December 15, 2015

The Role of Counsel in Intrastate Securities Crowdfunding

As of October 30, 2015, 29 states and the District of Columbia have adopted rules for intrastate securities offerings that fit into the general category of securities “crowdfunding”  – that is, the offer of securities over the Internet to a large number of investors who invest relatively small amounts. Some state rules are expressly for crowdfunding and mandate the use of an online funding platform. Other state rules merely ease restrictions on registration for small offerings. This article will refer to these various state statutes and rules collectively as “intrastate crowdfunding rules.” 

What each of these intrastate crowdfunding rules has in common is the rationale of the various state legislatures – providing entrepreneurs with expanded access to capital. Many early-stage companies and small businesses rely on investor capital, and many find that hard to access. The companies that these intrastate crowdfunding rules are meant for are those companies that may not have physical assets for collateral, or whose owners do not have the personal assets necessary to obtain a bank loan. By easing previously existing rules regarding the filing requirements to register or qualify an intrastate securities offering, the new intrastate crowdfunding rules should allow these types of companies to more easily approach their friends, family, customers, and local community for funding. 

The earliest intrastate crowdfunding rules went into effect in Kansas and Georgia in 2011, but most have gone into effect only in the last 18 months (at the time of enactment, the Kansas and Georgia rules were not identified as “crowdfunding”; that term became popular later). Through August 1, 2015, 118 issuers have filed with their respective states to take advantage of intrastate crowdfunding. The North American Securities Administrators Association (NASAA) says that the types of issuers undertaking intrastate crowdfunding run the full gamut of main-street and high-tech commerce. Breweries, grocery stores, exercise studios, software companies, night clubs, medical device companies, salons, dog groomers, and small manufacturers have all filed to take advantage of the rules. 

While there are important variations on a state-by-state basis, the rules of each state follow the same pattern and have the same general requirements, including: available to all investors who are residents of the same state of the issuer with contribution limits based on income; not available to Exchange Act reporting companies, investment companies, and blank check companies; maximum offering amounts ranging from $250,000 to $4 million over a 12-month period; audited financials if the offering is over $1 million; and filing, but not review, of a basic disclosure document adapted from the NASAA Form U-7. Maryland is a notable exception to this pattern as issuers are only allowed to raise a total of $100,000 in any 12-month period, investors are limited to contributing $100, and the securities may only be debt securities. 

Counsel to these issuers will play an important role helping entrepreneurs meet the statutory and regulatory requirements to comply with intrastate crowdfunding rules, and preparing issuers to meet the corporate governance obligations for taking on outside investors. At CrowdCheck, Inc., a due diligence and disclosure company specializing in online alternative investments and crowdfunding, we regularly encounter entrepreneurs who have great ideas for their companies, but lack the knowledge of the legal limitations on offering securities to outside investors. In our experience, the core areas of concern for counsel assisting an issuer with an intrastate crowdfunding offering are promotion of the offering, antifraud compliance, valid issuance of the securities, and records of investors.

Meeting the Requirements for the Federal and State Exemptions from Registration of Securities

Any discussion of securities law must begin with the catechism that every offer or sale of securities must be registered or exempt from registration, both at the federal and state level. While there are a couple of outlier states whose rules are based on other federal exemptions, in general intrastate crowdfunding rules rely on the federal exemption from registration established by Section 3(a)(11) of the Securities Act of 1933, and the safe harbor for Section 3(a)(11) offerings created under Rule 147 by the SEC. 

Section 3(a)(11) provides that federal registration is not required for “any 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.” The Rule 147 safe harbor provides that a company is a resident of the state in which it is incorporated or organized, and it does business in the state in which it generates 80 percent of its revenues, holds 80 percent of its assets, and intends to use and uses 80 percent of the proceeds from the offering. Additionally, the Rule 147 safe harbor requires the securities to “come to rest” in-state by imposing a nine-month restriction on secondary sales or transfers to persons out of state. 

For a small company, the most significant restriction under the language of Section 3(a)(11) is that all communications that amount to an offer of securities (which is effectively any communications that mention the offering in any way) must be restricted to within the state, because securities may be offered and sold only to persons resident within that state. This effectively precludes free social media marketing because communications platforms like Twitter and Facebook are inherently interstate communications. 

In amendments to Rule 147 proposed by the SEC on October 30, 2015, the SEC would lift these restrictions on offers so long as all sales are made in-state. The proposed rules clarify that general solicitation may be used – allowing for the use of Internet communication fora. 

The SEC has also proposed easing the residency requirements for compliance with Rule 147. In particular, a company would no longer be required to be organized under the laws of the same state in which it does business. Additionally, the proposed rules simplify the residency requirement for companies to provide that the state in which the company’s principal place of business is where the company’s principal officers control and coordinate the activities of the company and require that it meet one of the 80 percent thresholds, rather than all three. This would permit companies that are local in nature but organized under the laws of a different state to take advantage of the intrastate exemption. 

The proposed rules would retain the nine-month limit on resales to out-of-state investors. The SEC believes this provision to be necessary to ensure that the securities purchased by residents through an intrastate offering were purchased without a view to further distribution to non-residents. 

Rule 147 as proposed to be revised by the SEC would create a new exemption from registration, as opposed to amending or reinterpreting the old exemption. The SEC, of course, has no power to amend the statutory requirements of Section 3(a)(11), which includes the condition that the issuer (if a corporation) must be organized under the laws of the state in question. New Rule 147 would be adopted under the SEC’s statutory authority under Sections 3(b)(1) and 4(a)(2) of the Securities Act for small and non-public offerings. This may cause confusion among the states whose intrastate exemptions precondition reliance on their state crowdfunding exemption on compliance with Section 3(a)(11). Some states will need to make conforming changes through legislative fixes in order to permit issuers to rely on the revised rules. 

Until adoption of the proposed rules, companies must comply with existing law. The SEC staff has provided some guidance in the form of Compliance and Disclosure Interpretations (C&DIs) with respect to the intrastate offering requirement. In that guidance, the Staff affirms its understanding that Section 3(a)(11) and Rule 147 do not prohibit general solicitation, but that any solicitation must be directed within the state to persons who are residents of that state. As a practical matter, this means that the company may not advertise its securities offering on an openly accessible web page, but it may advertise through the Internet so long as any person who desires to view the offering information has made a representation that such person is a resident of the state in which the offering is being made. 

It is unlikely that companies that fail to keep their communications regarding intrastate crowdfunding in-state will be on the receiving end of an enforcement action from the SEC. The SEC is not regularly scouring Twitter and Facebook for information about small, crowdfunding offerings. However, that is not the only source of liability. By using open, and by definition interstate, communication fora, the issuer may no longer be eligible for the Section 3(a)(11) intrastate securities offering exemption, because it will have made an interstate offer of securities. As a result, the issuer might be found to have violated Section 5 of the Securities Act. And if an issuer has violated Section 5 of the Securities Act, the remedy includes a right of rescission by each investor. For a cash-strapped company, the requirement to return investor contributions could be a company-ending event. 

State laws have similar liability provisions to Section 5 of the Securities Act, triggered when an interstate offer is made. Indiana, for example, enacted its intrastate crowdfunding statute in 2014 and it is conditioned on compliance with Section 3(a)(11) of the Securities Act and Rule 147. Noncompliance with these federal rules results in liability under Chapter 5, Section 9(a) of the Indiana Uniform Securities Act because a sale of securities would be made in violation of the Indiana Uniform Securities Act. Liability under this section includes the right of rescission to the investor plus 8 percent annual interest. This cause of action exists for three years from the date of sale and during that time is essentially a “put” for investors who could demand return of the investment if they did not like the direction the company was taking. 

Where state law under rules based on the Uniform Securities Act differ from federal law is that controlling persons of the issuer are jointly and severally liable to the purchaser of the security. As a result, if the company did not have the funds to return investor contributions, the individual officers and directors would be personally liable as well.

The Dangers of Providing Selective Information to Investors

Each intrastate crowdfunding rule provides for some information to be filed with the state securities regulator. The information may be quite limited, as in the case of Kansas and its one-page Form IKE, which only requires identification of the issuer name and address, names and addresses of persons involved in making offers, and the name and address of the bank or depository institution where funds will be held in escrow. In some states, the information requirement is more extensive. To qualify for the intrastate crowdfunding exemption in the District of Columbia, one issuer was required to submit a 34-page offering statement on the Form DC EO-1 (excluding the attached exhibits). In any case, issuers are not limited to only providing to investors the information contained in the documents filed with its state regulator. There is no “monopoly of the prospectus” when it comes to crowdfunding and issuers are likely to supplement any information filed with the state regulator with slide decks, videos, info-graphics, and other presentation formats that only work because the information is being presented to prospective investors over the internet. This is where issuers, in their optimism regarding their own prospects for success, may violate the antifraud provisions under state and federal securities law. 

It is a violation of the antifraud rules under state and federal securities laws to make a false or misleading statement regarding any material fact, or to omit to state a fact necessary to make any other statement made not misleading. While most issuers will have no issue with the first clause, it is the second that has a way of tripping up entrepreneurs. 

Entrepreneurs are optimistic by nature. That optimism can lead to omissions of required information for investors. In February 2015, the Financial Conduct Authority in the United Kingdom issued a report indicating that a majority of the crowdfunding offerings it reviewed cherry-picked information and downplayed risks involved with the investment. Such cherry-picking or downplaying of risks may well be a violation of the antifraud rules in the United States at both the federal and state level as it could be considered an omission of facts necessary to make another statement not misleading. 

Counsel should work with issuers to determine how to present information and what could be considered misleading. Any statement made must be verifiable, and any statement made must present a complete picture of the fact being stated.

Confirming That Securities Are Authorized at the Terms the Issuer Wants and Are Validly Issued

A challenge facing counsel when advising issuers undertaking an intrastate securities offering is the issuers’ relative inexperience with the corporate formalities necessary to offer securities, and ensure that the securities are validly issued. The small dollar amounts being sought by issuers in intrastate offerings do not change these requirements, but do mean that issuers will be very cost conscious when confronted with deficiencies that could create issues for the offering. This is where free corporate document templates can be both helpful and harmful to small companies. 

In a typical start-up scenario, an entrepreneur will have filed a bare bones certificate of incorporation with the company’s state of incorporation. Later, that entrepreneur will decide to undertake an intrastate crowdfunding offering. Using documents obtained online, the issuer believes that the best course of action is to offer preferred stock to investors. What the issuer did not do, however, is amend the certificate of incorporation to authorize preferred stock. In a private offering to accredited investors, this may not be a concern as many corporate formalities will be undertaken at the close of the offering. Intrastate crowdfunding, on the other hand, is a public offering that requires these formalities to be satisfied prior to close. In the case of amending the certificate of incorporation, the formalities may include drafting the amendment, obtaining board and stockholder consent, filing the amended certificate of incorporation, and board approval of the offering itself. Skipping these corporate formalities and not maintaining a record of required approvals and written consents by the issuer could result in one of its core representations in the securities purchase agreement – that the securities are duly authorized and validly issued – being incorrect. 

These same start-up and small company practices may even more problematic for an entrepreneur who has formed a limited liability company (LLC). This entrepreneur may not realize that the template LLC operating agreement pulled off the internet does not do what the entrepreneur wants it to do when establishing the roles and relationship between members and managers. For instance, the default rules that exist under many state LLC laws may require unanimous approvals for amending the operating agreement in the future, or admitting additional members. Or, more problematically, may result in the investors having management roles in the issuer as a member-managed LLC. Prior to engaging in any offering, the issuer will need to be certain that the operating agreement authorizes membership interests as the terms desired by the issuer (e.g., non-voting, preference upon liquidation, manager-managed, etc.). 

Whether for a corporation or an LLC, in a typical intrastate crowdfunding offering, the issuer will likely require an amendment to the certificate of incorporation or operating agreement in order to authorize the desired securities. Counsel has an important role to ensure that the issuer has properly undertaken the corporate governance formalities to authorize and validly issue those securities. Counsel can also add value to any services performed during the initial organization of the company by setting them on the right path towards properly documenting the issuance of ownership in the company through discussion future plans of the company beyond the initial organization and understanding what the company intends to do if it needs additional capital.

Keeping Track of Investors 

Securities sold in intrastate crowdfunding offerings are not restricted securities, but there are other regulatory and practical limitations to the transfer or those securities. As such, counsel needs to be aware of such limitations and help companies protect themselves from transfers that they do not want to be made. 

Rule 147 provides that securities sold in an intrastate offering may not be resold out of the state for a period of nine months. The nine month holding period was established to ensure that the securities come to rest in the state and are not part of an interstate distribution of securities. The interstate resale of an issuer’s securities within that nine-month period may result in the retroactive loss of the intrastate exemption, leading to a violation of Section 5 of the Securities Act. 

The SEC’s proposed revisions to Rule 147 would provide some cover for companies to avoid retroactive loss of the exemption. By taking certain precautions against interstate sales through the prominent placement of a legend on the document evidencing the security sold, as well as issuing stop transfer instructions to the company’s transfer agent, a company would not be liable for the interstate resale by an investor before the nine-month interstate transfer restriction expires. 

On a more practical level, companies will want to know who their investors are and who is currently holding their securities. This requires certain measures to be put in place, such as investor covenants to not resell or to inform and obtain approval from the company before any resale. Inexperienced entrepreneurs will need to know their options for these types of covenants.

Conclusion

Intrastate crowdfunding can work for small companies looking for local capital to get off the ground, but they will need informed counsel to do it correctly. Each state has its own set of requirements for operation of the intrastate crowdfunding rules at the state level. Additionally, each intrastate crowdfunding rule is subject to the restrictions that exist in Section 3(a)(11) of the Securities Act and Rule 147. The proposed changes to Rule 147 by the SEC will make intrastate crowdfunding a more attractive option for issuers as it will open up the possibility of being organized in a state other than the one in which it does business and will enable issuers to more effectively use online tools and communication to promote the offering. Each state will need to adopt conforming amendments to its intrastate crowdfunding rules for issuers to be able to rely on the revised version of Rule 147, unless the SEC keeps and updates existing Rule 147 in addition to adopting the proposed version of Rule 147. 

Additionally, issuers need to be advised of the dangers of selective disclosures and cherry-picking information. While this type of behavior may be driven by nefarious motives, it may result in liability to the issuer if information has been omitted that is necessary to make other information not misleading. 

Further, unsophisticated issuers will also need assistance with understanding the basic corporate governance obligations of taking on investors, from understanding their charter documents and terms of their authorized securities, to maintaining accurate records of investors. 

Even with these challenges, intrastate crowdfunding rules should be beneficial to many issuers who are seeking to more easily access capital from their family, friends, customers, and well-wishers.

Additional Resources

For other materials on this topic, please refer to the following. 

ABA Web Store

The Final Frontier: Regulation A+ and Crowdfunding 

Business Law Section Program Library

The Final Frontier: Regulation A+ and Crowdfunding (PDF) (Audio)
Presented by: State and Regulation of Securities Committee
Location: 2015 Spring Meeting

New Opportunities for Unregistered Securities Offerings – Today and Tomorrow (PDF) (Audio)
Presented by: Federal Regulation of Securities Committee, Middle Market and Small Business Committee, State Regulation of Securities Committee
Location: 2015 Annual Meeting

Emerging Investment Platforms – Peer to Peer, Crowdfunding, and Affinity Investing (PDF) (Audio)
Presented by: Business Financing Committee, Federal Regulation of Securities Committee
Location: 2014 Annual Meeting