Crowdfunding doesn’t screw up the issuer’s cap table. Nevertheless, because many issuers and investors think it does, the SEC adopted 17 CFR §270.3a-9 earlier this year, providing that a Reg CF issuer may use a “crowdfunding vehicle” to issue securities to investors, thereby adding only one entry to its own cap table.
The use of SPVs to own securities is common in the Title II (Rule 506(c)) world and in the world of securities generally. We form a separate entity, typically a limited liability company, to own securities of the “main” company. Indeed, a variation of the SPV structure is required in securitized real estate financing.
But that’s not what the SEC has in mind with crowdfunding vehicles in Title III. The SEC has in mind an entity that is a mirror image, you might say an alter-ego, of the issuer. For example, the crowdfunding vehicle:
- Can have no purpose other than owning securities of the issuer;
- Must have the same fiscal year end as the issuer;
- May not borrow money;
- Must be reimbursed for all its expenses only by the issuer; and
- Must “Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”
What does that last requirement mean? To me, it sounds as if the “rights” associates with the issuer’s securities must be the same as the “rights” associated with the crowdfunding vehicle’s securities.
The “rights” associated with securities are defined in part by contract, which we can control, but in part by state law. Corporate laws vary widely from state to state and even within a state the laws of corporations are often very different than the laws of limited liability companies. This is intentional: limited liability company statutes were written to be different than the corresponding corporate statutes. For example, LLC statutes typically give members of an LLC far greater freedom of contract while corporate laws, for historical reasons, take a more paternalistic view.
When the regulations were proposed, CrowdCheck (Sara Hanks) submitted the comment pointing out that because of the differences in laws among types of entities and states, it would be difficult or impossible for the rights associated with owning an issuer to be identical to the rights associated with owning a crowdfunding vehicle. When the final regulations were issued, the SEC had not changed the language of the regulation and responded to comment as follows:
“As one commenter pointed out, because investors are investing in the crowdfunding vehicle, and not directly in the crowdfunding issuer, there may be slight differences in the rights in the crowdfunding vehicle that investors receive. However, we do not believe these slight differences in rights should in any way affect the ability of the crowdfunding vehicle to issue securities with rights that are materially indistinguishable from the rights a direct investor in the crowdfunding issuer would have [bold added].”
The differences in rights described in the CrowdCheck’s comments were not “slight.” To the contrary, the differences in rights between, say, a New Jersey corporation and a Delaware limited liability company would be “material” in any other area of the securities laws. Having filed a registration statement that identified the wrong type of entity and the wrong state, I can imagine a lawyer arguing to the SEC staff “Who cares? Those are only slight differences!”
How should we interpret the SEC’s response? Why didn’t the SEC just change the language of the regulation, rather than pretend the differences in state laws aren’t “material”? Can issuers and funding portals do whatever they want?
There are two issues:
- The first issue is just cost. Issuers and portals want to automate SPVs, using the same type of entity, the same state, and the same contracts for all of them.
- The second issue is taxes. If the issuer is a corporation and the crowdfunding vehicle is also a corporation, then dividends paid by the issuer to the crowdfunding vehicle will be subject, in part, to double tax.
The question is more than academic. When investors lose money they’re unhappy and often look for someone to blame. If a Mississippi corporation uses a Delaware limited liability company as a crowdfunding vehicle and an investor loses money, a clever plaintiff’s lawyer (no jokes here) won’t find it hard to argue that the Delaware LLC failed to qualify under 17 CFR §270.3a-9 and that the offering was therefore illegal, giving his client the right to get her money back from the issuer and its principals and possibly from the funding portal and its principals as well.
As readers know, I think the SEC has done a terrific job with Crowdfunding, going out of its way to support the industry time after time. For that matter, the SEC introduced crowdfunding vehicles only because of the mistaken impression that Crowdfunding “screws up your cap table.” As crowdfunding vehicles become more widely-used, however, I think more straightforward guidance is required, if only to dissuade clever plaintiffs’ lawyers. For example, the SEC could say explicitly “Differences in rights arising solely from state laws governing corporations, limited liability companies, limited partnership and other legal entities will not be taken into account for these purposes.”
Until that happens, I would be cautious and bear in mind that issuers don’t really need a crowdfunding vehicle in the first place.