SEC Modernizes Intrastate Crowdfunding; Amending Rules 147 And 504; Creating New Rule 147A
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On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amend Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). In addition, the SEC has created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC has amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC has repealed the rarely used and now redundant Rule 505 of Regulation D.
Amended Rule 147 and new Rule 147A will take effect on April 20, 2017. Amended Rule 504 will take effect on January 20, 2017, and the repeal of Rule 505 will be effective May 20, 2017. The rule changes had initially been proposed in October 2015. My two-part blog on the proposed amendments can be read HERE and HERE.
Background on Rule 147 and Rationale for Amendments
Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a 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.” Section 3(a)(11) is often referred to as the Intrastate Exemption.
Rule 147 was adopted as a safe harbor under Section 3(a)(11) to provide further details on the application of the Intrastate Exemption. Rule 147 was adopted in 1974 and until now had not been updated since that time. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.
Section 3(a)(11) and Rule 147 has limitations that simply do not comport to today’s world. For example, the Rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and, if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.
Also, Rule 147 required that an issuer be incorporated in the state in which the offering occurs. In today’s world many company’s incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be overly burdensome.
The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 made it difficult for issuers to take advantage of these new state crowdfunding provisions.
At the same time, many current state intrastate exemptions are modeled after the language in Section 3(a)(11) and the existing Rule 147. As a result, simply amending Rule 147 to allow changes to the manner of offering to include advertising through Internet, television, radio and other forms of media that could be seen by out-of-state residents, would have left a disparity between state and federal rules. Accordingly, the SEC determined to amend Rule 147 within the statutory constraints of Section 3(a)(11) and add new Rule 147 without such constraints.
Summary of the New Rules
Amended Rule 147 remains a safe harbor under Section 3(a)(11) of the Securities Act allowing companies to continue to rely on the rule for current state law exemptions. New Rule 147A is a stand-alone rule not attached to Section 3(a)(11) and therefore not constrained by the specific language in that Section. New Rule 147A is substantially similar to amended Rule 147 but eliminates the restrictions on offers such that the Internet and websites can be used for such offers, and eliminates the requirement that a company be incorporated in the state in which it is conducting the offering as long as certain conditions are met. Sales will still be limited to residents of the company’s state.
Other than provisions allowing out-of-state offers (such as by use of a website) and offerings by states incorporated out of state, amended Rule 147 and new Rule 147A are substantially the same.
Both amended Rule 147 and new Rule 147A include the following: (i) a requirement that the issuer has its “principal place of business” in-state and satisfy at least one in-state “doing business” requirement; (ii) a new “reasonable belief” standard for issuers to rely on in determining the residence of the purchaser; (iii) a requirement that issuers obtain a written representation regarding residency from each purchaser; (iv) determining residency of an entity purchaser using the “principal place of business” standard; (v) limiting resales to persons within the same state for a period of six months; (vi) an integration safe harbor for any other prior offering and some subsequent offerings; and (vii) legend requirements for offerees and purchasers related to resale limitations.
Both amended Rule 147 and new Rule 147A remain intrastate exemptions and must comply with all state laws regarding any offerings. States are free to impose additional disclosure requirements, bad-actor prohibitions and other state-specific investor protections. No notice or Form D filing is required to be made to the SEC.
Rule 504 of Regulation D is a registration exemption for small offerings available to companies that are not Exchange Act reporting, investment companies or blank-check companies. Generally Rule 504 requires that the issuing company comply with state law as to the particular offer and exemption requirements, including, where required, a state level registration. The new rule maintains the structure, and bows to state law requirements but increases the aggregate offering amount from $1 million to $5 million and adds bad-actor disqualifications from reliance on the rule.
The SEC has repealed Rule 505 of Regulation D.
Amended Rule 147 and New Rule 147A – Specifics
Manner of Offering
New Rule 147A will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon.
Amended Rule 147 will continue to prohibit offers to out-of-state residents. Both Rules 147 and 147A will require that all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state. To accommodate space-constrained social media, such as Twitter, the SEC will allow the use of hyperlinks. In particular, where offering materials or information is distributed through a medium with limitations on the number of characters or text that may be included, and the information with disclaimers would exceed such limitations, the company can satisfy its disclosure obligation by including an active hyperlink to the required disclosures. The communication must prominently indicate that the required language is provided through the hyperlink. Where an electronic communication is capable of including the required statements, along with the other information, without exceeding the applicable limit on number of characters or amount of text, a hyperlink should not be used.
Determining Whether an Issuer is a “Resident” of a Particular State
Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual. Amended Rule 147 maintains this basic requirement, but supplants “principal office” with “principal place of business,” a term that is also used in new Rule 147A. Under amended Rule 147 a company will be deemed a “resident” of a particular state in which it is both incorporated and has its principal place of business.
An issuer’s “principal place of business” is defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” The concept of principal office has been eliminated.
Under new Rule 147A residence will be determined solely using the “principal place of business” test without regard to state of incorporation. Under both amended Rule 147 and new Rule 147A, companies may only sell securities to purchasers in the same state in which such company has its principal place of residence. As noted above, Rule 147A does not so limit “offers.”
Where a company changes state of residence, under both rules, it will not be able to conduct another offering until the securities sold in the first offering have “come to rest.” That is, both rules provide that where an issuer completes an offering in one state, it would not be able to conduct an offering in another state until six months after the last sale in the prior state. This six-month period is also used for the resale limitation in both rules, which is an amendment from the prior nine-month rule under old Rule 147.
Other than the above manner of offering and determination of residence provisions, amended Rule 147 and new Rule 147A are identical. Accordingly, each of the following discussed provisions apply equally to both Rule 147 and new Rule 147A.
Determining Whether an Issuer is “Doing Business” in a Particular State
In addition to issuer residency, a company must satisfy at least one test establishing that such company is “doing business” in the state of the offering. Old Rule 147 required that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Amended Rule 147 and new Rule 147A add a fourth test based on majority of employees, and only require that a company satisfy one of the four test to qualify for the use of the offering within that state.
In particular, an issuer shall be deemed to be doing business within a state if the issuer meets one of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state; or (iv) a majority of the issuer’s employees are located within the state.
Presumably a majority is satisfied by a greater than 50% determination. An employee would be located in a state if he or she is based in an office located in the state. A particular example provided in the rule release is one where an employee services the Virginia, Maryland and Washington, D.C., area for a company with an office in Maryland. In such case, the employee would be deemed based in Maryland.
Amended Rule 147 eliminates an exception from the 80% rule previously in place for companies with $5,000 or less in revenues.
As with all provisions of amended Rule 147 and new Rule 147A, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.
Determining Whether the Investors and Potential Investors are Residents of a Particular State
Amended Rule 147 and new Rule 147A define the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. Again, “principal place of business” is defined as the location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.
Amended Rule 147 and new Rule 147A add a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state at the time of the purchase of securities, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. As with 506(c), the SEC is reluctant to provide a firm list of requirements that satisfy the reasonable belief standard but rather urges a company to consider all facts and circumstances. However, the rule release does contain some example considerations, including (i) a pre-existing relationship between the company and prospective purchaser that includes knowledge of residency; (ii) evidence such as the address on utility and house bills; (iii) pay stubs; (iv) tax returns; (v) documents issued by a federal or state governmental authority including a driver’s license; and (vi) public records.
In addition to the reasonable belief requirements, a company must obtain a written representation of residency from the investor. The representation of the investor can serve as evidence of residency but is not dispositive. A self-attestation from an investor, without more, is not enough to create a reasonable belief.
The SEC provides examples of proof of residency. For individuals proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”
Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the intrastate offering. Amended Rule 147 and new Rule 147A shorten this holding period to six months from the date of the sale. Market makers or dealers desiring to quote such securities after the six-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information.
Bona fide gifts are specifically not subject to the resale limitations. However, the donee would still be bound by the same limitation. Accordingly, if an issuer conducted an intrastate offering in Florida, for example, and a purchaser than made a bona fide gift to a charity in California, that charity would be limited to resales to purchasers in Florida until the six-month period had expired. In this case, the charity could tack onto the holding period of the original purchaser.
The resale limitation is confined to the state in which the issuer conducts the offering. If an issuer changes its principal place of business following an offering, the resale limitations would stay in the state where the offering had been conducted.
Moreover, Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. In the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence. Finally, persons reselling will need to consider whether they could be considered an underwriter if they purchase with a view to distribution. For purposes of determining underwriter status, a purchaser can rely on the guidance in Rule 144.
Avoiding Integration While Using the Intrastate Exemption
The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.
Current Rule 147(b)(2) provides an integration safe harbor based on a hard six-month rule. Amended Rule 147 and new Rule 147A amend the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, offers and sales under Rule 147 and Rule 147A will not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering.
The Rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test. As part of an integration analysis, an issuer will need to consider the particular offering exemptions and requirements, including the use of general solicitation and advertising. For instance, a regulation crowdfunding, which by its nature solicits residents in all states, would not be consistent with a Rule 147 offering, but may work with a Rule 147A offering.
Moreover, an issuer will need to be mindful of gun-jumping issues where a registered offering is begun immediately after the conclusion of a Rule 147 or 147A offering that involved solicitation and advertising. In such cases, like testing the waters under Rule 105(c) of the JOBS Act, solicitations will need to be limited to qualified institutional buyers and institutional accredited investors for the 30 days prior to filing the registration statement. In practice, I suspect most issuers will simply wait for a 30-day period after completing an intrastate offering, prior to filing a registration statement.
Under amended Rule 147 and new Rule 147A, a disclosure about the limitations on resale needs to be given to each offeree and purchaser at the time of any offer or sale. The disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser. In addition, a written disclosure must be provided to all purchasers a reasonable period of time before the date of the sale.
Amended Rule 147 and new Rule 147A specifically require the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Such legend must also identify the state in which the intrastate offering was completed for purposes of the resale restrictions.
State Law Requirements
Although the SEC had initial proposed limitations as to the availability of the offering to states that, in turn, had registration or exemptions with particular specified provisions including limits on investment amounts, the final rules do not contain such provisions. The SEC believes the states can regulate such offerings without particular federal requirements. The SEC notes that most state crowdfunding or intrastate offering protections already contain total offering limits and per-investor investment limitations.
Intrastate Broker-dealer Exemption
Section 15 of the Exchange Act exempts any broker whose business is exclusively intrastate and who does not use any facility for a national securities exchange, from broker-dealer registration requirements (the “intrastate broker-dealer exemption”). At the request of commenters, the SEC clarifies that a broker will not lose its ability to rely on the intrastate broker-dealer exemption merely because it maintains a website that can be viewed by out-of-state persons so long as such broker takes reasonable steps to ensure that its business remains exclusively intrastate. Such reasonable measures can include disclosures and disclaimers and taking measures to determine the state of residency of a potential client or lead.
Section 12(g) Registration
Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors to register such class of securities with the SEC. After consideration, including the fact that intrastate offerings do not impose any ongoing reporting requirements, the SEC determined not to exempt securities sold in Rule 147 and 147A offerings from the Section 12(g) registration requirements.
Exclusion of Investment Companies
Under Section 24(d) of the Investment Company Act of 1940, Section 3(a)(11) is not available to investment companies registered or required to be registered under the Investment Company Act. Accordingly, investment companies will remain excluded from Section 3(a)(11) and amended Rule 147. For consistency, the SEC specifically excludes investments companies from the use of new Rule 147A.
Amendments To Rules 504 And 505
Overview of Current Rule
Currently Rule 504 of Regulation D provides an exemption from registration for offers and sales up to $1 million in securities in any twelve-month period. Current Rule 504, like Regulation A/A+, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Moreover, current rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).
Rules 504, 505 and 506 together comprise Regulation D. Rule 506 is promulgated under Section 4(a)(2) of the Securities Act and preempts state law. Rules 505 and 506 are promulgated under Section 3(b) of the Securities Act and do not preempt state law. Currently Rules 505 and 506 have bad-actor disqualification provisions but Rule 504 does not.
The vast majority of states require the registration of Rule 504 offerings. Rule 504 is similar to the offering exemption found in Section 3(a)(11) in that on the federal level it defers to state legislation and oversight. In fact, of the 34 states that have recently passed state-based crowdfunding exemptions, Maine specifically allows an issuer to rely on Rule 504 in utilizing its crowdfunding provisions.
As Rule 504 is, in essence, a deferral to the states for small offerings, the SEC is of the position that it does not warrant imposing extensive regulation on the federal level. I agree. As stated by the SEC, the purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions and general solicitation and advertising is prohibited unless sales are limited to accredited investors.
The SEC has increased the amount of securities that may be offered and sold in reliance on Rule 504 to $5 million in any 12-month period, and has added bad-actor disqualification provisions to the rule. The SEC believes the change will help facilitate capital formation and give states greater flexibility in developing state-coordinated review programs for multi-state registrations. The proposed rule also corrects the technical reference to Section 3(b) of the Securities Act in the Rules 504 to Section 3(b)(1), which change was made by the JOBS Act in 2012.
The proposed bad-actor disqualification provisions are substantially the same as those in place for Rule 506 offerings. For a review of the Rule 506 bad-actor disqualification provisions, see my blog HERE.
Repeal of Rule 505
The SEC has repealed the almost never used Rule 505 in its entirety.
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