soon. If access to angel funds is choked off, financial reform may turn out to be the “Jobs Prevention Act of 2010,” and we’re going to be enjoying 9.7% unemployment (or higher) for some time to come.

With a report released today showing unemployment in Philadelphia now at 11.4%, one thing we DON’T need is government guarding millionaire angels – from themselves.