Equity crowdfunding comes to Florida - or has it?
The good news is that the Florida Legislature sought to respond to the capital needs of small businesses. The bad news is that Florida continues to be an outlier state when it comes to securities laws. Our securities statute, including the crowdfunding amendment, is much more restrictive on the capacity of small businesses to raise capital than the securities laws of nearly all other states. (3) Florida's crowdfunding exemption reflects this restrictive tradition by imposing numerous conditions, limitations, liability pitfalls, and cost elements not imposed in analogous crowdfunding exemptions adopted in other states. The result is that one must seriously question whether Florida's exemption will provide a viable process for small business financing.
What is Crowdfunding?
Crowdfunding has been with us for a long time. The term refers to the use of mass marketing to obtain relatively small amounts of donations from a large and diverse group of people. The Internet has become a major source of crowdfunding, and websites have developed to facilitate financing efforts. (4) Music groups seeking funds for a tour, artists seeking help in creating new works, and budding entrepreneurs needing funding for their research and development efforts have all turned to such sites. Donors generally receive nothing more than gratitude or perhaps a small token of appreciation. Requests for financial support could not be accompanied with any offer or suggestion of an economic return, as that would trigger the securities laws and violate long-standing prohibitions against nonregistered offerings being mass-marketed. Thus, until recently, the notion of equity-based crowdfunding did not exist within the federal and state securities laws. Small business advocates pushed for some kind of relief that would allow businesses to raise capital in a crowdfunding-type manner. The Securities and Exchange Commission (SEC) appeared unresponsive to those pleas, but Congress took up the task as part of the JOBS Act of 2012. (5)
The JOBS Act of 2012
What began as a simple concept to allow small businesses to use the Internet to raise relatively small amounts of capital from a broad variety of investors turned into a highly complex set of conditions and requirements by the time the crowdfunding portion of the JOBS Act was completed. It is appropriate to ask: "What happened on the way to the forum"? (6) The role played by the ever-cautious SEC in developing the statutory conditions is uncertain, but it is clear that a perceived concern that a fairly simple exemption allowing the use of Internet solicitation of investors would lead to abusive and fraudulent offerings was a major factor in piling on requirements that go beyond those for most other exemptions. As a result, the federal crowdfunding exemption is replete with significant, time-consuming, and potentially costly conditions, including the mandatory use of a licensed broker or federally registered intermediary to act between the company and the investors; substantial obligations imposed on intermediaries to supervise and police the offering; extensive disclosure requirements that, for some offerings, include audited financial statements; limitations on advertising; and annual filings with the SEC. And that is before any supplemental SEC rules are adopted as required in several statutory sections. It is a sign of the inherently defective statutory exemption that, three years after its enactment, the SEC has yet to adopt rules necessary to make the exemption effective. (7) As commentators have noted, whatever supplemental SEC rules are adopted will not save the exemption from its strict statutory requirements. (8) The only redeeming feature of the federal exemption is that it preempts state laws and, therefore, provides for nationwide solicitation and sales without the need to comply with state registration or exemption provisions. That feature, however, is of limited value if the federal exemption itself is, as many believe, basically a nonstarter. (9)
The Impetus for State Crowdfunding Exemptions
To date, about half of all states have adopted a state-based crowdfunding exemption by legislation or regulation. The state exemptions are generally much less restrictive than the federal counterpart. (10) State adoptions have been in response to the recognized need for an enhanced financing capacity for small businesses and the apparent failure of the federal crowdfunding exemption to meet this need. However, compliance only with a state exemption is not enough. The federal securities laws apply to all offers and sales of securities through the use of an instrumentality of interstate commerce, (11) which covers nearly every securities offering imaginable. Therefore, an offering under a state's crowdfunding exemption must also comply with a federal exemption. The federal exemption that state crowdfunding exemptions have turned is the federal intrastate offering exemption found in [section]3(a) (11) of the Securities Act and in Rule 147 adopted by the Securities and Exchange Commission. (12) The intrastate exemption exempts from the federal registration process offers and sales of securities solely to state residents by locally formed businesses whose primary operations and revenues are derived from the state. If a local business satisfies this federal intrastate exemption, it can engage in the broad solicitation of potential investors pursuant to its state crowdfunding exemption. (13)
As a result of the various state adoptions, small businesses seeking to raise capital through crowdfunding will have a choice between 1) the federal crowdfunding exemption, which preempts state laws and allows nationwide solicitation and sales; and 2) their own state crowdfunding exemption that may have fewer restrictions, but must comply with the federal intrastate exemption that limits offers and sales solely to residents within their state. This will not always be an easy decision, as it is affected by the issuer's perceived ability to attract investors and to satisfy the federal intrastate exemption requirements. (14)
Florida's Crowdfunding Exemption: Basic Elements
Florida's exemption has the following basic elements:
1) The issuer must be a for-profit business entity formed under Florida law, have its principal place of business in Florida, and derive its revenues primarily from in-state operations; (15)
2) The offering must comply with the federal intrastate offering exemption; (16)
3) Transactions must be conducted through a state-registered dealer or a state-registered intermediary; (17)
4) The maximum amount an issuer can raise is $1 million in a 12-month period; (18)
5) Investors who are not "accredited investors" as defined by federal securities law (19) are limited in their investment to the greater of $2,000 or 5 percent of their annual income or net worth if their annual income or net worth is less than $100,000, and 10 percent of their annual income or net worth, not to exceed $100,000, if their annual income or net worth is equal to or greater than $100,000.
6) All investor funds must be placed into an escrow account in a federally insured financial institution and cannot be distributed to the issuer until the sales have reached a target amount set in the offering. (20)
7) Issuer must provide to each investor a disclosure document that includes financial statements. Depending on the amount of the offering, the financial statements must either be reviewed by independent accountants or audited; (21)
8) Investors may rescind any commitment to purchase up to three days before the offering deadline;
9) No offering is allowed if any of the disqualification provisions applicable to the issuer, its management, and principal shareholders are triggered; (22) and
10) The issuer must file an offering notice with the Office of Financial Regulation and pay a $200 fee at least 10 days prior to commencing an offering or displaying the offering on a website. The notice must include certain information relevant to the issuer's eligibility to engage in the offering, identify the intermediary that will supervise the offering, and name the financial institution that will hold the funds in escrow. (23)
Several of these basic elements are analogous to crowdfunding exemptions in other states. However, there are some major exceptions, and it is those exceptions that, unfortunately, make one seriously wonder whether the Florida exemption will, in fact, serve the necessary needs of this state's small businesses.
Florida's Exemption Replicates the Federal Exemption's Most Onerous Provisions
Florida, unlike most states, chose to adopt a crowdfunding exemption that mirrors the onerous federal requirements. The most burdensome of these requirements relates to the mandate that the issuer offer its securities through a licensed dealer or a state-registered intermediary and the obligations imposed on such intermediaries. The issuer cannot engage in an offering solely on its own. It must employ and pay the fees and costs of a licensed dealer or state-registered intermediary. Many states do not mandate the use of a dealer or intermediary. (24) In some states, there is such a requirement, but the obligations imposed on intermediaries are much less extensive and burdensome than the Florida exemption. (25) A partial listing of the obligations imposed in Florida on an intermediary includes requirements to: (26)
1) Take measures as established by rule to reduce the risk of fraud, including verifying that the issuer is in compliance with its obligations;
2) Provide information on its website regarding the high risk of investment, limitation on resale of securities, and the potential loss of the entire investment;
3) Obtain from each investor residence information to confirm that the person is a Florida resident;
4) Obtain an affidavit from each investor that the investment is consistent with the investor's income requirements prescribed in the exemption;
5) Direct the release of investor funds from escrow if the target amount has been reached;
6) Require each investor to answer questions demonstrating an understanding of the risk of investment; and
7) Implement written policies and procedures that are reasonably designed to achieve compliance with federal and state securities laws, anti-money laundering, and privacy requirements applicable to brokers.
These are daunting, liability prone requirements. Three concerns are readily apparent: 1) Given Florida's large number of snowbirds and foreign visitors, what liability risk does the intermediary take with regard to the question of the investor's state residency? 2) How will the intermediary be assured that sufficient investor proceeds have been paid into escrow to allow their release to the issuer? There is considerable federal caselaw regarding improper releases from escrow when the apparent proceeds have not been properly generated. 3) What questions should the intermediary ask to determine whether the investor understands the risk of the investment, and what potential liability does the intermediary undergo if the answers to those questions are some what ambiguous? Perhaps some of these concerns will be answered by state agency rules, but it is questionable whether any rules would ease an intermediary's concern regarding its responsibilities and potential liabilities.
Any intermediary considering whether to scale the mountain of obligations and their potential for liability will ask: What is in it for me? The answer is: not much. The statute forbids compensation based on the sale of securities. (27) One revenue source will be issuers through fees and agreements to cover certain costs. This is a doubling of disincentives, imposing costs on issuers, and limiting the revenue received by intermediaries. Licensed dealers are not under this limitation and, therefore, can be compensated from sales proceeds, but compensation for licensed dealers is limited by industry norms to standardized commissions. Whether many licensed dealers will be willing to undertake the risks associated with such offerings for relatively low compensation remains to be seen.
Florida also repeats the federal requirement for 1) public accountants' review of financial statements for offerings between $100,001 and $500,000; and 2) audited financial statements for offerings between $500,001 and $1 million. (28) Small businesses generally cannot afford and do not implement the kind of internal accounting controls that public accountants want to work with and review. Given the usual informal nature of small businesses, and the risk of misleading disclosure, one can appropriately wonder whether licensed public accountants will be willing to put their financial necks on the line as having reviewed the financials of the issuing company. And how much will any such review cost the issuer? The liability and cost concerns are exacerbated for offerings over $500,000, for which the issuer is obligated to provide audited financial statements. Not only is this requirement not one imposed by most other federal exemptions, but it is fair to ask whether anyone during the legislative process inquired as to how many small businesses actually have or could afford to pay for audited financial statements. Most other states do not impose a requirement for audited financials unless the offering is between $1 million and $2 million. (29) Florida not only limits its exemption to $1 million, but imposes an auditing requirement for offerings over $500,000.
What Should Florida Small Businesses Do to Raise Capital?
Florida's legislature missed a golden opportunity to assist small businesses in raising capital under our state securities laws. For a state interested in attracting enterprise formation, Florida's crowdfunding exemption creates a distinct disadvantage compared to the exemption adopted in other states. The Florida crowdfunding exemption might be workable for some small businesses and willing intermediaries, but the costs, impositions, and liability risks inherent in the exemption suggest that its use will be very limited.
Are there alternatives to the crowdfunding exemption? Fortunately the answer is yes, at least for businesses that are able to utilize either of the federal private offering exemptions found in Rule 506(b) or Rule 506(c) of Regulation D. (30) Both of these exemptions preempt state registration and exemption provisions. Both allow an unlimited amount to be raised. Both allow for nationwide offers and sales of securities. Rule 506(b) allows up to 35 nonaccredited investors and an unlimited number of accredited investors. The principal drawback of Rule 506(b) is the prohibition against general advertising and general solicitation of potential investors, a prohibition strictly interpreted by the SEC. (31) However, for businesses that are able, within the marketing limitation, to attract sufficient investors, Rule 506(b) is a very workable method to raise capital. Rule 506(c) goes even further and allows general advertising and general solicitation, but the principal limitations are that all purchasers must be accredited investors and the issuer is obligated to take somewhat substantial efforts to verify that each investor, in fact, qualifies as an accredited investor. For small businesses willing to undertake the verification requirements, Rule 506(c) offers an opportunity to undertake broad advertising of the offering to attract potential investors.
An additional drawback to Florida's crowdfunding exemption is its limitation of $1 million within a 12-month period. That amount is often below levels necessary for many developing companies. If capital requirements are in the several million dollar range, or larger, the issuer might consider, in addition to the Rule 506 exemptions, the recently revised Regulation A federal exemption. (32) Regulation A requirements go well beyond those of Rule 506, but for companies that need to engage in broad solicitation and cannot be assured of obtaining sufficient capital solely from accredited investors, the Regulation A alternative should be considered.
In short, Florida-based small businesses have several options available for capital raising without undertaking a time-consuming and expensive registered offering. Crowdfunding is one of those options, albeit in Florida, a very limited one. Perhaps with experience, potential statutory modifications might be considered if the crowdfunding exemption proves to be of little practical value. The door has opened to assist small business financing; time will tell where that effort goes from here.
(1) H.B. 275, signed by Gov. Scott on June 16, 2015, creating the Florida Intrastate Crowdfunding Exemption, FLA. STAT. [section]517.0611. Several statutory provisions must be supplemented by administrative rulemaking. Although the exemption has a nominal effective date of October 1, 2015, the exemption will not become operative until the Office of Financial Regulation issues supplemental rules.
(2) Florida's principal exemption from registration for capital formation is in FLA. STAT. [section]517.061(11), which prohibits "any form of general solicitation or general advertising in this state."
(3) Florida's securities laws, contained in FLA. STAT. Ch. 517, are not consistent with the Uniform Securities Act adopted in many states. Nor has Florida adopted either the Uniform Limited Offering Exemption nor the Accredited Investor Exemption found in most states to assist small business capital formation. It appears that the reluctance on the part of Florida's Division of Securities to expand capital formation opportunities is a fear that relaxing marketing rules may adversely impact senior citizens who are often targets for securities and financial frauds.
(4) Well-known websites include Kickstarter, GoFundMe, and IndieGoGo.
(5) Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). Crowdfunding is covered in Title III, [section][section]301-305 of the JOBS Act, adding a new exemption as [section][section]4(6) and 4A of the 1933 Securities Act, 15 U.S.C.A [section]77d(6).
(6) See, e.g., Joan MacLeod Heminway, How Congress Killed Investment Crowdfunding: A Tale of Political Pressure, Hasty Decisions, and Inexpert Judgments That Begs for a Happy Ending, 102 Ky. L. J. 865 (2013-2014).
(7) The latest SEC announcement indicates that rules will be announced in late 2015.
(8) See, e.g., Rutherford B. Campbell, Jr., The New Regulation of Small Business Capital Formation; The Impact--If Any--of the JOBS Act, 102 Ky. L. J. 815, 832 (2014) ("[T]he mandatory provisions of the [a]ct itself may make it difficult for the [c]ommission to construct an efficient regulatory crowdfunding regime....").
(9) See Stuart R. Cohn, The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 64 FLA. L. REV. 1433 (2012); C. Steven Bradford, The New Federal Crowdfunding Exemption: Promise Unfulfilled, 40 Sec. Reg. L. J. 195 (2012).
(10) The list of states adopting crowdfunding legislation and links thereto can be found at the website of the North American Securities Administrators Association (NASAA), http://www.nasaa.org.
(11) The fundamental requirement set forth in [section]5 of the 1933 Securities Act is that all offers and sales of securities that employ an instrumentality of interstate commerce must be federally registered. Other provisions in the statute provide limited exemptions from this requirement.
(12) Section 3(a)(11), 1933 Securities Act, 15 U.S.C.A. 77c(a)(11). Rule 147, 17 C.F.R. [section]230.147, is an independent safe harbor exemption. An issuer can comply with either of these exemption provisions to satisfy the federal intrastate exemption. Every state crowdfunding exemption contains the express requirement that the offer and sale of securities satisfies the federal intrastate exemption.
(13) Media advertising and Internet announcements regarding the offer of securities that extend beyond the state borders do not violate the federal intrastate exemption as long as the announcements make it clear that offers and sales will be made only to residents of the particular state involved. SEC Rel. No. 33-4434, Exemption for Local Offerings from Registration (Dec. 6, 1961).
(14) Compliance with the intrastate exemption requirements requires, among other things, that a substantial portion (80 percent under Rule 147) of the issuer's assets be located in and its revenues derived from within the state. There might also be integration concerns. If, for example, the issuer has sold securities in recent months to persons outside the state, those sales might preclude a current intrastate offering under the SEC's integration doctrine that might regard the out-of-state sales as part of the current planned offering.
(15) The issuer cannot be a company with undefined business operations or business plan, a company that lacks a stated investment goal for the intended proceeds, or a company that plans to engage in a merger with or acquisition of an unspecified business entity. Fla. Stat. [section]517.0611(4)(d).
(16) Florida's crowdfunding provision, Fla. Stat. [section]517.0611(3), requires compliance with both [section]3(a)(11) and Rule 147, although these are distinct and different intrastate exemptions and satisfaction of either is sufficient for federal purposes. The dual requirement is found in a number of other state crowdfunding exemptions, which suggests that the requirement for satisfaction of both the statutory and regulatory exemptions was not accidental drafting and was intended. Inasmuch as the Rule 147 provisions are more specific and objective, compliance with Rule 147 will likely be the expected norm.
(17) Intermediaries must go through a registration process with the Office of Financial Regulation pursuant to rules to be adopted by the OFR. FLA. STAT. [section]517.12. The office ultimately determines whether the applicant "is of good repute and character and has complied with the provisions of this chapter and the rules adopted thereunder...." Fla. Stat. [section]517.12(e).
(18) The $1 million ceiling is reduced by all securities sales within the preceding 12 months, excluding sales to directors, officers, partners, or persons of similar status and 20 percent shareholders.
(19) Accredited investors as defined in [section]501(a) of Regulation D, 17 C.F.R. [section]230.501(a) include individuals who 1) have a net worth, or joint net worth with one's spouse, that exceeds $1 million, exclusive of the individual's primary residence; or 2) an income in excess of $200,000, or joint income with a spouse in excess of $300,000, in each of the two most recent years and has a reasonable expectation of reaching that level in the current year. The term also includes certain substantial entities, e.g., banks and trusts with assets exceeding $5 million.
(20) Curiously, the statute does not provide for any minimum target amount. Some states, e.g., Massachusetts, requires that the minimum be 30 percent of the entire offering amount. The minimum target is 50 percent in Mississippi. The lack of a minimum percentage should be corrected through legislation or rule.
(21) FLA. STAT. [section]517.0611(10). Financial statement requirements are discussed below.
(22) The disqualification provisions, applicable to the issuer and each director, officer, and person performing similar functions, and each 20 percent shareholder, are adopted from Regulation D, Rule 506(d) under federal law, 17 C.F.R. [section]230.506(d). The provisions essentially disqualify the issuer from using the exemption if any of the applicable parties have been the subject of criminal or regulatory actions involving financial misdeeds.
(23) FLA. STAT. [section]517.0611(5).
(24) A state-by-state survey indicates that a majority of the states do not require either a dealer or an intermediary. Issuers are not prohibited from using intermediaries, but the state exemption does not mandate such use or impose substantive offering obligations upon such intermediaries. For an example of a relatively simple, straight-forward crowdfunding exemption that does not mandate the use of any dealer or intermediary, see Ga. Stat. 590-4-4-.08.
(25) States that require a dealer or intermediary impose limited disclosure obligations on the intermediary and none of the more substantive requirements found in Florida. See, e.g., TEXAS ADMIN. CODE, Title 7, Part 7, Ch. 139, Rule 139.25; ARIZ. REV. STAT. [section]44-1844(D).
(26) These and other intermediary requirements are set forth in FLA. STAT. [section]517.0611(13). "Intermediary" is broadly defined to include any natural person or entity that facilitates the offer or sale of securities under the crowdfunding exemption. FLA. STAT. [section]517.021(13).
(27) FLA. STAT. [section]517.0611(14) ("An intermediary not registered as a dealer under [[section]]517.12(6) may not ...(c) compensate employees, agents, or other persons for the solicitation of, or based on the sale of, securities offered or displayed on its website.").
(28) FLA. STAT. [section]517.0611(7)(h). For offerings of $100,000 or less, the issuer must disclose its most recent income tax return, if any, and a financial statement certified by the principal executive officer as true and complete. For offerings more than $100,000 up to $500,000, the issuer's financial statements must be prepared in accordance with generally accepted accounting principles and be reviewed by a certified public accountant. For offerings over $500,000 up to $1 million, financial statements must be audited by a certified public accountant.
(29) See, e.g., Mass. 950 CMR 14.420(B)(13) (o), the Massachusetts Crowdfunding Exemption.
(30) 17 C.F.R. [section]230.501-508.
(31) Rule 502(c), 17 C.F.R. [section]230.502(c).
(32) In March 2015, the SEC responded to another mandated portion of the JOBS Act of 2012 by substantially revising the Regulation A exemption. Regulation A now consists of two exemptions: Tier 1 for offerings up to $20 million and Tier 2 for offerings up to $50 million. The Tier 1 exemption does not require audited financials, but it does not preempt state law, which means that the offering will likely have to be registered in Florida and other states where offers are made. If the issuer is willing to have audited financial statements and otherwise comply with the requirements for Tier 2 Regulation A offerings, the offering will preempt state registration and exemption provisions. 17 C.F.R. [section][section]230.251-263.
Stuart Cohn is the Sam T. Dell Professor of Law at the University of Florida Levin College of Law. He is a member of the Executive Council of The Florida Bar Business Law Section and is the academic vice chair of the section's Committee on Corporations, Securities and Financial Institutions.
The views expressed in this article do not necessarily reflect those of the Business Law Section, which did not participate in the formulation of the crowdfunding legislation.
This column is submitted on behalf of the Business Law Section, Alan Howard, chair, and Stephanie C. Lieb, editor.
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|Author:||Cohn, Stuart R.|
|Publication:||Florida Bar Journal|
|Date:||Dec 1, 2015|
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