Securities laws rarely provide the introductory hook writers dream about, but they do represent a substantial challenge that many real estate developers must address. Over the last two years, the United States Congress and North Carolina State House each proposed crowdfunding legislation that lessens the regulatory burden for small-dollar securities offerings. The federal Jumpstart Our Business Startups Act (federal JOBS Act) and North Carolina Jumpstart Our Business Start-Ups Act (NC JOBS Act) are designed to assist startup companies and small businesses; however, real estate professionals and economic development managers should also be aware of the new fundraising tools now at their disposal. This post outlines how existing federal and state securities laws are modified by crowdfunding legislation, beginning first with an overview of the existing securities laws, and followed by a deeper dive into each of the federal and state law changes.
“Crowdfunding” has become an ambiguous term as media outlets and investors attach it to fundamentally different types of fundraising efforts. Today there exist three scenarios in which crowdfunding might be used to describe a fundraising effort. First, crowdfunding might refer to websites like Kickstarter and Indiegogo, which allow businesses to publicly raise money via donations or product pre-purchases. Retail- or donation-based crowdfunding does not involve the sale of securities, and therefore no securities laws are triggered. Second, crowdfunding might refer to changes to existing securities laws that allow for more broad-based investor participation. Third, and perhaps most accurate, crowdfunding might refer to the completely new federal and state laws that allow a business to solicit small investments over the internet from a large number of people, with decision-making enhanced by the “wisdom of the crowd.” We limit our discussion here to the latter two types of crowdfunding in which an entity seeks to raise money pursuant to either (i) an existing, but modified, securities law or (ii) an entirely new crowdfunding law.
Securities Law Background
Federal law requires any public sale of securities to be registered with the SEC (an initial public offering) or conducted pursuant to an exemption from registration (such as Regulation D and Regulation A). The SEC defines a security as any investment in a common enterprise from which the investor expects to derive profits solely or substantially from the efforts of a third party. A real estate developer that publicly sells any form of “interest” in a project to non-managing investors is conducting a securities offering that must be either registered with the SEC or fit under an exemption. Given the expense and disclosure requirements of a registered offering, most businesses and projects choose to offer securities pursuant to an exemption from registration.
1. Lifting Reg D’s General Solicitation Ban
A “Private Placement” is the generic term for a non-public security sale that is exempt from registration under Regulation D (Reg D), or, less commonly, Regulation A (Reg A). Reg D is by far the most used exemption and provides three different options for a business to conduct a limited, private offering of securities without filing a registration statement. The most common of the three Reg D exemptions is Rule 506(b), which allows issuers to skip state securities regulation and raise an unlimited amount of money from an unlimited number of accredited investors (typically a business or investor with significant financial assets). However, Rule 506(b) caps the number of non-accredited investors at 35 and does not allow public solicitation or advertising. Without public solicitation, issuers are limited to prospective investors with whom the issuer has a bona-fide, pre-existing relationship. One of the goals of crowdfunding is to reach more investors, both accredited and non-accredited, through more general solicitations.
The federal JOBS Act, signed into law in 2012, widens the investor pool somewhat under a new provision, Rule 506(c). Under Rule 506(c), an issuer may publicly solicit investors, provided the solicitations target accredited investors and the offering only allows accredited investors to actually buy the securities. Crowdfunding, yes, but limited to a small, wealthy crowd.
2. Reg A’s Second Tier
Reg A differs from Reg D in that it allows a company to conduct a public securities offering by soliciting both accredited and non-accredited investors. Despite the potentially broad audience, Reg A is rarely used because Reg A offerings are subject to state-level registration requirements, are capped at $5 million, and require the issuer to file a “mini” registration statement with the SEC.
The federal JOBS Act added a second tier to Reg A that raises the fundraising cap to $50 million, provided the company regularly files audited financial statements with the SEC. Perhaps more important, the second tier Reg A exemption preempts state securities laws so that an issuer need not comply with each state’s laws.
3. Intrastate Securities Sales and North Carolina JOBS Act
The Intrastate Exemption shifts regulation of certain “local” securities sales to state agencies. To qualify under the Intrastate Exemption, an offering must be restricted only to investors that reside in the same state as the issuer. Unlike Rule 506 of Reg D and the second tier of Reg A, the Intrastate Exemption requires compliance with the appropriate state’s securities laws and regulations. Traditionally, state securities agencies regulate securities offerings in a manner that closely resembles federal registration, making the Intrastate Exemption an “exemption” in name only. In an effort to change that trend, at least in North Carolina, the NC JOBS Act proposes a much simpler regulatory framework for small, crowd-funded offerings that fit within the federal Intrastate Exemption. Last fall, the NC JOBS Act passed the North Carolina House with bipartisan support and a vote of 103 to 1. In July of 2014, the North Carolina Senate inserted the unmodified NC JOBS Act into a larger and more controversial economic development bill that the NC House subsequently rejected on the final day of the short session. On August 19, 2014, the North Carolina House again failed to pass the combined bill.
If the NC JOBS Act is enacted, a North Carolina business could raise up to $2 million in any 12-month period. However, an issuer’s total aggregate fundraise would be limited to $1 million if the issuer has not undergone a GAAP audit with respect to the most recently completed fiscal year. The NC JOBS Act would cap non-accredited investors’ investment at $2,000 per offering; while accredited investors’ investment would be uncapped (but subject to the total offering cap of $1 or $2 million). Offers or sales to controlling persons (officer, director, 10% shareholder) would not count toward the total offering limit.
Advertising and Solicitation. The NC JOBS Act would permit issuers to publicly promote and advertise their offering to investors. However, the SEC has taken the position that social media and other Internet-based promotion will likely involve offers to out-of-state residents, thereby violating the Intrastate Exemption (and by extension the NC JOBS Act). At this point, it is unclear exactly what types of general solicitation and advertising are permissible under the NC JOBS Act.
Testing the Waters and Intermediaries. An issuer may “test the waters” under the NC JOBS Act since the proposed law does not require notice of the offering to be filed with the state securities commission until the issuer begins general solicitation or executes the 25th sale, whichever occurs first. After an offering under the NC JOBS Act, the issuer is required to make available to shareholders (by posting on the issuer’s website or through direct mail) quarterly reports that include director and officer compensation and company financial data.
Resale. The Intrastate Exemption (under which the NC JOBS Act exists) restricts resale of securities to residents of the state during the offering and for the nine month period following the last sale of securities. The offered securities must include a legend stating that they are not registered under the 1933 Securities Act, and investors that purchase securities via a website intermediary must provide evidence or certification of their North Carolina residency. An issuer is disqualified from conducting a securities offering under the NC JOBS Act if it (i) has filed a registration statement in any state that is the subject of an effective stop order, (ii) has been convicted of certain securities-related felony and misdemeanors, or (iii) is the subject of certain administrative or court orders.
4. Federal Crowdfunding
The federal JOBS Act added Section 4(a)(6) (Federal Crowdfunding) to the 1933 Securities Act, creating a completely new statutory exemption from registration in addition to Reg D, Reg A, and the Intrastate Exemption. Federal Crowdfunding was signed into law last year, although its effectiveness is delayed until the SEC finalizes the proposed regulations, which is expected to occur sometime during 2014. Like North Carolina’s crowdfunding law, the federal law is designed to reduce the cost of a low-dollar offering (under $1 million) and utilize publicly-available internet platforms to solicit a large “crowd” of non-accredited investors.
Federal Crowdfunding allows an entity to publicly solicit an unlimited number of accredited and non-accredited investors in any state, provided the offering meets certain requirements laid out below. Federal Crowdfunding is subject to a $1 million cap within the 12 months preceding the first sale. While other exempt offerings under different federal exemptions do not count toward Federal Crowdfunding’s $1 million cap, Federal Crowdfunding sales may count toward another offering’s cap (or be integrated with another offering if the two offerings are not sufficiently separate in time and character).
Who can invest? In addition to the $1 million offering cap, Federal Crowdfunding also caps an issuer’s sales to an individual investor based on the investor’s annual income or net worth. If the investor’s annual income or net worth is less than $100,000, sales to that investor cannot exceed the greater of $2,000, or 5 percent of the investor’s annual income or net worth. If the investor’s annual income or net worth is greater than $100,000, sales to that investor cannot exceed the lesser of $100,000, or 10 percent of the investor’s annual income or net worth. The issuer may rely on the efforts of an intermediary (defined below) to ensure that the aggregate amount of securities purchased by an investor will not exceed the investor’s respective limits.
Intermediary required. Federal Crowdfunding requires a third-party intermediary to facilitate or broker the sale of securities. An intermediary may be either an SEC-registered broker-dealer or a newly defined entity called a “funding portal.” A funding portal includes any person or entity acting as an intermediary for the offer or sale of only crowdfunded securities. The JOBS Act and proposed regulations burden intermediaries with the task of ensuring that no investor exceeds the individualized investment limits. An intermediary is also responsible for disclosing relevant transaction data to investors and regulators.
Disclosures. Initially, the issuer must file with the SEC and disclose to investors (i) the identity of directors, officers, and major (20% ownership) investors, (ii) a description of the business and anticipated business plan, and (iii) financial information that varies with the issuer’s target offering amount. Issuers targeting an offering of $100,000 or less must provide the company’s most recent income tax returns and CEO-certified financial statements. Issuers targeting between $100,000 and $500,000 must provide financial statements reviewed by an independent public accountant. Finally, issuers targeting between $500,000 and the maximum $1,000,000 must provide audited financial statements. On an on-going basis, issuers must file with the SEC and provide to investors an annual report that includes the year’s operations and financial results, as well as additional information the SEC may require by rule.
The issuer must also disclose to investors, file with the SEC, and provide to the intermediary the following information: purpose of offering, intended use of the proceeds, target offering amount and deadline to reach it, progress updates, securities’ price (or method of determining the price if undetermined), and both current and future capital structure/ownership projections.
Advertising. Federal Crowdfunding does not prohibit advertising or public solicitation, except issuers themselves may not advertise the terms of their own offering, other than providing “tombstone-like” notices that direct investors to the crowdfunding intermediary. If the issuer hires a person or company to promote its offering, the promoter must clearly disclose its financially-interested relationship.
The “democratizing power” of crowdfunding is widely heralded, and for good reason. But before meaningful capital will freely flow from non-accredited investors to capital-starved small businesses, the proposed crowdfunding schemes need to overcome significant hurdles. First and foremost, Federal Crowdfunding still awaits a final regulation from the SEC to make the law effective. The proposed Crowdfunding Regulation is 585 pages and will demand substantial legal, accounting, and intermediary-related costs that make crowdfunding expensive, and, for the smallest offerings, nonsensical. A better balance between regulatory burden on issuers and flexibility for investors may be the new Rule 506(c), which now allows general solicitation and advertising of Rule 506 offerings, provided the offerings are restricted to a “crowd” of accredited investors. This expanded access to accredited investors may be the simplest path to “crowdfund” real estate development in North Carolina communities.
North Carolina took the lead last year with the introduction of the NC JOBS Act. Now, the NC JOBS Act is just one part of a controversial economic development bill that was defeated in the North Carolina House this summer and will not be revisited until November, if at all. And even if it is eventually signed into law, the NC JOBS Act is not perfect. In particular, it caps investments by non-accredited investors at $2,000, requiring successful crowdfunding campaigns to involve participation by hundreds of investors. A higher fixed cap or a scaled cap could provide issuers and investors with more flexibility and the additional cost savings associated with economies of scale. State-level crowdfunding has the potential to provide entrepreneurs and real estate developers with an additional public fundraising tool that is far simpler than its federal counterpart. Unfortunately, given the NC JOBS Act recent defeat, North Carolina small businesses seeking to raise capital more widely may best be served by advice that is far simpler than securities laws: write your legislator.
Dan Tracey graduated from the University of North Carolina at Chapel Hill in 2014 with a law degree and masters in business administration. He conducted the research for this post as part of an independent study during the Spring 2014 semester.
 17 CFR § 230.147, Preliminary Note 3 (“The legislative history of that Section suggests that the exemption was intended to apply only to issues genuinely local in character, which in reality represent local financing by local industries, carried out through local investment.”).
 15 U.S.C. § 77c (2012). The Intrastate Exemption is available for an offering in which securities are sold only to persons resident within a single State or Territory, and in which the issuer is a resident and/or incorporated and doing business within same state that the investors reside. An issuer is a resident of the state or territory in which: (i) it is 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 is located, if a general partnership or other form of business organization that is not organized under any state or territorial law; (iii) his or her principal residence is located if an individual. An issuer is considered to be doing business in a state if the issuer derives at least 80 percent of its gross revenues and those of its subsidiaries on a consolidated basis in the state. Id.
 For example, using the SEC’s cost estimates, an issuer that sells $50,000 of stock under Federal Crowdfunding would initially net only $38,540 and would be required to pay $4,000 per year to comply with on-going annual reporting requirements. See Jeff Thomas, Making Equity Crowdfunding Work for the Unaccredited Crowd, 4 Harvard Bus. Rev. Online 62, 67 (2014).