The guys end the week by talking about an international crowdfunding site getting censured by the SEC. They also answer, "I live in California but my LLC is setup in another state. At what point am I doing business in California?"
Full Podcast Transcript
NASIR: All right, welcome to our podcast where we cover business in the news and answer some of your business legal questions that you, the listener, can send in to firstname.lastname@example.org.
My name is Nasir Pasha.
MATT: And I’m Matt Staub.
NASIR: That’s right, and we are covering probably the most entertaining topic, I think, known to man – not pizza, but SEC censures.
MATT: Well, I don’t know. If people are listening to these in order, the last thing we just got done talking about was tax.
NASIR: Oh, yeah.
MATT: People really hate that stuff. I like it, but…
NASIR: That was the last episode and we lost, basically, I’m already predicting, like, the stats just… everyone just stopped listening after that point. So, that’s okay. We covered the San Diego Magazine and that’s still going on.
MATT: Yeah, we should get a trademark for “Hidden San Diego” for podcasts.
NASIR: If we get as much controversy as they did, it’d be a great hit for us.
MATT: All right. Well, like I said, this is a crowdfunding site. I assume it’s Eureka Capital SPC.
NASIR: Uh, yeah.
MATT: Eureka Capital.
NASIR: I was thinking, like, yeah, Eureka… Oregon or Washington? I can’t remember which. I think it’s Washington.
MATT: Washington. I don’t know.
NASIR: They’re basically the same state.
MATT: There’s a Eureka, California, up north.
NASIR: Well, it doesn’t matter. They’re spelled differently and not in the northwest.
MATT: So, the reason it was spelled differently is because it’s incorporated outside the United States.
MATT: So, I think that’s why, and that’s pertinent to this because, according to the SEC which is the South Eastern Conference which is a big football powerhouse conference for those listening.
NASIR: Ah, that’s right. Also, called the Securities and Exchange Commission, I believe.
MATT: That’s also true.
MATT: Apparently, the way this was set up, they’re not allowed to have investors come from the United States. So, the way they prevented US investors from coming in was asking them, you know, there’s a disclaimer saying, “No US individuals can invest” and they had a thing saying that but then, if you went to register, one of the options was the United States and then you were able to register and invest. So, obviously, that’s a problem. It’s like, if you went to a brewery website and it says, “No one can be on this site unless you’re 21 or older,” then you put in some information for 1998 as your birthday and they still let you in. Or, I guess, if you went to a bar and you’re like, “Oh, I’m not 21,” and it’s like, “All right! Come on in then!”
NASIR: Come on in! Yeah, that’s actually a pretty good analogy I would say, and the reason this is an issue is because SEC is obviously designed to restrict the sale of securities and, you know, whether you’re selling equity in your company or what-have-you raising funds, whatever you offer has to be regulated by them. In complying with that regulation, it’s not too easy for most companies – depending upon how much you’re raising – when a third party gets involved and getting a percentage, you know, acting basically as a broker dealer, that’s also prohibited unless you’re licensed and doing it properly. I think, in this case, they were set up in the Cayman Islands – that’s kind of suspicious in itself – and, even though they weren’t publicly targeting United States citizens, it seems like it was pretty accessible to them and it reminds me of the online gambling thing, right? Wasn’t there a time where all the legal gambling was a dot-net but then the illegal ones was dot-com or vice versa and, technically, you weren’t allowed to do so from the US side but they were doing it anyway. Do you recall any of that?
MATT: I think a lot of them now are different countries – like, Argentina or something like that. It raises an interesting point and I know there are states that are trying to adopt their own crowdfunding rules, but crowdfunding is nice in some sense. It’s basically just getting free money from people, but sometimes it can be really beneficial for these startup companies that, I guess, have no other way to raise money and to make their product or enhance their service.
NASIR: I think you’re talking about, also, the classic crowdfunding of Kickstarter and stuff like that. But some of the things that are being developed now is where you can actually crowdfund your company and actually sell securities or sell equity in your company.
MATT: Oh, yeah, yeah.
NASIR: Which is a little bit different in the sense that, I mean, we can talk a little bit about what’s going on with that. A few years ago, the JOBS Act was passed and implemented and they created basically another exception which allows general solicitation to only accredited investors and you have to go through steps to verify. But then, it also allowed the SEC to develop regulations which would allow general solicitation to unaccredited investors.
And, right now, they have the published opinion – not opinion – proposed rules that have been commented on, but nothing’s really happened from it. But those rules included, like, basically an issuer could raise up to a million dollars without having to register. But, with offerings between $100,000 to $500,000, then they would have to provide some financial data, but not that much; under that, you wouldn’t actually have to provide that much educational materials. And so, that’s what’s going on now. But compare it to this company in the Cayman Islands, forget about what they were trying to do, even if they were in the United States, they would be prohibited from doing so – as of right now – unless they were an authorized broker dealer as well as if they’re actually verifying that the investors are accredited investors as well.
MATT: And I guess that’s something to look in for this company that was doing it. It said they did not verify three of the investors or didn’t verify that they were accredited investors.
NASIR: There you go.
MATT: Would the same issue have risen if they would have verified that? I mean, it seems like a pretty easy thing to do.
NASIR: Yeah, it kind of depends upon which rule they’re relying upon for exception. But, obviously, I don’t think they really even cared to comply with any SEC rule, right? So, they were kind of operating off the cuff here – not “off the cuff.” What’s the word? On the fringes of society? No.
MATT: I’ll let you think about that a little bit more and I’ll get into the question of the day.
MATT: Another question dealing with doing business outside of where business is actually being done.
“I live in California but my LLC is set up in another state. At what point am I doing business in California?”
NASIR: Yeah, this is a classic question. The problem is, California, the Franchise Tax Board, they’re like tax Nazis, aren’t they?
MATT: I often say that the Franchise Tax Board is more aggressive than the IRS.
NASIR: Oh, yeah. I think you even mentioned in the past, they don’t negotiate, right?
MATT: It’s a lot tougher. I mean, you can. IRS is just a lot easier to negotiate with.
NASIR: Yeah. Doing business in California, I mean, that is kind of the legal standard. But, the problem is, there’s not really a very great definition of what exactly that is, but I can say this, the Franchise Board will try to construe it in any way possible to say that you are doing business in California as much as possible. So, whenever you’re on the fence, it’s always like, just register. It’s higher risk not to do so, for sure.
MATT: I share the same belief. There’s a recent case that just came out and, in this situation, it was an Iowa corporation that owned a 0.2 percent interest in a California investment fund. If it was that little of an ownership and it still was a huge issue, that shows you right there, if there’s any sort of inclination that they’re doing business in California or have any ownership, because if you look at one of the things – what’s considered doing business in California – one of the things is the taxpayers organized in a commercially domicile in California, and then there’s a bunch of other things, too.
NASIR: The Swart case you’re referencing is actually really interesting from a legal perspective but, you know, from a practical perspective, in this case, the FTB have the opinion that they should have been registered and the court ended up signing in favor of the corporation saying that they didn’t have to be registered.
Basically, you have a corporation that is a member of an LLC. And the question was whether that outside corporation had to be registered in California and this LLC was a member-managed LLC. Sorry, it was a manager-managed LLC; this is opposed to a member-managed LLC where every member has management authority and where it’s a manager-managed then the members actually have to hire or appoint a manager to actually run the business.
And so, there was very well-established case law, even from the FTB’s opinion that, if the entity is a limited partner in an entity in California then, because of the nature of them in a partner, they have no ability to actually manage the day-to-day operations, they’re not doing business in California. But, in the same case, they didn’t make the distinction between the different types of LLCs in the FTB’s perspectives. (There’s too many acronyms here.) They didn’t make this distinction in the FTB’s opinion. And so, right now, if we were to take the same case, the Swart case is not binding authority apparently. I don’t even think it’s been published. So, therefore, in the same exact circumstance where you own 0.2 percent in an entity of an LLC that’s even manager-managed, you still may not be protected from filing as a foreign corporation in California.
MATT: Yeah, I don’t know if anyone stuck with that.
NASIR: It’s complicated stuff, for sure.
MATT: This is an example. Let’s say, a passive member of a member-managed LLC that has no management authority in the LLC.
NASIR: Yeah, just try to say that three times fast.
MATT: The funniest thing about this is the whole dispute is over just paying that $800 to the state of California which I think is hilarious.
NASIR: That’s a good point. But, if you think about it, if this ruling went the other way, first of all, it’s very common for minority shareholders or members – not even minority – any shareholders or members to hold their ownership interest in an entity. And, if that entity is out of state, now each of those owners would have to, if this went against them, they would have to register in California and that’s 800 times – who knows how many entities that would have to pay that? That’s a pretty big grab from California’s perspective. So, I understand why they want to do it, but I think it’s a little unfair.
MATT: The only way this would have made sense for the company, Swart…
NASIR: Oh, to fight it, you mean?
MATT: Yeah, would be that they had someone who did it for free because $800 is nothing.
NASIR: It’s very possible that this Iowa company has a lot of other interests in California under, you know, minority interest just with that or maybe they pool their money together because there’s plenty of other people around the country that would have an interest in this holding, for sure.
MATT: It’s a victory against the Franchise Tax Board, but it’s a pretty…
NASIR: It’s limited, yeah.
MATT: Yeah, it’s a very limited victory.
NASIR: I really wish, though, they’d publish this opinion because I think this is a good law that they came out with, but they need to actually make it enforceable here.
MATT: It’s like you said at the beginning, it’s pretty grey in terms of what is considered doing business in California and, the more definiteness we have, the better. But, you know, it’s not going to be that way.
NASIR: Yeah, I think the statutory definition – I have it in front of me – is “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” That’s pretty general.
MATT: Way too general.
NASIR: It’s heavy stuff, for sure. I mean, I think it’s a very common question as to whether you need to file as a foreign entity, and we’ve talked about it in the past. A lot of people that want to avoid the minimum franchise fee tax in California and they form in Delaware, Texas, or Nevada, and then they end up having to pay anyway – and even being fined by the FTB, possibly.
MATT: I mean, it’s a huge issue and it’s one that a lot of people try to get around so it’s good for them to know.
NASIR: That’s what we’re here for. Thanks for joining us, everyone.
MATT: Keep it sound and keep it smart.