Providing community solar market participants with the basics of securities law.
(WSGR) – Across the country, state governments are actively enacting and implementing community solar programs. “Community solar” generally refers to shared solar energy arrangements that allow several energy customers to share the benefits of one local solar energy power project. Policymakers, industry, and environmental leaders are trumpeting such programs as a democratizing force that will enable urban apartment dwellers and low-to-moderate-income earners to participate in advantageous state net metering programs that largely have been utilized by suburban homeowners to date. As a result of state policy actions and healthy public demand for community solar access, three gigawatts of community solar projects are currently in development in the United States, and a massive 410 megawatts are expected to be installed in 2017 alone. As community solar gardens bloom in states such as Minnesota, Massachusetts, and New York, project developers and regulators alike are considering what protections may be needed for a new segment of solar energy consumers. A specific inquiry that has given rise to some trepidation within the solar industry is whether a consumer’s participation in a community solar project should be regulated as a security by the U.S. Securities and Exchange Commission (SEC) and by its state counterparts. In fact, in 2015, the National Renewable Energy Laboratory (NREL) stated that uncertainty about the applicability of securities laws to community solar projects is one of the top concerns raised by community solar stakeholders. Illustrating this concern, Xcel Energy expressly states in the standard community solar contract offered by it under Minnesota’s community solar garden program that Xcel “makes no warranty or representation concerning the implication of any federal or state securities laws” on how community solar subscriptions are handled and urges community solar garden owners and subscribers “to seek professional advice regarding these issues.” In California, the public utility commission went even further, requiring that community solar developers obtain and deliver to the applicable utility a legal opinion relating to securities law issues.
Given the complexity of the regulatory framework applicable to sales of securities, the nail-biting among regulators, community solar project developers, and investors is not unwarranted in the absence of clear federal or state safe harbors from securities regulation for community solar programs. With a bit of thoughtfulness, however, community solar programs, agreements, and marketing materials can be shaped to significantly reduce the likelihood of a community solar offering being classified as a security subject to SEC and state regulation.
What is Community Solar?
NREL has defined “community solar” as solar energy systems “that allocate the electricity of a jointly owned or third-party owned (TPO) system to offset multiple individual businesses’ or households’ [electricity] consumption.” This definition properly excludes utility rate plans that simply allow customers to pay for electricity that is bundled with renewable energy certificates. Such certificates might be associated with distant renewable energy projects having no relation to the applicable community. NREL’s definition should be supplemented with the additional clarification that a community solar project must be located in the same utility service territory as the businesses and households whose electricity consumption it is offsetting, thereby giving at least broad effect to the “community” aspect of community solar. Additionally, it is worth noting that the credit received by businesses and households for energy generated by the community solar project might not equate to a reduction of their energy consumption on a one-to-one basis with the rate charged for such consumption. Rather, the mechanics and valuation of this credit (and thereby the attractiveness of community solar) vary from state to state.
What do Community Solar Arrangements Look Like?
Consistent with this definition of community solar, most community solar arrangements involve a solar project developer, a utility, and a number of individual project participants. The project participants may be individual consumers or businesses, and are often referred to as “subscribers” because they contractually subscribe to an allocation of the solar project’s electrical capacity or electrical production. In most community solar arrangements, the project developer develops, constructs, and operates the project while simultaneously lining up and maintaining subscribers for the project’s capacity. Once the project is built and interconnected with the utility, the project operator delivers all of the electricity generated by the project to the local electric utility and enters into an arrangement with the utility under which the utility credits amounts attributable to the project’s generation against the electric bill of the project’s subscribers in proportion to their subscriptions. The rate at which the utility credits the project subscribers (and the rate at which the utility pays the project operator for any unsubscribed energy) is dictated by state law or the terms of the program approved by that state’s public utility commission.
It is the involvement of multiple participants contributing payments to a project operator in exchange for the operation of a solar energy facility and the generation of related bill credits, which represent a potential financial gain to subscribers, that makes it necessary to confront the question of whether a community solar subscription may constitute a security.
Why Should Project Developers and Investors Care about Securities Law Issues?
If a community solar arrangement is found to involve the offer or sale of a “security,” then the arrangement would become subject to a complex multi-jurisdictional web of securities regulation that could ultimately render the arrangement economically less attractive or commercially unviable. These regulations, as discussed in greater detail below, may involve burdensome disclosure requirements or limitations on the manner in which, and to whom, a community solar arrangement may be marketed and sold. Moreover, the project developer, as well as its directors, officers, and employees, could be subject to liability for failure to comply with applicable securities requirements. Suffice it to say that, at a minimum, community solar project developers have adequate incentive to gain a basic understanding of securities law concepts, and the following paragraphs seek to set the stage toward that end.
The offer and sale of securities in the United States is subject to both federal and state securities regulation. At the federal level, under Section 5 of the Securities Act of 1933 (the Securities Act), any “securities” offered or sold in the United States must be registered with the SEC, unless an exemption from registration is available.  Registering securities with the SEC involves the preparation and filing of a highly detailed and complex offering document or registration statement that includes penetrating disclosure regarding a company’s business, risks, financial results, management team, executive compensation, and principal stockholders. This process can be prohibitively costly and require a significant dedication of management and company resources over a period of several months. Companies that register securities with the SEC also become obligated to an ongoing periodic reporting regime that includes filing quarterly and annual reports with the SEC, among other requirements. Similarly, states have regulatory frameworks that structurally mirror the federal regime, including state filing and approval requirements in the absence of an applicable exemption from such state requirements.
Due to the burden of registering securities with state and federal securities regulators, securities of private companies in the United States are often offered and sold pursuant to an exemption from those registration requirements. The class of exemptions frequently relied upon (including for private placements) are those available for offerings not involving a public offering, under Section 4(a)(2) of the Securities Act. Specifically, Section 4(a)(2) provides an exemption for offerings of securities to a small number of sophisticated investors who are capable of fending for themselves with respect to the risks of the investment. Regulation D, promulgated as a safe harbor under Section 4(a)(2), provides exemptions to companies that, for example, limit their offerings to so-called “accredited investors” or a small number of non-accredited investors and meet certain disclosure requirements similar to those prescribed under the SEC registration statement described above. Other exemptions exist under both federal and state law that companies may consider; however, generally speaking, each exemption is likely to have limitations on the number or type of investors to whom the offering may be marketed, the aggregate size of the offering, and/or the type of disclosure that must be provided.
Companies that violate Section 5 of the Securities Act by offering or selling securities either without registering the securities with the SEC or without complying with an exemption therefrom will face liability under Section 12 of the Securities Act. Section 12 is quite simple: if securities are sold in violation of the registration requirements of the Securities Act, the purchaser has the right to undo the transaction and receive all of their money back, plus interest (minus any income received). Under Section 12, the seller’s intent or knowledge of the violation is irrelevant (i.e., it is essentially “strict liability”). Liability under Section 12 also can extend to “control persons” who, through ownership, agency, or otherwise, are deemed to control the person or entity liable under Section 12. Further, violation of federal or state securities laws may result in enforcement actions pursuant to which the SEC and state securities regulators can seek injunctions, disgorgement of profits, monetary penalties, and orders barring individuals from certain types of securities-related activities for a period of time. This is in addition to other bases upon which liability may arise, including for aiding or abetting any of the foregoing or for violating anti-fraud statutes, specific state securities laws, or consumer protection statutes.
Finally, individuals and companies who are involved in the sale of securities may also be subject to federal or state broker-dealer regulation. The broker-dealer rules require that any individual or entity that is compensated on the basis of transactions, success fees, or commissions on the sales of securities must register as a broker-dealer with the SEC. Registration as a broker-dealer subjects the registrant to an additional regulatory framework that involves strict financial and compliance reporting requirements with governmental and quasi-governmental entities that regulate broker-dealer conduct in the United States.
Therefore, from a practical perspective, compliance with federal or state securities laws often may be incompatible with the development, marketing, and financing of community solar projects. For example, a community solar developer would likely find it impractical for a community solar project to comply with the rigorous disclosure obligations of a broadly marketed offering. At the same time, it may be impractical to limit an offering to solely accredited investors. Even where an offering could be more limited, it may also be untenable to subject the firm responsible for the marketing and sales of the community solar subscriptions to registration as a broker-dealer. As such, community solar project developers, when faced with the potential implications of being found to be engaged in the offering and sale of a security, may conclude that the most commercial path forward is to ensure that a community solar subscription is not deemed to involve the offer or sale of a “security” for securities law purposes in the first instance.
What is a Security?
The securities regulations set forth a list of specific items that would constitute a security (such as stock, bonds, notes, debentures, and the like), but rely on the expansive term of “investment contract” to sweep into securities regulation more creative and elaborate investment arrangements. While there is no bright-line rule for determining whether an instrument is an investment contract, some guiding principles have emerged from case law. Most courts follow the seminal case of SEC v. W.J. Howey Co, under which the test for whether a particular instrument is considered an “investment contract” under the federal statutes is set forth. In Howey, the United State Supreme Court reasoned that a security “embodies a flexible principle capable of adaptation to meet the countless and variable schemes devised by those who seek the use of other peoples’ money on the promise of profit.” In Howey, which involved the sale of an interest in an orange grove and an agreement on the part of the promoters to develop the property and harvest the bounty to be sold for profit, the court found the arrangement to involve a security, articulating what has become a widely followed four-factor inquiry: (1) whether there is an investment of money (2) in a common enterprise (3) with the expectations of profits that are (4) derived from the entrepreneurial or managerial efforts of others.
While a majority of states follow the Howey test, a minority of states follow the so-called “risk capital test” handed down by the California Supreme Court in Silver Hills Country Club v. Sobieski. In California, an arrangement could be found to be an “investment contract” and therefore a security if either the Howey test or the risk capital test is satisfied. In Sobieski, which involved the sale of a charter membership in a country club to be developed, the court articulated a standard that focuses on the following elements: (1) whether funds are being raised for a business venture or enterprise; (2) whether the transaction is offered indiscriminately to the public; (3) whether the investors are substantially powerless to affect the success of the enterprise; and (4) whether the investors’ money is substantially at risk and not otherwise substantially collateralized.
In light of the expansive view regarding whether a particular arrangement constitutes a security for federal or state securities law purposes, promoters often seek SEC guidance through the SEC’s no-action letter request process. In 2011, a promoter sought SEC no-action guidance under a set of facts that are noteworthy by analogy to community solar projects. In its no-action letter, CommunitySun, LLC, a solar developer, described an arrangement that contemplated the offer and sale of real estate interests in solar projects that were marketed as “solar condos.” Ownership of a solar condo would allow production of self-generated, individually owned solar electricity without installing solar panels at the property where the owner consumed electricity. CommunitySun emphasized the consumptive nature of the arrangement in its no-action letter (i.e., the consumer’s purpose appeared to be primarily to self-generate energy and receive credits for that energy, not to make a profit-motivated investment). CommunitySun further advocated that “[e]ven if the owner’s primary motivation is a reduction in his or her electric bill, . . . such a reduction should not be considered ‘profits,’” as applicable case law had established that “low rent[s] attributable to state financial subsidies no more embod[y] income or profit attributes than other types of government subsidies.” CommunitySun asserted that the virtual net metering arrangement allowing for the receipt of bill credits based on energy generated at another site was “analogous to the low rent from state financial subsidies” because it “reduces a consumer’s bill at the retail electric rate, which is higher than the rate paid by the utility to other producers of electricity.” In response to CommunitySun’s no-action letter emphasizing the consumptive nature of the SolarCondo arrangement and the subsidy-like nature of the participants’ financial reward, if any, the SEC recommended not taking enforcement action against the described arrangement.
Reducing Risk of Securities Liability through Intelligent Program Design
Whether a particular community solar arrangement would be considered to involve the offer and sale of a security for federal and state securities law purposes will depend on the facts and circumstances of the arrangement at issue, evaluated in relation to the factors set forth in Howey and under the risk capital test. Because the application of securities laws is ultimately highly fact-dependent, in the absence of SEC registration or taking the necessary steps to comply with an exemption from registration, there is no silver bullet that eliminates entirely the risk that a particular solar arrangement could be challenged as a violation of applicable securities laws. Some community solar market participants may decide to pursue a strategy to mitigate the risk of securities liability by seeking an SEC no-action letter with respect to their particular set of facts or by obtaining an opinion of legal counsel, but often these strategies are impractical because of the delays and costs involved. Whether community solar developers pursue such strategies or not, they should at a minimum be able to take concrete steps to design a community solar offering and shape marketing communications and customer agreements in view of the Howey factors and other legal guidance described above to increase the likelihood that the offering is not ultimately subject to state and federal securities regulation.
For example, in order to reduce the likelihood that a community solar arrangement would involve the investment of money, community solar project developers may forego requiring customers to make any meaningful up-front payments that would be at risk (e.g., payment should be due only after electricity is being generated by the project). In order to reduce the likelihood that a community solar arrangement would involve a common enterprise, customer contracts should be crafted in a manner that is consistent with the purchase of a good or a service engagement and does not represent an interest in the profits and losses of the community solar project itself. In order to reduce the likelihood that customers in a community solar arrangement would participate with the expectation of profits, the customer contracts should be designed and the program marketed in such a way as to make it clear that the customer’s primary motivation is to purchase a subscription in the energy output of a solar energy project (even where that subscription is being effectuated through a bill credit mechanism)—not to make profits. In addition, restrictions on transferability in customer contracts should be drafted in such a manner that a customer could not reasonably expect to profit from the sale or transfer of their interest in the community solar offering.
These are merely examples of community solar offering design guardrails and are not intended to constitute comprehensive legal advice. Parties that intend to develop or participate in a community solar offering should consult with legal counsel having expertise in these matters to discuss the facts and circumstances of the particular community solar offering and to develop a strategy to navigate the potential applicability of state and federal securities regulatory regimes to the offering.
Robert G. O’Connor, Tim Cronin and Andrew Sparks are attorneys with Wilson Sonsini Goodrich & Rosati and are San Francisco, California-based members of the firm’s Energy & Infrastructure practice.
The views expressed in this article are those of the authors and are not necessarily those of Wilson Sonsini Goodrich & Rosati or its clients.
The authors thank Todd Glass, Rob Rosenblum, Randy Lewis and Barry Kaplan for their contributions to this article.