On October 26, 2016, the US Securities and Exchange Commission (SEC) issued new rules designed to make capital-raising for small businesses easier.
The two exemptions the SEC has updated, the intrastate offering exemption and Rule 504, are the two most commonly used strategies for companies doing direct public offerings to raise capital from their own community. At Cutting Edge Capital, we are very pleased to see the SEC implement changes that make it easier, rather than harder, to access community capital.
The important highlights are:
- Rule 504 DPOs, which can be conducted in more than one state, will now have a $5 million limit, versus the previous $1 million limit.
- The SEC is also making it easier to conduct intrastate DPOs (that is, offerings in one state only, typically with no dollar limit) by:
- Relaxing the standards to identify state residency for investors,
- Reducing the restrictions on transfer of securities purchased,
- Protecting these offerings from integration with different types of offerings conducted near the same time,
- Allowing offers to be made to anyone (e.g. via a website) as long as the actual sale is restricted to residents of the state of the offering, and
- Allowing an issuer to be formed in any state, even if it is different from the state of the offering.
Here are the details.
Rule 504 Offerings
The SEC made two important changes to Rule 504, effective January 20, 2017. First, the aggregate cap is increased from $1 million to $5 million in a 12-month period. This change will make Rule 504 much more useful for companies whose investors are in more than one state but who need to raise more than $1 million in a year. Previously, such a company would have been forced to make a compromise: Either limit the investors to one state, or limit the offering to $1 million, or utilize the more burdensome Regulation A. We anticipate that more of our DPO clients will now opt for a Rule 504 offering.
The second change to Rule 504 imposes the same “bad actor” limitations on Rule 504 as are currently in place for private placements under Rule 506. This means that a company may not use Rule 504 if any of its key people (for example, an officer, director, manager, promoter, or 20% owner, besides the issuer itself) is the subject of a disqualifying event relating to securities transactions, such as criminal convictions, SEC orders, court injunctions and the like.
To protect an issuer who may be unaware of a key person’s past disqualifying event, there is a reasonable care exemption, which provides that as long as the issuer has made an appropriate inquiry (such as by requiring each of its key people to complete a questionnaire), it will not be disqualified from using Rule 504 if it turns out that one of its key people lied. As an additional protection for issuers, a disqualifying event that occurred prior to the new rules will not actually prevent the issuer from using Rule 504; but the disqualifying event must be disclosed to potential investors.
Previously, most Intrastate Offerings were conducted in reliance on Rule 147, which provided a “safe harbor” that ensured an offering would meet the requirements for the intrastate exemption in section 3(a)(11) of the Securities Act of 1933.
Effective April 20, 2017, the SEC is revising Rule 147 to relax some of its requirements. At the same time, the SEC is implementing a new Rule 147A, which is largely identical to Rule 147 but further relaxes the requirements in two important respects that take it out of section 3(a)(11).
Here is what the revised Rule 147 and the new Rule 147A have in common:
Issuer’s Relationship with the State of the Offering: Under the new rules, an issuer must have its principal place of business in the state of the offering (which could include a US territory) and meet any one of the following additional requirements demonstrating the in-state nature of their business:
- 80% of gross revenues are from:
- Operation of a business in the state,
- Real estate located in the state, or
- Rendering services in the state.
- 80% of its assets are located in state as of end of its last semi-annual period.
- 80% of net proceeds from the offering will be used in connection with:
- Operation of a business in the state,
- Purchase of real estate located in the state, or
- Rendering services in the state.
- Majority of its employees are based in state
Under the old rules, an issuer had to meet all of the first three requirements, which made it difficult for many businesses to qualify, particularly if they offered goods or services online. The new rules will now make it much easier for businesses to qualify to do an intrastate offering.
State of Residence of Investors: Under the new rules, every investor in an Intrastate Offering must actually be a resident of the state in which the offering is conducted or, if an investor is not actually a resident, the issuer must have had a reasonable belief that the investor is a resident of the state. Under the old rules, an investor’s reasonable belief did not matter; if one investor was not actually a resident of the state of the offering (even if they claimed they were), the issuer might have inadvertently violated securities laws.
The new rules also require that every investor in the offering provide a representation that they are a resident of the state of the offering (this is usually included in the subscription agreement). However, a written representation is not enough to establish the issuer’s reasonable belief of residency status for investors. In other words, if an investor represents that they are a resident of the state but they are not, without additional evidence of their state of residence, the issuer could still be in violation of the securities laws.
What does it take to establish reasonable belief as to residence status? The SEC provides the following examples for individual investors, though this is not an exclusive list, and the reasonableness of an issuer’s belief will depend on the specific circumstances in each case:
- Personal knowledge based on a pre-existing relationship with the investor
- Utility bill
- Tax return
- Driver’s license or other government-issued document
- Directory listings
- Public records
- Other reliable databases, such as credit bureaus
For an investor that is a legal entity, such as a corporation, LLC, or partnership, it’s the principal place of business that counts. This means the location at which the officers, partners, or managers of the entity primarily direct, control and coordinate its activities.
Significantly, a trust that is not a separate legal entity under the law of its creation is deemed to be a resident of each state in which a trustee is resident, which could be more than one state. This implies that an out-of-state resident who wants to invest in an intrastate offering could establish a revocable trust (which will normally not be deemed a separate legal entity) with an in-state trustee to make the investment. It also implies that a trust with multiple trustees, each of whom is resident in a different state, could invest in intrastate offerings in any of the states in which one of its trustees is a resident.
Restrictions on Transfer: Under the new rules, securities acquired in an Intrastate Offering may not be sold to an out-of-state investor until six months after the securities were purchased, regardless of when the offering ends. This is a significant change because the previous holding period was nine months, and the previous holding period did not begin until the issuer completed its offering, which could have been up to a year after a particular investor purchased their securities.
The SEC also clarified that bona fide gifts are not subject to this holding requirement (and are not subject to registration requirements at all under the 1933 Act); but sales by the recipient of donated securities are covered, which means those securities still cannot be sold to a nonresident of the state of the issuer during the holding period, even if the donee/seller is a resident of a different state).
Integration Safe Harbor: The new rules provide an important new integration safe harbor: Offers or sales under the intrastate exemption will not be integrated with any of the following:
- Prior offers or sales under any legal strategy
- Subsequent offers or sales that are:
- Registered with the SEC (except that in the 30 days before a registration statement is filed, the safe harbor only covers offers to institutional accredited investors)
- Exempt under Regulation A
- Exempt under Rule 701 (for securities-based compensation)
- Under an employee benefit plan
- Exempt under Regulation S (for offerings in other countries)
- Exempt under section 4(a)(6) (commonly known as Title III crowdfunding)
- Made more than six months after the completion of the intrastate offering
This is a significant loosening of the integration rules. Previously, for example, a Rule 506 private placement could be integrated with a subsequent Intrastate Offering, and the effect could have been that the combined (integrated) offering would not meet the requirements for either strategy. Under the new rules, that is no longer a risk. This means any kind of offering can occur up until the date immediately before an Intrastate Offering commences, whether it’s a private placement or otherwise. And, offerings under the strategies listed above can occur immediately after an Intrastate Offering.
However, the SEC points out that the integration safe harbor doesn’t mean, for example, that the advertising of an offering that permits general solicitation will not affect a different offering that does not permit general solicitation, or that imposes restrictions on general solicitation. An issuer must still strictly follow the requirements for each offering strategy.
New Rule 147A: The new Rule 147A, which is also effective April 20, 2017, is largely identical to the revised Rule 147 but with two key differences. First, the issuer does not need to be formed under the laws of the state of the offering. This will be a significant benefit to organizations that are incorporated in one state (for example, Delaware) but are based in and otherwise meet all the requirements for an offering in another state.
Second, and perhaps more importantly, offers can be made anywhere, as long as actual sales are only made to residents of the state of the offering. This is intended to solve the problem presented when issuers put their securities offering on their website: If not done very carefully, the fact that non-residents of the state of the offering can access the website and see the offering could mean the issuer has inadvertently offered the securities to a non-resident, which is not permitted under Rule 147. But under Rule 147A, this concern is eliminated. Issuers will have more freedom to advertise the offering, as long as actual investors are limited to residents of the state of the offering.
One may wonder why Rule 147 has been retained at all, if Rule 147A serves the same purpose but with more liberal rules. The answer is that many of the state crowdfunding laws that have been implemented in the past few years explicitly require the use of Rule 147. The SEC retained Rule 147 (albeit in its updated form) to avoid placing a cloud of uncertainty over offerings made under those state laws. But for companies considering an intrastate DPO, Rule 147A will almost always be the better strategy.
We believe community capital is a necessary element of a more equitable and inclusive economy. Unfortunately, it is still not widely understood; many people, including lawyers and investment professionals, still do not realize it is possible to raise community capital. We expect these new SEC rules will now bring attention to this win-win strategy that allows entrepreneurs to raise capital from their ideal investors, allows accredited and non-accredited investors to invest in and profit from businesses in their community, and allows communities to build wealth organically through a continuous cycle of investment, growth, profit, and reinvestment.
This article is offered for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer to our clients, including Direct Public Offerings, visit www.cuttingedgecapital.com or email us at email@example.com