Hands ready to fill a cheque

The Georgia Securities Commissioner’s office recently held a fairness hearing pursuant to a request by two merging local banks seeking to facilitate their merger by forgoing the need to register newly issued securities at both the state and federal levels. The hearing, which is Georgia’s second in the last four years, was held on July 26, 2017. A copy of the Commissioner’s Order of Approval is available on the Georgia Secretary of State’s web site.

The fairness hearing process is a unique statutorily-codified transactional registration exemption which exists in a number of states—mostly those states having enacted some form of the model Uniform Securities Act of 2002. While not widely used historically, the fairness hearing process generally provides an exemption from registering securities at the state level for certain mergers and acquisitions (“M&A”) transactions where the state securities regulator passes on the “fairness” of the terms of the merger after conducting an evidentiary administrative hearing. What makes the fairness hearing process especially appealing is that the federal Securities Act of 1933 contains a sister provision at Section 3(a)(10), which provides a federal registration exemption for securities issued in certain M&A transactions where “the terms and conditions of such issuance and exchange are approved, after a hearing upon the fairness of such terms and conditions” by any state or federal governmental authority “expressly authorized by law to grant such approval.” This effectively means that a successful fairness proceeding conducted at the state level not only entitles the applicant to a state “Blue-Sky” registration exemption—but also a federal registration exemption as well.

In Georgia, the fairness hearing exemption is codified at Section 10-5-11(9) of the Georgia Uniform Securities Act of 2008, which exempts M&A transactions where the “fairness of the terms and conditions have been approved by the Commissioner after a hearing.” The Georgia Securities Commissioner’s office has promulgated administrative rules setting forth the roadmap for making an application pursuant to Section 10-5-11(9) as well as the conduct of the actual hearing. These rules, which were implemented in mid-2014, require, among other things, that the transaction have a significant nexus to the state of Georgia (residency of securities holders, place of business of the applicants, etc.), that the applicants submit a detailed application package containing specific transaction documentation, and that the applicants pay a filing fee and a processing fee and undertake to reimburse the Commissioner’s office for its out-of-pocket costs.

In his first public speech as the newly-appointed head of the SEC, Chairman Jay Clayton delivered an outline of the “guiding principles” that he will look to in guiding his leadership of that agency going forward. Clayton delivered his remarks on July 12th to the Economic Club of New York in New York City. The full text of Clayton’s speech may be found on the SEC’s website.

The primary takeaway from Clayton’s speech is that under his tenure, capital formation issues will likely take a higher profile, and, in turn, the concerns of businesses seeking ways to raise capital will likely be given a heavier weight of consideration than in the past.

In what was generally a bullish speech for the advancement of capital formation, Clayton first and foremost reiterated the SEC’s three-part mission to: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. However, Clayton specifically noted that “each tenet of that mission is critical,” stating that “if we stray from our mission, or emphasize one of the canons without being mindful of the others, investors, companies (large and small), the U.S. capital markets, and ultimately the economy will suffer.”

Approximately 35 states have created exemptions in their securities acts or rules in order to allow businesses seeking relatively small amounts of capital to raise funds locally without undergoing an expensive and complicated registration process. Offerings under these exemptions – typically called intrastate “crowdfunding” exemptions – have usually required compliance with the federal intrastate offering exemption under either Section 3(a)(11) of the 1933 Securities Act, or SEC Rule 147, which allows issuers to avoid the burdens of federal registration as well.

A key element of most of these newly-adopted state provisions has been to allow issuers to use general solicitation to seek investors. However, the federal exemption, together with restrictive historical SEC staff guidance, effectively operated to prohibit internet advertising, and restrict other types of solicitation. The federal intrastate exemption prohibited out-of-state offers of securities, even when those offers were deemed such solely because of their being visible to non-home state residents on the internet. The federal rules also prohibited an issuer formed in another state from availing itself of the intrastate exemption in its “home” state for all other purposes. Other constraints dealing with the issuer’s business activity (such as determining the percentage of its revenue derived from the home state) sometimes complicated the determination about whether an issuer would qualify for the federal, and therefore the state, exemption.

These restrictions, which had not been significantly changed in many years, led to widespread criticism that changing business and legal practices, not to mention the rise of the internet as a marketing tool, had made the intrastate exemption largely obsolete.

As previously noted in this firm’s sister blog (see “Private Placement Brokers Should be Legalized along with M&A Brokers” in the RIA Compliance Blog, Jan. 21, 2015), there has long been a large gray market of unregistered private placement brokers. Also see “Report and Recommendations of the Task Force on Private Placement Broker-Dealers” (American Bar Association Business Law Task Force, 2005). This cadre, often calling themselves “finders,” have continued to operate in plain sight, with little response from the SEC other than the issuance of a few inconsistent no-action letters and an occasional enforcement action against such brokers whose conduct was egregious in other ways.

The SEC’s Advisory Committee on Small and Emerging Companies (the “Committee”) has twice weighed-in on this subject urging SEC action.

The Committee first reported on this subject September 23, 2015, noting that:

The JOBS Act requires the SEC to make inflation adjustments to certain JOBS Act rules every five years. Recent SEC action marks the first of these adjustments, effective on the fifth anniversary of the JOBS Act’s April 5, 2012 adoption. The following adjustments have been announced for Title III Regulation Crowdfunding or “Regulation CF”:

1. The maximum aggregate amount an issuer can sell under Regulation CF in a 12 month period has been increased from $1,000,000 to $1,070,000;

2. The threshold for assessing an investor’s annual income or net worth to determine investment limits is increased from $100,000 to $107,000;

As Regulation Crowdfunding or “Reg CF,” the SEC’s extensive rules implementing the federal/interstate crowdfunding provisions (Title III) of the JOBS Act, recently marked its one-year anniversary, the congressional author of Title III, Congressman Patrick McHenry (R-NC), is now urging the SEC to essentially rewrite Reg CF.

McHenry, a leading crowdfunding industry proponent, outlines his proposal in a seven page May 15th letter to newly sworn-in SEC Chairman Jay Clayton. In his letter to Clayton, McHenry calls for a “comprehensive reform” of Reg CF, outlining in great detail 13 specific revisions to Reg CF that he believes necessary for start-ups and small businesses to fully take advantage of the opportunities that crowdfunding offers. McHenry is hardly alone in his criticism of Reg CF, as the crowdfunding community has roundly panned Reg CF as excessively regulatory in nature and far too costly for start-ups to comply with. While it is unclear if or when the SEC will respond to McHenry’s letter, the proposal should be considered as the opening salvo in what will likely be a full court press by the crowdfunding community to have the rules implementing interstate crowdfunding rewritten in a way much more favorable to the start-up and growth company sectors. Indeed, Clayton’s multi-decade background as an M&A lawyer suggests that the SEC may at least adopt a heightened focus on capital formation issues.

Importantly, McHenry’s recommendations, in his opinion, are all fully within the SEC’s rulemaking ambit, and do not require any legislative action by Congress. Specifically, the main thrusts of McHenry’s proposal are as follows:

Last October, the Securities and Exchange Commission adopted amended rules in several areas designed to facilitate capital formation by small businesses, in large part by coordinating federal requirements with requirements of state “crowdfunding” statutes and rules adopted by approximately 35 states since 2011.

Specifically, the SEC amended Rule 504 of Regulation D to raise the offering limit from $1,000,000 to $5,000,000, and created new Rule 147A, broadening the parameters under which intrastate offerings under existing Rule 147 could be conducted. Rule 147A, among other things, allows unlimited solicitation of offerings, including on the Internet, loosens requirements for issuers to qualify as “doing business in” a state, and allows corporate entities formed out-of-state to conduct intrastate offerings in the state where they primarily do business. Also, the previous requirement that intrastate offerings could only be offered to residents of a single state has been eliminated; the single-state restriction now considers only actual sales.

The effective date for the Rule 504 changes was January 20. However, the effective date of the new Rule 147A does not occur until April 20. Most states’ small business crowdfunding exemptions, whether adopted by statute or by rule, are conditioned upon compliance with Section 3(a)(11) of the 1933 Act or Rule 147. In order for issuers in those states to be able to fully utilize the new Rule 147A, those states will have to amend their exemptions to remove that condition.

On October 26, 2016, the SEC adopted final rules in a year-long administrative rulemaking proceeding seeking to modernize the decades-old federal securities registration exemptions applicable to intrastate (i.e., within the borders of one state) offerings and certain small ($1-5 million) offerings.  The SEC’s adopting order in this proceeding both amends the current intrastate offering “safe harbor” found at Rule 147 under the Securities Act of 1933 (“1933 Act”) and creates a new free-standing intrastate exemption designated Rule 147A.  The newly-released order also impacts small exempt offerings by increasing the offering limit for capital raises conducted pursuant to Rule 504 under Reg D of the 1933 Act to $5 million from $1 million.  Finally, the order repeals the sparsely-utilized Reg D Rule 505.

The primary impetus for this rulemaking and its oft-stated goal of “modernizing” the SEC’s regulatory regime regarding intrastate offerings clearly has been the spread of intrastate crowdfunding exemptions recently adopted pursuant to state “blue sky” securities laws.  Notably, 42 states have currently enacted, or are in some stage of enacting, an intrastate crowdfunding exemption—the vast majority of these relying upon 1933 Act section 3(a)(11) (the statutory provision for which Rule 147 acts as a safe harbor).  Intrastate crowdfunding, however, despite its quick proliferation over the last four years, has not been immune to controversy.  Perhaps the biggest issue has been how to properly fit 21st century securities offerings based on internet communications and marketing/sales platforms onto a securities exemption crafted in 1933.

Section 3(a)(11) provides an exemption from federal registration for “[a]ny security which is part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within, or, if a corporation, incorporated by and doing business within, such State or Territory.”  Accordingly, it has been the SEC’s contention that any kind of general advertising or solicitation must be conducted in a manner consistent with the requirement that offers made in reliance on Section 3(a)(11) and Rule 147 be made only to persons resident within the state or territory of which the issuer is a resident.  In a published 2014 pronouncement, the SEC has stated that while use of the internet would not be incompatible with a claim of exemption under Rule 147, crowdfunding portals would need to implement adequate measures so that offers of securities are made only to persons resident in the relevant state or territory.