CLIENT ALERT: SEC Proposes Amendments to Modernize and Expand Eligibility for Intrastate Securities Offerings

Spencer G. Feldman and Kenneth A. Schlesinger

Proposed Rule 147 amendments would establish a new Securities Act exemption for intrastate offerings of securities by companies doing business in-state, including offerings relying upon newly adopted and proposed crowdfunding provisions of state securities laws.

The U.S. Securities and Exchange Commission has recently issued proposed amendments to modernize and to expand Rule 147 under the Securities Act of 1933, which provides a safe harbor for intrastate offerings exempt from registration pursuant to Securities Act Section 3(a)(11).  The text of SEC Release No. 33-9973 is available here.  The amendments are aimed at modifying certain regulatory requirements of the rule that are no longer compatible with evolving business practices and communication technologies, which have resulted for some time in limiting the utility of the rule for intrastate offerings, particularly in offerings by issuers seeking to raise capital through recently adopted state crowdfunding securities laws.  The amendments would eliminate the current restriction on offers via online advertising, while continuing to require that sales be made only to residents of the issuer’s state.  The amendments would also redefine what it means to be an “intrastate offering” and ease some of the issuer eligibility requirements in the rule, making the rule available to a greater number of businesses.

The SEC proposal limits the availability of the exemption to issuers that (i) have registered the offering in the state in which all of the purchasers are resident or (ii) conduct the offering pursuant to an exemption from state law registration in such state that limits the amount of securities the issuer may sell pursuant to such exemption to no more than $5 million in a 12-month period and limits the amount of securities an investor can purchase in any such offering.

If adopted, Rule 147 would no longer be a safe harbor for compliance with Section 3(a)(11), but would be a stand-alone registration exemption.  A more in-depth description of the proposed amendments to Rule 147 is set forth below.

Elimination of Limitation on Manner of Offering

Currently, offers pursuant to Rule 147 must be limited to state residents of the state of incorporation of the issuer.  The proposed amendments to Rule 147 would allow an issuer to make offers to residents not located in the issuer’s state of incorporation, as long as sales are made only to residents of the state which is the issuer’s principal place of business.  The proposed amendments would require issuers to include disclosure on all offering materials stating that sales will be made only to residents of the same state as the issuer, while also disclosing that the securities being sold are unregistered securities and have resale restrictions for a nine-month period.

The proposed amendments would enable Rule 147 issuers to engage in broad-based solicitations, including on publicly accessible websites, in order to successfully identify potential in-state investors.  For example, for a New York-based Rule 147 offering, issuers would be permitted under proposed Rule 147 to advertise and disseminate offering information through online media to reach New York residents that work, have a second home or vacation in New Jersey, Connecticut or Pennsylvania, even though such information can be viewed by residents of those other states.  This broad-based solicitation is not permitted under the current rule.

The proposed amendments to Rule 147 are designed to provide issuers with flexibility to utilize a wider array of options to advertise their offerings, taking advantage of the Internet and social media platforms that would allow investors inside and outside the state in which the issuer’s principal place of business is located to openly access offering information.  The SEC commented that the proposed amendments may be particularly effective at facilitating state-based crowdfunding offerings that rely heavily on online platforms to bring issuers and investors together.  Online advertising provides a cheaper and more efficient means of communicating with a more diffused base of prospective investors, according to the SEC, and consequently, the elimination of offering limitations to residents should result in lower search costs for issuers.

The amended provisions also may reduce issuers’ uncertainty about compliance as they would not need to limit advertising or take additional precautions to ensure that only in-state residents could view the offering.  Furthermore, issuers undertaking broadly advertised Rule 147 offerings would be able to more effectively compete for potential investors with issuers undertaking Rule 504, Rule 506(c) and Regulation A offerings, where general solicitation is permitted.

Ease of Eligibility Requirements for Issuers                                       

• Incorporation and Residency Requirements

The proposed amendments to Rule 147 would eliminate the requirement that issuers need to be incorporated in the state where the offering is conducted and would revise the current residency requirement to focus on the issuer’s “principal place of business” rather than where its “principal office” is located.  The “principal place of business” would be defined as the location from which officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.

The proposed elimination of the requirement that the issuer be registered or incorporated in the state where the offering is being conducted would align the rule’s provisions with evolving business practices, making it easier for a greater number of issuers to utilize the exemption.  A significant number of companies are incorporated in states other than where their principal place of business is located.  Most of these companies have chosen to incorporate in places where corporate laws, including corporate and franchise tax laws, are more permissive and the regulatory environment is more settled such as in Delaware and Nevada.  As such, the SEC found that the choice of legal home state may not be substantially related to where the business operations of the issuers are located.

While smaller firms are less likely than larger firms to have separate states of incorporation and primary places of business, the SEC found that a considerable number of small businesses are currently unable to meet the state of incorporation requirement in order to use the existing Rule 147 safe harbor.  Since geography of investment and employment is aligned more closely with the principal place of business of an issuer than with place of incorporation, the SEC stated that replacing the current incorporation and residency tests with a principal place of business test would be consistent with the intrastate objective of Rule 147 and make it easier for more issuers to utilize the exemption.

Eliminating the requirement to be incorporated in-state also would enable foreign-incorporated issuers that have their principal place of business in a U.S. state to access the Rule 147 capital market.

Recognizing the potential for issuers to switch their principal place of business to a different state in order to conduct Rule 147 offerings in multiple states, the proposed amendments limit issuers that change their principal place of business from utilizing the exemption to conduct another intrastate offering in a different state for a period of nine months from the date of last sale of securities under the prior Rule 147 offering.  This would be consistent with the duration of the resale limitation period during which sales to out-of- state residents are not permitted.

•  “Doing Business” In-State Requirements

The proposed amendments to Rule 147 would modify the current “doing business” in-state tests for issuers by requiring them to have a principal place of business in-state and to satisfy one of four specified tests.  The proposed amendments would include a new alternative test in which issuers can qualify if a majority of their employees are located in the state.  Under proposed Rule 147, in order to be deemed “doing business” in a state, issuers would have to have a principal place of business in-state and satisfy at least one of the following requirements:

• 80% of the issuer’s consolidated assets are located within such state;
• 80% of the issuer’s consolidated gross revenues are derived from the operation of a business located in or from the rendering of services within such state;
• 80% of the net proceeds from the offering are intended to be used by the issuer, and are in fact used, in connection with the operation of a business or the rendering of services within such state; or
• A majority of the issuer’s employees are in such state.

As currently required, satisfying all the existing “doing business” in-state tests may be burdensome even for small businesses that are largely located in one state.  In recent years, the SEC observed that new business models have emerged that may make satisfying all the eligibility tests ill-suited for relying on the Rule 147 exemption as a capital-raising option.  For example, businesses that use new technologies to make their operations more efficient tend to be more geographically distributed in their operations or revenues than what is permitted under current Rule 147.  The rapid adoption of connected devices has fundamentally changed how information can be stored, distributed, modified and assimilated, which has enabled businesses to become more geographically dispersed and modular rather than centralized into discrete units.  Requiring an issuer to own a majority of its assets in one state, to invest most of the capital raised in one state and to obtain revenue mostly from in-state sales creates inefficient constraints for startups and small businesses to operate and grow, the SEC additionally observed.

Maximum Offering Amount and Investment Limitations

The proposed amendments would limit the availability of the exemption at the federal level to offerings that are either (i) registered in the state in which all of the purchasers are resident or (ii) conducted pursuant to an exemption from state law registration in such state that limits the amount of securities the issuer may sell pursuant to such exemption to no more than $5 million in a 12-month period and imposes an investment limitation on investors.  Of the states that have enacted provisions that require an issuer to comply with Rule 147, either alone or in conjunction with Section 3(a)(11), no state has enacted a provision with an aggregate offering amount that exceeds $4 million and almost all of these states have adopted provisions that impose investment limitations on investors.  Current intrastate crowdfunding provisions have investment limits specifically for non-accredited investors.

No Preemption from State Registration (Blue Sky) Requirements

While the proposed amendments expand issuer eligibility for intrastate securities offerings, issuers relying on this exemption should be aware that they would need to comply with state “blue sky” securities laws.  For instance, because an offering made pursuant to Rule 147 is not a Securities Act Rule 506 (Regulation D) offering, which has the advantage of preemption from state registration, a New York issuer that is conducting its first securities offering in the State of New York would need to complete and file a Form M-11 with the New York State Attorney General’s Office to qualify for an exemption from registration, as opposed to filing a more streamlined Form 99 notice.

Additional Amendments to Rule 147

The proposed rules would include a number of additional amendments to Rule 147, including removing the requirement that an issuer obtain investor representations as to residency status and establishing a reasonable belief standard for determining whether a purchaser is a state resident at the time of the sale of the securities.  This proposed amendment would be consistent with similar requirements in Regulation D offerings.  Additionally, providing a reasonable belief standard for ascertaining the in-state residency of investors would provide greater flexibility for Rule 147 issuers who currently are required to obtain a written representation from investors about their residency, and who are provided no relief under the rules for sales to persons that are not, in fact, in-state residents.

The proposed rules would add a provision to define the residence of a purchaser that is a legal entity as the location where, at the time of the sale, the entity has its principal place of business.  This definition would create consistency in defining the place of residence of entity investors with that of the issuer.

The proposed rule also would include a provision to amend the limitation on resales in Rule 147(e) to provide that resales can be made only to in-state residents during the nine-month period from the date of sale by the issuer.  By amending the start date for the restricted period from “date of last sale” to “date of sale” for the particular security, investors may be able to sell before the entire offering is completed, while preserving the intent of restricting resales during a nine-month holding period to provide assurance that the securities have come to rest in-state before out-of-state sales begin to occur.

Finally, the proposed rule would expand the current Rule 147 integration safe harbor such that offers and sales pursuant to Rule 147 would not be integrated with (i) any prior offers or sales of securities, (ii) any offers or sales made more than six months after the completion of the offering, or (iii) any subsequent offer or sale of securities that is either registered under the Securities Act, exempt from registration pursuant to Regulation A, Regulation S, Rule 701 or Section 4(a)(6), or made pursuant to an employee benefit plan.  An issuer would also need to wait 30 calendar days between its last offer made in reliance on Rule 147 and the filing of a registration statement with the SEC.

Comments on the proposed SEC amendments are due on or before January 11, 2016.

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For more information regarding the proposed amendments to Rule 147, please contact the Olshan attorney with whom you regularly work or the attorneys listed below.

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