On October 26, 2016, the SEC adopted final rules that (1) modernize Rule 147, (2) create a new Rule 147A, (3) amend Rule 504, and (4) repeal Rule 505 (collectively, the “Amendments”). The adopting release can be found here. Several of the significant changes brought about by the Amendments are broadly summarized below.
Modernization of Rule 147 and Creation of New Rule 147A
Rule 147 was adopted in 1974 for the purpose of providing guidance to issuers conducting unregistered offerings under Section 3(a)(11). This section provides an exemption from registration for “[a]ny security which is part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within, or, of a corporation, incorporated by and doing business within, such State or Territory.”
Rule 147 has not been substantively amended since its enactment. In light of this reality, the SEC noted: “[D]ue to developments in modern business practices and communications technology in the years since Rule 147 was adopted, we have determined that it is necessary to update the requirements of Rule 147 to ensure its continued utility.”[1]
In addition to modernizing the existing Rule 147, the SEC also created a new Rule 147A. The amended Rule 147 and the new Rule 147A “are substantially identical, except that . . . new Rule 147A allows an issuer to make offers accessible to out-of-state residents and to be incorporated or organized out-of-state.”[2]
Given the similarity of the Amendments (except as specifically set forth above) as they relate to existing Rule 147 and new Rule 147A (collectively, the “Rule 147 Amendments”), they will be treated together in this portion of the article. The Rule 147 Amendments can be divided under six headings:
1. Modification of “Doing Business” Requirements
Two significant changes were made to the “doing business” requirements of Rule 147. First, the Rule 147 Amendments add an alternative “doing business” test based upon the location of a majority of the issuer’s employees. Under the new “employee test,” an issuer can satisfy the “doing business” requirement by showing that a majority of its employees are based in the state where the offering is being made. This is a relatively straight forward test that, in many cases, will not require a significant amount of analysis.[3]
Second, the Rule 147 Amendments change the relationship of the “doing business” requirements from conjunctive to disjunctive. That is, an issuer no longer has to meet all of the “doing business” requirements. Rather, the issuer now only needs to satisfy one of the “doing business” requirements. This is a significant change that greatly reduces the difficulty of satisfying the existing “doing business” requirements.[4]
2. Addition of “Reasonable Belief” Standard
The Rule 147 Amendments include a “reasonable belief” standard in connection with the issuer’s determination as to the purchaser’s residence. The necessity of the inclusion of this standard is highlighted in the adopting release as follows:
“Under current Rule 147(d), regardless of the efforts an issuer takes to determine that potential investors are residents of the same state in which the issuer is resident, the exemption is lost for the entire offering if securities are offered or sold to just one investor that was not in fact a resident of such state.”[5]
In connection with the inclusion of a “reasonable belief” standard, the Rule 147 Amendments require the issuer to obtain a written representation from each purchaser as to its residence. The receipt of the written representation, however, is not the end of the story. The determination as to whether the issuer has a “reasonable belief” as to the residency of a purchaser is determined on the basis of all the facts and circumstances.[6]
3. Revision of Entity Residence Tests
For both issuing and purchasing entities, the Rule 147 Amendments replace the “principal office” test with the “principal place of business” test for the purpose of determining residency. The “principal place of business” is the “location from which the officers, partners, or managers of the [entity] primarily direct, control and coordinate the activities of the issuer.”[7]
4. Six-Month Resale Limitation
The Rule 147 Amendments make two significant changes to the existing resale limitation in the context of Rule 147 offerings. The current resale limitation is triggered by the termination of the Rule 147 offering and lasts for a period of nine months. The resale limitation adopted by the Rule 147 Amendments is shorted to a six-month period and is now triggered by date of purchase by each purchaser.[8]
It is significant to note that securities issued in reliance upon Rule 147 and Rule 147A are not “restricted securities” under Rule 144(a)(3). Accordingly, the resale of such securities must, as a general matter, only comply with state securities laws.[9]
5. Addition of Bright-Line Integration Safe Harbor
The Rule 147 Amendments adopt a “bright-line integration safe harbor” which precludes the integration of offers or sales of securities made prior to the commencement of a Rule 147 or Rule 147A offering and certain specified offers and sales made after the completion of a Rule 147 or Rule 147A offering.[10] Of particular note, the Rule 147 Amendments provide that an offer or sale of securities made more than six months after the completion of a Rule 147 or Rule 147A will not be integrated.
6. Disclosure and Legend Requirements
The Rule 147 Amendments change the mode of the disclosure requirements by allowing the disclosures to be made in the same form that the offer is made. Thus, if the offer is made orally, the disclosures can be made orally to the offeree at the time of the initial offer. However, every purchaser must be given a written disclosure a reasonable period of time before the actual sale in reliance on Rule 147 or Rule 147A.
The Rule 147 Amendments also provide specific language to be used in connection with the required legend (the existing version of Rule 147 does not provide specific language).
Finally, it should be noted that securities sold under Rule 147 and Rule 147A are not “covered securities” for purposes of the National Securities Markets Improvement Act of 1996 (“NSMIA”) and compliance with applicable state securities law is still required.
The Rule 147 Amendments will be effective on April 20, 2017.
Amendment of Rule 504
The Amendments increase the aggregate amount of securities that can be offered and sold in reliance on Rule 504 during any twelve-month period from $1,000,000 to $5,000,000. The last increase to the maximum aggregate amount under Rule 504 was in 1988 when the cap was raised from $500,000 to $1,000,000. Further, the adopting release appears to express an openness to raise the cap higher (perhaps $10,000,000 as was suggested by a commenter) after having the opportunity to observe market activity with the new cap.[11]
Prior to the Amendments, Rule 504 did not include a bad actor disqualification provision. The Amendments incorporate by reference the bad actor disqualification provision of Rule 506(d). The utilization of the same bad actor provision in the context of Rule 504 and Rule 506 is part of the SEC’s overall effort to create a “consistent regulatory regime across Regulation D” and simplify due diligence efforts on the part of issuers.[12]
Like securities sold under Rule 147 and Rule 147A, securities sold under Rule 504 are not “covered securities” for purposes of NSMIA and compliance with applicable state securities laws is still required.
The amendments to Rule 504 became effective on January 20, 2017.
Repeal of Rule 505
Given the increase of the Rule 504 threshold from $1,000,000 to $5,000,000, the SEC repealed Rule 505 because of its belief that it was no longer needed. Even before the amendment to Rule 504, only 3% of Regulation D offerings were made in reliance upon Rule 505.[13]
The repeal of Rule 505 will be effective on May 22, 2017.
Conclusion
As the adopting release noted: “The final rules will primarily impact the financing market for startups and small businesses.”[14] The Amendments could potentially revitalize and expand the use of Rule 147 and Rule 504 in the context of intrastate and regional offerings, thereby giving smaller issuers more viable options as they seek to raise capital through securities offerings.
Additionally, the revisions to Rule 147 and the enactment of new Rule 147A will likely expand the utilization of intrastate crowdfunding offerings as “most states that have enacted crowdfunding provisions require issuers that intend to conduct intrastate crowdfunding offerings to use Rule 147.”[15]
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[1] Exemptions to Facilitate Intrastate and Regional Securities Offerings, SEC Release No. 33-10238, 18 (Oct. 26, 2016). Of note, the release goes so far as to discuss particular disclosure requirements in the context of Twitter or like social media platforms with similar space limitations. Id. at 18-19.
[2] Id. at 26. It should also be noted that new Rule 147A does not have a limit on the permitted size of the offering.
[3] The adopting release does anticipate potential complications that could arise given the ever-changing and mobile workplace: “[I]f an employee provides services in the Maryland, Virginia and Washington, DC metro area out of the offices of a company in Maryland, the employee would be based in Maryland for purposes of this test.” Id. at 33.
[4] The SEC noted the onerous nature of the existing “doing business” requirements: “Given the increasing “interstate” nature of small business activities, we believe it has become increasingly difficult for companies, even smaller companies that are physically located within a single state or territory, to satisfy the issuer “doing business” requirements of current Rule 147(c)(2).” Id. at 30.
[5] Id. at 36.
[6] Id. at 37. The adopting release mentioned several data points that may be of particular importance: (1) an existing relationship between the issuer and purchaser, (2) recent utility bill, (3) pay-stub, (4) state or federal tax returns, (5) identification documentation such as a driver’s license, and (6) information obtained by the utilization of credible databases. Id. at 37-38.
[7] One nuance of interest (particularly in Louisiana) for purchasing trusts is that a trust in a jurisdiction where trusts are not deemed to be a separate entity will be “deemed to be a resident of each estate or territory in which its trustee is, or trustees are, resident.” Id. at 40.
[8] Id. at 43-47.
[9] The adopting release did note the risk of being deemed an “underwriter” or as one participating in a “distribution” if securities are acquired with a view to distribution. Id.at 47.
[10] Id. at 49-54. The post-sale safe harbors include offers or sales (1) registered under the Securities Act, except as provided in Rule 147(h) or Rule 147A(h), (2) exempt from registration under Regulation A, (3) exempt from registration under Rule 701, (4) made pursuant to an employee benefit plan, (5) exempt from registration under Regulation S, (6) exempt from registration under Section 4(a), and (7) made more than six months after the completion of an offering conducted pursuant to Rule 147 or 147A.
[11] Id. at 77-78.
[12] Id. at 78.
[13] The empirical data behind this percentage was taken from Form D filings with the SEC from 2009 to 2015. Exemptions to Facilitate Intrastate and Regional Securities Offerings, SEC Release No. 33-10238, 11 & n.22 (Oct. 26, 2016).
[14] Id. at 88.
[15] Id. at 91. According to the North American Securities Administrators Association (“NASAA”), as of July 18, 2016, 35 states had enacted crowdfunding statutes. A link to NASAA’s intrastate crowdfunding update can be found here. A link to the NASAA’s Intrastate Crowdfunding Directory can be found here.