What’s Wrong With State Crowdfunding Exemptions?
When the U.S. Congress passed the crowdfunding exemption under the Jumpstart Our Business Startups Act (the “Jobs Act”) in 2012, there was much anticipation and optimism for the ability of issuers of securities to be able to utilize the Internet to directly connect with public investors to sell their securities. Unfortunately, the federal crowdfunding exemption remains unusable until the SEC finalizes pending rules to implement the exemption.
While we wait for the SEC, a number of states have passed their own version of the crowdfunding exemption to be used exclusively within their own borders. To date, 12 states have enacted a crowdfunding exemption, primarily because of the uncertainty as to when the SEC will finalize its rules and, when that time comes, if the federal crowdfunding exemption will be too cumbersome and impractical for issuers to utilize.
The use of the Internet by entities offering their securities is growing. The Jobs Act also allows general solicitation and advertising for entities to raise capital solely from persons who are accredited investors, either directly or through online portals, if the issuer either by itself or through certain third parties, has verified the accredited investor status of each purchaser in the offering. According to recent reports, entities utilizing this exemption raised nearly $400 million through the spring of 2014 and are projected to reach the $800 million level by the end of the year.
The fact that state legislators and regulators are stepping up to enact their own state crowdfunding exemptions is laudable, but such exemptions are oftentimes enacted to set up the issuer for failure while utilizing the exemption.
The crowdfunding exemptions (both federal and state) cap the amount that may be raised in the offering to $1 million in a 12-month period. Such limitation renders the exemption unusable except for a small subset of issuers in the very early stage. Further, the state exemptions generally require the issuer to comply with the federal intra-state exemption under Sec. 3(a)(11) and Rule 147 of the Securities Act of 1933, which, in part, requires that all offers and sales be conducted exclusively in the home state of the issuer. The problem with this is the inadvertent offer by the issuer to a person out-of-state. Such an inadvertent offer would serve to disallow the use of the state crowdfunding exemption, exposing the issuer and its principals to civil, administrative, and even criminal liability under the state securities law. States would be better advised not to condition the use of their crowdfunding exemptions in compliance with the federal intra-state exemption if they do not want to set up their state issuers to inadvertently face such liability exposure.
In addition, most of the state crowdfunding exemptions state that all offers and sales in the offering must be conducted exclusively within internet portals. All well and good except that this language does not allow for the issuer to directly make any statements either to the media or prospective investors about the availability of its offering. This unfortunate “muzzling” of the issuer and its principals from announcing the offering is a severe limitation on the ability of the offering to be successful. The term “offer” is a defined term under most state securities laws to include “any attempt” to sell a security. That definition and the requirement that the offering be conducted exclusively through the internet portal preclude the issuer from even speaking to the media about the commencement of its offering. Accordingly, there is no means to publicize the offering. States would be better advised when enacting these crowdfunding exemptions to first consult with representatives of issuers in their states who may take advantage of the exemption, to first determine the necessary measures to include within the exemption to provide the issuer the ability to successfully raise capital through the state crowdfunding exemption.
SEC Division Director of Investment Management Summarizes Regulatory Practices
In a recent presentation to industry representatives of insurance company securities products, Norm Champ, Director of the SEC’s Division of Investment Management explained the concerns and practices of his Division in regulating such products. Director Champ, in his presentation, noted that the insurance securities industry has changed dramatically over the last couple of years and it is incumbent upon the SEC to keep up with those changes and adopt policies to mitigate the risks that such changes may mean to investors. Mr. Champs’s presentation covered the following topics:
Closed-End Fund May Not Omit Shareholder Proposal on Trading Discount
Key Take Away: The staff of the Securities and Exchange Commission appears inclined to allow shareholder proposals to be included in fund proxy materials even when the proponent may have failed to comply with all of the technical requirements of Rule 14a-8. Funds should be aware of this inclination when weighing their response to shareholder proposals and the likelihood of the staff supporting the exclusion of a shareholder proposal from proxy materials.
Summary: A closed-end fund received the following shareholder proposal and sought to exclude the proposal:
“Resolved: The shareholders of Ellsworth Fund request that the Trustees begin the process of amending the Declaration of Trust to provide that:
“If the shares of Ellsworth Fund Ltd. have traded at an average discount to net asset value of more than 10% during a fiscal year of the Fund, then the Fund will promptly make an [sic] self-tender offer to all shareholders to repurchase 20% of its outstanding shares for cash at 98% of net asset value, with proration if more than 20% are tendered.”
The fund argued that the proposal could be excluded for several reasons: (1) contrary to the requirements of Rule 14a-8(b), the proposal was incomplete when originally made; (2) the first submission of proof of ownership by the proponent covered a time period that did not comply with the requirements of Rule 14a-8(b); and (3) the proponent sent the first submission of proof of ownership after the fund’s deadline for submission of shareholder proposals and sent a second submission of proof of ownership almost four weeks after the deadline.
Despite these arguments, the staff of the Securities and Exchange Commission stated that it was unable to concur in the view that the fund could exclude the proposal pursuant to Rule 14a-8(b). Therefore, the staff believed the fund would have to include the proposal in its proxy materials.
Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:
Terry D. Nelson
Peter D. Fetzer