Can A Crowdfunding Issuer Sell Its Own Securities?

Securities Cash  Register

Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?

For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.

For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.

Section 18(a)(1) of Securities Act

Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:

Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.

Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?

Here’s the statute again, with extra words removed:

No law requiring registration or qualification of securities transactions shall apply to a covered security.

A sale of a security is definitely a “securities transaction.” So here’s the question:  does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.

But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.

For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.

What’s At Stake

If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.

The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.

I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.

And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.

What To Do

The simplest solution is to sell through a clearing broker licensed in every state.

Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).

If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.

Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.

__________________________________________________________________________________________

My thanks to Jillian Sidoti, Esq. and Anthony Zeoli, Esq., who provided valuable insight.

Questions? Let me know.

Tagged: , , , , , , , , , , , , , , , , ,

2 thoughts on “Can A Crowdfunding Issuer Sell Its Own Securities?

  1. Roland Wiederaenders August 8, 2016 at 3:55 pm Reply

    After reading your article, I thought of this position paper from the New York Bar Association (http://www.nysba.org/Sections/Business/Committees/Securities_Regulation_Committee/Position_Paper_on_Private_Offering_Exemptions_and_Exclusions.html). Here is a quote:

    “It is clear that § 18 preempts the registration requirements under GBL § 352-e for real estate offerings made pursuant to Rule 506 (leaving aside the fact that under New York statutory provisions, such offerings are private offerings outside of the purview of § 352-e in any event). Section 18(a)(1) provides that no such registration requirement, whether of securities or of securities transactions shall apply, directly or indirectly, to a covered security. Thus, because of §18 preemption, New York State may not require the registration of issuers as dealers as a way of indirectly requiring registration of transactions in covered securities. All New York State could do (if it were permitted to do so under its statutory provisions) would be to impose notice filing requirements substantially similar to those required by Rule 503 and Form D.”

    It seems like we would have the caselaw that you describe under old Rule 506. It sounds like you are saying that issuers now must use of brokers to sell their securities under Rule 506(c) even though for ages they have not had to do that using essentially the same exemption, “old” Rule 506. Now, though, the use of general advertising changes things so dramatically that now brokers are required. It seems like if that is what Congress intended they would have added that requirement.

  2. Roland Wiederaenders August 8, 2016 at 4:06 pm Reply

    Also, from the Texas State Securities website (https://www.ssb.texas.gov/securities-professionals/regulation-securities/exemptions-registration) (no mention of requiring a broker for a Rule 506(c) offering unless you are paying commissions or fees):

    Rules 109.13(k)(16) & 114.4(b)(1)

    SEC Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption of Section 4(a)(2) of the Securities Act of 1933. Securities offered in a Rule 506 offering are “covered securities” and are not subject to registration in Texas.

    There are two distinct exemptions that fall under Rule 506 of Regulation D:

    Rule 506(b) exempts sales by the issuer or by a registered dealer acting on the issuer’s behalf to up to 35 non-accredited investors and to an unlimited number of accredited investors. No public solicitation or advertisements may be made in connection with the offering.
    Under Rule 506(c), a company can broadly solicit and generally advertise, but still be deemed to be undertaking a private offering if the investors in the offering are all accredited investors and the issuer has taken reasonable steps to verify that its investors are accredited investors.
    Issuers relying on the Rule 506 exemption can raise an unlimited amount of money. For either exemption, a notice filing must be made with the Securities Commissioner no later than 15 days after the first such sale in Texas. Also, a filing fee of 1/10 of 1% of the aggregate amount of the offering, up to a maximum fee of $500, must be filed. More information on how to file a Form D and the related fee can be found here.

    No commissions, fees or other form of remuneration may be paid to any person who solicits investors in Texas under Rule 506 unless that person is licensed in Texas as a securities dealer or agent.

Leave a Reply

%d bloggers like this: