SEC Adopts Final Rules Modernizing Intrastate and Regional Securities Offering Laws to Assist Companies with Capital Formation
On October 26, 2016, the Securities and Exchange Commission (SEC) adopted final rules (Final Rules) addressing intrastate and regional securities offerings. The Final Rules complement recent efforts by Congress, as well as those of several state legislatures and state securities regulators, to modernize securities laws to assist smaller companies with capital formation. The SEC deemed these updates to be particularly necessary in light of several significant changes to securities laws, including the amendment to Rule 506 of Regulation D under the Securities Act of 1933, as amended (the Act), allowing for general solicitation and general advertising and the SEC’s adoption of Regulation Crowdfunding, which permits companies to use the internet to offer and sell securities through crowdfunding.
The Final Rules (i) amend intrastate offering exemption Rule 147 of the Act, (ii) create a new intrastate offering exemption designated Rule 147A of the Act, (iii) amend Rule 504 of Regulation D and (iv) repeal Rule 505 of Regulation D. As discussed more fully below, the amended Rule 147 and new Rule 147A are designed to aid companies’ capital raising efforts, including through offerings relying upon intrastate crowdfunding provisions, while maintaining appropriate investor protections. Amended Rule 504 increases the aggregate amount of securities that may be offered and sold and provides additional protections to investors, which essentially rendered Rule 505 superfluous, necessitating its repeal.
Amended Rule 147 and new Rule 147A will become effective 150 days after publication in the Federal Register, and Amended Rule 504 will become effective 60 days after publication. The repeal of Rule 505 will take effect 180 days following publication.
Rule 147 Amendments and New Exemption Rule 147A
Since its adoption in 1974, Rule 147 has served as a safe harbor for intrastate offerings exempt from registration pursuant to Section 3(a)(11) of the Act. Section 3(a)(11) exempts from registration “[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, if a corporation, incorporated by and doing business within, such State or Territory.” Rule 147 was adopted to provide objective standards for local businesses seeking to rely on Section 3(a)(11) and assurances that the intrastate exemption would be used for the purpose Congress intended in enacting Section 3(a)(11)—the local financing of companies by investors within the company’s state or territory. To achieve this, old Rule 147 set out definitions of “person resident” for both issuers and offerees or purchasers and “doing business” for issuers for purposes of Section 3(a)(11).
In the Final Rules, the SEC elected to retain Rule 147 as a safe harbor for exempt intrastate offerings under Section 3(a)(11), while updating several of the requirements under the Rule in light of developments in modern business practices and communications technology in the years since the Rule’s adoption. Additionally, the SEC created a new intrastate offering exemption, Rule 147A, which is substantially similar to Rule 147 but allows issuers to make offers accessible to out-of-state residents, as long as sales are limited to in-state residents. Rule 147A is intended to allow issuers to engage in general solicitation and general advertising of their offerings, such as on the internet, while ensuring that sales remain local in nature, consistent with the legislative intent of Section 3(a)(11). Amended Rule 147 and new Rule 147A set forth the following provisions:
- Issuer “residence”: Under Amended Rule 147, an issuer’s residence is the location where the issuer: (1) has its (a) principal place of business, defined as the location from which the officers, partners, or managers of issuer primarily direct, control and coordinate the activities of issuer—replacing the “principal office” requirement in the old Rule 147; and (b) in the case of a corporation, limited partnership, trust or other company organized under state or territorial law, where it is incorporated or organized; or (2) has its principal residence (if an individual). Rule 147A defines residence in terms of principal place of business only. Under both Rules, an issuer that has changed its residence after making sales in an intrastate offering under these Rules cannot conduct another such offering for a period of six months from the date of last sale in the prior state. The SEC declined to impose an in-state formation residence requirement in Rule 147A, as it determined this would be unnecessarily restrictive and limit the usefulness of the exemption, potentially to the detriment of local economic development.
- Issuer “doing business”: In addition to establishing residency, an issuer must satisfy at least one or more of the following “doing business” requirements to demonstrate the in-state nature of its business:
- The issuer derived at least 80% of its consolidated gross revenues from the operation of a business or of real property located in or from the rendering of services within such state or territory;
- The issuer had at the end of its most recent semi-annual fiscal period prior to an initial offer of securities in any offering or subsequent offering pursuant to this section, at least 80% of its assets and those of its subsidiaries on a consolidated basis located within such state or territory;
- The issuer intends to use and uses at least 80% of the net proceeds to the issuer from sales made pursuant to this section in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state or territory; or
- A majority of the issuer’s employees are based in such state or territory.
This is a departure from the old Rule 147, which set forth a more complex set of elements and required an issuer to satisfy all four to establish that it was “doing business” within a given state or territory. The SEC explained that this amendment to Rule 147 and provision in new Rule 147A are designed to expand the universe of issuers that may conduct exempt intrastate offerings under Section 3(a)(11) and Rules 147 and 147A, while continuing to require issuers to have a sufficient in-state presence. Moreover, the SEC noted that this expanded definition addresses the difficulty faced by many companies trying to satisfy the “doing business” standard under old Rule 147 in light of the increasing “interstate” nature of business activities.
- Offeree/Purchaser Residency:
- “Residence”: An offeree or purchaser’s residence is where such offeree or purchaser (1) has its principal place of business (as defined for issuers above); or (2) has its principal residence (if an individual). Unlike issuers, entity offerees/purchasers need not be incorporated or organized in a state or territory in order to be considered a “resident” of such state or territory.
- New “reasonable belief” standard for determining offerees’/purchasers’ residency: Offers and sales shall be made only to residents of the state or territory in which the issuer is resident or, alternatively, who the issuer “reasonably believes” at the time of the offer and sale are residents of such state or territory. Under old Rule 147(d), regardless of their efforts to confirm potential investors’ in-state residency, issuers would be unable to utilize the exemption if just one investor was, in fact, not an in-state resident. The SEC explained that a more flexible “reasonable belief” standard would increase utility of amended Rule 147 and new Rule 147A by providing issuers with additional certainty about the availability of the exemptions under these Rules while still providing appropriate investor protections.
- Written representation: Issuers must obtain a written representation from each purchaser confirming his or her residence, which will be one factor in the issuer’s “reasonable belief” determination.
- Limitations on resales: The Final Rules contain a limit on resales to persons resident within the state or territory of the offering for a period of six months from the date of the sale by the issuer to the purchaser of a security sold pursuant to the exemption. The old Rule 147(e) had imposed a nine-month restriction. The SEC stated that a period of six months would be adequate to establish that the securities sold in an intrastate offering had “come to rest” in that state.
- Disclosures to investors: More comprehensive disclosure requirements, including detailed legend requirements, to offerees and purchasers about the requirements for intrastate offerings and restrictions on resales are required under the Final Rules. In addition, unlike old Rule 147, amended Rule 147 and new Rule 147A do not require that disclosures to offerees be made in writing. Rather, the required disclosures are to be made in the same manner in which the offer is communicated. The SEC explained that this will provide appropriate flexibility to issuers in conducting offerings and avoid potential confusion in certain situations, such as where an offer is made orally. The SEC also noted that requiring an oral disclosure in the case of an oral offer will help ensure that the investor receives the disclosure when it is most relevant, at the time the investor learns about the offer.
- Integration safe harbor: The Final Rules also provide an integration safe harbor. The integration doctrine aims to prevent issuers from improperly avoiding registration by artificially dividing a single offering into multiple offerings in order to claim an exemption under the Act. For purposes of determining eligibility to rely on rules 147 and 147A, offers or sales made in reliance on Rules 147 and 147A will not be integrated—or combined—with:
- Prior offers or sales of securities; or
- Subsequent offers or sales that are: (i) registered under the Act, except as provided in Amended Rule 147(h) or 147A(h); (ii) exempt from registration under Regulation A; (iii) exempt from registration under Rule 701; (iv) made pursuant to an employee benefit plan; (v) exempt from registration under Regulation S; (vi) exempt from registration under section 4(a)(6) of the Act; or (vii) made more than six months after the completion of an offering conducted pursuant to Rules 147 and 147A.
This integration safe harbor aligns with the approach taken in Rule 251(c) of Regulation A and alleviates issuers’ need to have to conduct an integration analysis to determine whether two offerings would be treated as one for purposes of qualifying for exemption. It is intended to provide issuers, particularly smaller issuers whose capital needs frequently change, with greater certainty about their eligibility to comply with a registration exemption.
Rule 504 Amendments
In the Final Rules, the SEC amended Rule 504, a historically underutilized exemption due to its low offering amount limit of $1 million—which had not been raised since 1988—and the comparatively more popular Rule 506 exemption, which imposes no state registration requirement. Amended Rule 504: (1) increases the aggregate amount of securities that may be offered and sold in any twelve-month period to $5 million; and (2) adds a new disqualification provision to prevent certain bad actors from participating in Rule 504 offerings by referencing the disqualification provisions of Rule 506 of Regulation D. The SEC articulated that the increased limit would facilitate issuers’ ability to raise capital, while the bad actor disqualification would create a more consistent regulatory scheme within Regulation D and provide additional protections to investors participating in Rule 504 offerings.
Repeal of Rule 505
Last, the SEC repealed Rule 505 of Regulation D, which had provided a safe harbor from registration for offerings up to $5 million annually that were sold to accredited investors or to no more than 35 non-accredited investors and met additional requirements. In support of its decision, the SEC noted that Rule 505 had been used only infrequently, and the amendment to Rule 504 increasing the aggregate offering amount from $1 million to $5 million further diminished the utility of Rule 505.
The foregoing amendments are intended to align the above rules with other recent changes in securities laws as well as acknowledge the increasing use of the internet and other communication technologies by issuers in the course of offering and selling securities. However, Rule 147 and Rule 504 have seen limited historical use and although the SEC's intent is to assist companies with capital formation by modernizing these rules, it remains to be seen whether the changes result in any increased reliance of these particular exemptions which continue to be much more limited in scope than Rule 506(b) and (c) of Regulation D.
For questions or additional information, please contact Alexandria Kane (firstname.lastname@example.org; 212.631.4409), Lori Smith (email@example.com; 212.714.3075) or Bridget Henwood (firstname.lastname@example.org; 212.631.4421).
 Under old Rule 147, an issuer was deemed to be a “resident” of the state or territory in which: (i) it was incorporated or organized (if a corporation, limited partnership, trust or other form of business organization that is organized under state or territorial law); (ii) its principal office was located (if a general partnership or other form of business organization not organized under any state or territorial law); or (iii) his principal residence was located (if an individual).
 An offeree or purchaser under old Rule 147 was deemed to be a “resident” of the state or territory in which, at the time of the offer and sale: (i) it had its principal office (if a corporation, partnership, trust or other form of business organization, except that any such entity organized solely for the purpose of acquiring part of an issue under the Rule will only be deemed to be resident of state or territory if all of its beneficial owners are residents of such state or territory); or (ii) his principal residence was located (if an individual).