crowdfunding letter - final 26 feb 2014

Securities Law CommitteeOf the Business Law Section

Washington State Bar Association

February 26, 2014

The Honorable Jan Angel, Co-ChairThe Honorable Steve Hobbs, Co-ChairFinancial Institutions Housing & Insurance Committee

Re: The Washington Jobs Act of 2014House Engrossed Substitute Bill No. 2023

Dear Senators Angel and Hobbs:

We noted that House Engrossed Substitute Bill No. 2023 (the “Bill”) was recently referred toyour committee.

This letter represents the views of the Securities Law Committee of the Business Law Section ofthe Washington State Bar Association (“WSBA”). The committee’s members are lawyers whopractice primarily in the field of corporate law and securities regulation.

The Board of Governors of the WSBA, the Business Law Section and individual members of theWSBA and their associated firms or companies have not reviewed the issues addressed in thisletter, and may not concur with the views expressed in this letter.

The committee does not offer an opinion in favor of or opposed to the Bill. The committee hasidentified several concerns with the text of the Bill that we respectfully request be consideredbefore the legislature acts upon the final version of the Bill.

We note Sec. 3, paragraph 1(a) of the Bill requires that “The offering is first declaredexempt by the director after:” (certain requirements are met). This requirement maycreate a conflict with RCW 21.20.360, an existing provision of the Securities Act ofWashington (the “Act”), which prohibits the director from giving “approval” to anyperson, security or transaction, and makes unlawful any representation to any prospectivepurchaser, customer or client that the Director has given such “approval.” RCW21.20.400 makes it a Class B Felony to willfully violate these prohibitions. Further, RCW21.20.540 expressly provides, consistent with a principle of both Federal and statesecurities laws, that “the burden of proving an exemption, an exception from a definition,or a preemption of a provision of this chapter is upon the person claiming it.” Such a“declaration” of “exemption” by the Director would appear to contradict RCW 21.20.540,

The Honorable Jan Angel, Co-ChairThe Honorable Steve Hobbs, Co-ChairFinancial Institutions Housing & Insurance CommitteeFebruary 26, 2014

and in doing so create a barrier to enforcement of the civil remedies afforded to injuredinvestors by the statute—given the recognized principle that our courts afford greatweight to an interpretation of the Director with respect to the Act. Accordingly, werecommend a slightly different approach that will retain consistency with existing law.We recommend modifying that paragraph to read as follows (text is redlined to showdeletions as “line-outs” and insertions as text in red):

(a) Either:

(i) The issuer files the offering with the director aclaim of exemption in such form as required by thedirector; or

(ii) A portal, on behalf of the issuer,working incollaboration with the director files the offeringwith the director, on behalf of the issuer, a claim ofexemption in accordance with under section 4 of thisact and in such form as required by the director;

* * *

(j) The issuer and investor provide any otherinformation reasonably requested by the director.; and

(k) The director does not deny the claim of exemptionreferenced in subparagraph (a)(i) or (a)(ii) abovewithin fifteen (15) business days after receiptthereof.

Disclosure of material information concerning the operations of companies is critical topreventing fraud and abuse under Washington’s securities laws. We note with concernthe qualifying language of Sec. 3 paragraph (3) which imposes disclosure obligations onthe issuer only, as that section states: “If the issuer elects to use a portal under section 4of this act”. As a result, issuers who do not use a portal for crowdfunding would have nocontinuing disclosure obligations to investors under the Bill.1 The committee stronglybelieves that all crowdfunding investors should have access to ongoing information

1 While Section 3 paragraph 3 may be somewhat ambiguous on the disclosure obligations of issuers thatdo not use a portal, the “Effects” section at the conclusion of the Bill eliminates any ambiguity by statingthat the Bill “Limits reporting to issuers working through portals.” While the Washington BusinessCorporation Act requires companies to provide financial information to shareholders, there is not asimilar requirement to provide financial information to holders of debt or convertible debt.


following their investment—not just those investors who purchase their securitiesthrough a “portal.” Accordingly, the committee recommends that the above referencedqualifying language of Section 3 paragraph (3) be deleted and that Section 3 paragraph(3) be revised to read as stated below.

While perhaps unintentional, the Bill contains a glaring omission in the issuer disclosurerequirements, since as drafted issuers are not required to provide financial statements toinvestors. Federal and state securities laws have, for over 80 years, consistently requiredissuers to provide financial statements to investors – it is a bedrock principle of protectinginvestors. Financial statements best enable investors to evaluate the performance of thecompany and hold management accountable.

Further, we believe the statute needs to be more precise regarding the informationrequired in the on-going reports. To offset the burden of increased disclosure on issuers,we suggest the quarterly reports contain only financial statements, and annual reportscontain more complete disclosure, including financial statements and the currentlycontemplated narrative analysis of the business and financial condition, managementcompensation, and job creation. We are concerned that the narrative analysis in quarterlyreports would quickly become boilerplate and of little value to investors. We believe thisapproach allows an issuer to focus on producing a meaningful report once a year, and ifproduced before an annual shareholders’ meeting, could significantly improve the qualityof the disclosure to investors.

We also believe that the ongoing reporting requirements should terminate in severalscenarios, such as if the issuer conducts a public offering or its securities becomeregistered under federal law, if the issuer dissolves or liquidates under applicable statelaw or all the securities are transferred to accredited investors (so that the crowdfundinginvestors have been bought out).

According, the committee recommends that Section 3 paragraph (3) be amended andrestated in its entirety (with new text in red) as follows:

(3) For as long as securities issued under theexemption provided by this section are outstanding,unless all such securities are held by accreditedinvestors, the issuer is dissolved or liquidated inaccordance with state law, the issuer conducts aregistered public offering or the class of securitiesis registered under the Securities Exchange Act of1934, as amended, the issuer shall provide thefollowing reports to the holders of such securities:


(a) A quarterly report, within forty-five days of theend of each the first, second, and third fiscalquarter of each fiscal year, which report must containthe following information: financial statements,consisting of unaudited statements of income for thefiscal quarter and an unaudited balance sheet as ofthe end of such fiscal quarter, prepared in accordancewith generally accepted accounting principles, subjectto changes resulting from normal year-end adjustmentsand excluding any notes related thereto.

(b) An annual report, within ninety days of the end ofeach fiscal year, which must contain the followinginformation:

(i) the names of the directors and officers (orpersons serving in similar positions or performingsimilar functions) of the issuer, the period of timesuch persons have held such position, the amount ofvoting equity securities of the issuer held by suchpersons, the cash compensation earned by such personsfor the applicable fiscal year, and any bonuses orother compensation, including stock options or otherrights to receive equity securities of the issuer orany affiliate of the issuer, received by them;

(ii) An analysis by management of the issuer of thebusiness operations and financial condition of theissuer;

(iii) financial statements, consisting of unauditedstatements of income for the fiscal year, and aunaudited balance sheet as of the end of such fiscalyear, prepared in accordance with generally acceptedaccounting principles, excluding any notes relatedthereto; and

(iv) a summary estimate of the employment positionscreated in Washington, not to include names ofemployees, since and attributable to receiving fundingunder this section. The summary must include:(i) Thenumber of employment positions; (ii) The number of


employment positions according to the following wagebands: Less than thirty thousand dollars; greater thanthirty thousand dollars, but less than sixty thousanddollars; and sixty thousand dollars or greater; (iii)The nature of benefits, including medical, dental, andretirement benefits, provided to a majority of theemployment positions; and for an issuer conducting anoffering through an economic development organizationthat receives public benefits or resources such as taxincentives, a description of the public resourcesreceived.

(c) The issuer may satisfy its obligation to providereports under this section by making such reportsaccessible, free of charge, at the issuer's website,provided the report remains so accessible until thenext report is provided under this section. In makingany report accessible on its website, the issuer mayrequire security holders to create a user name andpassword (or similar security method) to access suchreport.

(d) In no event will the issuer be required to provideany trade secrets or other confidential information tosecurity holders under this section. If the issuer hasaudited financial statements, it shall provide thosein lieu of the unaudited versions.

(e) The failure of an issuer to comply with quarterlyand annual reporting requirements of this section willnot result in the loss of the exemption fromregistration provided by this section.

Under Section 4, paragraph 1 of the Bill, “portals” are limited to economic developmentorganizations, defined as local associate development organizations (as defined in RCW43.330.010) and port districts. The committee recommends that the definition of “portals”be expanded to be consistent with the federal definition, as well as include those entitiesthat qualify under rules that the director could adopt. Since the concept of a “portal” isnew and none currently exist, the committee believes a more flexible approach inidentifying entities that may qualify as portals may be important if the crowdfundingexemption is to have a meaningful impact on raising capital for smaller businesses.Accordingly, the committee recommends that Section 4, paragraphs (1) and (2) beamended as follows (new text in red):


(1) Only an economic development organization, anorganization that qualifies as a funding portal withinthe meaning of Section 4A(a)(1)(b) of the SecuritiesAct of 1933, or an organization that qualifies as aportal pursuant to regulations promulgated by thedirector, may register with the director as a portalunder this chapter. For the purposes of this section,"economic development organization" means any localassociate development organization, as defined in RCW43.330.010, or port district.

(2) An economic development organization portal shallrequire, at a minimum, the following information froman applicant for exemption prior to offering servicesto the applicant or forwarding the applicant'smaterials to the director:

Under the JOBS Act, crowdfunding is not available to “investment companies,” thosecompanies whose business is investing in the securities of other entities, e.g., a mutualfund or venture capital fund, and not directly in job creation. While investmentcompanies can play an important role in providing capital to startups, the intent ofcrowdfunding is to focus on providing such startup capital by allowing the public to servein that role, which has been otherwise unavailable to the issuers that we expect to rely onthis exemption. Investment companies also raise significant legal and disclosure issuesthat are addressed in detail by the Investment Company Act of 1940, as amended, andpose a greater risk of fraud. Accordingly, the committee recommends that Section 3,subparagraph (1)(c)be amended to read as follows (new text in red):

(c) The issuer is an entity organized and doingbusiness in the State of Washington, and is neither (i)an “investment company” as defined in section 3(a) ofthe Investment Company Act of 1940, as amended, nor(ii) a person excluded from the definition ofinvestment company by section 3(b) or section 3(c) ofthe Investment Company Act of 1940;

Under the federal JOBS Act, the $1 Million-in-12-months federal crowdfunding limitapplies to all companies under common control with the issuer. This restriction isessential in order maintain the integrity of this limitation, as otherwise a promoter couldform an unlimited series of related entities to each raise $1 million in a 12 month periodand turn what is intended to be a registration exemption for small offerings into an endrun around the oversight, disclosure and investor protections required of substantial,


registered public offerings. Accordingly, the committee recommends that Section 3,subparagraph (1)(f) be amended to read as follows (new text in red):

(f) The aggregate purchase price of all securitiessold by an issuer (including all entities controlledby or under common control with the issuer) pursuantto the exemption provided by this section does notexceed one million dollars during any twelve-monthperiod;

Under Section 3 Paragraph (1)(h) of the Bill, the offeror is required to obtain anelectronic signature from investors. We suggest that the requirement that the signature beelectronic be struck:

(h) The investor acknowledges by electronic signaturethe following statement conspicuously...

Under the federal JOBS Act, “bad actors” are excluded from utilizing the crowdfundingexemption; individuals that have violated securities laws are not allowed to usecrowdfunding to raise money for their companies. We so no reason why such individualsshould be permitted to take advantage of the state crowdfunding exemption. Accordingly,the committee recommends that the following language be added to the end of Section 3:

(5) “The Director shall adopt disqualificationprovisions under which this exemption shall not beavailable to any person or its predecessors,affiliates, officers, directors, underwriters, orother related persons, which provisions shall besubstantially similar to the disqualificationprovisions adopted by the Securities and ExchangeCommission pursuant to the requirements of Section401(b)(2) of the JOBS Act of 2012 or, if none, asadopted in Rule 506 of Regulation D. Notwithstandingthe foregoing, this exemption shall become availableas soon as this law is effective.”

Section 6 of the Bill, which appears primarily to be a reauthorization of the current

exemptions under the Public Records Act, includes subparagraph (23) for all “financial

information” submitted to the Department of Financial Institution (which is plural in the

Bill). We note that the subsection references “under section 3 of this act”. While we defer

to the Code Reviser’s Office, we believe that is an incorrect reference, and should


reference RCW 21.20 (the chapter where the exemption appears, rather than the Public

Records Act, RCW 46. 56).

We hope you will find these comments of assistance in your committee’s deliberations on theBill.

Respectfully,

Mark R. BeattyChairSecurities Law [email protected]

Members of the Task Force:

Kyle HultenBrian E. LewisJohn L. MericleJoe SkocilichJoe Wallin

crowdfunding letter - final 26 feb 2014

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