Thursday, February 4, 2016

Time for the States to Step up on Crowdfunding or Become Irrelevant



By: Jim Verdonik


Jim Verdonik is an attorney with Ward and Smith, P.A. in Raleigh and is the author of Crowdfunding Opportunities and Challenges .

 He can be reached at


(This article incorporates an article originally published in Triangle Business Journal in November 2015)


On October 30, 2015, the Securities and Exchange Commission issued final rules for Federal Crowdfunding offerings under Section 4 (a) (6) of the 1933 Act, which will become effective in May 2016 ("Section 4(a)(6) Federal Crowdfunding Rules").


Although the Section 4(a)(6) Federal Crowdfunding Rules were long awaited, the changes to SEC Rules 147 and 504 that the SEC proposed the same day to make it easier for more businesses to rely on Rules 147 or 504 to do State crowdfunding offerings may have a bigger positive impact on capital-raising than the Section 4(a)(6) Federal Crowdfunding Rules.


The proposed changes to Rule 147 and Rule 504 are important, because the Section 4(a)(6) Federal Crowdfunding Rules combine a low $1 million maximum offering amount with many expenses and restrictions on both issuers raising capital and platform operators.  The combination of restrictions with a low annual maximum offering amount make it likely that the Section 4(a)(6) Federal Crowdfunding Rules will not be a cost inefficient alternative for most businesses or platform operators.  The history of old SEC Regulation A over several decades proved that few people use an exemption when the exemption is not cost efficient.  Regulation A became something of a joke.  The Section 4(a) (6) Federal Crowdfunding Rules create many inefficiencies by:

  • Only allowing offerings to be made on a platform operated by a registered funding portal or a registered broker.
  • Restricting how funding portals operate their offering platforms, including the types of search tools funding portals can provide investors.
  • Restricting what issuers can say to promote the offering on their own outside the offering platform.
  • Discouraging platform operators that are not registered brokers from disclosing their due diligence investigations to investors.
  • Having a $1 million maximum offering amount.  This will discourage platform operators from spending money on marketing and diligence, because operators will earn relatively low fees for small offerings.   
    Because of these and other limitations in the Section 4 (a) (6) Federal Crowdfunding Rules, no single Federal exemption from registration authorized by the JOBS Act (Rule 506 (c), Regulation A+ and the Section 4 (a) (6) Federal Crowdfunding Rules) gives businesses all of the following attributes of an ideal exemption:

  • The ability to raise large amounts of money.
  • Disclosure flexibility, subject to general rules about material facts.
  • Cost efficiency.
  • The ability to advertise.
  • The ability to sell to both accredited and non-accredited investors.
  • Minimum post-offering duties.

Each Federal exemption lacks one or more of these attributes: 

  • Rule 506(c) does not allow sales to non-accredited investors.
  • Regulation A+ offerings are expensive and Tier 2 of Regulation A+ imposes ongoing reporting requirements on issuers.
  • Section 4(a)(6) Federal Crowdfunding Rules allow you to raise only $1 million, impose fairly inflexible disclosure requirements (including in some cases, excessive financial statements requirements) beyond the normal securities rules about disclosing material facts that increase costs and impose some ongoing disclosure requirements on private companies that may harm their ability to compete.
    The SEC's proposed changes to Rule 147 and Rule 504, however, will clear the way for the states to create offering exemptions that allow businesses to achieve all their goals by: 

  • Allowing businesses to raise up to $5 million.
  • Clarifying that using the Internet and other advertising does not cause issuers to be deemed to be violating rules about making offers in more than one state.
  • Allowing many more types of businesses to use state crowdfunding laws in conjunction with Rule 147 by creating greater flexibility in the current requirements that the business operate in only one state.
  • Permitting multi-state offerings by registering in only one state, if states enact reciprocity laws.
    Facing substantial criticism that the Section 4 (a) (6) Federal Crowdfunding Rules and other JOBS Act exemptions are too restrictive, the SEC is telling the States: "If You Think You Can Do It Better, Go Ahead and Try!"
    So, it's time for the states to finally get their act together.  Both the Federal government and the critics of Federal crowdfunding are encouraging the states to create a better solution.  But will the states really try to solve the problem?  Or will the states enact laws that just pretend to solve problems?

  • Let's take a quick look at the recent history of state securities registration laws and exemptions from registration.
  • Long considered a backwater of the securities regulation world, states securities regulation literally and legally became "fly over country" when Congress pre-empted the states from requiring businesses to register specified types of offerings.  For over two decades Rule 506 offerings have preempted state registration laws for both public and private companies and public issuers have had their own preemption based on where their securities were traded. 
    Preemption became immediately popular and soon 99% of offerings qualified for preemption.  Think about that.  How many things do Americans agree about 99% of the time?  That's how inefficient state securities law compliance was.
    State securities regulators face the same problems that countries face. 
    Laws are not really mandatory.  A law is simply an offer by a country or by a state that businesses and people can either accept or reject. 
    The offer is that if you decide to do something in the country or state, then you must also do a list of things or you must not do a list of things.  If a business doesn't like a country's or a state's tax rates or other regulations, the business can simply reject the offer and not do business there.  Or the business can find a bigger government to protect them from inefficient state laws.  That's exactly how the Federal pre-emption of state securities registration laws started more than two decades ago – businesses just got fed up with the time and expense of complying with state laws that served little purpose.
    Now, state securities administrators are being given a second chance.  The SEC is encouraging businesses to deal with state securities laws by making Rule 147 and Rule 504 more user-friendly to businesses.  I hope the states don't blow it.  People who blow second chances don't usually get third chances. 
    So, here's a blue print for state securities administrators to become relevant again.  Actually we need two blue prints - one that applies to existing state laws that work in conjunction with SEC Rule 147 and the other that relates to state laws that are used in conjunction with SEC Rule 504.
    Some of these issues are relevant to state laws that work in conjunction with either Rule 147 offerings or Rule 504 offerings:

  • The Golden Rule.  Obey the golden rule on fees.  Not all offerings will be successful.  Companies that raise money can afford to pay modest fees.  Businesses that fail to raise money cannot.  Upfront fees and expenses prevent capital-raising.  Charge fees only if businesses actually raise capital.
  • Financing Fraud Prevention.  Stopping securities fraud is in everyone's interest.  Don't expect filing fees to pay for police enforcement against scam artists.  Fund fraud prevention and prosecution from the state budget not from legitimate businesses raising capital.  If these businesses raise capital and grow, they will contribute far more to the state's budget in direct and indirect taxes than the state could ever hope to collect in filing fees.
  • Securities Administrators Need Humility.  Rely on disclosure rules to let investors make decisions.  Give up on merit review that requires state securities regulators to pre-judge whether investors will lose money.  That raises an important question: How often do people who have that valuable skill decide to work for state government?  That's not an insult to government workers.  It's a rare skill in the private sector too. 
  • Current Securities Laws Have Created Unsophisticated Investors.  The general public has been deprived of information about private securities offerings for many years by securities laws that restrict the public's access to information about private offerings.  By giving the public the ability to look at many deals online, Crowdfunding ;aws will help the public to educate itself.  The Internet gave the public greater information about features, quality and prices for consumer goods.  Most people became better shoppers because of the Internet.  The same is likely to be true when people can comparison shop investment transactions.  The amount non-accredited investors are allowed to invest in Crowdfunding offerings is generally much less than the cost of buying cars or houses or planning family vacations, which requires equally complex decision-making skills as investing requires.  The key to good decision-making is access to relevant information and practice doing comparison shopping.  We harm both consumers and investors when laws restrict access information and comparison shopping.
  • Investor Tools.  Let investors develop tools to protect themselves.  Accredited investors in Rule 506 (c) offerings like to join investor syndicates by investing in a limited liability company or other entity that manages the investment in a portfolio company for them.  This promotes due diligence, ongoing scrutiny of the portfolio company by the LLC manager and the combination of voting power by many small investors.  Most of all, this practice promotes diversification by allowing investors to invest small amounts in many syndicates.  Most financial advisers encourage portfolio diversification, but many state and Federal exemptions specifically exclude the LLCs that allow investors to create diversified portfolios by excluding LLCs (which technically are investment companies) that use an exemption other than Rule 506 to sell securities.  Why would any law restrict the ability of investors to diversify their investments?  And why would securities laws discriminate against non-accredited investors?
  • Financial Statements.  Recognize that it's unusual for small businesses to create GAAP compliant financial statements or to pay for audits or reviews by independent CPAs.  Don't require such financial statements in situations, unless they are material and theyare the only way to disclose material information.  Often financial statements are not material for businesses that are still at the idea stage.  Often there are other less expensive ways to disclose information that is material.  Give businesses the flexibility to disclose material facts in a cost efficient way.
  • No Harm No Foul.  Until a business actually sells securities, investors cannot possibly suffer any harm.  Focus on making sure that full disclosure occurs before the issuer receives investor money.  That means two things.  First, we need flexible rules that enable issuers to test the water before starting offerings so they can determine whether the chances for success justify incurring offering expenses.  Second, we need flexible rules about how and when issuers update disclosures during long offerings.  Businesses should be able to gather market information before making major spending decisions.  Banning market tests before making a securities offering is like prohibiting businesses from doing focus group consumer testing before launching a new product line.  The focus group participants are not harmed, because they are simply giving opinions and are not actually buying anything, but the business can avoid making costly mistakes.  Testing investor preferences is likewise both smart and harmless.
  • Flexibility.  Make state laws flexible enough to change automatically when Federal law changes.  Many state statutes will have to be amended to work with proposed changes to Rule 147 and Rule 504.  Federal crowdfunding rules will continue to change.  Don't create state exemptions that become obsolete when Federal laws change.
  • Integration.  Federal crowdfunding laws contain explicit rules that avoid integrating the different types of crowdfunding offerings with most other offerings.  States should follow this example.  This will help businesses that choose one offering exemption from losing other offering exemptions later.  Harming a business' ability to raise more capital increases risks for all investors.  Why create laws that increase investor risk?
  • Intermediary Flexibility.  Recognize that investment bankers who register as broker-dealer have already clearly proven that they are not interested in doing small deals for small businesses.  Therefore, don't require all intermediaries who operate platforms to be registered broker-dealers or impose other expensive restrictions on platform operators.  Likewise, permit intermediaries, businesses and investors to define the services intermediaries can provide and how intermediaries are compensated for their services.  The crowdfunding market won't work without flexible rules for platform operators so that they can provide the types of services investors want or fees that businesses raising capital can afford.   Federal rules will have to change to be more flexible too, but states should not lock in inflexible Federal rules.
  • Self-Reliance.  Some issuers won't need intermediaries.  They may be able to sell securities to their own customers through their own websites and other advertising.  Who knows a business better than its customers?  Don't force businesses to hire intermediaries to do what they can do for themselves. 
  • Value.  Adding value makes you relevant.  States can add value in multi-state offerings by training administrators who review offering documents to be industry specialists like both the SEC and the private sector do.  Every state can't have specialists for every industry.  That's another reason interstate cooperation makes sense.
  • Technology Efficiency.  Use technology to make offering compliance efficient.  Most states facilitate multi-state filings on a single website.  Holdouts look like they are in the Stone Age.
  • Interstate Service Providers.  Platform operators and escrow agents operate in many states.  Don't limit such service providers to those that are incorporated in your state.  It's too inefficient for these service providers to incorporate subsidiaries everywhere.  Such requirements would limit choices by both investor and business that are raising capital.
  • Local Restrictions.  Be careful about adding local restrictions.  Don't force businesses to pay lawyers to identify arcane local rules.

Now let's address state laws that will be used in conjunction with SEC Rule 504.

Rule 504 permits both advertising and general solicitation and sales to non-accredited investors, if the offering is registered in a state. 

Registration is normally a long and expensive process, but Rule 504 does not specify the process states must use to register sales of securities.  The registration process can be as short as the process for filing disclosure documents with state securities administrators under state crowdfunding laws that are currently used in conjunction with Rule 147.  That would permit general solicitation and sales to non-accredited investors in one state.  But if a state's law provides that registration in another state constitutes registration in both states, the door would be open to multi-state crowdfunding offerings that use Rule 504.  If the states apply the same limits on the amounts non-accredited investors can invest that they do in state crowdfunding laws, investors will be protected from making big mistakes.   

Such multi-state offerings under state crowdfunding laws and Rule 504 would resolve many of the problems issuers and platform operators face in Federal crowdfunding offerings under Section 4 (a) (6).  The primary impediment is whether the states will enact reasonable reciprocity laws.

State reciprocity laws are not a new concept.  State reciprocity laws make many aspects of our lives more convenient.  States currently have many reciprocity laws that specify a minimum standard and that give reciprocity to any state whose laws meet that minimum standard.  Reciprocity laws help licensed professionals move from one state to another without repeating licensing tests in each state, permit licensed drivers of one state to drive in other states and allow students who study in one state to transfer to schools in other states without repeating classes. 

The key to reciprocity is agreeing on a common minimum standard.  Luckily, most current state crowdfunding laws specify very similar lists of required disclosures and review processes.  The states have already done most of the work required to enact the common reciprocity standard.  All that is lacking is the will to do so. 

State reciprocity has been limited in securities regulations.  States have traditionally tried to wall off their economies by requiring businesses that have registered offerings in one state to do a new registration to sell in their state.  This inefficient system was the primary reason Federal laws preempted state registration laws.    

Therefore, the basic issue is whether it makes sense for 50 states to review and require changes to the same offering documents and to have businesses pay 50 registration fees. 

Was this system really designed to protect investors?  Or did these laws just reflect distrust of outsiders, a desire to generate revenue from filing fees and a desire to wall off state economies?

Let's be generous and assume that there were good reasons to create this system 100 years ago.  The pertinent issue is whether this system has any relevance in an interconnected national and global economy.  I have never heard a convincing argument that it does.

Trying to build walls around state economies simply doesn't make sense and is in fact impossible to achieve if it did make sense.  Imagine an interstate highway that ends at a state border.  Such a road to nowhere will either be underused or will result in traffic jams where the road ends.  Capital-raising is also a multi-state game.

Businesses and their shareholders, officers and directors have valuable personal and business contacts in many states. 

  • How many people have gone to school in other states?
  • How many people have lived in other states?
  • How many people have family in other states?
  • How many people have customers and vendors or branch offices in other states?
    All of these interstate personal and business contacts are valuable when businesses raise capital.  State laws that restrict offerings to one state deprive businesses of these valuable capital raising resources.
    Of course, if states irrationally deprive businesses of capital raising resources, pressure will build for more preemption of state securities laws.  States are facing important choices – either create a rational system or entirely lose their role in regulating securities offerings.   
    It will be interesting to see which alternative state securities regulators choose.


1 comment:

  1. New times requires new approaches!
    Crowdfunding becomes more and more popular specially for start-ups that are not able to get venture capital as a whole.
    I can also recommend virtual data rooms (something like Ideals would be great) for getting all necessary data managed and classified in the cloud.