SEC ISSUES EMERGENCY RULES TO FACILITATE TITLE III CROWDFUNDING DURING COVID-19 CRISIS

With credit markets tightened and 30 million Americans newly out of work, the SEC has adopted temporary rules to make Title III Crowdfunding a little easier from now until August 31, 2020.

The temporary rules are available here. They aim to make Title III a little faster and easier in four ways:

#1 – Launch Offering without Financial Statements

An issuer can launch the offering – go live on a funding portal – before its financial statements are available. (But investment commitments aren’t binding until the financial statements have been provided.)

#2 – Lower Standard for Some Financial Statements

An issuer trying to raise between $107,000 and $250,000 in a 12-month period doesn’t have to produce financial statements reviewed by an independent accountant, only financial statements and certain information from its tax return, both certified by the CEO.

#3 – Quicker Closing

An issuer can close the offering as soon as it has raised the target offering amount, even if the offering hasn’t been live for 21 days, as long as the closing occurs at least 48 hours after the last investment commitment and the funding portal notifies investors of the early closing.

#4 – Limit on Investor Cancellations 

Investors can cancel within 48 hours of making a commitment, but can’t cancel after that unless there’s a material change in the offering.

CAVEAT:  These rules are not available if the issuer:

  • Was organized or operating within six months before launching the offering (e., this is not for brand-new companies); or
  • Previously raised money using Title III Crowdfunding but failed to comply with its obligations.

I’m not sure how much difference these rules will make in practice. But that’s not the main point as far as I’m concerned. The main point is that with about a million other things on its plate, the SEC took the time to think about and draft these rules. The SEC must believe that equity Crowdfunding can play an important role in our capital markets.

On that basis, I predict that the proposals the SEC made on March 4th will be adopted soon after the public comment period expires on June 1st. And after that, who knows.

SEC PROPOSES MAJOR UPGRADES TO CROWDFUNDING RULES

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.

The Cashflow Hustle Podcast: Crowdfunding Techniques to Level Up Your Business

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CLICK HERE TO LISTEN

Mark Roderick appeared on the Cashflow Hustle Podcast with Justin Grimes, where he discussed Crowdfunding Techniques to Level Up Your Business.

In this Episode, You’ll Learn About:

1. The Crowdfunding and its flavors
2. The deductions in Crowdfunding
3. The role of SEC
4. Blockchain technology in Crowdfunding
5. The Investor portals
6. Tokenized security in Crowdfunding

Questions? Let me know.

The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

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Our guest on this episode of The Wealthy Wellthy Podcast is Mark Roderick, an attorney who devotes most of his time to crowdfunding. Maybe you are like me in thinking that crowdfunding is pretty straightforward and self-explanatory. I mean, if your friend is looking to start a business and you want to support them, you can donate or invest through their crowdfunding page online and that’s that, right?

Every entrepreneur faces the stage in their business where they need to acquire capital, either from acquaintances, networking, angel investors, venture capitalists, or strategic partners. This process is messy and confusing, filled with regulations and stipulations that may make acquiring the capital more trouble than it is worth. This was partially due to the antiquated laws that were created in the aftermath of The Great Depression and were stifling in the modern economic climate. However, in 2012, the Jobs Act made it legal for entrepreneurs to advertise to raise capital. This opened up a whole new world for small business owners and others who were desperate to be able to connect more easily with potential investors as well as investors who were eager to find new opportunities.

During the interview, Mark distinguishes between the 3 kinds of crowdfunding: (1) to accredited investors only, (2) Regulation A to accredited or non accredited investors, and (3) Title 3 – which is the most common. He also talks about the factors that are most important from a legal perspective when you are determining which crowdfunding site to use to raise capital or to invest capital. It was also interesting to hear Mark spell out the 3 reasons why people invest through crowdfunding: (1) they want to support the company, (2) to do social good, and (3) to make money.

Mark even gave me some advice about a real estate deal I am considering and revealed that 90-95% of the capital exchanged through crowdfunding is for real estate transactions. Finally, he busted a couple of myths regarding the amount of risk involved in crowdfunding and whether money raised from others is subject to securities laws.

What We Covered

  • [2:16] – Who is Mark Roderick?
  • [3:28] – Mark describes the fragmented traditional ways of raising capital.
  • [8:58] – Angel investors and how to present your “deck” to them.
  • [11:08] – Working with venture capitalists and strategic partners.
  • [13:31] – A brief history of the laws affecting capital.
  • [22:34] – What does crowdfunding look like for startup entrepreneurs?
  • [27:20] – How to find a regulated site to post your capital request on.
  • [30:58] – Crowdfunding is the intersection of old and new school.
  • [34:57] – Advice to keep in mind when you are using a crowdfunding site.
  • [38:06] – Mark tells us 3 of the crowdfunding sites he works with.
  • [40:08] – When should an entrepreneur hire an attorney during this process?
  • [42:40]– The prevalence of real estate in the crowdfunding world.
  • [53:24] – What message does Mark want to get out there?
  • [56:17] – Mark busts 2 myths about crowdfunding.

Questions? Let me know.

Podcast: The Complete Guide to Investment Crowdfunding Regulations in the US

Podcast MSR Blog Post

CLICK HERE TO LISTEN

Are the countless rules, regulations and exemptions surrounding crowdfunding in the US starting to get too difficult to keep track of?

Katipult recently partnered with Mark Roderick to help you get a better understanding of regulation relevant to your company. In this podcast, Mark shares information that will help you navigate the complex crowdfunding regulations in the US.

Questions? Let me know.

Non-U.S. Investors and Companies in U.S. Crowdfunding

Non-US Investors and Companies in US Crowdfunding

When I was a kid, back in the 1840s, we referred to people who live outside the United States as “foreigners.” Using the more globalist and clinical term “non-U.S. persons,” I’m going to summarize how people and companies outside the U.S. fit into the U.S. Crowdfunding and Fintech picture.

Can Non-U.S. Investors Participate in U.S. Crowdfunding Offerings?

Yes. No matter where he or she lives, anyone can invest in a U.S. Crowdfunding offering, whether under Title II, Title III, or Title IV.

The Crowdfunding laws don’t distinguish U.S. investors from non-U.S. investors. Thus:

  • To invest in an offering under Title II (SEC Rule 506(c)), a non-U.S. investor must be “accredited.”
  • If a non-U.S. investor invests in an offering under Title III (aka “Regulation CF”), he or she is subject to the same investment limitations as U.S. investors.
  • If a non-U.S. investor who is also non-accredited invests in an offering under Tier 2 of Title IV (aka “Regulation A”), he or she is subject to the same limitations as non-accredited U.S. investors, e., 10% of the greater of income or net worth.

What About Regulation S?

SEC Regulation S provides that an offering limited to non-U.S. investors is exempt from U.S. securities laws. Mysterious on its face, the law makes perfect sense from a national, jurisdictional point of view. The idea is that the U.S. government cares about protecting U.S. citizens, but nobody else.

EXAMPLE:  If a U.S. citizen is abducted in France, the U.S. military sends Delta Force. If a German citizen is abducted in France, Delta Force gets the day off to play volleyball.

Regulation S is relevant to U.S. Crowdfunding because a company raising money using Title II, Title III, or Title may simultaneously raise money from non-U.S. investors using Regulation S. Why would a company do that, given that non-U.S. investors may participate in Title II, Title III, or Title IV? To avoid the limits of U.S. law. Thus:

  • A company raising money using Title II can raise money from non-accredited investors outside the United States using Regulation S.
  • A company raising money using Title III can raise money from investors outside the United States without regard to income levels.
  • A company raising money using Tier 2 of Title IV can raise money from non-accredited investors outside the United States without regard to income or net worth.

Thus, a company raising money in the U.S. using the U.S. Crowdfunding laws can either (1) raise money from non-U.S. investors applying the same rules to everybody, or (2) place non-U.S. investors in a simultaneous offering under Regulation S.

What’s the Catch?

The catch is that the U.S. is not the only country with securities laws. If a company in the U.S. is soliciting investors from Canada, it can satisfy U.S. law by either (1) treating the Canadian investors the same way it treats U.S. investors (for example, accepting investments only from accredited Canadian investors in a Rule 506(c) offering), or (2) bringing in the Canadian investors under Regulation S. But to solicit Canadian investors, the company must comply with Canadian securities laws, too.

Raising Money for Non-U.S. Companies

Whether a non-U.S. company is allowed to raise money using U.S. Crowdfunding laws depends on the kind of Crowdfunding.

Title II Crowdfunding

A non-U.S. company is allowed to raise money using Title II (Rule 506(c)).

Title III Crowdfunding

Only a U.S. entity is allowed to raise money using Title III (aka “Regulation CF”). An entity organized under the laws of Germany may not use Title III.

But that’s not necessarily the end of the story. If a German company wants to raise money in the U.S. using Title III, it has a couple choices:

  • It can create a U.S. subsidiary to raise money using Title III. The key is that the U.S. subsidiary can’t be a shell, raising the money and then passing it up to the parent, because nobody wants to invest in a company with no assets. The U.S. subsidiary should be operating a real business. For example, a German automobile manufacturer might conduct its U.S. operations through a U.S. subsidiary.
  • The stockholders of the German company could transfer their stock to a U.S. entity, making the German company a wholly-owned subsidiary of the U.S. entity. The U.S. entity could then use Title III.

Title IV Crowdfunding

Title IV (aka “Regulation A”) may be used only by U.S. or Canadian entities with a “principal place of business” in the U.S. or Canada.

(I have never understood why Canada is included, but whatever.)

If we cut through the legalese, whether a company has its “principal place of business” in the U.S. depends on what the people who run the company see when they wake up in the morning and look out the window. If see the U.S., then the company has it’s “principal place of business” in the U.S. If they see a different country, it doesn’t. (Which country they see when they turn on Skype doesn’t matter.)

Offshore Offerings

Regulation S allows U.S. companies to raise money from non-U.S. investors without worrying about U.S. securities laws. But once those non-U.S. investors own the securities of the U.S. company, they have to think about U.S. tax laws. Often non-U.S. investors, especially wealthy non-U.S. investors, are unenthusiastic about registering with the Internal Revenue Service.

The alternative, especially for larger deals, is for the U.S. entity to form a “feeder” vehicle offshore, typically in the Cayman Islands because of its favorable business and tax climate. Non-U.S. investors invest in the Cayman entity, and the Cayman entity in turn invests in the U.S. entity.

These days, it has become a little fashionable for U.S. token issuers to incorporate in the Cayman Islands and raise money only from non-U.S. investors, to avoid U.S. securities laws. Because the U.S. capital markets are so deep and the cost of complying with U.S. securities laws is so low, this strikes me as foolish. Or viewed from a different angle, if a company turns its back on trillions of dollars of capital to avoid U.S. law, I’d wonder what they’re hiding.

What About the Caravan from Honduras?

Yes, all those people can invest.

Questions? Let me know.

Podcast: The Business Credit & Financing Show Focusing on How to Avoid Crowdfunding Legal Pitfalls with Mark Roderick

MSR Podcast OCt 2018

CLICK HERE TO LISTEN | Also available on iTunes & Spotify

During This Show We Discuss…

  • Your potential legal liability using crowdfunding platforms
  • When a potential investor can sue the project creator
  • The “3 flavors” of crowdfunding you should know about
  • Legal issues with flex versus fixed funding
  • How the new tax law affects crowdfunding
  • 20% tax deduction in crowdfunding transactions
  • Getting crowd funding for real estate investing
  • What you should know about peer-to-peer lending
  • Issues with bonuses you may offer to donors
  • What to know about the SEC’s role in crowdfunding
  • What an opportunity zone fund is and how they work
  • Why trusts invest in crowdfunding projects
  • Other big investors who are investing in crowdfunding campaigns
  • Potential legal pitfalls in peer-to-peer lending?
  • And much more

Mark Roderick is one of the leading Crowdfunding and Fintech lawyers in the United States. Expanding on his in-depth knowledge of capital-raising and securities law, Mark represents many portals and other players in the Crowdfunding field. He writes a widely read blog, crowdfundattny.com, which provides readers with a wealth of legal and practical information for portals, issuers and investors. He also speaks at Crowdfunding events across the country and represents industry participants across the country and around the world.

The New 20% Deduction in Crowdfunding Transactions

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Co-Authored By: Steve Poulathas & Mark Roderick

The new tax law added section 199A to the Internal Revenue Code, providing for a 20% deduction against some kinds of business income. Section 199A immediately assumes a place among the most complicated provisions in the Code, which is saying something.

I’m going to summarize just one piece of section 199A: how the deduction works for income recognized through a limited liability company or other pass-through entity. That means I’m not going to talk about lots of important things, including:

  • Dividends from REITS
  • Income from service businesses
  • Dividends from certain publicly-traded partnerships
  • Dividends from certain cooperatives
  • Non-U.S. income
  • Short taxable years
  • Limitations based on net capital gains

Where the Deduction Does and Doesn’t Help

Section 199A allows a deduction against an individual investor’s share of the taxable income generated by the entity. The calculation is done on an entity-by-entity basis.

That means you can’t use a deduction from one entity against income from a different entity. It also means that the deduction is valuable only if the entity itself is generating taxable income.

That’s important because most Crowdfunding investments and ICOs, whether for real estate projects or startups, don’t generate taxable income. Most real estate projects produce losses in the early years because of depreciation deductions, while most startups generate losses in the early years because, well, because they’re startups.

The section 199A deduction also doesn’t apply to income from capital gains, interest income, or dividends income. It applies only to ordinary business income, including rental income*. Thus, when the real estate project is sold or the startup achieves its exit, section 199A doesn’t provide any relief.

Finally, the deduction is available only to individuals and other pass-through entities, not to C corporations.

*Earlier drafts of section 199A didn’t include rental income. At the last minute rental income was included and Senator Bob Corker, who happens to own a lot of rental property, switched his vote from No to Yes. Go figure.

The Calculation

General Rule

The general rule is that the investor is entitled to deduct 20% of his income from the pass-through entity. Simple.

Deduction Limits

Alas, the 20% deduction is subject to limitations, which I refer to as the Deduction Limits. Specifically, the investor’s nominal 20% deduction cannot exceed the greater of:

  • The investor’s share of 50% of the wages paid by the entity; or
  • The sum of:
    • The investor’s share of 25% of the wages paid by the entity; plus
    • The investor’s share of 2.5% of the cost of the entity’s depreciable property.

Each of those clauses is subject to special rules and defined terms. For purposes of this summary, I’ll point out three things:

  • The term “wages” means W-2 wages, to employees. It doesn’t include amounts paid to independent contractors and reported on a Form 1099.
  • The cost of the entity’s depreciable property means just that: the cost of the property, not its tax basis, which is reduced by depreciation deductions.
  • Land is not depreciable property.
  • Once an asset reaches the end of its depreciable useful life or 10 years, whichever is later, you stop counting it. That means the “regular” useful life, not the accelerated life used to actually depreciate it.

Exception Based on Income

The nominal deduction and the Deduction Limits are not the end of the story.

If the investor’s personal taxable income is less than $157,500 ($315,000 for a married couple filing a joint return), then the Deduction Limits don’t apply and he can just deduct the flat 20%. And if his personal taxable income is less than $207,500 ($415,000 on a joint return) then the Deduction Limits are, in effect, phased out, depending on where in the spectrum his taxable income falls.

Those dollar limits are indexed for inflation.

ABC, LLC and XYZ, LLC

Bill Smith owns equity interests in two limited liability companies: a 3% interest in ABC, LLC; and a 2% interest in XYZ, LLC. Both generate taxable income. Bill’s share of the taxable income of ABC is $100 and his share of the taxable income of XYZ is $150.

ABC owns an older apartment building, while XYZ owns a string of restaurants.

Like most real estate companies, ABC doesn’t pay any wages as such. Instead, it pays a related management company, Manager, LLC, $500 per year as an independent contractor. All of its personal property has been fully depreciated. Its depreciable real estate, including all the additions and renovations over the years, cost $20,000.

Restaurants pay lots of wages but don’t have much in the way of depreciable assets (I’m assuming XYZ leases its premises). XYZ paid $3,000 of wages and has $1,000 of depreciable assets, but half those assets are older than 10 years and beyond their depreciable useful life, leaving only $500.

Bill and his wife file a joint return and have taxable income of $365,000.

Bill’s Deductions

Calculation With Deduction Limits

Bill’s income from ABC was $100, so his maximum possible deduction is $20. The Deduction Limit is the greater of:

  • 3% of 50% of $0 = $0

OR

  • The sum of:
    • 3% of 25% of $0 = 0; plus
    • 3% of 2.5% of $20,000 = $15 = $15

Thus, ignoring his personal taxable income for the moment, Bill may deduct $15, not $20, against his $100 of income from ABC.

NOTE: If ABC ditches the management agreement and pays its own employees directly, it increases Bill’s deduction by 3% of 25% of $500, or $3.75.

Bill’s income from XYZ was $150, so his maximum possible deduction is $30. The Deduction Limit is the greater of:

  • 2% of 50% of $3,000 = $30

OR

  • The sum of:
    • 2% of 25% of $3,000 = 15; plus
    • 2% of 2.5% of $500 = $0.25 = $15.25

Thus, even ignoring his personal taxable income, Bill may deduct the whole $30 against his $150 of income from XYZ.

Calculation Based on Personal Taxable Income

Bill’s personal taxable income doesn’t affect the calculation for XYZ, because he was allowed the full 20% deduction even taking the Deduction Limits into account.

For ABC, Bill’s nominal 20% deduction was $20, but under the Deduction Limits it was reduced by $5, to $15.

If Bill and his wife had taxable income of $315,000 or less, they could ignore the Deduction Limits entirely and deduct the full $20. If they had taxable income of $415,000 or more, they would be limited to the $15. Because their taxable income is $365,000, halfway between $315,000 and $415,000, they are subject, in effect, to half the Deduction Limits, and can deduct $17.50 (and if their income were a quarter of the way they would be subject to a quarter of the Deduction Limits, etc.).

***

Because most real estate projects and startups generate losses in the early years, the effect of section 199A on the Crowdfunding and ICO markets might be muted. Nevertheless, I expect some changes:

  • Many real estate sponsors will at least explore doing away with management agreements in favor of employing staff on a project-by-project basis.
  • Every company anticipating taxable income should analyze whether investors will be entitled to a deduction.
  • Because lower-income investors aren’t subject to the Deduction Limits, maybe Title III offerings and Regulation A offerings to non-accredited investors become more attractive, relatively speaking.
  • I expect platforms and issuers to advertise “Eligible for 20% Deduction!” Maybe even with numbers.
  • The allocation of total cost between building and land, already important for depreciation, is now even more important, increasing employment for appraisers.
  • Now every business needs to keep track of wages and the cost of property, and report each investor’s share on Form K-1. So the cost of accounting will go up.

As for filing your tax return on a postcard? It better be a really big postcard.

Improving Legal Documents in Crowdfunding: Get Rid of the State Legends!

I see lots of offering documents like this, with pages of state “legends.” The good news is that in Crowdfunding offerings – Title II (Rule 506(c)), Title III (Regulation Crowdfunding), and Title IV (Regulation A) – you can and should get rid of them.

The legal case is pretty simple:

  • Before 1996, states were allowed to regulate private offerings. Every state allowed exemptions, but these exemptions often required legends, differing from state to state.
  • The National Securities Market Improvement Act of 1996 added section 18 to the Securities Act of 1933. Section 18 provides that no state shall “impose any conditions upon the use of. . . .any offering document that is prepared by or on behalf of the issuer. . . .” in connection with the sale of “covered securities.”
  • The securities sold under Title II, Title III, and Title IV are all “covered securities.”
  • Hence, section 18 prohibits states from imposing any conditions regarding the issuer’s offering documents, including a condition that requires the use of a state legend.

If the capitalized legends just take up space, why not include them anyway just to be safe? Take Pennsylvania’s legend as an example:

These securities have not been registered under the Pennsylvania Securities Act of 1972 in reliance upon an exemption therefrom. any sale made pursuant to such exemption is voidable by a Pennsylvania purchaser within two business days from the date of receipt by the issuer of his or her written binding contract of purchase or, in the case of a transaction in which there is not a written binding contract of purchase, within two business days after he or she makes the initial payment for the shares being offered.

If you include the Pennsylvania legend “just to be safe,” you’ve given Pennsylvania investors a right of rescission they wouldn’t have had otherwise!

Two qualifications.

First, the North American Securities Administrators Association –the trade group of state securities regulators – suggests including uniform legend on offering documents. I include this or something similar as a matter of course:

IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN EXAMINATION OF THE COMPANY AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND RISKS INVOLVED. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT, AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS SHOULD BE AWARE THAT THEY WILL BE REQUIRED TO BEAR THE FINANCIAL RISKS OF THIS INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.

Second, some states, including Florida, require a legend to appear on the face of the offering document to avoid broker-dealer registration. Because Section 18 of the Securities Act doesn’t prohibit states from regulating broker-dealers, some lawyers recommend including those legends, while others believe those requirements are an improper “back door” way for states to avoid the Federal rule. I come out in the latter camp, but opinions differ.

Questions? Let me know.

Can A Crowdfunding Issuer Sell Its Own Securities?

Securities Cash  Register

Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?

For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.

For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.

Section 18(a)(1) of Securities Act

Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:

Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.

Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?

Here’s the statute again, with extra words removed:

No law requiring registration or qualification of securities transactions shall apply to a covered security.

A sale of a security is definitely a “securities transaction.” So here’s the question:  does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.

But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.

For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.

What’s At Stake

If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.

The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.

I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.

And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.

What To Do

The simplest solution is to sell through a clearing broker licensed in every state.

Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).

If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.

Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.

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My thanks to Jillian Sidoti, Esq. and Anthony Zeoli, Esq., who provided valuable insight.

Questions? Let me know.