Overview

On October 26, 2016, the SEC adopted final rules regarding “intrastate” offerings. The SEC “modernized” Rule 147 under the Securities Act of 1933 to reflect developments in current business practices and communication technologies, particularly the internet, to ensure the “continued utility” of Rule 147 as a safe harbor for offerings relying on Section 3(a)(11) of the Securities Act. At the same time, the SEC adopted a new Rule 147A that is similar to Rule 147 but has added flexibility for issuers.

In the FAQs below, we explain these new developments and how they may rejuvenate the intrastate offering exemption for the 21st century. The SEC’s adopting release can be found at https://www.sec.gov/rules/final/2016/33-10238.pdf. All quoted language below is from the adopting release unless otherwise identified. The new rules will become effective on April 20, 2017. (In this Client Alert, we refer to the version of Rule 147 that is currently in effect as “current Rule 147” and the version of Rule 147 that will become effective on April 20, 2017 as “amended Rule 147.”)

After the FAQs below, we give our views on the practicable effects of the new rules in the Conclusions section of this Client Alert.

FAQs

Q1. What is the “intrastate” offering exemption?

A. Section 3(a)(11) of the Securities Act exempts from registration “any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.”

The SEC initially adopted Rule 147 in 1974 to serve as a safe harbor for issuers that conduct intrastate offerings. If an issuer complies with all of the provisions of Rule 147, then the issuer will be deemed to have complied with Section 3(a)(11).

Q2. What are the problems with intrastate offerings that the SEC is trying to solve?

A. The SEC identified the following issues, among others, that have reduced the utility of current Rule 147:

  • Under Section 3(a)(11) and Rule 147, a single “offer” to a nonresident causes the issuer to lose the registration exemption for the entire offering. Given the pervasive influence of the internet, this aspect of Section 3(a)(11) and Rule 147 has made the intrastate offering exemption useful only in very narrow circumstances.
  • Under Section 3(a)(11) and current Rule 147, the issuer must be organized under the laws of the state where the offering takes place. As the SEC noted, “there are valid business reasons for incorporating or organizing in states, such as Delaware, which do not detract from an issuer’s connection to the state in which its principal place of business is located.”
  • Current Rule 147 contains multiple tests that an issuer must satisfy to be deemed to be doing business in a state, and fewer companies “do business” locally today in a way that can satisfy all of the required tests.

For these and other reasons, lawyers have often advised issuers that the intrastate offering exemption is either not available or is fraught with risk.

Q3. Why did the SEC amend Rule 147 AND adopt a new Rule 147A, instead of just amending Rule 147?

A. The SEC decided to retain Rule 147 “as a safe harbor under Section 3(a)(11) to preserve the continued availability of existing state exemptive provisions [including crowdfunding provisions] that are specifically conditioned upon issuer reliance on Section 3(a)(11) and Rule 147.” Given the restrictive language in Section 3(a)(11) and the need to retain Rule 147 as a safe harbor, the SEC determined that it could not address the “single offer” problem and the “state of organization” problem noted above by amending Rule 147. Instead the SEC (a) amended Rule 147 where it could do so without contradicting the express language in Section 3(a)(11) and (b) adopted a new intrastate offering exemption—Rule 147A—pursuant to the SEC’s general exemptive authority under Section 28 of the Securities Act.

States are free to amend their current exemptive laws or regulations to refer to Rule 147A instead of Section 3(a)(11) and Rule 147. Until that happens, the amended Rule 147 will be available to issuers upon its effectiveness, but the additional benefits of Rule 147A will not be available for offerings intended to comply with state laws or regulations that explicitly refer to Section 3(a)(11) and Rule 147, as many such laws and regulations do.

Q4. How do amended Rule 147 and Rule 147A differ?

A. Amended Rule 147 and new Rule 147A are almost identical, except that Rule 147A:

  • has no restriction on offers to out-of-state residents, which permits issuers to use the internet or other technologies to offer the securities;
  • allows issuers to be incorporated or organized outside of the state in which the intrastate offering is conducted as long as they maintain their principal place of business in the state; and
  • is not a safe harbor under Section 3(a)(11) and thus is not subject to its statutory limitations.

Q5. Are securities sold under amended Rule 147 and Rule 147A “covered securities” (i.e., securities for which state securities law registration and qualification requirements are preempted)?

A. No. As is the case with current Rule 147, issuers must comply with any applicable state law relating to the offer and sale of securities issued pursuant to amended Rule 147 or Rule 147A.

Q6. Who can conduct an intrastate offering under amended Rule 147 and new Rule 147A?

A. Under amended Rule 147, an issuer must:

  • have its “principal place of business” in the state;
  • be incorporated or organized in the state; and
  • be doing business in the state where the securities are offered and sold.

Under new Rule 147A, an issuer must:

  • have its “principal place of business” in the state and
  • be doing business in the state where the securities are sold.

Under both amended Rule 147 and new Rule 147A:

  • “Principal place of business” means “the location in which the officers, partners, or managers of the entity primarily direct, control and coordinate its activities.”
  • To meet the “doing business” requirement, an issuer must satisfy at least one of the following four requirements:

(a) derive at least 80% of its consolidated gross revenues within the state,

(b) have at least 80% of its consolidated assets within the state at the end of its most recent semi-annual fiscal period,

(c) use at least 80% of the offering’s net proceeds within the state, or

(d) have a majority of its employees based in the state.

The above requirements are significantly less restrictive than those under current Rule 147.

If an issuer uses amended Rule 147 or Rule 147A for an offering in one state and then changes its principal place of business to another state, the issuer may not use the exemption “to conduct another intrastate offering in [the other] state for a period of 6 months from the date of the last sale of securities under the prior” offering.

Q7. Who can purchase the securities offered in an intrastate offering under amended Rule 147 and Rule 147A?

A. At the time of the sale of securities, all purchasers must be residents of the same state in which the issuer is a resident.

Q8. How does an issuer determine the residency of a purchaser under amended Rule 147 and Rule 147A?

A. An issuer will satisfy the requirement that the purchaser in the offering be a resident of the same state in which the issuer is resident “by either the existence of the fact that the purchaser is a resident of the applicable state or territory, or by establishing that the issuer had a reasonable belief that the purchaser of the securities in the offering was a resident of such state or territory.”

Q9. How can an issuer establish a “reasonable belief” that the purchaser of the securities in an offering under amended Rule 147 or Rule 147A was a resident of the state where the offering is made?

A. A “reasonable belief” will be determined based on the facts and circumstances, which include (according to the SEC’s adopting release, but not the provisions of the rule itself):

  • a pre-existing relationship between the issuer and the prospective purchaser that provides the issuer with sufficient knowledge about the prospective purchaser’s principal residence or principal place of business so as to enable the issuer to have a reasonable basis to believe that the prospective purchaser is an in-state resident or
  • evidence of the prospective purchaser’s home address as documented by a recently dated utility bill, pay-stub, information contained in state or federal tax returns, any documentation issued by a federal, state, or local government authority, such as a driver’s license or identification card, or a public or private database that the issuer has determined is reasonably reliable, including credit bureau databases, directory listings, and public records.

Q10. How does an issuer determine the residence of a legal entity?

A. The residence of a purchaser that is a legal entity is where the legal entity has its “principal place of business” at the time of the sale. A purchaser’s “principal place of business” is determined in the same manner as an issuer’s residency, as explained above.

Q11. Can an issuer just rely on a written certification from the purchaser regarding the purchaser’s residency?

A. No. Although the issuer must obtain a written representation from each purchaser that the purchaser resides in the state, this representation, by itself, is not enough to meet the “reasonable belief” standard.

Q12. When and how can purchasers resell the securities they acquire in an intrastate offering pursuant to amended Rule 147 and Rule 147A?

A. For a period of six months from the date of the issuer’s sale of a security to the purchaser, any resale by the purchaser must be made only to residents of the state in which the issuer resided at the time the issuer sold the security. After this six-month period, the securities are freely saleable.

Q13. Can an issuer use other securities offering exemptions while employing amended Rule 147 or Rule 147A?

A. When a company issues securities under an offering exemption, it must examine whether the offering might be “integrated” with other offerings that the issuer has conducted before, during, or after the offering. If the offerings are integrated, the supposedly separate offerings could “be treated as one for purposes of qualifying for either exemption.” That integration could be fatal to both exemptions.

Amended Rule 147 and Rule 147A provide for an expanded six-month integration safe harbor that is consistent with Regulation A’s integration safe harbor provision. Offers and sales made in reliance on the rules will not be integrated with:

  • offers or sales of securities made before the amended Rule 147 or Rule 147A offering begins or
  • offers or sales of securities made after the completion of offers and sales under amended Rule 147 or Rule 147A that are:
    • registered under the Securities Act, except as described below*;
    • exempt under Regulation A;
    • exempt under Rule 701;
    • made pursuant to an employee benefit plan;
    • exempt under Regulation S;
    • exempt under the statutory federal crowdfunding exemption (Section 4(a)(6) of the Securities Act); or
    • made more than six months after the completion of the amended Rule 147 or Rule 147A offering.

* If, after relying on the Rules to make offers solely to qualified institutional buyers (QIBs) and institutional accredited investors (IAIs), the issuer decides to register the offering, the amended Rule 147 or Rule 147A offers will not be integrated with any subsequent registered offering. If the issuer, relying on amended Rule 147 or Rule 147A, makes offers to persons other than QIBs and IAIs, the offers will not be integrated with the subsequent registered offering if the issuer waits 30 days between the last offer made under amended Rule 147 or Rule 147A and the filing of the registration statement.

An amended Rule 147 or Rule 147A offering will not be integrated with concurrent offerings made under other exemptions so long as the offerings comply with the requirements of their respective exemptions. As explained in considerable detail on pages 48-53 of the adopting release, however, the integration analysis for concurrent offerings and for registered offerings that closely follow offerings under amended Rule 147 and Rule 147A can be highly complex.

Q14. What must an issuer disclose to offerees and purchasers when conducting an offering under amended Rule 147 or Rule 147A?

A. Issuers must:

  • make disclosures to offerees and purchasers regarding the limitations on resale;
  • satisfy the revised, less burdensome requirements regarding affixing legends on the certificate or other document evidencing the security; and
  • identify on the legend the state “in which the issuer was a resident at the time of the original sale of the security.”

Q15. Are securities issued in reliance upon amended Rule 147 or Rule 147A exempt from the reporting requirements of Section 12(g) of the Securities Exchange Act of 1934?

A. No. As amended by the JOBS Act, Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors to register that class of securities with the SEC. Unlike Tier 2 offerings under Regulation A or Regulation Crowdfunding, where the SEC provided conditional exemptions from registration under Section 12(g), issuers that use the exemptions under amended Rule 147 or new Rule 147A will not be required to comply with ongoing reporting requirements. Given the lack of ongoing reporting requirements, the SEC stated in the adopting release that the Section 12(g) record holder and asset thresholds continue to provide an important baseline above which issuers should generally be subject to the disclosure obligations of the Exchange Act.

Q16. State securities regulators and the SEC have sometimes battled over federal preemption for covered securities and Tier 2 Regulation A offerings, among other things. What do state securities regulators think about amended Rule 147 and new Rule 147A?

A. The initial reaction by the President of the North American Securities Administrator Association (NASAA) in a statement released on October 25, 2016 was positive:

“The SEC’s rule changes represent a significant step toward better alignment with modern technology and business practices. These changes will allow small companies to make better use of state crowdfunding and limited offering exemptions to raise capital. Investors and small companies will also benefit from changes to capital formation rules that include significant investor protections and preserve state authority. We look forward to closely reviewing the final rules and working with the Commission in their implementation.”

This statement, issued on the date of the SEC vote on the new rules, is consistent with the SEC’s statements in the adopting release about the benefits of state registration of securities offerings under coordinated review programs.

Conclusion

We believe that the modernization of the rules for intrastate offerings may make intrastate offerings more popular for private company capital raises, especially if states revise their state crowdfunding laws or regulations to refer to Regulation 147A. Below are a few of the relevant considerations for issuers and their counsel to consider as they analyze what registration exemptions to use in various circumstances:

Rule 506(b):

Advantages:

  • exemption is widely used, so investors, issuers, placement agents, and lawyers are familiar with it
  • available to public companies
  • amount that can be raised is not capped
  • state blue sky laws are preempted
  • offering is not limited to the state where issuer has its principal place of business and is doing business
  • no line item disclosures are required unless sales are made to unaccredited investors (Rule 506(b) offerings are rarely structured to do so)
  • if necessary, however, an issuer can sell to up to 35 unaccredited investors and must provide the required disclosures

Disadvantage:

  • general solicitation and advertising is not permitted

Rule 506(c):

Advantages:

  • general solicitation and advertising is permitted
  • amount that can be raised is not capped
  • state blue sky laws are preempted
  • offering is not limited to the state where issuer has its principal place of business and is doing business
  • no line item disclosures are required (because securities can be sold only to accredited investors)

Disadvantages:

  • issuer cannot sell to unaccredited investors
  • issuer must take “reasonable steps” to verify accredited investor status

Rule 505: Repealed effective May 22, 2017

Amended Rule 504: Effective January 20, 2017

Advantages:

  • offering cap recently increased to $5 million from $1 million (less the aggregate offering price for all securities sold within the 12 months before the start of and during the offering of securities under Rule 504, in violation of section 5(a) of the Securities Act)
  • unaccredited investors can purchase securities
  • no need to verify accredited investor status (unless issuer is relying on state law exemptions from registration that permit general solicitation and general advertising so long as sales are made only to "accredited investors")
  • offering is not limited to the state where issuer has its principal place of business and is doing business

Disadvantage:

  • no state blue sky law preemption, so offering must either be registered in the state(s) in which the offering is being made or must be made under an available state registration exemption

Federal Regulation Crowdfunding:

Advantages:

  • unaccredited investors can purchase securities
  • issuer is not required to verify accredited investor status
  • issuer is entitled to a conditional exemption from registration under Section 12(g) of the Exchange Act
  • offering is not limited to the state where the issuer has its principal place of business and is doing business
  • state blue sky laws are preempted

Disadvantages:

  • SEC filing is required
  • audited financial statements are required in certain circumstances
  • offering is capped at $1 million, including amount of securities sold through crowdfunding exempt offerings during the preceding 12-month period
  • offering costs are relatively high in light of $1 million offering cap
  • amount each investor can invest is limited
  • issuer must file an annual report with the SEC no later than 120 days after the end of its fiscal year
  • issuer must use an intermediary

Amended Rule 147:

Advantages:

  • amount that can be raised is not capped
  • no line item disclosures are required (other than mandated disclosures about sales and certain resales being made only to residents of a specific states)
  • "reasonable belief" as to residency of purchasers is now sufficient
  • no need to verify accredited investor status

Disadvantages:

  • offers and sales are limited to the state where the issuer has its principal place of business and is doing business
  • a single offer to a nonresident causes the issuer to lose the exemption for the entire offering
  • state blue sky laws are not preempted

New Rule 147A:

Advantages:

  • same as Rule 147 plus
  • out of state offers are permitted
  • issuer does not have to be organized in the state where the offering is made

Disadvantages:

  • sales are limited to the state where the issuer has its principal place of business and is doing business
  • state blue sky laws are not preempted

In summary, we believe that if the states amend their exemptive laws and rules to coordinate with new Rule 147A, the use of state crowdfunding for “local” issuers and investor bases may increase. Those offerings may incur lower offering costs than (a) federal Regulation Crowdfunding offerings, which have the considerable drawbacks cited above, or (b) Rule 504 offerings that must be registered in the state where the offering is made in the absence of other state exemption(s). Issuers may also use Rule 147A for offerings that are larger than $5 million (unlike Rule 504) and that are registered with the applicable state.

As helpful as the amendments to Rule 147 and the adoption of new Rule 147A may otherwise be, however, the unwillingness of the SEC to provide a permanent exemption from Section 12(g) registration under the Exchange Act for securities sold in an offering under amended Rule 147 or Rule 147A may limit the usefulness of these rules as a practical matter.