Client Alert: A Quick Look at Arizona’s New Crowdfunding Law (SB 1450/HB 2591)
Through existing “crowdfunding,” a large number of people each provide a relatively small amount of money over the Internet for a profit or nonprofit enterprise, in return for goods or services (often a promise to receive goods or services that can only be produced after the crowdfunding campaign succeeds) or, in some cases, in return only for an acknowledgement of a donation, with perhaps a token T-shirt. That process is often facilitated through websites such as GoFundMe, KickStarter and other similar companies which earn a percentage of funds raised. Now, we are on the brink of equity crowdfunding, in which the person providing the money over the Internet receives a “security” (such as stock) in the enterprise. This involves the offering and sale of a security, subject to both federal and state securities laws which, generally, prohibit offers and sales unless they qualify for an exemption. While the SEC continues to debate the requirements of a specific federal exemption for crowdfunding, several states – including Arizona – have passed statutes authorizing equity investment through crowdfunding that rely on an exemption from federal registration for the sale of securities wholly within one state -the intrastate exemption.
Arizona’s law (SB 1450/HB2591) adds a new exemption from registration at the state level. Companies using this exemption will be permitted to “distribute a limited notice” containing a link to the website of an operator unaffiliated with the company who is either a registered dealer or someone who does not “receive a commission or remuneration, directly or indirectly, for the offer or sale of the security.” (This raises some important questions: who will offer these website services? GoDaddy? Amazon? Sites that also link to accredited investors? Unlike the proposed federal crowdfunding exemption, there is no requirement of registration of the “portal” if it is not taking a commission or "remuneration".) The website operator may not be a purchaser in any offering made pursuant to this exemption, and may not hold an interest in or be affiliated with or under common control with any issuer making an offer or sale pursuant to this exemption. (Note: This is not limited to the issuer in the offering, but all issuers in all offerings relying on this exemption.) The website operator must give the Arizona Corporation Commission access to the website and must limit website access to Arizona residents.
This is a brief summary of the requirements to qualify for the new exemption (there are 21 sections of the bill, so this summary is necessarily incomplete):
Local Arizona companies. To use this exemption, a corporation, LLC or limited partnership must be formed in Arizona (not another state—no Delaware corporations, for example), all of the investors must be residents of Arizona, at least 80 percent of the issuer’s revenues must come from business within Arizona, 80 percent of the issuer’s assets must be located in Arizona, and 80 percent of the money raised in the offering must be used in Arizona. Any resales must be to Arizona residents until nine months after the end of the offering.
Funding limits. There is a cap on funds raised in a 12-month period ($1 million if audited financials for the last fiscal year are not provided: $2.5 million if the issuer provides audited financials for the last fiscal year that comply with GAAP) and no more than $10,000 may be raised from any single purchaser unless the purchaser is an accredited investor (under federal definitions).
Disclosure document. All investors must receive a disclosure document containing specified topics. But note: There are separate federal and state statutes that always require disclosure of all material information--SEC Rule 10b-5 and Arizona’s counterpart—no exemption eliminates the duty under those statutes, or liabilities for failure to do so. Please click here to read the Disclosure Document requirements for the Arizona crowdfunding exemption.
Escrow and other purchaser protection. All investor funds must be deposited into a single escrow account maintained by a bank, credit union or other depository financial institution in Arizona (the law also refers to regulated trust company or corporate fiduciary, savings bank, savings and loan association) that maintains deposit or share insurance. Offers must state a “target offering amount” and an offering deadline (which must be between 21 days and one year from the date the offer is made) and at least 80 percent of the target offering amount must be in escrow by the stated deadline. Purchasers can cancel up to 48 hours before deadline or 72 hours after receiving notice of an early closing (any early closing requires notice to all purchasers).
Filing with Arizona Corporation Commission. At least ten days before the commencement of the offering, the issuer must file with the ACC: a prescribed notice, a copy of the disclosure document (the ACC is not expected to give it any “merit” review), a copy of the escrow agreement, and any other documents or information the commission may require.
Future quarterly reports required (perhaps forever). The issuer must provide to purchasers quarterly reports of compensation to directors and officers, and an analysis by the issuer's management of the business operations and financial condition of the issuer. (This requirement does not expire until all securities issued under the exemption are no longer outstanding).
Disqualifications. Certain kinds of issuers are disqualified (“blind pools” having no business plan, investment companies, and publicly reporting companies, as well as issuers who have been the subject of certain “bad boy” orders or violations (same if any person “affiliated with the issuer or offering” is subject of the same).
Determination of residency and investor status. Each purchaser is required to make a prescribed certification that he or she understands the risks of the investment, and the issuer must obtain evidence that the prospective purchaser is an Arizona resident (drivers license, voter registration or general property tax records suffice) and evidence that anyone purchasing more than $10,000 is an accredited investor (“self-certification” is probably not evidence.)
Will the exemption be useful? Commentators differ. Some say, if one who is enthusiastic about a company can now put in their money and get a T-shirt, why not let them get a piece of the action? Others predict that crowdfunding will attract investors who are less sophisticated and who do less due diligence simply because they are investing smaller amounts, and therefore crowdfunding money will have a stigma of poorer quality—the company may be perceived as one that couldn’t raise “smart money”—and that the inability of investors to know, before investing, who else is “in the deal” will also lead to lower quality (because traditional investors have the reassurance of knowing whether other, presumably “smart” money, is being invested, as a check on the quality of the investment). But other commentators have said that crowdfunding may work best if local information is used by local investors, who are in a better position to know that a local business can or cannot succeed in their market. In that case, the money actually is smart, on a local basis.
The SEC’s proposed federal crowdfunding rules, first released in October 2013, were not finalized as of the date of this Client Alert.
If you have any questions regarding this article, please contact Scott DeWald: