Monday, November 2, 2015
Here’s something everyone who has ever taken Securities Regulation should know: Section 3(a)(11) of the Securities Act, the intrastate offering exemption, has a safe harbor, Securities Act Rule 147.
As Lee Corso would say, “Not so fast, my friend.” The SEC is proposing to overturn that longstanding wisdom. If the SEC’s proposed changes to Rule 147 are adopted,Rule 147 would no longer be tied to section 3(a)(11) and section 3(a)(11) would no longer have a safe harbor. The intrastate nature of Rule 147 would be preserved, but the proposed changes would be adopted under the SEC’s general exemptive authority in section 28 of the Securities Act.
Here are the most significant changes that the SEC has proposed:
Tied to State Regulation
The premise of section 3(a)(11) and its Rule 147 safe harbor is to relegate purely intrastate offerings to state regulation. But there’s currently nothing in Rule 147 to enforce that premise; federal exemption does not depend on state regulation of the offering.
The SEC proposal would expressly tie the federal Rule 147 exemption to state regulation. An offering would qualify for the federal exemption only if it was (1) registered at the state level or (2) sold pursuant to a state exemption that imposes investment limits on purchasers and limits the amount of the offering to $5 million in any 12-month period. (This second possibility is clearly aimed at the crowdfunding exemptions that many states have recently enacted.)
Rule 147 does not currently limit the amount of the offering. The SEC proposal would limit the offering amount to $5 million in any 12-month period, unless the offering is registered at the state level.
State of Incorporation
Rule 147 currently requires that the issuer be incorporated or organized in the state in which the securities are sold. Because of that, even a corporation or LLC with all of its business in a single state cannot use Rule 147 if it happens to be incorporated or organized in another state, such as Delaware.
The SEC proposes to eliminate the focus on state of incorporation or organization, and require instead that the issuer’s “principal place of business” be within the state in which the offering is made. This would be defined as the state where “the officers, partners or managers . . . primarily direct, control and coordinate” the issuer’s activities.
Doing Business in the State
Under the current rule, the issuer must meet four requirements to establish that it is doing business in the state:
- It must derive at least 80% of its gross revenues from operations within the state;
- At least 80% of its assets must be located within the state;
- It must intend to use and actually use at least 80% of the offering proceeds in connection with operations in the state; and
- Its principal office must be located in the state.
All four of those requirements must be met.
The proposed rule is much less restrictive. An issuer only has to meet any one of the following requirements:
- It derives at least 80% of its gross revenues from operations in the state;
- At least 80% of its assets are located in the state;
- It intends to use and uses at least 80% of the offering proceeds in connection with operations in the state; or
- A majority of its employees are based in the state.
(Notice the addition of the new fourth test.) It will obviously be easier to satisfy a single one of the new requirements that it is to satisfy all four of the requirements under the current rule.
Intrastate Offers and Sales
Rule 147 currently provides that the securities must be offered and sold only to state residents. In other words, it’s not enough to screen out non-residents before sale. You can’t even solicit non-residents.
The SEC proposes to eliminate the restriction on offerees. An issuer could make a general public solicitation to the world, as long as it only sells the securities to state residents. This obviously makes it much easier to make Rule 147 offerings on the Internet.
Reasonable Belief Standard
The current rule requires that all of the purchasers (and offerees) be residents of the state. If one of them is a non-resident, the exemption is lost, even if the issuer thought the person was a resident.
The proposed rule adds a reasonable belief standard. The exemption is protected as long as the issuer had a reasonable belief that the non-resident purchaser was a resident.
Resales and the Issuer’s Exemption
Both the current rule and the SEC’s proposal limit resales to non-residents. However, there’s a crucial difference between the two.
The current rule makes the exemption dependent on meeting all of the terms and conditions of the rule, including the resale limit. Thus, if a purchaser immediately resold to a non-resident, the issuer could lose the exemption.
The proposed rule, like the current rule, requires the issuer to take certain precautions to prevent resales to non-residents, but the prohibition on resales is no longer a condition of the issuer’s exemption. Thus, if the issuer took the required precautions and a purchaser resold to a non-resident anyway, the issuer would not lose the exemption.
Protection from Integration
Rule 147 currently has a provision that protects the Rule 147 offering from integration with sales pursuant to certain other exemptions six months prior to or six months after the Rule 147 offering.
The SEC proposal offers a much broader anti-integration safe harbor, similar to the integration safe harbor included in Regulation A. Offers or sales under the amended Rule 147 exemption would not be integrated with any prior offers or sales. And Rule 147 offerings would not be integrated with subsequent offers or sales that are (1) federally registered; (2) pursuant to Regulation A; (3) pursuant to Rule 701; (4) pursuant to an employee benefit plan; (5) pursuant to Regulation S; (6) pursuant to the crowdfunding exemption in section 4(a)(6); or (7) more than six months after completion of the Rule 147 offering.
There is also some protection against integration when an issuer begins an offering under Rule 147 and decides to register the offering instead.
Section 3(a)(11) Remains Available
As I mentioned earlier, the amended Rule 147 would no longer be a safe harbor for section 3(a)(11) of the Securities Act. But Section 3(a)(11) would remain available. It just wouldn’t have a safe harbor.
An issuer would be free to use the section 3(a)(11) statutory exemption, but I wouldn’t recommend it unless everything is unquestionably intrastate. It was the uncertain interpretations of section 3(a)(11) that led to Rule 147 in the first place.
A Move in the Right Direction
I think the proposed exemption is a move in the right direction. Rule 147, one of the SEC’s earliest surviving safe harbors, was a little long in the tooth. The proposed changes will make it a little more viable.