Legal Ways To Offer and Sell Securities Without Registering With the SEC
WARNING: THIS PAGE IS EXTREMELY BORING. ANYONE WISHING TO AVOID THE BRAIN DAMAGE CAUSED BY THE NUANCES OF SECURITIES LAWS AND THEIR OVERLAPPING, PROSAIC RULES SHOULD RUN SCREAMING FROM THIS PAGE. DO NOT SAY WE DID NOT WARN YOU!
A company’s securities offering may qualify for one of several exemptions from the registration requirements. The most common exemptions are explained below.Note that if all conditions of the exemptions are not met, purchasers may be able to obtain refunds of their purchase price. In addition, offerings that are exempt from provisions of the federal securities laws may still be subject to the notice and filing obligations of various state laws. Make sure you check with the appropriate state securities administrator before proceeding with your offering.And for pity’s sake, talk to a securities lawyer and financial advisor before even thinking about using any of this stuff.
Even if your company’s securities are exempt, please be aware that even exempt transactions are subject to the anti-fraud provisions of the federal securities laws. This means that you and your company will be responsible for false or misleading statements (whether oral or written).Misleading statements can be statements which are misleading as to a particular fact (i.e., lies) or misleading because important facts are left out of the discussion (e.g., neglecting to mention that the company selling the securities is currently being investigated by police).
The government vigorously enforces the federal securities laws through criminal, civil and administrative proceedings, and people often go to jail for committing securities fraud, so be careful about not violating the securities laws when looking for investors.(Please note that some enforcement proceedings are brought through private lawsuits as well, one variant of these private suits are those nasty class action suits you may hear about.)
Intrastate Offering Exemption
Section 3(a)(11) of the Securities Act is generally known as the “intrastate offering exemption.” This exemption facilitates the financing of smaller, local business operations. To qualify for the intrastate offering exemption, your 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 needs to 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. And without the exemption, your company could be in violation of the Securities Act registration requirements. Moreover, if one of the instate purchasers of your company resells the securities to an out-state person within a short period of time after the company’s offering is complete (the usual test is nine months), the entire transaction, including the original sales, might violate the Securities Act.So you need to ensure that your purchasers will not resell to out-state persons in a way that causes your company to lose its exemption for the securities sales.This is not that difficult since, typically, companies issuing securities under the intrastate exemption know the purchasers of the securities and directly negotiate the terms of the sale with those purchasers.Moreover, the terms of purchase involve contractual arrangements to help prevent prohibited sales.
Note that if your company holds some of its assets outside the state, or derives a substantial portion of its revenues outside the state where it proposes to offer its securities, it will probably have a difficult time qualifying for the exemption.
You may follow Rule 147, a “safe harbor” rule, to ensure that you meet the requirements for this exemption. It is possible, however, that transactions not meeting all requirements of Rule 147 may still qualify for the exemption.
Private Offering Exemption
Section 4(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; and
- have access to the type of information normally provided in a prospectus; and agree not to resell or distribute the securities to the public.
In addition, the offering company may not use any form of public solicitation or general advertising in connection with the offering.
The precise limits of this private offering exemption are uncertain.As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption.And please remember that if you offer securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.
Rule 506, another “safe harbor” rule, provides objective standards that you can rely on to meet the requirements of this exemption. Rule 506 is a part of Regulation which we describe more fully down below.
Section 3(b) of the Securities Act authorizes the SEC to exempt from registering small securities offerings, and under this authority the SEC created Regulation A, an exemption for public offerings of$5 million or less in any 12-month period. 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 resemble registered offerings in some ways. 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 tradable 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 500 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.(This is really important for smaller to medium-sized businesses who want to offer securities publicly but do not know if there is enough interest in them to warrant the legal fees and accounting fees associated with offerings.)
All types of companies which do not report under the Exchange Act may use Regulation A, except “blank check” companies, those with an unspecified business, and investment companies registered or required to be registered under the Investment Company Act of 1940. In most cases, shareholders may use Regulation A to resell up to $1.5 million of securities.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.
Regulation D establishes three exemptions from Securities Act registration.
1. 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. Your company may use this exemption so long as it is not a blank check company and is not subject to Exchange Act reporting requirements. Some of the most important characteristics of a Rule 504 offering are:
- You can sell securities to an unlimited number of persons;
- You can use general solicitation or advertising to market the securities; and
- Purchasers receive securities that are not “restricted.” This means that they may sell their securities in the open market without registration or other sales limits imposed on privately placed securities.
Rule 504 does not require issuers to give disclosure documents to investors. Nonetheless, you should take care to provide sufficient information to investors to avoid violating the anti-fraud 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 that omission makes the information provided to investors false or misleading.
2. 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 other persons (who do not need to satisfy the sophistication or wealth standards associated with other exemptions). Purchasers must buy for investment only, and not for resale. The issued securities are “restricted.” 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.An “accredited investor” is:
- 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;
- 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.
It is up to you to decide what information you give to accredited investors, so long as it does not violate the anti-fraud 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.
Here are some specifics about the financial statement requirements applicable to this type of offering:
- Only financial statements for the most recent fiscal year need be certified by an independent public accountant;
- If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s balance sheet (to be dated within 120 days of the start of the offering) must be audited; and
- Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.
3. Rule 506
As we discussed earlier, Rule 506 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(2) exemption:
- You can raise an unlimited amount of capital;
- You cannot use general solicitation or advertising to market the securities;
- You can sell securities to an unlimited number of accredited investors (the same group we identified in the Rule 505 discussion) and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors (either alone or with a purchaser representative) must be sophisticated-is, they must have sufficient knowledge and experience in financial and business matters to make them 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 anti-fraud 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;
- Financial statement requirements are the same as for Rule 505; and
- Purchasers receive “restricted” securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering.
Accredited Investor Exemption – Section 4(6)
Section 4(6) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.
The definition of accredited investors is the same as that used in Regulation D. Like the exemptions in Rule 505 and 506, this exemption does not permit any form of advertising or public solicitation. There are no document delivery requirements. Of course, all transactions are subject to the antifraud provisions of the securities laws.
Hey, Dudes! Don’t forget California’s 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 registration 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.
If you made it to the end of this page, perhaps you should be a lawyer or accountant, not an entrepreneur!