Some Thoughts on the NASAA Crowdfunding Exemption

"NASAA" stands for the North American Securities Administrators Association, an organization of state and provincial securities regulators. NASAA and its member regulators have been paying attention to the crowdfunding bills in the current US Congress.

Careful attention.

NASAA does not like the fact that the McHenry bill, which passed the House with very broad, bi-partisan support, would preempt the jurisdiction of state regulators over stock offerings that would qualify for the contemplated federal exemption. NASAA is making efforts to persuade the Senate that the Senate's version of a crowdfunding exemption (there are at least two bills to be chosen from or reconciled) should preserve prescriptive state regulatory authority, or at least some state role in a federally conceived exemption.

Suggestion boxTurf battle? That's part of it. But it's more than that. In many ways, the bills the federal legislators are drafting don't take a realistic view of the SEC's culture, or its lack of bandwidth to administer a crowdfunding exemption.

In other words, it actually makes some sense that a crowdfunding offering might be administered by a relevant state agency, IF the crowdfunding exemption was uniform in all 50 states and IF one state only had the lead and IF there was no merit review or other up front impediment (something like the McHenry design, if you will, but administered by a single, chosen state regulator, rather than the SEC).

I shudder as I slip from the prior paragraph, because, in interacting with entrepreneurs (non-laywers) in recent months who are proponents of a crowdfunding exemption, I've gotten the sense that entrepreneurs don't appreciate what a tangle of complication, cost and delay can be entailed when you try to conduct a securities offering across several states, and you are not using the federal Reg D regime. There's a reason that almost all startup financing today takes advantage of Reg D. It preempts state regulation and it doesn't involve any prescriptive SEC review. Crowdfunding proponents who are securities lawyers by and large are inclined to want Congress to pass a federal crowdfunding exemption that preempts state law in the same ways Reg D today preempts state law.

NASAA is making the pitch that it can keep jurisdiction over a crowdfunding exemption that is uniform across the country and that won't require issuers (fancy term for startups that issue stock) and intermediaries (the crowdfunding platforms or sites) to deal with 50 different state agencies. That is reflected in their proposal with even more sensitivity than I saw from the NASAA representative in a Senate hearing on crowdfunding late last year.

As I mentioned yesterday, Jim Hamilton's blog provides a good overview of the NASAA proposal. (By the way, I credited the post to Jim, but I see now that the byline credits John Jascob. My apologies to Jim and John for that mistake.) At some point I'll probably try to update the chart I've been iterating which compares the McHenry, Brown, Merkley bills and the NASAA concept (now the NASAA draft rule). In the meantime, I would direct you to the post on the Hamilton blog, or to the NASAA document itself [clarification: as I get ready to hit "publish," I see that the NASAA document appears to have been taken off the NASAA site], for the key thresholds set by the NASAA exemption on offering amounts and individual investments, and on other structural points.

What I want to call out in this post are certain features of the NASAA proposal that reflect a mindset different from that animating the McHenry bill. These features happen also to raise details of implementation that we supporters of a crowdfunding exemption ought to be talking about, but which haven't been forced to the fore in discussion of the federal exemptions, so far.

(I'm going to skip the NASAA proposal's requirement that the crowdfunding intermediary, or platform, be a registered broker dealer. That is probably the biggest difference of the NASAA proposal, though that approach is also reflected in the mess that is the Merkely bill.)

1. The NASAA crowdfunding exemption proposes that all advertising and promotion of a crowdfunded take place on the crowdfunding platform's site.

Some background here: NASAA is not on the bandwagon to repeal the prohibition on "general solicitation." To the contrary, state regulators, who do battle with fraudsters who dress up scams as "Reg D offerings," don't like public promotion of offerings that are not regulated.

When it comes to crowdfunding, one might assume offhand that you have to make peace with the fact that the crowdfunding investors are going to be "generally solicited," on the internet - that the very nature of the activity is public.

But NASAA doesn't assume that. It's draft exemption provides that companies seeking crowdfunding must not promote the offering outside the regulated platform site. Tweets about the offering? Those should do nothing other than link the public to the platform's site. In a sense, the state regulators have the crowdfunding site acting as the offering circular or prospectus for the deal.

Here's pertinent language from the NASAA draft:

"(6) Restrictions on advertising and communications. The issuer shall not advertise the specific details of the offering, except for notices which direct investors to the intermediary’s website. Potential investors that have reviewed the information maintained on the intermediary’s website shall have the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy or clarify the information provided on the intermediary’s website.  If such additional information is material, the issuer and the intermediary shall immediately amend the information contained on the intermediary’s website to provide such information. The intermediary may also maintain a forum on its website whereby potential investors may ask questions of and receive answers from the issuer. Such forum shall be available to all potential investors as well as state securities regulators as provided in paragraph (c)(5)."

2. The NASAA crowdfunding exemption contemplates that crowfunding startups and crowdfunding platforms will be continually updating disclosure about the deal, based on investor questions.

This second point restates what you just read in the block quote above.

It's obvious to me right away that what NASAA is saying about continuous investor feedback and updating of the offering materials is not practical. The second sentence above ("Potential investors that have reviewed the information maintained on the intermediary’s website shall have the opportunity to ask questions and receive answers concerning the terms and conditions of the offering . . .") draws on process that is both prudent and feasible for an all-accredited offering, but query how the issuer and platform will deal with the unrestricted comments of hundreds of investors?

And yet, a process for identifying how changes to the offering terms might be made, and for how those might be communicated to investors already in escrow, is something any actually viable crowdfunding exemption is going to have to address.

3. The NASAA crowdfunding exemption contemplates that crowdfunding platforms will enforce, not only individual investment limits per deal, but also aggregate caps on each individual investor's activity across all crowdfunding deals.

Also in the draft NASAA rule:

"(3) Enforcement of investment limits. The intermediary shall take reasonable measuresto ensure that no investor exceeds the investment limits set forth in subsection (b)(2). In addition, the intermediary shall take reasonable measures to ensure that no investor has purchased securities in multiple offerings conducted in reliance upon this exemption that,in the aggregate, would exceed the greater of: (A) $2,000, if the investor has an annual income of less than $50,000; (B) Four percent of the annual income of the investor, if the investor has an annual income of at least $50,000 but less than $100,000; or (C) Eight percent of the annual income of the investor, if the investor has an annual income of at least $100,000."

The individual limits referenced are $1,000 per year. Assuming an investor maxes out her individual limit on each deal, that means she can do between two and eight crowdfunding deals per year, depending on her income.

Will different crowdfunding platforms have to share information with each other about crowdfunding investors? Will a platform be able to rely on information given by the investor?

4. The NASAA crowdfunding exemption contemplates that crowdfunding investors can demand their money back, at any time until escrow is broken.

Here's the provision in the draft NASAA rule concerning escrow:

"(7) Target amount, offering period, and escrow requirements. The issuer shall establish a target offering amount and an offering period of not more than 12 months from the date of filing the notice as set forth in paragraph (b)(4). All offering proceeds shall be held in an escrow account maintained by a qualified custodian until offering proceeds (less any offering proceeds from the issuer, its management or affiliates) totaling at least the target offering amount are received. If the target offering amount is not received by the end of the offering period, the proceeds shall be returned to the investors within thirty days. All investors shall have the right to withdraw their investment, without deduction of any kind, until such time as offering proceeds (less any offering proceeds from the issuer, its management or affiliates) totaling at least the target offering amount are received and the offering proceeds are released by the qualified custodian from the escrow account to the issuer."

If investors can ask for their money back at any time until escrow is broken, that could make it a challenge for the platform and the startup raising money to keep track of where it is on the amount in escrow, and how far away it is from breaking escrow. It certainly renders the escrow threshold a moving target.

Also note the investments by insiders do not count toward the minimum escrow threshold.

5. The NASAA crowdfunding exemption gets a bit more granular on what platforms will have to do to check out the startups whose offerings they list.

NASAA wants the platforms to do background checks, that the platform must share with regulators on request:

"(2) Reduction of fraud risk. The intermediary shall take reasonable measures to reducethe risk of fraud in connection with the offer or sale of the securities. Such measures shall include obtaining a criminal background check and securities enforcement regulatory check on the issuer and the issuer’s management, and notifying the issuer ofany information that may disqualify the issuer from using this exemption pursuant toparagraph (b)(9). Upon request from the Administrator, the intermediary shall provide the results of the background check and securities enforcement regulatory check, unless the intermediary has already provided this information to the Securities Administrator in the state in which the issuer filed its notice under paragraph (b)(4)."

Concluding thought: The NASAA proposal was directed to its member securities regulators in the form of a "request for comment." Email addresses and contact information are provided in the document. While comments from the public were not invited, why don't we provide some, anyway?

Flickr photo by sethoscope.

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