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.
Realizing the obvious tension between its existing rules and the growing crowdfunding phenomenon, the SEC opened this proceeding in October of 2015 by proposing a new Rule 147 designed to address “certain regulatory requirements of the rule that no longer comport with modern business practices or communications technology, thereby limiting the utility of the safe harbor for intrastate offerings.” The final rules adopted one year later do not deviate dramatically from the rule proposed last year in that both amend the existing regulatory construct by permitting issuers to make offers accessible to out-of-state residents, so long as sales are limited to in-state residents. How the SEC accomplished this goal is the interesting part—and explains why the SEC both amended the existing Rule 147 and created a new Rule 147A.
The SEC’s proposed Rule 147 published in October 2015, which permitted out-of-state offers (and contained other enhancements) was meant to be a free-standing exemption promulgated pursuant to the SEC’s general exemptive authority under Section 28 of the 1933 Act. That is, Rule 147, as initially proposed to be amended, would no longer fall within the statutory parameters of Section 3(a)(11). This however created a problem that was seized upon in the comment letters of many persons, including NASAA, participating in this proceeding’s public comment process. In a nutshell, the problem with making the new Rule 147 a free-standing exemption (and doing-away with the safe harbor) is that, as noted above, the vast majority of state crowdfunding laws/rules make reliance on Section 3(a)(11) an integral part of satisfying the state exemption. Accordingly, if the new Rule 147 were to be unhinged from Section 3(a)(11), then compliance with the many existing state crowdfunding provisions would be rendered impossible. Indeed any state with a crowdfunding provision on the books would need to go back and amend it—all of which would take considerable time given the nature of state legislative and/or administrative rulemaking processes.
Taking these commenters’ concerns into consideration, the SEC’s adopting order therefore creates new Rule 147A to allow issuers to make offers accessible to out-of-state residents, so long as sales are limited to in-state residents, while simultaneously retaining an amended Rule 147 as a safe harbor under Section 3(a)(11) to preserve the continued availability of existing state exemptive provisions that are specifically conditioned upon issuer reliance on Section 3(a)(11) and Rule 147. Issuers relying on the amended Rule 147 as a safe harbor under Section 3(a)(11) must continue to limit all offers and sales to in-state residents. Alternatively, new Rule 147A will permit issuers to engage in general solicitation and general advertising of their offerings, using any form of mass media, including unrestricted, publicly-available Internet websites, so long as sales of securities so offered are made only to residents of the state or territory in which the issuer is resident. Additionally, the new Rule 147A will not require issuers to be incorporated or organized in the same state or territory where the offering occurs so long as issuers can demonstrate the in-state nature of their business.
Both the new Rule 147A and the amended Rule 147 include the following common provisions: (1) a requirement that the issuer has its “principal place of business” in-state and satisfies at least one “doing business” requirement that would demonstrate the in-state nature of the issuer’s business; (2) a new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser at the time of the sale of securities; (3) a requirement that issuers obtain a written representation from each purchaser as to residency; (4) a limit on resales to persons residing within the state or territory of the offering for a period of six months from the date of the sale by the issuer to the purchaser; (5) an integration safe harbor that would include any prior offers or sales of securities by the issuer made under another provision, as well as certain subsequent offers or sales of securities by the issuer occurring after the completion of the offering; and (6) legend requirements to offerees and purchasers about the limits on resales.
Regarding the above-referenced “common provisions” to be found in both the new Rule 147A and the amended Rule 147, it is worth noting that the new “doing business” requirements are a significantly-lessened regulatory burden as compared to the current test (the “3x 80% test”), which requires that the issuer derive 80% of its gross revenues, hold 80% of its assets in, and use 80% of its offering proceeds in the home state. The new rules add a 4th prong—that 80% of the issuer’s employees be based in the state—but, importantly, only require that only one (not all) of the four prongs be satisfied.
In summary, we see the new intrastate offering regulatory construct in a positive light. By keeping the existing safe harbor structure in place, the current status of intrastate crowdfunding under state blue sky law should be unaffected. The “common provisions” referenced above are in general a more issuer-friendly regulatory approach. And, the creation of new Rule 147A, which fully allows offers to be accessible to out-of-state residents and allows issuers to be incorporated or organized out-of-state, should, over time, be a significant opportunity for issuers and crowdfunding participants alike.
Briefly looking at the Reg D rule changes, it should be noted that, at present, offerings conducted under both Rules 504 and 505 are relatively rare. Indeed, in 2015, there were only 519 Rule 504 offerings and only 179 Rule 505 offerings conducted in the entire United States (the SEC obtains these totals based on the number of Form Ds filed), totaling an aggregate offering amount under $200 million. In this regard, the SEC’s actions in eliminating the Rule 505 exemption, and attempting to breathe some life into the Rule 504 exemption (by raising the offering limit to $5 million) should come as no surprise.
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