Federal Securities Exemptions

Federal Exemptions from Securities Registration

While there are several attractive exemptions available for small business capital fundraising, the major problem remains the SEC’s stubborn refusal to fix the “general solicitation” and “general advertising” issues.

Regulation D Offerings

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or qualify as an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC. The three exemptions are found in Rules 504, 505, and 506 of Regulation D.

Form D

While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company. It is now filed electronically so it can be better monitored by the SEC.

Antifraud Rule Applicable to All Securities Transactions

There is no exemption to the antifraud rule contained in federal and state securities laws. Even if a company makes a private sale where there are no specific disclosure delivery requirements, a company must provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. This means that any information a company provides to investors must be free from false or misleading statements. Similarly, a company should not exclude any information if the omission makes what is provided to investors false or misleading. The disclosures can be oral or written. However, it is unwise to rely on oral representations. If the investment loses money, the company, its officers, and directors could be facing a legal action pitting their memory of what was said against the memory of the investors. We recommend a professionally prepare private placement memorandum be used in most situations.

Rule 504

A company can use this exemption so long as it is not a blank check company and does not  file reports under the Securities Exchange Act of 1934. Unless the securities are registered under state law (explained below), the exemption does not allow companies to solicit or advertise their securities to the public Purchasers receive “restricted” securities, meaning that they may not sell the securities without registration or an applicable exemption  (Rule 144) .

Rule 504 does allow companies to sell securities that are not restricted, if one of the following circumstances is met:

  1. The company registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;

  2. A company registers and sells the offering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or

  3. The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to “accredited investors.”

Rule 505

Rule 505 of Regulation D allows some companies offering their securities to have those securities exempted from the registration requirements of the federal securities laws. To qualify for this exemption, a company:

  1. Can only offer and sell up to $5 million of its securities in any 12-month period;

  2. 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;

  3. Must inform purchasers that they receive “restricted” securities, meaning that the securities cannot be sold for at least one year (Rule 144) without registering them; and

  4. Cannot use general solicitation or advertising to sell the securities.

Rule 505 allows companies to decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws (see above). But companies must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company must also be available to answer questions by prospective purchasers.

Under Rule 505, financial statements need to 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. 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.

Rule 506

Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption of Section 4(2) of the Securities Act. Companies using the Rule 506 exemption can raise an unlimited amount of money. A company can be assured it is within the Section 4(2) exemption by satisfying the following standards:

  1. The company cannot use general solicitation or advertising to market the securities; and

  2. The company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases.

Unlike Rule 505, 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 make them capable of evaluating the merits and risks of the prospective investment. Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws (see above). But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company must be available to answer questions by prospective purchasers.

Financial statement requirements are the same as for Rule 505.

Purchasers receive “restricted” securities under Rule 144, meaning that the securities cannot be sold for at least a year without registering them.

Accredited Investor Exemption

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. As with all securities transactions, the antifraud provisions of the securities laws apply.  It is usually too risky to rely on oral representations so it is advisable to prepare a private placement memorandum.

Not Involving a Public 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:

  1. 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;

  2. have access to the type of information normally provided in a prospectus; and

  3. agree not to resell or distribute the securities to the public.

In addition, you 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. You should know 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 D, which we described above.

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 local business operations. To qualify for the intrastate offering exemption, your company must:

  1. be incorporated in the state where it is offering the securities;
  2. carry out a significant amount of its business in that state; and
  3. 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. Without the exemption, the company could be in violation of the Securities Act registration requirements. If a purchaser resells any of the securities to a person who resides outside the state 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. Since secondary markets for these securities rarely develop, companies often must sell securities in these offerings at a discount.

It will be difficult for your company to rely on the intrastate exemption unless you know the purchasers and the sale is directly negotiated with them. 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.

Regulation A

Section 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities offerings. By this authority, we created Regulation A, an exemption for public offerings not exceeding $5 million 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 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 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.

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.

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 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.

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 at least $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.

Researching the Federal Securities Laws Through the SEC Website

Note: Unless you are an experienced professional, it is hard to interpret correctly the federal securities exemptions.

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