All offers or sales of securities must either be registered or qualify for an exemption from registration. Sections 3 and 4 of the Securities Act of 1933, as amended (“Securities Act”) set forth the exemptions available for certain transactions and certain offerings. Generally, the exemptions available are non-exclusive. In other words the sale of securities may be exempt from the registration requirements under more than one exemption, and a Company can claim as many exemptions as may apply. Exemptions are strictly as to the registration requirements of the Securities Act. Exempt offerings are still subject to other regulatory provisions and in particular the anti-fraud provisions of the Securities Act. Moreover, Companies must be sure to comply with both state and federal securities laws when offering its securities for sale. The term “accredited investor” is used often in discussing exemptions. An “accredited investor” is defined as:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation or partnership with assets exceeding $5 million;
- a director, executive officer, or general partner of the company selling the securities;
- a business in which all the equity owners are accredited investors;
- a natural person with a net worth of at least $1 million not including their primary residence;
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.
The following is a brief description of the most common exempt offerings:
Private Offering Exemption The private offering exemption is the most widely used exemption. Section 4(a)(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering.” To qualify for this exemption, the purchasers of the securities must:
- have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (the “sophisticated investor”), or be able to bear the investment’s economic risk;
- have access to the type of information normally provided in a prospectus; and
- agree not to resell or distribute the securities to the public for a minimum period of time, generally 6 months if the issuer is reporting and one year if the issuer is non-reporting
In addition, public solicitation and general advertising may not be used to effectuate sales to non-accredited investors. Rules 506(b) and (c), promulgated under the Securities Act, sets forth a “safe harbor” with objective standards that an issuer can rely on to meet the requirements of the 4(a)(2) exemption for both advertised and non-advertised offerings and Rule 506(d) provides for bad actor disqualification standard for use of the 506 exemptions. Regulation D Regulation D explains three exemptions from Securities Act registration. Rule 506(b) Rule 506(b) is a “safe harbor” for the private offering exemption. If your company satisfies the following standards, you can be assured that you are within the Section 4(a)(2) exemption:
- You can raise an unlimited amount of capital;
- You cannot use general solicitation or advertising to market the securities for offerings that sell to both accredited and unaccredited investors;
- You can use regulated and limited general solicitation and advertising for offerings that result in sales only to accredited investors
- You can sell securities to an unlimited number of accredited investors and up to 35 other purchasers. All non-accredited investors, either alone or with a purchaser representative, must be sophisticated – that is, they must have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment;
- It is up to you to decide what information you give to accredited investors, so long as it does not violate the antifraud prohibitions. But you must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well;
- You must be available to answer questions by prospective purchasers;
- Information requirements vary depending on whether the Company solicits any un-accredited investors. If a Company solicits even one unaccredited investors it must provide certain disclosures including audited financial statements prepared by a PCAOB qualified auditor; and
- Purchasers receive “restricted” securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering
Rule 506(c) Rule 506(C) is an exemption promulgated under Section 4(a)(2). If your company satisfies the following standards, they will have complied with Rule 506(c):
- You can raise an unlimited amount of capital;
- General solicitation is freely allowed however, all investors must be accredited;
- The Issuer must take reasonable steps to verify that the purchasers are accredited;
- All terms and conditions of Rule 501 (definitions) and Rules 502(a) (integration rule) and (d) (securities are restricted) must be satisfied;
- You can sell securities to an unlimited number of accredited investors
- All investors (accredited investors) must be given access to the type of information that would be available in a prospectus
- You must be available to answer questions by prospective purchasers;
- Purchasers receive “restricted” securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering
Although the SEC declined to define what actions suffice as reasonable steps, leaving it to the Issuer to make a factual determination, the SEC did publish a non-exclusive list of methods that issuers may use to satisfy the verification requirement. According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.” Among the factors that issuers should consider under the fact and circumstance analysis are:
- a. The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker dealer registered with the SEC, verification could be a simple check on the FINRA website. Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements. Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that issuers may use to satisfy the verification requirement.
- b. The amount and type of information that the issuer has about the purchaser. Clearly, the more information, the better. The SEC lists the obvious (W-2; tax returns; letters from a bank or broker dealer). Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.
- c. Nature and terms of the offering, such as type of solicitation and minimum investment requirements. The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former. The SEC highlights the obvious, such as that the higher the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.
The SEC included four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the Issuer does not have actual knowledge that the purchaser is not accredited. Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:
- aa. Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
- bb. Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit report from a nationwide agency.
- cc. Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
- dd. A written certification verifying accredited investor status from existing accredited investors of the Issuer that have previously invested in a 506 offering with the same Issuer.
Rule 505 Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, you may sell to an unlimited number of “accredited investors” and up to 35 unaccredited investors. Purchasers must buy for investment only, and not for resale. The issued securities are restricted under Rule 144. Consequently, you must inform investors that they may not sell for at least a year without registering the transaction. You may not use general solicitation or advertising to sell the securities. Information requirements vary depending on whether the Company solicits any un-accredited investors. If a Company solicits even one unaccredited investors it must provide certain disclosures including audited financial statements prepared by a PCAOB qualified auditor. It is up to the Company to decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions. But you must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well. You must also be available to answer questions by prospective purchasers. Regardless of whether a Company is soliciting only accredited investors or not, it is important to deliver a complete and thorough disclosure documents to protect the Company against future claims of a violation of the anti-fraud provisions of the Securities Act. Federal law does not pre-empt state law for a Rule 505 offering. Accordingly, in addition to meeting the requirements for Rule 505, a Company must be careful to meet all relevant state law requirements, which can vary greatly. As a result of this, Rule 505 is rarely used. Rule 504 Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. A company may use this exemption so long as it is not a blank check or development stage company and is not subject to Exchange Act reporting requirements. Rule 504 is basically a state exemption, in that if an offering is under $1,000,000 and meets all the requirements of a state law exemption, it will generally meet the requirements of a Rule 504 exemption. Moreover, investors will receive freely tradable securities under the following circumstances:
- You register the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a disclosure document to investors;
- You register and sell in a state that requires registration and disclosure delivery and also sell in a state without those requirements, so long as you deliver the disclosure documents mandated by the state in which you registered to all purchasers; or,
- You sell exclusively according to state law exemptions that permit general solicitation and advertising, so long as you sell only to “accredited investors.”
Even if you make a private sale where there are no specific disclosure delivery requirements, you should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. This means that any information you provide to investors must be free from false or misleading statements. Similarly, you should not exclude any information if the omission makes what you do provide investors false or misleading. Intrastate Offering Exemption Section 3(a)(11) of the Securities Act and Rule 147 promulgated thereunder, is generally known as the “intrastate offering exemption.” This exemption is intended to facilitate the financing of local business operations. The preliminary notes to Rule 147 explain: “Section 5 of the Act requires that all securities offered by the use of the mails or by any means or instruments of transportation or communication in interstate commerce be registered with the Commission. Congress, however, provided certain exemptions in the Act from such registration provisions where there was no practical need for registration or where the benefits of registration were too remote. Among those exemptions is that provided by Section 3(a)(11) of the Act for transactions in “any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within…such State or Territory.” To qualify for the intrastate offering exemption, a company must:
- be incorporated in the state where it is offering the securities;
- carry out a significant amount of its business in that state; and
- make offers and sales only to residents of that state.
There is no fixed limit on the size of the offering or the number of purchasers. Your company must determine the residence of each purchaser. If any of the securities are offered or sold to even one out-of-state person, the exemption may be lost, causing a violation of the registration requirements of the Securities Act. This provision can be problematic for Company’s conducting consecutive offerings or seeking investment capital through the use of more than one type of exempt financing. A Company must be careful that a consecutive offering, or separate form of financing, is not integrated with the Intrastate Offering, thus destroying the exemption. There is no specific prohibition against general solicitation and advertising and in fact, is the exemption that many states are relying upon in enacting state specific crowdfunding statutes. Although the securities sold are not restricted under Rule 144, for a period of nine months, re-sales may only be made to a person or entity that is resident of the state of the offering. Many states allow some form of advertising or solicitation for intrastate offerings. Current Regulation A Current Regulation A, promulgated under Section 3(b) of the Securities Act of 1933, is an exemption for public offerings not exceeding $5 million in any 12-month period. Although it is technically an exempt offering, practitioners really refer to it as a mini registration. If you choose to rely on this exemption, your company must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review. Regulation A offerings share many characteristics with registered offerings. For example, you must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not “restricted,” meaning they are freely tradeable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are:
- The financial statements are simpler and don’t need to be audited;
- There are no Exchange Act reporting obligations after the offering unless the company has more than $10 million in total assets and more than 2,000 shareholders;
- Companies may choose among three formats to prepare the offering circular, one of which is a simplified question-and-answer document; and
- You may “test the waters” to determine if there is adequate interest in your securities before going through the expense of filing with the SEC.
If you “test the waters,” you can use general solicitation and advertising prior to filing an offering statement with the SEC, giving you the advantage of determining whether there is enough market interest in your securities before you incur the full range of legal, accounting, and other costs associated with filing an offering statement. You may not, however, solicit or accept money until the SEC staff completes its review of the filed offering statement and you deliver prescribed offering materials to investors. Crowdfunding Exemption – Section 4(a)(6) Please see our crowdfunding page for a detailed discussion of this exciting new exemption and opportunity. California Limited Offering Exemption – Rule 1001 SEC Rule 1001 provides an exemption from the registration requirements of the Securities Act for offers and sales of securities, in amounts of up to $5 million, that satisfy the conditions of ¤25102(n) of the California Corporations Code. This California law exempts from California state law offerings made by California companies to “qualified purchasers” whose characteristics are similar to, but not the same as, accredited investors under Regulation D. This exemption allows some methods of general solicitation prior to sales. Exemption for Sales of Securities through Employee Benefit Plans – Rule 701 The SEC’s Rule 701 exempts sales of securities if made to compensate employees. This exemption is available only to companies that are not subject to Exchange Act reporting requirements. You can sell up to $1,000,000 of securities under this exemption, no matter how small your company is. You can sell even more if you satisfy certain formulas based on your company’s assets or on the number of its outstanding securities. If you sell more than $5 million in securities in a 12-month period, you need to provide limited disclosure documents to your employees. Employees receive “restricted securities” in these transactions and may not freely offer or sell them to the public. However, the restriction on securities issued under Rule 701 is lifted three months after a company goes public and becomes subject to the reporting requirement of the Securities Exchange Act.