Comparing the Federal Crowdfunding Rules with Washington State's

Note from Bill: Before returning to private practice, my colleague, Jordan Rood, worked as a state securities regulator. What's more, Jordan was directly involved in the implementation of the crowdfunding law my friend Joe Wallin was so instrumental in driving into law in the State of Washington. I asked Jordan to give us his perspective on how the new federal Regulation Crowdfunding, promulgated by the SEC pursuant to Title III of the JOBS Act, compares with Washington State's crowdfunding law. Here are his thoughts, in Q&A format.

JordanRood-WebQ: Jordan, before you re-entered private practice, you worked for a few years as a state securities regulator for Washington State. During your time there, I understand you were the person tasked with writing and implementing the Washington crowdfunding rules, which is based on the legislation Joe Wallin proposed and got passed through the sponsorship of Cyrus Habib. So you presumably know the Washington crowdfunding law well. Based on that knowledge base, how do you rate the new federal crowdfunding rules, by comparison?

Great question, Bill. There are actually many similarities between the Washington and federal crowdfunding rules, as certain provisions of the Washington state bill and administrative rules draw from the federal rules. However, there are also some very key differences to consider between the two that make the particular circumstances of an issuer a dispositive factor in determining whether the federal or Washington crowdfunding exemption makes the most sense. For locally-oriented issuers, the Washington exemption may prove feasible, whereas an issuer with greater horizons may find the federal exemption, or another exemption, a better fit.

First, some of the similarities include:

  • Disclosure Requirements: The Washington state rules require that issuers provide prospective investors with material disclosures about the Company, its business and the offering via the “Washington Crowdfunding Form” which is available on the Washington Securities Division’s website, and acts as a short form disclosure document for the issuer. These disclosures include information such as the minimum offering amount, use of offering proceeds, a description of the business and management of the company and risk factors. The federal rules will require similar types of information to be filed on a proposed “Form C” that will be used to provide such information to investors. A significant difference here is that the Washington Crowdfunding Form must be submitted to the Washington Securities Division for review, and potential commentary, prior to the exemption being acknowledged by the Division, whereas the federal Form C must be notice filed with the SEC. However, the information in Form C must be provided to investors by the broker-dealer or crowdfunding intermediary used to offer the securities under the federal rules (more on this below), so it is seems likely that these intermediaries may play a role in setting standards for the information contained in the issuer disclosure materials.
  • Investment Limitations: Both the Washington and federal rules limit the amount of money individuals may invest in offerings conducting under the crowdfunding offerings in a 12-month period. Both exemptions state that  such investment may not exceed:  (1) $2,000 or 5% of the investor’s annual income or net worth, whichever is greater, if either annual income or net worth is less than $100,000; or (2) 10% of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more. A key difference here is that observance of these limitations must be performed by the broker-dealer or crowdfunding intermediary under the federal rules, whereas the Washington rules require the Company to make such determination (however, each set of rules allows this to be done by investor self-certification, absent the issuer’s knowledge the contrary).
  • Ongoing Reporting: Both the Washington and federal rules require the Company to maintain ongoing reports so long as the securities sold pursuant to the exemption are outstanding. The federal rules require the issuer to post on its website an annual report on Form C-AR, containing an updated version of the information required in the Form C offering statement, as well as financial statements of the issuer certified by its principal executive officer.The Washington rules require quarterly reports to be posted on the issuer’s website, which must contain officer and director compensation, the names of directors, officers, managing members or similar persons and major securityholders (20% or more of the outstanding securities), as well as a brief analysis by the issuer of its business operations and financial conditions.

However, as noted above, there are some significant differences between the federal and the Washington State crowdfunding exemptions:

  • Rule 147 v. Rule 4(a)(6): Perhaps the greatest difference between the two exemptions is that the federal exemption relies on Rule 4(a)(6) of the federal Securities Act, which preempts state blue sky laws in connection with such offerings (with the exception of anti-fraud enforcement authority), and the Washington act relies of federal Rule 147 which allows certain “intrastate” offerings to be exempt under the federal Securities Act. What this means, is that the federal exemption will allow for sales to a nationwide audience, whereas to comply with Rule 147, the Washington exemption is subject to significant restrictions limiting both who may be offered securities, and the operations of the Company itself, to Washington state. Specifically, issuers relying on the Washington exemption may only offer securities to Washington state residents (merely offering securities to out of state parties could jeopardize the offering). Further, for an offering to qualify as “intrastate” to the Securities and Exchange Commission, the activities of the issuer and its use of investment proceeds must be substantially within Washington. In particular, the issuer must be organized in Washington, the principal office must be located in Washington, the issuer must derive at least 80% of its gross revenues from operations within Washington, 80% of the issuer’s assets must be located in Washington and 80% of the proceeds of the offering must be used for operations within Washington. The SEC just recently proposed prospective amendments to Rule 147 that would loosen some of these 80% restrictions, however, until such rules are adopted, the intrastate constraints of Rule 147 make the Washington exemption much more restrictive than an offering conducted pursuant to the federal exemption.
  • Financial Statements: The Washington rules require that the Company’s financial statements be GAAP-compliant, with applicable footnote disclosure, but does not require the statements be reviewed or audited by an independent public accountant. The federal rules have heightened requirements for financial reporting that phase as the size of the offering increases, as follows: (1) if the offering is $100,000 or less, the financial statements must be certified by a principal executive officer of the Company, or if reviewed or audited financial statements are already available for the Company, they must be disclosed; (2) if the offering is between $100,000-$500,000, the financial statements must be reviewed by an independent public accountant, unless audited financial statements are already available, then they must be disclosed; and (3) for offerings greater than $500,000, audited financial statements must be provided, with an exception for first-time issuers, which may have their financial statements reviewed by an independent public accountant.
  • Eligible Issuers: The Washington crowdfunding exemptions prohibits many types of issuers from relying on the crowdfunding exemption, including companies involved in petroleum exploration or production, mining or other extractive industries, real estate programs, “blind pools,”  development stage companies with no specific business plan or purpose, equipment leasing companies, and investment companies subject to the Investment Company Act of 1940, among others. The federal rules only exclude investment companies under the Investment Company Act, while retaining the authority to exclude any issuer the SEC, by rule or regulation, determines appropriate.
  • Eligible Securities: The federal exemption does not provide a limitation on the types of securities that may be offered, and note that debt securities may be offered, though it does not provide a specific exemption from the Trust Indenture Act of 1939. The Washington crowdfunding exemption only allows the sale of equity securities by the issuer, with a prohibition on debt securities and resales. An issuer may issue preferred stock under the exemption, as long as the investors receive the protections called for in WAC 460-99C-030(5) (e.g. liquidation preference, anti-dilution protection, voting rights on the creation of senior securities, among other protective provisions, among others).
  • Intermediaries: A significant difference between the two exemptions is that the federal rules require the offering be conducted online via a single broker-dealer or a crowdfunding intermediary, which will allow the “crowd” to assess the offering through review of the disclosed issuer information, and a public forum for prospective investors to exchange information about the issuer and offering. The Washington exemption has no requirement that the offering be conducted by a broker-dealer or intermediary (though use of a broker-dealer is permitted), and contemplates that the issuer will be marketing the offering itself. However, due to the constraints of federal Rule 147 that the Washington exemption relies on, the issuer is limited in its ability to directly offer the securities on the internet, which is global by nature, or other public forums, as Rule 147 requires all offers of securities be to Washington state residents. The Securities and Exchange Commission has provided Rule 147 C&DI guidance (Questions 141.03-141.05) noting that while Rule 147 doesn’t prohibit general advertising or general solicitation, direct marketing on a Company’s website or social media would likely cause offers to be made to out of state residents, jeopardizing the Rule 147 exemption. The SEC does state in 141.05 that it believes issuers may be able to implement technological measures to limit communications constituting an offer of securities to in-state residents, such as limited communications to those with IP addresses originating from zip codes with the state, but does not provide specific guidance on how to address this issue. As such, although the Washington exemption does not require the use of an online intermediary or broker-dealer, the restrictions of Rule 147 may make it difficult for an issuer to conduct web advertising of its securities without running afoul of the strict intrastate offering requirements called for in Rule 147. However, under the federal exemption, requiring the use of an intermediary or broker-dealer will almost certainly add substantial cost to any offering conducted, as compared to an offering run directly by the issuer under the Washington exemption.

Q: Should a startup based in Washington use the Washington crowdfunding rules, or should it use the federal rules?

As noted above, there are key differences between the two that may make one more attractive than the other based on the specific circumstances of the issuer. For a locally-oriented issuer (e.g. a microbrewery), the Washington exemption may make the most sense, as the Rule 147 restrictions may be less burdensome, the offering cost is likely lower as the issuer may market the offering directly and there is no requirement that financial statements be audited or reviewed by an independent accountant.However, for an issuer that intends to generate substantial business outside Washington, the federal exemption would be the vehicle of choice, as the Rule 147 restrictions would not apply. Although some of the offering and accounting costs may be higher, the issuer will be able to reach a wider, national audience for its offering, potentially increasing its chances of meeting its funding goals, and enhancing its exposure to customers. The issuer may also be able to issuer convertible debt, or other preferred securities that aren’t subject to the requirements of the Washington exemption, as well.

Q: In what ways might Reg A+ make more sense?

Regulation A+ may make more sense for issuers that will need to raise additional proceeds and/or reach a wider investor base, as the issuer may raise up to $50 million (as opposed to the $1 million allowed under the Washington and federal crowdfunding exemptions), and the offering may be advertised in up to all 50 states. Particularly for an issuer that is relying on the federal exemption, Regulation A+ may be a more attractive option as the issuer will already be required to spend a significant amount of money on the offering due to the legal costs of organizing the offering, preparing the offering circular and incurring the costs of a broker-dealer or crowdfunding intermediary to market the offering. As it is conceivable that these costs may rise into the realm of tens, if not hundreds of thousands of dollars, it may make more sense for the issuer to spend the additional money required to prepare a Form 1-A offering circular, and continued reporting requirement, if it is able to raise a significantly higher amount of money under Regulation A+. However, Regulation A+ does have higher regulatory hurdles to clear before the offering may become effective. “Tier 1” offerings, which may include offerings under $20 million, are subject to review and commentary by the SEC and each state securities division where the securities will be sold, and “Tier 2” offerings, which may be up to $50 million, are subject to continuing federal reporting requirements after the conclusion of the offering, as long as there are securities from the offering outstanding.

Q: Gosh, lots of strings and conditions and requirements and expenses. Any other alternatives?

Another “crowdfunding” vehicle arising from the federal JOBS Act of 2012, was the creation of Rule 506(c) which allowed for “accredited crowdfunding” as an alternative to the “old-fashioned” Rule 506 private placement exemption that accounts for the vast majority of private securities offerings. Rule 506(c) allows an issuer to raise an unlimited amount of money, from an unlimited number of investors, through “generally solicitation” (i.e. publicly advertising) its private securities offering, which historically has been prohibited under federal and state securities laws. A key condition, however, is that the issuer must verify that each investor is accredited.  This means that the issuer must actually verify the issuer is “accredited” by obtaining tax returns, bank statements, the opinion of counsel or an accountant or other method by which the issuer can actually establish accredited status. The SEC Rule 501 definition of “accredited investor” includes individuals who have made $200,000 over the prior two years ($300,000 with spouse), or have a net worth of $1 million, excluding the value of the individual’s primary residence. The definition also sets forth multiple institutional investors who will meet the definition, as well. While this is a new area of the law that has been showing promise, the risk involved is that the admission of even one unaccredited investor will disqualify the issuer from relying on Rule 506(c), but will leave it without another private offering exemption to claim if it has engaged in any general solicitation in connection with the offering

Q: You can always do it the old fashioned way, right?

In creating these new crowdfunding exemptions (crowdfunding rules, Regulation A+, Rule 506(c)), Congress and the SEC have left in place the “old-fashioned” 506(b) exemption, which remains the primary way by which issuers conduct private securities offerings. Rule 506(b) allows for issuer’s to raise an unlimited amount of money, from an unlimited number of accredited investors, so long as no “general solicitation” is conducted in connection with the offering, and that each investor has a substantive, pre-existing relationship with the issuer or person offering the securities of its behalf. A key feature here (and in 506(c)) is that the disclosure required to be provided about the issuer in connection with the offering is relaxed for sales to accredited investors. As such, most 506(b) offerings are only sold to accredited investors (even though the Rule allows for the sale of up to 35 non-accredited investors), as the sale to any unaccredited investors requires significantly heightened disclosure to such investors, which can be costly and burdensome to provide, and may increase the exposure of an issuer to liability under federal and state securities acts.

Want to Avoid "General Solicitation?" Focus on Relationships!

The following is adapted from remarks prepared for the Angel Capital Association's 2015 Angel Insights Exchange, held in New Orleans the week of November 9. I am the volunteer chair of an advisory council to the ACA, but the views I express below are personal to me, and not a reflection of ACA views or policy; nor are they a reflection of views of my law firm.

As we all know, Dodd-Frank (2010) and the JOBS Act (2012) brought big changes to the rules that govern what’s okay and what’s not okay in the world of federal exemptions from securities registration requirements.

Couple-by-Paul-Kline-Creative-CommonsOne of the biggest reforms – permitting startups and other private companies to advertise a securities offering, provided that all purchasers are accredited investors – has caused the most consternation, at least in the early implementation. That’s largely because this particular reform – “lifting the ban on general solicitation” in Rule 506, the primary federal exemption on which almost all angel-backed companies rely – came with a catch. The catch is this: if you advertise or otherwise “generally solicit,” you will have a newly-invented1 and heightened burden to verify the accredited investor status of your purchasers.

This has caused many entrepreneurs and angels to shun Rule 506(c). Because the new rules made clear that the old rule (now called Rule 506(b)) remains available on a parallel track, you can still raise your money privately the old way; the heightened verification burden will not apply.2

But still there are gray areas: what about demo days; what about online platforms that restrict access so that only accredited investors can see deals; what about angels syndicating deals with other angels? In the early days of implementation of these reforms, people are worried – even more than they were before the JOBS Act, it seems3 – on whether they might trip accidently into conduct that could be deemed “general solicitation.”

Thankfully, we’ve had new guidance from the SEC this year pertinent to the quandary of “general solicitation” and what we might call the 506(b)/506(c) divide. 2015 has brought us:

  • No fewer than eleven (11) new questions-and-answers on general solicitation, to be added to the Division of Corporation Finance’s ongoing Compliance and Disclosure Interpretations; and
  • A new “No Action” letter, called “Citizen VC,” which tells an online platform how it might avoid slipping into Rule 506(c) territory.

The theme of the new SEC guidance is this: a “pre-existing, substantive relationship” can be a terrific antidote to the virus4 of “general solicitation.”

Now, the concept of the pre-existing, substantive business relationship has been around for a long time. It’s been a way of demonstrating that a given deal is indeed private, and prior guidance from the SEC has long held that an issuer can extend the utility of the concept by including, not only persons the issuer knows, but also the relationships of a broker dealer participating in a given offering.

The new SEC guidance, however, now makes it expressly clear that it’s more than okay for an issuer to be introduced by an angel to other angels the issuer might be meeting for the first time, without tripping into “general solicitation.”5 Here’s an excerpt from the answer to Question 256.27:

[W]e acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members . . . may introduce [the] issuer to other members. Issuers . . . may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Similarly, the new SEC guidance at Question 256.33 states that demo days can be “insulated” by the pre-existing, substantive relationships that a demo day organizer has with attendees:

Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network [of angels] as described in Question 256.27.

Finally, I want to highlight the Citizen VC No Action Letter, because it speaks to what an online angel investing platform might do, should it wish to remain under the ambit of Rule 506(b). Here’s how Dan DeWolfe, a member of the ACA Advisory Council and the attorney who wrote the no-action request on behalf of Citizen VC, summarized in a blog post (co-written with Samuel Asher Effron) his take on the import of this particular guidance:

In essence, the approach under the CVC Letter is to make the online private placement offering similar in policies and procedures to an offline private placement. The pre-existing relationship is not time based nor is it satisfied by answering a mere two questions. Rather, the establishment of a pre-existing relationship depends on the QUALITY of the relationship between the issuer and a potential investor. While the vast majority of online offerings will clearly fall within the new Rule 506(c), the CVC Letter does spell out a way to conduct a true private placement in a password protected web page that does not give rise to a general solicitation.

How can an online platform be sure it is not using general solicitation? That’s right, the answer is in line with the guidance theme for 2015: establish a substantive, pre-existing relationship with prospective investors. In the case of online platforms, establishing such a relationship must occur prior to, and not in the context of, a given offering by an issuer on the platform.

Photo credit: Paul Kline (Creative Commons)

1. On the “newly invented” nature of the verification burden imposed by offerings that are generally solicited pursuant to new Rule 506(c): many securities lawyers might emphasize that Rule 506 has always, always required an issuer to have a reasonable basis on which to conclude that its purchasers were accredited. I myself predict that the distinctions between 506(b) and 506(c), on the point of verification, will inevitably blur over time. But it is certainly fair to say that current industry practices that pass muster as sufficient under 506(b) do not pass muster under 506(c).

2. It’s fair, and probably important, to point out that the verification pitfall is connected with another aspect of Rule 506(c) that is scary to startup and emerging company lawyers, and should be to entrepreneurs and angels as well: if you’re relying on an exemption that expressly stipulates that you have engaged in general solicitation, then, unlike what would be typical in most Rule 506(b) offerings, you will not have other private offering exemptions to fall back on, should your Rule 506 exemption somehow fail. Claiming exemption under 506(c) is like walking a highwire without a net.

3. Anxiety about the meaning of “general solicitation” dates back to the rollout of Rule 506(c) two years ago. See this piece I wrote for the Wall Street Journal:

4. Is my metaphor over the top, or is it really dangerous and unhealthy for a startup to conduct a Rule 506(c) offering? This is a question I would like to put back to all of you!

5. Technically speaking, it does not appear as though the new guidance is saying that a given angel’s network extends the reach of the issuer’s pre-existing, substantive relationships, at least not in the same way that a broker-dealer’s relationships might. See Question 256.29. Rather, the long-standing practice of introductions via angel networks appears to be a similar but independent method of “neutralizing” general solicitation.

First Cherry Blossom

Wet and temperate in Seattle this morning.

And look, Spring!

First Cherry Blossom

Lark & Environs

Interesting stuff going on at, let's call it 10th and Seneca, about a half block east of Broadway off Madison.

Lark has recently moved there, and, based on one dinner experience at the new location, is as good or better than ever.

There are also different spaces, and different branded food experiences, built into the lofys and crannies of the old industrial warehouse. One is called "Slab," and it will serve sandwiches from 10 to 3. Including what the menu describes as a 12 hour brisket!

All this not a stone's throw from middle-America chains like Silver Cloud and IHOP.

Lark & Environs

One Thousand Things Worth Knowing

This weekend I've read Paul Muldoon's newly published collection of poems, "One Thousand Things Worth Knowing." (The dust jacket sports a very pleasing design by the ubiquitous Quemadura, a brilliant designer and a kind man I will never forget for how he helped me during a brief turn I took as a publisher.)

I say I've read the book, present perfect, but I'm still reading it by way of re-reading it. Muldoon is new to me, and I don't yet find familiar his poetics or his themes.

His strangeness, to me, derives from his different commitments, you might say.

For instance, he utilizes the sonnet and other traditional stanzas with end rhymes (or slant rhymes; that itself is not unfamiliar); but his lines most often aren't in a regular meter, or at least not in a consistent pattern of feet.

Sometimes the effect (of what I might call free verse wrapped around visually recognizable stanzas and traditional rhyme schemes) is like that of a planet nearing the sun, utilizing the acceleration of gravity to whip itself around the star and propel itself away.

The density and earthiness of Muldoon's diction seems very much of a well-established, modern, Irish tradition, recognizable as the idiom of Seamus Heaney, not least of all when the poems allude to The Troubles and growing up in Ireland.

But Muldoon is an American as well. A verse in this book is just as apt to traverse the Civil War or the Southwest as Ireland or England or Viking invasions.

The best example I am able to give you – I'm not suggesting this is one of the finer poems in the book, just that it illustrates what I am currently able to describe - is a poem in the middle of the book called, "Some Pitfalls and How to Avoid Them," about the party of Lewis and Clark and their reliance on mercury-laden laxatives. Here is an excerpt, most of the final three stanzas:

"... Who would have guessed
that J.M.W. Turner was perfecting in his ability to scumble
cumulonimbus and stratocumulus
precisely as Lewis and Clark reached the Pacific coast

"And build Fort Clatsop? The Cheyenne chewed the gum
of both ponderosa
and lodgepole pines. Bear in mind how our fireside banter
may be lost to the generations to come

"but their native scouts
will still be able to follow our route across America
by the traces of mercury
in our scats."

You see what I mean. Stanzas of four lines in an ABBA in a rhyme or slant rhyme pattern; references to the exploration of the Pacific Northwest and to the most famous British landscape painter of the time.

Photo from a tweet by The Irish Times.

One Thousand Things Worth Knowing

ACA Webinar on Accredited Investor Definition and Established Angel Group Certification

I've just listened to an archived recording of an excellent webinar presented by the Angel Capital Association last week (I had intended to listen in real time, but got pulled away): ACA Webinar on Accredited Investor Definition and Established Angel Group Certification.

Presented by ACA Executive Director Marianne Hudson and ACA Chair David Verrill, the hour long webcast covers how the accredited investor definition might change (and how that might impact the startup investing ecosystem) and what the Angel Capital Association is doing to facilitate the transition to the brave new world of general solicitation.

The chief initiative of the ACA is the "Established Angel Group" certification program, which is designed to help issuers implement the "principles based method" in satisfying the heightened accredited investor verification burden under new Reg D Rule 506(c) (which allows general solicitation). The Established Angel Group (or "EAG") certification program has potentially broader implications as well - for instance, if the accredited investor definition changes to put more weight on, or define an alternative path to accreditation based on, investor sophistication, the EAG could be important for purposes of both Rule 506(b) and Rule 506(c).

Inside baseball stuff, I know, but if you're interested in the history of how it came to be that only high net worth people were allowed to invest in startups, how that situation was seemingly democratized (somewhat) by the 2012 JOBS Act, and the rearguard action of state securities administrators and others to put a lid on the reforms, giving an hour of your time to this webinar will help fill you in.

A Sestina About Copyright

Last week Boing Boing published a sestina I wrote earlier this year on the subject of copyright.

I'm thrilled about this and hope you will check it out:

626px-Sestina_system_alt.svgWhat is a sestina? It is a verse form involving a patterned repetition of the same six words. This chart, credited on Wikipedia to Phil Wink, explains the pattern.

As you can imagine, the sestina as a structure requires copying; as a poetic practice, it demands of the practitioner the audacity to remix and engage in transformative use in transparent ways.

Sestinas are all about copyright!