The Jumpstart Our Business Startups Act (JOBS Act) of 2012 created the promise of widespread crowdfunding of new business ventures. While non-equity crowdfunding options like Kickstarter and Indiegogo had been around for years, companies could not entice investors with a share of their businesses without completing extensive disclosures, limiting their offers to accredited investors, or capping the size of their fundraising rounds to fit within various exemptions from registration as required by the Securities Act of 1933. Now, however, businesses would be able to raise capital from a large number of investors beyond the traditional “Reg D” investors and without many of the onerous disclosures that are otherwise required of companies issuing securities, all because of these new equity crowdfunding rules.
That was the promise, but the necessary federal regulations were slow in coming. Into that gap stepped numerous intrastate crowdfunding laws, passed at the state level (including in Illinois), that allowed companies to issue securities within one state, accepting in exchange a small amount of money from each of many small investors. Even when the federal regulations eventually appeared, many businesses were frustrated by the low cap on the size of federal fundraising rounds, and thus interest in intrastate offerings remained.
Still, the volume of intrastate offerings has not kept pace with the hopes and predictions of some advocates. Accordingly, in November 2016, the Securities and Exchange Commission (SEC) announced amendments to some of its rules with the intent of expanding opportunities for fundraising by businesses, including through intrastate crowdfunding. Two of those changes that affect crowdfunding became effective on April 20, 2017: a significant reworking of Rule 147, and the promulgation of a new Rule 147A.
More Companies Now Eligible
Rule 147 has been around since 1974, creating a safe harbor for intrastate offerings under Section 3(a)(11) of the Securities Act. Securities offerings that fall within Section 3(a)(11) get to bypass the registration statements ordinarily required by Section 5 of that Act. Offerings can qualify for Section 3(a)(11) without satisfying Rule 147, but the issuer then has the burden of proving they qualify; hence, most issuers just rely on complying with Rule 147, as that automatically ensures qualification under Section 3(a)(11).
Crucially, companies qualify under Rule 147 to issue securities in at most one state, and many companies cannot satisfy Rule 147 in any state, so that they are effectively locked out of the intrastate crowdfunding market. Under the version of Rule 147 in place prior to April 20, 2017, a company could only qualify in the state where it was incorporated or organized, and it also had to satisfy all of the following in that same state:
- It derived at least 80% of its revenues from that state; and
- It had at least 80% of its assets in that state; and
- It planned to use at least 80% of the proceeds from its fundraising round in that state; and
- Its principal office was located in that state.
A Delaware corporation that operated out of Illinois could not qualify. An Arizona company that obtained 30% of its revenues from California could not qualify. A Tennessee business that wanted to raise money to establish a small second office in Kentucky could not qualify.
The new version of Rule 147 substantially liberalizes this. A company can still only issue securities in the state in which it is organized or incorporated, and it still has to have its principal office (now rephrased as “principal place of business”) there, but now it need only satisfy one of the remaining criteria. Also, a fourth option has been added to cover companies that are not 80% focused in one state. Specifically, a company may now issue securities under Rule 147 in the state of its state of incorporation if it maintains its principal place of business there and satisfies any of the following:
- It derives at least 80% of its revenues from that state; or
- It has at least 80% of its assets in that state; or
- It plans to use at least 80% of the proceeds from its fundraising round in that state; or
- The majority of its employees are based in that state.
Companies are thus still restricted to using Rule 147 in only one state, but many companies qualify to use that rule — and hence intrastate crowdfunding — for the first time.
Yet More Companies, Plus Solicitation of Investors… Eventually
Going yet further, the SEC issued new Rule 147A, again effective April 20, 2017. This new rule makes exempt intrastate offerings available to even more companies, and it allows for general solicitation of investors for the first time. That said, because of the way the Securities Act and intrastate crowdfunding acts are written, the immediate impact of Rule 147A will be limited. The SEC is opening a new door with Rule 147A, through which intrastate crowdfunding can proceed later, if states pass new laws to take advantage of it.
In creating Rule 147A, the SEC loosened the restrictions from Rule 147 in two significant ways. First, companies do not have to be incorporated or organized in the state of their principal place of business if they use Rule 147A. This opens intrastate crowdfunding up for the first time to companies that are located in one state but incorporated in another, such as Delaware. Second, while Rule 147 restricts both offers and sales to the state in question, Rule 147A only limits the sales of securities to that state. That enables issuers to use television advertising that could bleed over into adjacent states, online advertising without bars on where it can be viewed, and so on. Together, these rules greatly expand the number of companies eligible for such exempt intrastate offerings and increase the efficiency with which companies can raise new capital.
The problem with this is that compliance with Rule 147 qualifies a company for the exemption in Section 3(a)(11) of the Securities Act, and Section 3(a)(11) explicitly requires that the issuer be incorporated in the state in question and only offer securities there. Hence, complying with Rule 147A does not qualify an issuer for Section 3(a)(11). The SEC can still exempt Rule 147A issuances from Section 5 registration requirements under the agency’s Section 28 general exemptive authority, but most current intrastate crowdfunding laws require issuers to satisfy Rule 147, Section 3(a)(11), or both. (That’s what happens when Rule 147 and Section 3(a)(11) are the only game in town, and states build their laws around them.) Until those laws are amended, a company satisfying Rule 147A stands to be in good shape with the SEC but potentially in trouble with the government of the state in which it issues its securities.
Also, two restrictions on Rule 147A are worth noting. First, investment companies cannot use Rule 147A, although they remain eligible for Rule 147. And second, companies that rely on Rule 147 or Rule 147A for one issuance cannot simply move their principal place of business to another state in order to launch a second (or third, or…) Rule 147A issuance in another region; six months have to pass after the end of one intrastate issuance before a company may use Rule 147A to issue securities in a different state.
Reasonable Belief, Resales, and Integration
The SEC also made three other amendments to Rule 147 that encourage investment, all of which apply to Rule 147A, as well.
First, whereas the old Rule 147 permitted sales only to investors who actually resided in the relevant state, the new version permits issuers to sell to investors that the issuers reasonably believe reside in that state. The issuers have to obtain written representations from the would-be investors as to their state of residence, and they also have to have some further basis for reasonably believing those representations in order to qualify. This reduces the risk to issuers if would-be investors misrepresent their residence in an attempt to gain access to the restricted offering. (This feels like a stretch under Section 3(a)(11), but the SEC has taken the position that even compliance under such a reasonable belief qualifies an issuer for Section 3(a)(11), much as reasonable belief as to accredited investor status is considered sufficient in Regulation D.)
Second, while investors are still barred from purchasing securities in such an intrastate offering and then immediately reselling them in a different state, the amendment has shortened the waiting period before such interstate resales are allowed. Specifically, under the old version of the rules, investors had to wait nine months from the last sale the issuer made as part of the Rule 147 offering. Now, investors only have to wait six months, and the clock starts on each share independently, so that an investor who buys early in the offering could resell his or her shares out of state even before the company’s offering closes. This is intended to calm potential investors’ fears of being stuck with shares for a long time and thus expand the set of people who would be willing to invest.
Third, the new rule creates a bright-line test for “integration.” This concept relates to instances in which a company raises money through two nominally separate rounds — one under Rule 147 or Rule 147A and one under another exemption: Under what circumstances will the SEC treat the two as actually just a single issuance, so that the out-of-state sales from one round contaminate what was intended as a separate, intrastate round and thus render it ineligible for Rule 147? Under the old rule, if the company issued no similar securities within six months (before or after) the Rule 147 offering, then issuances that took place more than six months before the start or after the end of that Rule 147 offering would not be deemed integrated with the Rule 147 offering. Anything within six months of the offering (before or after) was fair game, as were offerings outside of that window if the company also made any non-Rule-147 offerings during that window. Now, however, offerings that precede the Rule 147 offering (even by just a day) are never integrated, and the same is true for all offerings that take place more than six months after the Rule 147 offering ends, no matter what other issuances were made during the window right around the Rule 147 offering. Furthermore, offerings that come after the Rule 147 offering ends (even just a day later) will not be integrated if they fall within any of a list of preferred types, including Reg A+ offerings, employee compensation plans, and federal crowdfunding rounds. Outside of the designated safe harbors, now as before, integration is a question of fact that could be litigated, but now companies have a broad safe harbor on which to rely.
If You Build It, They Will Come?
In summary, the SEC’s changes to Rule 147 and creation of Rule 147A, both effective as of April 20, 2017, greatly expand the set of companies that can make intrastate securities offerings such as intrastate equity crowdfunding rounds without completing a lot of federal registration requirements, while also making it easier for such companies to find investors. Once states accommodate their laws to fit Rule 147A, intrastate crowdfunding stands to grow yet further. Will companies and investors take up the SEC’s invitation for more intrastate fundraising rounds under these revised rules?
Article by Zach Ziliak