Last week, the Department of Corporations issued this bulletin which it styled as a “Crowdfunding Update”. The Bulletin makes several important points.
Until the Securities and Exchange Commission adopts regulations, there is no federal crowd funding exemption. It should be noted that Congress mandated that the SEC adopt these regulations by December 31, 2012. As of today’s date, the SEC has missed that deadline by 77 days or 11 weeks or 1,848 hours or 110,880 minutes or 6,652,800 seconds (but who’s counting?). Because the SEC hasn’t even proposed regulations, it will be, at best, many months before final regulations are adopted. In most cases, the Administrative Procedure Act requires that a substantive rule be published in the Federal Register at least 30 days prior to its effective date. 5 U.S.C. § 553(d). However, there is an exception when the rule “grants or recognizes an exemption or relieves a restriction”.
Not all crowd funding is constitutes the offer and sale of a security. This acknowledgment is likely to hearten those who are already engaging in crowd funding based on the position that there is no offer and sale of security. The Department notes, however, that these arrangements may be subject to other laws. The Department doesn’t provide any examples, but several come to mind. If the crowd funding is for charitable purposes, then registration with the Attorney General may be required under the Supervision of Trustees and Fundraisers for Charitable Purposes Act, Government Code Section 12580 et seq. If a reward model is used, it may constitute a raffle or lottery.
The purpose of the DOC’s bulletin is to provide general information, it should not be relied upon as legal advice with respect to specific situations.
For example, when noting that certain types of crowd funding activities may not involve the offer and sale of securities, the DOC states “These types of crowdfunding are generally altruistic and contributors (who are not, strictly-speaking, investors) do not receive equity in the projects they are funding.” Under the Corporate Securities Law, securities may include debt as well as other numerous financial arrangements that aren’t strictly speaking “equity”. In fact, “equity” isn’t even included in the list of items constituting a “security” in Corporations Code Section 25019.
The bulletin also implies that the test for whether a security is being offered or sold is whether there is an expectation of profits (i.e., Justice Murphy’s classic definition of an investment contract enunciated in Securities and Exchange Comm’n v. W.J. Howey Co., 328 U.S. 293 (1946)):
The Department is aware of organizations that have raised millions of dollars from consumers who received no profits or offer of profits in exchange for their contributions.
However, the California Supreme Court has adopted an alternate definition of “security” – the so-called “risk capital” definition. See Silver Hills May Tarnish Crowdfunding.
The bulletin’s characterization of what constitutes a valid offering under Regulation D also should not be taken at face value. The bulletin states ”
The Reg D exemption, while currently legal, means offers must meet a specific set of rules. Generally, Reg D offers can only be made to “accredited” investors that meet specific income or net worth requirements and it is not currently legal to make Reg D offers over the Internet to the general public.
While many Regulation D offerings are limited to “accredited investors”, this is not a requirement. Regulation D is not a single exemption, it is a set of rules that embrace several distinct exemptions. Further, one of these rules, Rule 504, permits general solicitation and advertising (subject, of course, to the conditions set forth in that rule).