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WARNING: The Federal Exchange Act May Limit the Utility of State Crowdfunding Exemptions

Posted by Jeff Thomas and Malika Simmons

Historically, federal and state securities laws have made equity crowdfunding extremely difficult in the United States. ((See, e.g., Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, 13 Transactions: Tenn. J. Bus. L. 63, 92 (2011) (“[T]he current securities framework in the United States makes it extremely difficult for most promoters, and even some larger intermediaries, to build a vibrant investment crowdfunding market.”)) However, equity crowdfunding laws that create new exemptions from costly registration requirements have recently been passed in several states including Michigan, Kansas, Indiana, and Wisconsin. ((See, e.g., Steven Davidoff Solomon, S.E.C.’s Delay on Crowdfunding May Just Save It, N.Y. Times (Nov. 18, 2014), http://dealbook.nytimes.com/2014/11/18/s-e-c-s-delay-on-crowdfunding-may-just-save-it-2/?_r=1; North American Securities Administrators Association, intrastate crowdfunding directory available at http://www.nasaa.org/industry-resources/corporation-finance/instrastate-crowdfunding-resource-center/intrastate-crowdfunding-directory/.))

Several other states have similar legislation pending. ((Solomon, supra note 2. See, e.g., North American Securities Administrators Association, intrastate crowdfunding legislation (2015), available at http://www.nasaa.org/wp-content/uploads/2014/01/NASAA-Crowdfunding-Index-2-19-2015.pdf.)) These state crowdfunding exemptions are being heralded as a more viable solution than the federal crowdfunding exemption created by Title III of the Jumpstart Our Business Start-ups Act (the “JOBS Act”). ((See, e.g., Solomon, supra note 2.)) Moreover, many are skeptical of the Securities and Exchange Commission’s (the “SEC’s”) ability to adopt effective crowdfunding regulations. ((See id.)) However, the true value of the state crowdfunding initiatives may ultimately depend on action being taken at the federal level.

State crowdfunding rules may allow companies to offer or sell securities, using a crowdfunding platform, without incurring costly registration expenses necessary to comply with requirements under the federal Securities Act of 1933 (the “Securities Act”). Issuers can escape these costs by complying with the requirements of: (i) at least one federal exemption from registration (such as the intrastate exemption provided by section 3(a)(11) of the Securities Act, and its safe harbor, Rule 147); and, (ii) the applicable state crowdfunding exemption, if any. ((See, e.g., Tom Sharbaugh & Randy Barr, Single-State Crowdfunding—a Quicker and Cheaper Alternative, Wharton Entrepreneurship Blog (Jun. 3, 2014), http://beacon.wharton.upenn.edu/entrepreneurship/2014/06/single-state-crowdfunding-a-quicker-and-cheaper-alternative/.))

But, those companies must still keep an eye on the pricy reporting obligations required by the federal Exchange Act of 1934 (the “Exchange Act”). ((See, e.g., Crowdfunding, 78 Fed. Reg. 66,428, 66,509 (proposed Nov. 5, 2013) (citing surveys concluding that the average ongoing compliance cost of a public company is $1.5 million per year).)) Generally, the Exchange Act reporting requirements get triggered once a company has (i) total assets exceeding $10 million and (ii) 2,000 shareholders (or 500 non-accredited shareholders). ((See 15 U.S.C. § 78l (2014) (requiring the SEC to amend Section 12(g) of the Exchange Act to increase the number of allowable equity holders to 2,000 persons, or 500 non-accredited persons).))

Pursuant to the SEC’s proposed rules, shareholders purchasing securities exempted from registration under the JOBS Act will NOT count against the Exchange Act’s shareholder limitations. ((See, Crowdfunding, 78 Fed. Reg. at 66,498 (stating that “Proposed Rule 12g–6 provides that securities issued pursuant to an offering made under Section 4(a)(6) would be permanently exempted from the record holder count under Section 12(g).”).)) However, unless the federal government takes further action, shareholders acquiring securities covered solely by state crowdfunding exemptions will count towards the 2,000/500 threshold. Relief from the 2,000/500 threshold requirement, provided by the Proposed Crowdfunding Rules, is limited to Section 4(a)(6) offerings made under the JOBS Act’s crowdfunding exemption. ((See, e.g., Tom Sharbaugh, Does Lack of Crowdfunding Exemption Make Pa. Unfriendly to Startups?, The Legal Intelligencer, Morgan, Lewis & Bockius LLP (Apr. 29, 2014), http://www.morganlewis.com/pubs/crowdfundingexemptionpastartups?p=1.)) This is problematic since crowdfunding will involve companies issuing small amounts of securities, most likely stock, to potentially thousands of people in multiple states. ((See, e.g., C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).))

Thus, even though state crowdfunding initiatives may help companies mitigate the costs of registering offers or sales of securities under the Securities Act, the SEC’s final crowdfunding rules need to also exempt shares issued under state crowdfunding exemptions from the 2,000/500 threshold. Otherwise, the costs associated with requirements of the Exchange Act will spoil the celebration created by state crowdfunding exemptions once the company’s total assets exceed $10 million. Until the SEC takes such action, companies raising funds pursuant to state crowdfunding exemptions should consider: (i) the cost of growing into the Exchange Act’s requirements; (ii) reserving the right to buy back shares once the Exchange Act’s thresholds are approached; and, (iii) issuing debt, instead stock, in order to limit the number of equity holders.