Community solar and securities regulations
As the community or shared solar model becomes more popular, people are asking whether the customer agreements under which customers subscribe to a share of the electricity or buy into a community solar array could be considered securities.
If the customer agreement is considered a security, then developers would normally be required to register offerings of the contracts with state and federal regulators and would be subject to enhanced disclosure and anti-fraud requirements.
The time and expense of complying with these requirements would probably make development of community solar projects uneconomic, so the favorable resolution of this question is an important first step for developers.
The potential for confusion, and even litigation and fines, has led to requests for clarification from state and private entities seeking to avoid securities risk. For instance, the risk was perceived by the California Public Utilities Commission to be great enough to require a securities law opinion for developers to participate in the enhanced community renewables component of the “green tariff shared renewables program” in California. In a relatively early case, a developer — CommunitySun — requested and received a no-action letter from the US Securities and Exchange Commission in connection with its development of a “SolarCondos” project in Colorado.
This article describes the framework for evaluating securities issues in community solar projects and suggests appropriate actions for developers and financiers seeking to understand and mitigate the securities risk.
Federal Securities Laws
Whether a community solar customer agreement is subject to regulation as a “security” depends on how the arrangement is structured, how it is marketed by the developer and the customer’s motive for entering into the contract.
The US Supreme Court has laid out a four-factor test — known as the Howey test — for determining whether a contract should be considered an investment contract and, thus, a security. A contract falls in this category if there is (1) an investment of money (2) in a common enterprise (3) based solely on the efforts of a promoter or a third party (4) for which there is an expectation of profits.
Courts generally consider whether the contract requires an investment of money to be a simple question with an obvious answer.
There are two main structures used in community solar projects. The first is an “ownership model” that involves participants in a community solar program buying an ownership share of the community solar array. They may pay in full at inception or over time. The electricity from the project is delivered to the local utility. The utility gives the customers bill credits that can be used to offset their monthly electricity bills. It is usually clear that the customers have invested money.
The second community solar arrangement is a “subscription model” that looks more like a typical power purchase agreement between a project owner and a residential or commercial offtaker. In the subscription model, each customer buys a percentage of the electricity output from a solar array. The price is usually a fixed amount per kilowatt hour. The power is sold to the utility by the project owner, and the customers receive credits on their monthly utility bills for their shares of the electricity. In such arrangements, customers pay periodically as electricity is generated rather than making an upfront payment. With no upfront cash outlay, no ownership interest in the project itself and payments tied to monthly power generation by the project, the subscription model looks more like a service contract than a security. However, at least one early state securities analysis (by the Colorado Division of Securities) implies that subscription payments could be considered an investment of money. Because this element of the four-factor test has not been as extensively developed in litigation as the other three factors, it is helpful for developers, financiers and their lawyers to consider the three other prongs as well.
Turning to the second of the four factors, the “common enterprise” test has not been conclusively defined by the US Supreme Court. Courts generally look at whether the success of investors and the promoter are linked. On a common-sense level, a common enterprise is a business that a group of people is undertaking together. If one views community solar customers as investors rather than mere customers, then the common enterprise prong is probably met.
It may help to avoid having a securities regulator conclude that a common enterprise was formed for the customer agreements to be clear that the benefits to any particular customer do not depend on the participation of other customers, and the customers’ money is not being pooled together for the making of an investment. If the state regulatory regime allows for it, then developers using an ownership model might do better to sell individual solar panels rather than a share or undivided interest in the whole project.
Given the awkwardness of arguing that a “community” or “shared” arrangement is not a “common enterprise” developers would do well to focus on the other elements of the four-factor test to ensure their contracts are not securities.
The third factor is whether the benefits to participants come through the efforts of a third party — namely, the developer. The participants generally are passive and not involved in business decisions. Although the developer has no control over when the sun will shine, the benefits to the participants, in both the subscription and ownership models, depend to a material extent on the developer’s entrepreneurial and managerial efforts.
However, in so-called “condominium” arrangements, this factor may be absent. In its no-action letter request, CommunitySun explained that under its model, each condo owner has an individual net metering agreement with the local utility, and the condo owners govern a condo association that is free to hire and fire employees and enter into contracts for operation and maintenance services. This level of control by customers over the operation of the system in condominium arrangements makes it less likely that the efforts of a third party will be seen as central.
The fourth factor is whether the customer entering into the arrangement had an expectation of profits. Whether a customer agreement is a security often comes down to this question. The analysis may turn on the motive of the participant: did she enter into the shared solar arrangement to earn a profit or was the primary motivation to reduce her carbon footprint or monthly electricity bill? It is hard to see how a customer motivated by the latter has a profit motive. Nonetheless, it is important to examine both how the arrangement was marketed to customers and any evidence of customer motivations for entering into the agreement.
Developers should keep this in mind when marketing their projects to customers. Emphasize the environmental benefits and potential savings on utility bills. Do not suggest that customers will earn a profit.
There could be a profit motive if customers can sell their subscriptions to others, potentially at a gain, or make money if the customer’s share of energy generated exceeds what the participant uses. In some community solar arrangements, the excess or unused bill credits get rolled forward to be used on future bills and then are converted ultimately to cash. However, the customer’s subscription or ownership share is usually limited to a fraction of the customer’s expected energy usage. This makes it unlikely the customer will have unused bill credits to convert to cash.
If it looks from the four-factor test like community solar arrangement is a security, then the parties should examine whether an exemption to federal securities registration requirements is available. However, even if an exemption from registration applies, the marketing of customer agreements will require enhanced disclosure and compliance with anti-fraud requirements.
State Securities Laws
A separate securities analysis must be done to determine whether a community solar arrangement is subject to state securities registration and disclosure requirements.
Many states have adopted the federal four-factor Howey test for state purposes. However, other states use broader approaches, so an arrangement that is not be a security under federal law may still be considered a security under state law.
A minority of states adhere to a broader “risk capital” test that was first developed by the California Supreme Court. The California test looks at whether funds are being raised for a business venture or enterprise, the transaction is offered indiscriminately to the public at large, participants are substantially powerless to affect the success of the enterprise and participants’ money is substantially at risk because it is inadequately secured. Sixteen other states have adopted some form of this test.
Other states take a different approach. For example, in Minnesota, courts sometimes have relied on the federal four-factor test, but supplement it by adding “the placing of capital or laying out of money in a way intended to secure income or profit from its employment is an investment as that word is commonly used and understood.”
The Path Forward
The bottom line is that the ownership and subscription community solar models should be evaluated differently. The subscription model appears to be gaining currency in the market, and as discussed earlier, it may present fewer securities risks than the ownership model.
It is also important to consider securities issues on a state level, keeping in mind that even if an arrangement does not pose a problem under federal law, it may still be considered a security under state law.
The degree to which developers and financiers have been comfortable with the securities risk has varied in community solar transactions. Because community solar financings are relatively new, a standard for what lenders and equity investors will require is still emerging. The community solar models may also evolve further. In novel contexts, the parties may decide they need official guidance, like no-action letters. State and federal securities opinions have been requested and delivered in some deals. The California Public Utilities Commission required securities law opinions from developers in that state, although the requirement is being challenged by some stakeholders and may be subject to modification. In other cases, proper diligence has been enough to get the parties comfortable. Developers should expect that lenders and equity investors will want to see written evidence of how the projects were marketed to customers. Similarly, when acquiring the development rights to projects or operating projects, the buyer should investigate how the customer agreements were marketed.