Looking to raise capital? Developing a compliance strategy with federal and state securities laws is a complex and important part of raising money. A quick intro for those of you unfamiliar with securities laws – under the Securities Act of 1933 (the “Act”) any offering of securities is subject to registration requirements and anti-fraud provisions. States also have their own registration requirements and anti-fraud provisions, so compliance is often a dual-track analysis.
Exemptions from the registration requirement are available under Section 4(a)(2) of the Act and Rules 504 and 506 of Regulation D. Many companies avoid the registration requirements of the Act by conducting an offering under one of these private placement exemptions. Even offerings made in accordance with a private placement exemption are subject to the anti-fraud provisions, so all offerings must include full and fair disclosure to investors and cannot contain misleading statements or omissions that make a statement misleading.
It’s also important to understand the difference between accredited and non-accredited investors. The law requires a higher level of disclosure for non-accredited investors who are somewhat arbitrarily considered less sophisticated than accredited investors, which in reality may or may not be true. Accredited investors are individuals with “earned income that exceeded $200,000 (or $300,000 together with spouse) in each of the prior two years, and reasonably expects the same for the current year, OR has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
The following is a quick and (super) abbreviated summary of the private placement exemptions we use most often in our practice.
Section 4(a)(2) provides an exemption for private placements, but it does not set any clear guidelines making reliance on Section 4(a)(2) alone, the highest risk compliance strategy. Generally speaking, what you must prove is that those participating in the offering did not need the protection of the Securities Act and that there was no public offering of the securities. This is done by showing that the securities were not publicly advertised, that purchasers of the securities had the necessary business and financial knowledge to evaluate the merits and risks of the investment (i.e. the purchasers are sophisticated investors), that the purchaser was provided with sufficient information to make an informed decision, and that the issuer took reasonable steps to prevent the resale of the securities. These parameters have been established over the years through case law and having even one person who does not meet the requirements can disqualify the entire offering.
In response to the uncertainty created by Section 4(a)(2), the SEC created a safe harbor by issuing Rule 506 (discussed below). Non-compliance with Rule 506 does not mean that you have failed under Section 4(a)(2), but the burden is on the issuer to prove that the offering was in compliance with Section 4(a)(2) of the Act.
Conducting an offering pursuant to Rule 506 is lower risk than relying on Section 4(a)(2), but there are more onerous compliance requirements when the offering is made to non-accredited investors.
In response to the uncertainty around complying with Section 4(a)(2), the SEC created a set of specific requirements for conducting a private placement offering in Rule 506 known as a “safe harbor.” The most onerous requirement is producing an offering memo when the securities are sold to even a single non-accredited investor. The offering memo must be distributed prior to the sale of the securities and purchasers have to be given adequate time to review it and ask questions prior to purchasing the securities. Additional requirements under Rule 506 include the following:
- The securities can be sold to no more than 35 non-accredited investors, but an unlimited number of accredited investors.
- Non-accredited purchasers must have the knowledge and experience in financial and business matters necessary to make them capable of evaluating the merits and risks of the prospective investment.
- There can be no general solicitation or advertising of the offering.
- The securities sold are “restricted securities” as defined in Rule 144. Generally, this means that there are limitations on resale (the seller must register the security or find an exemption and sometimes comply with a minimum holding period) and the securities cannot be purchased with the intent to sell.
Rule 504 has clear, relatively simple compliance requirements and was adopted under Section 3(b)(1) of the Act. This exemption limits the offering to $5 million in a 12-month time period. Unlike Section 4(a)(2) and Rule 506, Rule 504 permits advertising and general solicitation. Compliance requirements under Rule 504 vary depending on whether you will be publicly advertising the offering.
- Private Offering:
- There can be no general solicitation or advertising of the offering.
- The securities sold are “restricted securities” as defined in Rule 144. Generally, this means that there are limitations on resale (the seller must register the security or find an exemption and sometimes comply with a minimum holding period) and the securities cannot be purchased with the intent to sell.
- Required to file a Form D with the SEC within 15 days of the first sale of securities.
- Must ensure compliance with state security laws in each state where an investor resides.
- Public Offering:
- The securities can be advertised and are unrestricted.
- The offering is made under one or more state laws that requires registration, public filing, and delivery of a substantive disclosure document before sale;
- Securities may be sold in one or more states without the requirements in (a) when the securities have been offered and sold in accordance with the requirements in (a) in at least one state and all purchasers in any state receive the disclosure documents in accordance with the requirements in (a); OR
- Securities are sold exclusively in a state that permits general solicitation and advertising and those securities are only sold to accredited investors
- Must ensure compliance with state security laws in each state where an investor resides.
Both Rules 504 and 506 contain a “bad actor disqualification” meaning that the issuer and certain other parties (directors, officers, promoters, etc.) cannot have certain criminal convictions, past enforcement action by the SEC, or suspension/expulsion from certain self-regulatory organizations.
If you are considering a securities offering you should always consult with an attorney. The exemptions are nuanced, and the consequences of non-compliance can be severe ranging from returning all the money to the investors to a criminal investigation.