On October 30, 2015, the Securities and Exchange Commission adopted the final rules for “Regulation Crowdfunding” nearly two years after issuing its proposed rules and over three years after the enactment of Title III of the JOBS Act. Since the publication of those final rules, many commentators have blogged about those rules, and many have not been kind, criticizing the final rules as, among other things, unusable by the very start up issuers for which they were supposed to be “the solution.” Lost in the shuffle that day was the announcement by the SEC of proposed changes to two other exemptions from the registration requirements of the Securities Act of 1933: Rule 147 and Rule 504. Rule 147 is a “safe harbor” provision for intrastate securities offerings exempted from registration by Section 3(a)(11) of the Securities Act, while Rule 504 is one of the four exemptions provided by Regulation D. Both of these rules have been seldom used in the modern era. Rule 147 has proven to have too many requirements and restrictions to be useful, especially in the modern age of the internet. Rule 504 has proven not to be attractive to issuers privately placing their securities, who have instead almost universally chosen to rely on Rule 506(b).With its proposed changes to these two rules, the SEC has taken positive steps toward creating more useful exemptions and alternatives to Rule 506(b) offerings.
Section 3(a)(11) of the Securities Act provides an exemption for “[a]ny security which is 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.” Rule 147 was adopted in the waning days of the Nixon administration (and has never been amended) to provide a safe harbor with objective standards for issuers relying on Section 3(a)(11). The problem was that the objective standards proved too draconian to be of much use to issuers other than, perhaps, a small local business looking for financing from its neighbors. It included a three part “80 percent” test, which required that 80% of the issuer’s consolidated gross revenues were in state, 80% of its consolidated assets were in state, and 80% of the proceeds from the offering be used in state. In addition, the issuer, if a corporation, had to be incorporated in the jurisdiction of the offering, which made it basically useless in a state such as New York which had then (and still has, despite amendments in the 1990s) a corporation law with unfavorable provisions, such as Section 630 of the Business Corporation Law that exposes the ten largest shareholders of the corporation to employee wage claims. Furthermore, while the preferred state of incorporation for most VC backed companies is Delaware, few have any significant operations in that state.
The proposed amendments to Rule 147 allow an issuer to both make offers to out of state residents and to be incorporated out of state. Since it no longer strictly is within the language of Section 3(a)(11) given these changes, the new Rule 147 exemption was technically created under Section 28 of the Securities Act. Some of the major changes are:
- The proposed new Rule 147 would permit an offering by the internet – the fact that it can be seen by people other than residents of the state is no longer fatal, just so long as the issuer has a “reasonable belief” that all the purchasers are of the same state as the issuer.
- Furthermore, the issuer is deemed to be “of the state” where its “principal place of business” is, rather than its state of incorporation. The issuer’s principal place of business is determined by the location where its managers primarily “direct, control and coordinate the activities of the issuer.
- The issuer needs to demonstrate the “in-state” nature of its business by complying with just one of the three “80 percent” tests or, alternatively, have a majority of its employees based in such state.
- The issuer needs to either register the offering in the subject state or rely on an exemption that has a $5 million limitation in any 12 month period as well as investment limitations on the investors, which is intended to dovetail with the “crowdfunding” legislation that has been adopted by many of the states.
Rule 504 was originally adopted as part of Regulation D in 1982. As it currently stands, Rule 504 can be used by certain non-public companies to raise up to $1 million in a 12-month period. Rule 504, however, is currently seldom relied upon – as noted by the SEC, during the period from 2009 through 2014, while $5.773 trillion was raised under Regulation D, only 0.1% was raised in reliance on Rule 504. Issuers instead virtually all relied on Rule 506 (now Rule 506(b)), which has no limit on the amount that can be raised and, if sold exclusively to accredited investors, has no disclosure requirement (though, of course, the anti-fraud rules still apply).
Rule 504 has its merits – for example, there is no limit on the number of non-accredited investors that can participate in certain Rule 504 offerings. In addition, the SEC has tried to make Rule 504 more attractive to issuers. One of the more notable experiments was the elimination of the prohibition against general solicitation in 1992. This change dramatically increased issuer reliance on Rule 504, but also increased the amount of fraudulent activity, especially in the secondary marketplace due to the then unrestricted nature of securities issued in Rule 504 offerings. As a result, in 1999 the SEC reimposed restrictions on general solicitation and restricted security status except for certain specified Rule 504 offerings.
The proposed amendments to Rule 504 would attempt to increase its utilization by increasing the cap on the amount offered and sold during any 12-month period from $1 million to $5 million. In addition, to conform with the current requirements of Rule 506, the “bad actor” disqualifying provisions would also be incorporated into Rule 504. Given this increase in the permitted offering amount, the SEC also requested comments on whether Rule 505 (which has similarly been underutilized) is still needed.
The SEC should be commended for the proposed amendments to Rule 147 and Rule 504, which reflect a thoughtful consideration of how to increase the usefulness of both these safe harbors, and with respect to Rule 147, bringing it into the 21st century. Whether the SEC determines to issue final rules mirroring the proposed rules after the comment period, and whether the final rules will actually prove to be embraced by the marketplace, remains to be seen. But both proposed amendments – especially the proposed revisions to Rule 147, given the documented problems with the final rules issued by the SEC on “Regulation Crowdfunding” – represents a focus by the SEC on creating exemptions from the registration requirements of the Securities Act that issuers can actually use.
The views expressed in the foregoing article are those of the author only and do not reflect the views of the SEC or the Securities and Exchange Commission’s Advisory Committee on Small and Emerging Companies.