Will this be the year that intrastate crowdfunding catches fire? The answer may depend upon the Securities & Exchange Commission, which is considering updates to a federal rule that underlies the vast majority of intrastate crowdfunding laws. After a public comment period ends on Monday, the agency will begin deliberating on changes that could make—or break—intrastate crowdfunding.
The proposal concerns Rule 147, a 40-year old federal “safe harbor” that all but two intrastate crowdfunding laws are based upon. Rule 147 contains some problematic flaws that have made it challenging to use for issuers, investors and crowdfunding platforms alike. Those flaws include a ban on advertising an offering beyond the borders of the state where it is filed, as well as a strict definition of an issuer’s residency that is often at odds with how companies are structured and operate today.
In addition, the current Rule 147 imposes harsh penalties for issuers who inadvertently (and despite their best efforts) sell shares to someone who is not a resident of the state or subsequently moves.
These ‘gotchas’ have held back widespread adoption of the new intrastate crowdfunding laws, which have been enacted by 30 states to date. For example, the prohibition on out-of-state advertising has all but ruled out the use of the Internet and social media to promote an offering—not to mention local newspapers and radio in regions that border another state. And the penalty for selling shares to an out of state resident—which could result in the entire offering being invalidated—has kept many lawyers and crowdfunding platforms away. In addition, many companies elect to incorporate in Delaware, which has more business-friendly laws, even though they are physically based in another state.
In response to feedback, the S.E.C. last fall proposed some very good amendments that would address these issues. For example, the agency wants to remove the ban on advertising out of state, as long as issuers only sell the securities to in-state residents. The agency also proposed a “reasonable belief” standard for determining a prospective investor’s residency at the time of an offering, more in line with the standard used for Regulation D offerings. The reasonable belief standard could be satisfied by a pre-existing relationship or common documents such as a recent utility bill or paystub or state-issued ID.
A public comment period ends on Monday, and the S.E.C. could release final rule changes by late spring.
In addition, it suggested more flexible ways of determining an issuer’s residency. For example, instead of state of incorporation, an issuer’s “principal place of business” would be used to determine an issuer’s residency. And the criteria an issuer would need to meet to prove they are “doing business” in their principal state would be eased.
These changes could go a long way in making intrastate crowdfunding a more attractive alternative and allowing community-oriented crowdfunding to flourish across the nation.
In addition to the changes to Rule 147, the S.E.C. also proposed to increase the amount that can be raised by an issuer under Regulation D, Rule 504, another commonly used exemption for community-based offerings, from $1 million to $5 million. That and other changes would help streamline multi-state offerings, especially in close knit regions such as New England.
As the Commissioners write: “The proposed amendments to Rule 147 and Rule 504 are intended to expand the capital raising options available to startups and small businesses, including through the use of intrastate and regional securities offering provisions that have been enacted or could be enacted by various states, and thereby promote capital formation within the larger economy.”
But before we break out the champagne, there is one potential spoiler—and it’s a big one. The S.E.C. has proposed that Rule 147—currently a “safe harbor” under Section 3(a)(11) of the Securities Act—become a standalone exemption. In doing so, the agency has made the proposed amendments, if approved, unusable by most states. That’s because most of the intrastate provisions are based upon and require compliance with Section 3(a)(11).
In its proposal, the S.E.C. assumes, rather blithely, that states will update their intrastate laws to be able to take advantage of the new rule changes—an unrealistic scenario, given how most state legislatures work. (For a more thorough legal explanation, see this piece by lawyer Anthony Zeoli.)
The S.E.C. has been seeking input on the proposed changes, as it does with any new rules or amendments. That comment period ends on Monday, January 11. The agency could release its final rule changes by late spring.
Not surprisingly, the Rule 147 issue has not drawn the widespread interest and comments that the proposed Title III (Regulation Crowdfunding) rules did. But most commenters have been in favor of the changes, with the exception of the removal of Rule 147’s “safe harbor” status.
“At the heart of the SEC’s proposed amendments appears to be a desire to significantly expand the viability and use of intrastate and regional securities offerings,” writes Anthony Zeoli in a comment letter to the S.E.C. “While I fully support this endeavor, the SEC’s proposal to make Rule 147 function as a separate exemption rather than a ‘safe harbor’ under Section 3(a)( 11) of the Act would have the absolute opposite effect.”
Some commenters raised additional issues that have been overlooked by the S.E.C. Sarah Hanks, CEO of Crowdcheck, points out in a comment letter dated January 2 that intrastate crowdfunding investors will likely have modest sums to invest, and therefore issuers may need to attract large numbers of investors. However, doing so could trigger Section 12(g) of the Exchange Act, which requires issuers with more than 500 unaccredited shareholders to register as fully public companies with the S.E.C. Rather than be faced with that dilemma, she says, “issuers may have to favor accredited investors or investors who can invest large amounts of money.”
“From a policy point of view this would be regrettable,” writes Hanks. “The purpose of crowdfunding is not only to provide issuers with additional sources of capital, but also to offer family, friends and fans of an enterprise the opportunity to share in its success, and broaden the investment opportunities of small investors. We suggest that a conditional exemption from Section 12(g) would be appropriate.”
Brandon Smith, managing principal of crowdfunding platform Localstake, urged the S.E.C. to consider setting policy at the federal level that would standardize the use of escrow agents—the third parties that handle funds in intrastate crowdfunding transactions. Many states require the escrow agent to be a bank registered within the state in which the offer is being made, and prohibit the funds from leaving the state at any point during the process. That’s made it hard for Localstake and other crowdfunding platforms to find escrow agents that qualify, effectively stymying the use of intrastate crowdfunding laws.
“The staff should work with the states or use language at the federal level that allows for any U.S. escrow agent to be utilized when using these exemptions,” Smith wrote.
Word is that the S.E.C. realizes the error of removing Rule 147 from Section 3(a)(11). But if you have strong views on intrastate crowdfunding and would like to see it have a real shot at success, now is the time to let the S.E.C. know what you think.
To submit a comment or read other comments, go here.
To read the full text of the S.E.C.’s proposed amendments, go here.