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.
Questions? Let me know.
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