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« The Jumpstart Our Business Startups Act and the Elimination of the Ban on General Solicitations | Main | Regulation A+, the JOBS Act, and Public Offering Lite »
Saturday
Apr272013

Crowdfunding and State Level Securities Fraud Enforcement under the JOBS Act

[PDF]

Michael W. Shumate*

Introduction

President Obama signed the Jumpstart Our Business Startups Act (“JOBS Act”) into law on April 5, 2012.[1] This Act combines a number of pieces of legislation that collectively seek to ease the difficulties inherent in raising capital for start-up companies.  Title III of the Act attempts to create certain exemptions for companies that raise capital through crowdfunding. Crowdfunding typically involves small investments made over the Internet through regulated funding portals. Title III, however, limited the role of states in the oversight of crowdfunded offerings.   

This paper discusses the history of state securities enforcement prior to the adoption of the JOBS Act. The paper will examine the concerns that led to the promulgation of Title III of the JOBS Act, including the decision to limit the oversight role of the states. The final section will discuss the implications of this approach.   

Background

The relationship between state and federal securities regulation is in many ways a unique one. While the SEC prosecutes most large-scale securities actions at the federal level, states also have their securities statutes, colloquially known as “blue sky laws,”[2] and bring their own enforcement actions.[3] Blue sky laws vary from state to state, but have traditionally focused on the registration of both broker-dealers and securities offerings. With respect to the registration of offerings, most states impose some sort of merit review.[4] States also typically have in place anti-fraud provisions that make actionable false statements made in connection with securities offerings.[5] These anti-fraud provisions apply regardless of whether registration is required.

Absent an applicable exemption, blue sky statutes typically require registration in each state where the offering occurs.[6] Registration, therefore, may be required in multiple states.[7] Researching each individual law and completing the registration process can add delay and cost to an offering and discourage capital raising.[8]

Aware of these costs, Congress selectively preempted state registration requirements in the National Securities Markets Improvement Act of 1996 (NSMIA). The statute eliminated state registration requirements for covered securities. Covered securities included, among others, shares sold in a private placement under Rule 506 of Regulation D and securities sold by companies trading on national stock exchanges.[9]  

NSMIA, however, left the other exemptions untouched. Offerings relying on Regulation A,[10] Rules 504 and 505 of Regulation D,[11] and private placements under Section 4(a)(2) of the ’33 Act[12] remained subject to state registration requirements. As a result, states retain significant oversight of small offerings.[13] Nonetheless, the impact of NSMIA has been significant. Most non-public offerings are made in reliance on Rule 506.[14]

States have nonetheless played an active role in securities enforcement. They can bring actions against fraudulent offerings or establish registration violations for offerings improperly made under Rule 506.[15] In 2011, securities regulators conducted 6,121 investigations, resulting in 2,602 enforcement actions, 436 of them criminal.[16] The actions provided for investor restitution of $2.2 billion, $126 million in fines and penalties, and 3,570 brokerage and advisory licenses withdrawn, denied, revoked, or conditioned.[17]   

The JOBS Act: Title III, Section 305

Crowdfunding originally arose in an effort to attract non-equity funding by Internet portals.[18] A budding enterprise would solicit funds through a website like Kickstarter.com and, in return for small contributions, provide individuals with some sort of tangible product (t-shirt, product sample, etc.).[19] These offerings did not implicate the requirements of the securities laws.

Title III of the JOBS Act sought to extend crowdfunding to equity offerings by providing an exemption from registration under the 1933 Act. The statute also provided an exemption from registration as a broker-dealer for the Internet portal offering the crowdfunding shares, although registration with a self-regulatory organization was required.[20] The role to be played by the states in oversight of the offerings and the portals, however, proved to be a difficult and controversial issue in the development of the exemption. 

A. The Legislative History

Title III began as the Entrepreneur Access to Capital Act (H.R. 2930).[21] Introduced September 14, 2011, by Representative McHenry, the bill was referred to the House Subcommittee on Capital Markets and Government Sponsored Enterprises. The legislation authorized crowdfunded offerings through intermediaries (including Internet portals) and explicitly preempted state registration requirements. The legislation capped the size of the offerings at $2 million but remained silent on state oversight of crowdfunding intermediaries, particularly portals. 

A hearing was held on September 21, 2011, on five separate bills, including H.R. 2930.[22] A number of witnesses broadly discussed the issue of state versus federal regulation. They stressed the difficulties in following various state regulations[23] and suggested federal –as opposed to state–oversight of intermediaries such as web portals.[24] Only one witness, Heath Abshure of the North American Securities Administrators Association (NASAA), argued for the retention of state authority, citing the importance of state review and policing of these offerings.[25]

The issue of state regulation came up again in hearings before the Senate Committee on Banking, Housing, and Urban Affairs on the JOBS Act. Some viewed state regulation as unnecessary. They suggested that existing oversight by the SEC of intermediaries and broker-dealers would sufficiently protect investors in crowdfunded offerings.[26] Moreover, they asserted that crowdfunding involved creation of an online community of trust, reducing the need for state regulation.[27] 

The exemptions from state law were left in the bill. A proposed amendment sought to require notice to states of crowdfunded offerings, facilitating awareness of the sales and enhancing the ability to police for fraud.[28] The amendment was not, however, adopted.[29] Opponents were concerned with the specific mechanics and potential burdens of notice filing.[30] 

The full committee approved the bill on October 26, 2011. Representative Perlmutter offered, and the House approved, one additional amendment relating to state enforcement rights. The amendment explicitly preserved the states’ authority to police fraud, deceit, misrepresentation, and other unlawful behavior despite any other preemption of state securities laws.[31] The Amendment also specified that states retained the authority to bring actions for “unlawful conduct by an intermediary, issuer, or custodian.”[32]

The final version, therefore, preempted the offerings under state law but left in place state authority to prosecute fraud and regulate Internet portals. For some, however, the amendment did no go far enough. Letters from NASAA and from the North Carolina Secretary of State complained that the amended bill would only permit states to police fraud after it occurred.[33] The final bill also provided that intermediaries must give notice of the offerings to the SEC.[34] The SEC was required to provide this information to the states.[35] The House approved the amended bill on November 3, 2011.

The issue of state regulation came up again in hearings before the Senate Committee on Banking, Housing, and Urban Affairs on the JOBS Act. Those testifying noted the previously discussed concerns over the potential for fraud but essentially dismissed them by noting the absence of any evidence with respect to existing crowdfunding ventures,[36] concluding state oversight was therefore unnecessary. The ability to police offerings through the anti-fraud provisions was enough.

State regulators continued to oppose preemption. Senator Harkin noted the views of the AFL-CIO that the scaling back of state enforcement authority would actually raise capital costs due to the increased risk of fraud.[37] The most outspoken critic, however, remained NASAA. The organization opposed the “unnecessary limits on the ability of state securities regulators to protect retail investors from the risks associated with smaller, speculative, investments.”[38] Moreover, NASAA viewed the reforms as unlikely to lead to the desired economic growth and asserted that they would instead “have precisely the opposite effect” by stunting growth and reducing the availability of capital. [39]

NASAA also questioned the adequacy of SEC enforcement.[40] The letter contended that the SEC was unable to give the offerings exempt under NSMIA the necessary oversight.[41] With the crowdfunded offerings capped at $1 million, the SEC lacked “the resources and time to effectively police these small-scale offerings.”[42] As a result, “[t]he bulk of the post-sale anti-fraud enforcement responsibility will fall to the states, which could lead to an enforcement nightmare.”[43]

In addition to the logistical need for state oversight, NASAA put forward several other reasons why state regulation of crowdfunding would be preferable. First, given the community-centric focus of crowdfunding, states were better positioned to tailor regulations to best serve the specific community of investors intended to be protected. Second, in response to arguments that the offerings would be subject to 50 different regulating bodies, NASAA pointed to a model state exemption that the states are creating that would streamline the registration process.[44]

The provision was rewritten in the Senate.[45] Senators Merkley, Bennett, Brown, and Landrieu introduced S.2190, the CROWDFUND Act, as an amendment to the JOBS Act on March 13, 2012.[46] The amendment contained essentially the same preemption language found in H.R. 2930 but strengthened the provisions designed to protect investors. Under Section 4A(a) of the JOBS Act, portals were required to provide disclosures to prospective purchasers, educate investors, and take various other steps designed to mitigate fraud in lieu of traditional state registration.

Moreover, the amendment strengthened the role of states with respect to crowdfunding by adding two provisions.[47] The first prohibited any “filing or fee” by a state with respect to a crowdfunding offering but did exempt the states where the issuer had its “principal place of business” or where at least 50% of the purchasers resided. This exemption preserved at least a small role for some states in the offering process.  Moreover, notice filings would allow these states to at least have some awareness of the offerings and potentially police for fraud.

More significantly, the second provision provided increased state oversight of portals.  The state where the portal had its principle place of business was authorized to make inspections and bring enforcement actions to enforce rules and regulations. Enforcement, however, was limited to “the requirements . . . established by the Commission.”[48]

Implementation

Crowdfunded offerings will often involve a high degree of risk. Startups have a high rate of failure. Moreover, some offerings will likely involve fraud. Given the $1 million limit on the size of the offering, the SEC will not be likely to engage in significant enforcement activities. While states can target crowdfunded offerings for fraud, the JOBS Act eliminated registration as an enforcement tool.   

Although states have little opportunity to police the offerings directly, they were given the right to oversee portals. Oversight was restricted to the state where the portal had its principal place of business. These states can conduct inspections and enforce rules and regulations, although only those established by the Commission. Thus, the states were given the ability to ensure that portals implement requirements designed to protect investors and that portals take the required steps designed to prevent fraudulent offers.  

The provision, however, is limited. States cannot add their own requirements. Moreover, the provision limits enforcement to rules and regulations adopted by the Commission. This does not, apparently, include enforcement of the rules and regulations of FINRA, the self regulatory organization where portals will register.

The Senate amendment to the crowdfunding provision, therefore, did not reinstate state oversight of the offerings. It did, however, provide a mechanism for state involvement through oversight of the portals. To the extent that portals remain the primary mechanism for ensuring adequate investor protection, states will likely play a role in making certain that portals perform this task. 

 

 

 


       *.     J.D. Candidate 2013, University of Denver Sturm College of Law.

       [1].     Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. (2012) (enacted).

       [2].     Kansas enacted the first blue sky law in Kansas in 1911, where Joseph Norman Dolley, the Commissioner of Banking, explained the laws were “designed to prevent the swindling of people through sales of ‘securities’ that are based mostly upon atmosphere.”  Lawrence R. Gelber, Blue Sky Laws, The Gelberlaw Glossary, http://www.gelberlaw.net/Glossary.html (copy. 2004-2011) (quoting The Saturday Evening Post (Vol. 184 No. 23) (December 2, 1911)).

       [3].     See, e.g., Hall v. Geiger-Jones Co., 242 U.S. 539, 550 (1917) (“The name that is given to the law indicates the evil at which it is aimed; that is, to use the language of a cited case, 'speculative schemes which have no more basis than so many feet of “blue sky;”’ or, as stated by counsel in another case, 'to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines, and other like fraudulent exploitations.'”).

       4.     “Approximately 40 states apply a ‘merit review’ approach to the registration of securities offerings.” Report on the Uniformity of State Regulatory Requirements for Offerings of Securities That Are Not “Covered Securities”, SEC.gov (Oct. 11, 1997), http://www.sec.gov/news/studies/uniformy.htm#FOOTBODY_9. 

       [5].     See, e.g., Del. Code Ann. tit. 6, § 2511-13 (2013).

       [6].     Blue Sky Laws, SEC.gov, http://www.sec.gov/answers/bluesky.htm (last modified Sept. 27, 2000) (“[M]ost states [sic] laws typically require companies making small offerings to register their offerings before they can be sold in a particular state.”).

       [7].     The offering may be exempt in some states. The Uniform Securities Act of 1956 exempted offerings made to fewer than 10 investors and was adopted by many states. The Uniform Securities Act of 2002, adopted by 14 states, provided a similar exemption for sales to fewer than 25 investors in a 12-month period, provided certain other conditions were met. Most blue sky laws exempt offerings or sales to existing shareholders. See Matthew A. Cordell, State securities regulation: Selling the blue sky, WRALtechwire.com (Sept. 24, 2008), http://wraltechwire.com/business/tech_wire/opinion/story/3597705/.

       [8].     An issuer is required to pay a filing fee in whichever state it wishes to sell securities. This fee varies by state but is generally several hundred dollars. Individual state regulations and fees can be found here: SecuritiesLawUSA, PC, BlueSkyLinks, seclawusa.com, http://www.blueskylinks.com/page3.html (last visited Feb. 10, 2013). For example, one small business spent $35,000 on registration and legal fees in the process of getting blue sky approval through 19 separate state-by-state blue sky applications. See, Steve Solomon, Follow the Money, Inc.com, (June 1, 1997), http://www.inc.com/magazine/19970601/1255.html. 

       [9].     National Securities Markets Improvement Act of 1996, Pub. L. 104-290, § 102(b), 110 Stat. 3416 (Oct. 11, 1996); Securities Act of 1933, 15. U.S.C. § 77r (2012). 

     [10].     17 C.F.R. § 230.251 (2013).

     [11].     17 C.F.R. §§ 230.504-.505 (2013).

     [12].     15 U.S.C. § 77d (2013).

     [13].     Rule 504 caps offerings at $1 million. Rule 505 and offerings under Regulation A cannot exceed $5 million, although Congress in the JOBS Act lifted the amount that could be raised under the latter exemption to $50 million. Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. § 401 (2012) (enacted); 17 C.F.R. §§ 230.251(b), 230.504-505 (2013).

     [14].     Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, S.E.C. Release No. 33-9211, 17 C.F.R. §§ 230, 239 (May 25, 2011) (“Rule 506 . . . is by far the most widely used Regulation D exemption, accounting for an estimated 90-95% of all Regulation D offerings and the overwhelming majority of capital raised in transactions under Regulation D.”).

     [15] While shares sold pursuant to Rule 506 are exempt from blue sky registration, states could bring registration violations against companies that did not meet the requirements of the Rule. This often occurred where issuers engaged in advertising in violation of the prohibition in Rule 506 on general solicitations. Letter from Jack E. Herstein et al., President, NASAA, to Senator Jack Reed, Chairman, Senate Comm. on Banking (Mar. 16, 2012) (on file at http://www.nasaa.org/wp-content/uploads/2011/07/NASAA-Final-Letter-on-Dem-Substitute-3-16-2012c.pdf); Richard I. Alvarez & Mark J. Astarita, Introduction to the Blue Sky Laws, SECLaw.com (2010), http://www.seclaw.com/bluesky.htm. This will likely become less useful, however.  The JOBS Act has authorized the use of general solicitations in connection with offerings under Rule 506.  See Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. § 201 (2012) (enacted); Press Release, Sec. Exch. Comm’n, SEC Proposes Rules to Implement JOBS Act Provision About General Solicitation and Advertising in Securities Offerings (Aug. 29, 2012) (on file at http://www.sec.gov/news/press/2012/2012-170.htm). 

     [16].     NASAA Enforcement Report, NASAA Enforcement Section (Oct. 2012) (on file at http://www.nasaa.org/wp-content/uploads/2011/08/2012-Enforcement-Report-on-2011-Data1.pdf).

     [17].     The most common enforcement actions were those dealing with unregistered securities, unlicensed individuals or firms, and dishonest or unethical activity. These actions primarily stemmed from either Rule 506/Regulation D offerings or real estate investments or interests. As would be expected, a large number of these schemes were aimed at “affinity” groups such as the elderly. Id.

     [18].     Bill Clark, The History & Evolution of Crowdfunding, Mashable.com, (Sep. 15, 2011), http://mashable.com/2011/09/15/crowdfunding-history/.

     [19].     Current crowdfunding platforms include: http://www.kickstarter.com, http://www.indiegogo.com, and http://www.fundable.com. This page provides a description of crowdfunded projects that have been the most successful to date: Discover / Most Funded: The most funded projects in Kickstarter history (since 2009!), Kickstarter.com, http://www.kickstarter.com/discover/most-funded (last visited Feb. 10, 2013).

     [20].     Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. § 4A(a) (2012) (enacted).

     [21].     Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong. (2011).

     [22].     Legislative Proposals to Facilitate Small Business Capital Formation and Job Creation: Hearing Before the Subcomm. on Capital Mkts. and Gov’t Sponsored Enters. of the Comm. on Fin. Servs., 112th Cong. (2011), available at http://financialservices.house.gov/uploadedfiles/112-63.pdf.

     [23].     See id. at 32 (statement of Dana Mauriello, Co-founder and President, ProFounder) (“The current regime of State regulation makes it extremely difficult to scale the model of crowdfunding, how this can happen.”), available at http://financialservices.house.gov/uploadedfiles/112-63.pdf.

     [24].     See id. at 27-28 (statements of Lona Nallengara, Deputy Director, Div. of Corp. Fin., U.S. Sec. & Exch. Comm’n, and Patrick T. McHenry, Rep., House Comm. on Fin. Servs.), available at http://financialservices.house.gov/uploadedfiles/112-63.pdf.

     [25].     See id. at 29-30 (statement of Heath Abshure, Arkansas Securities Comm’r, on behalf of the N. Am. Sec. Admin. Ass’n, Inc. (NASAA)), available at http://financialservices.house.gov/uploadedfiles/112-63.pdf. 

     [26].     See Examining Investor Risks in Capital Raising: Submitted Testimony of Mark. T. Hiraide Before the S. Comm. on Banking, Hous., & Urban Affairs, Subcomm. on Sec., Ins., & Inv., 112th Cong. 9 (2011) (“On the other hand, [the crowdfunding legislation], adopts a regulatory regime for intermediaries that requires them either to elect to register with the Commission as a broker-dealer or as a newly defined ‘funding portal,’ subject to several definitional proscriptions. [The legislation] appropriately limits the scope of permissible activity of a funding portal . . . .”) available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=348a885d-de31-4054-8d81-2941256c9607.

     [27].     The system would allow investors to “identify each other in a verifiable way (and so weed out sock-puppets and shills) [and provide a way to] communicate with one another about their common investments, rely on each other for information and advice, . . . the idea being that no one investor’s money would be used until the project had been ‘approved’ by virtue of a large number of other investors committing their money.” Examining Investor Risks in Capital Raising: Submitted Testimony of Professor John C. Coates IV Before the S. Comm. on Banking, Hous. & Urban Affairs, Subcomm. on Sec., Ins., & Inv., 112th Cong. 13 (2011), available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1d24b42e-3ef8-4653-bfe8-9c476740fafa.

     [28].     Representative Maloney offered an amendment on October 4, 2011, that would have required notice of an offering be given to the SEC and made available to state regulators. Examining Investor Risks in Capital Raising: Submitted Testimony of Rep. Carolyn Maloney Before the S. Comm. on Banking, Hous. & Urban Affairs, Subcomm. on Ses., Ins., & Inv., 112th Cong. 13 (2011), available at http://financialservices.house.gov/uploadedfiles/100511hr2930maloneyam.pdf.

     [29].     The subcommittee voted 19-12 against the amendment. See id., available at http://financialservices.house.gov/uploadedfiles/cm-35.pdf.

     [30].     Members of the subcommittee took issue with the amendment, concerned over the mechanics and potential burdens of the proposed notice (who exactly would need to be notified, what “notice” means, whether notice would be tantamount to full registration, etc.). The worry was that notice would be so burdensome that it would defeat the stated purpose of the bill of easing access to capital. Ultimately, it was put to a vote and voted down. Id., available at http://financialservices.house.gov/calendar/eventsingle.aspx?EventID=262490.

     [31].     Representative Watt expressed concern that this amendment was but a step in the right direction of preventing total preemption of state law, but that it did not go far enough because states were still prevented from pre-screening these offerings. A letter from NASAA read into the record reflected similar concerns. Representative McHenry expressed the opposing argument that requiring registration in every state would be cost-prohibitive for these small-scale offerings, but he did not oppose the proposed amendment. 157 Cong. Rec. H7306-08 (daily ed. Nov. 3, 2011) (Amend. 6, offered by Rep. Perlmutter).

     [32].     Id.

     [33].     157 Cong. Rec. H7307-08 (daily ed. Nov. 3, 2011) (Statement of Melvin Watt on behalf of NASAA and the North Carolina Secretary of State) (NASAA letter available at http://www.nasaa.org/wp-content/uploads/2011/11/NASAA-Letter-on-HR-2930.pdf).

     [34].     Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong. § 4A(a)(4), (a)(9), (a)(13), (b)(4), (b)(8), (b)(13) (2011).

     [35].     Id. at § 4A(d).

     [36].     See Spurring Job Growth Through Capital Formation: Submitted Testimony of Timothy Rowe Before the S. Comm. on Banking, Hous., & Urban Affairs, 112th Cong. 1-3 (2012), available at http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=395de986-77d8-45f6-886d-5da33f1a3593.

     [37].     158 Cong. Rec. S1825 (daily ed. Mar. 20, 2012) (statement of Sen. Harkin), available at http://www.gpo.gov/fdsys/pkg/CREC-2012-03-20/pdf/CREC-2012-03-20-pt1-PgS1824-2.pdf.

     [38].     Id. (quoting NASAA).

     [39].     Id.

     [40].     Herstein, supra note 14.

     [41].     Id. (“Since NSMIA, the provisions of Rule 506 and other limited or private offering provisions are being used by unscrupulous promoters to evade review and fly under the regulatory radar with little scrutiny by the SEC.”).

     [42].     Id.

     [43].     Id.

     [44].     Id. While a model state exemption would streamline the process, it is far from clear how or when this would occur or be implemented. The NASAA letter states that the exemption is currently in the rulemaking process, but does not go into specifics on a timeline or what the substantive provision of the exemption would look like. See id.

     [45].     Hearings were held in the Senate on the House version of crowdfunding. Spurring Job Growth Through Capital Formation While Protecting Investors: Hearings Before the S. Comm. on Banking, Hous., & Urban Affairs, 112th Cong. (2011) (webcast available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=a96c1bc1-b064-4b01-a8ad-11e86438c7e5). Several witnesses discussed preemption of state law, but only in the context of Regulation A offerings.  The exception was testimony from Jack Herstein of NASAA, who expressed similar concerns to those already discussed in the House. See id. (submitted testimony available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=a96c1bc1-b064-4b01-a8ad-11e86438c7e5&Witness_ID=669e8f4b-d74a-4490-83be-a40d0c3226e9).

     [46].     Earlier versions of crowdfunding legislation had been introduced in the Senate. See Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011, S. 1970, 112th Cong. (2011); Democratizing Access to Capital Act of 2011, S. 1791, 112th Cong. (2011).

     [47].     CROWDFUND Act, S. 2190, 112th Cong. (2012).

     [48].     Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. § 304 (2012) (enacted). Subsection (d) specifically addresses funding portals. It begins with a blanket preemption of any state law, rule, regulation, or other administrative action against a registered portal. The only exception to this is Subsection (B), which provides that the state in which the portal is located may examine and enforce laws that are not in addition to or different from Federal regulations established by the commission. Id. at § 304(d), (B).

 

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