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Exemptions from ’33 Act Registration Requirements

EXEMPTIONS FROM ’33 ACT REGISTRATION REQUIREMENT

The registration and public offering process is extremely burdensome for startup companies. Numerous statutory and rule-based exemptions to the securities registration process exist. The statutory exemptions fall under Sections 3 and 4 of the ’33 Act. The rule-based exemptions are based upon statutory exemptions and are found primarily in “Regulation A” and “Regulation D” of the ’33 Act. These statutory and rule-based exemptions either exempt this type of security from registration or exempt a particular type of transaction from registration. We address the various exemptions individually.
What are “exempt securities” and “exempt transactions”?

Certain types of securities and certain transactions are deemed by the SEC to be exempt from registration requirements.

• Exempt Security – Common types of exempt securities are government securities, bank securities, high-quality debt instruments, non-profit securities, and insurance contracts. Most important for private, for-profit companies is the broad exemption under Section 4 of the ’33 Act of “transactions by an issuer not involving any public offering.” This is known as a “private offering”. A private offering is generally for a lesser amount of money that is invested by a small number or closely-related investors.

⁃ Note: The exempt type of security never has to be registered, even if it is resold following the issuance.

• Exempt Transaction – An exempt transaction is a transaction that does not warrant full-blown registration. Exempt transactions generally involve either a limited amount of capital or sophisticated or accredited investors.

⁃ Note: A security sold in an exempt transaction may have to be registered to avoid violating the ’33 Act if resold within a short period of time.

• Discussion: Why do you think the securities laws exempt certain securities from regulations and certain types of transactions for regulation? How is your reasoning influenced by the underlying goals of the securities regulations?

• Practice Question: What is an exempt transaction and an exempt security and why does this designation matter?
What are “restricted securities”?

Restricted securities, as the name implies, are subject to restrictions on when they can be sold or transferred following their issuance. Rule 144 of the ’33 Act lays out the rules for restricted securities.

• Holder Restrictions – Restricted securities in public companies are those held by officers, directors, or major shareholders (10% of total shares). These individuals cannot sell a number of shares greater than 1) the average weekly trading volume for the shares during the prior 4 weeks of trading, or 2) a quantity equal to 1% of total shares outstanding.

• Transactional Restrictions – Securities issued pursuant to a transactional exemption are also restricted from immediate resale. Regulation D exemptions prohibit resale for 12 months following the date of the issuance. This is to make certain that an exemption is not used as a straw transaction to transfer shares to individuals who could not otherwise be investors under the applicable exemption.

• Discussion: Why do you think the securities laws restrict the ability of certain insiders from selling a specific quantity of their shares? Is this fair to those shareholders? Why or why not? Why do you think the securities laws limit the transfer of shares issued in an exempted transaction?

• Practice Question: Robert is a large shareholder and COO of ABC Corp, a publicly traded corporation. He acquired many of his shares when he joined ABC Corp, immediately prior to the company going public. He received the shares in an exempted transaction that did not require registration of the securities. He now believes that ABC Corp has plateaued in its share price and he wants to sell a large quantity of his shares on the open market. What limitations might Robert face in selling the shares?
What is a “Section 3 exemption” from registration under the ’33 Act?

Section 3(a) Exemption – Section 3(a)(11) is an “intrastate offering exemption” designed to allow businesses to seek local funding. The issuer may offer securities for sale to residents of the state in which the business primarily does business without registering the issuance or securities with the SEC.

⁃ Note: Issuers of securities pursuant to the section 3(a)(11) statutory exemption must be careful that no offer is made to prospective out-of-state purchasers. Even one offer to a non-resident will destroy the exemption. Issuers can use the legal fiction of publishing information likely to go only to intrastate residents with a legend, “this is an offer only to in-state residents” to try to protect themselves.

• Exempt Security – Section 3(a)(11) offers an exemption for a class of securities, rather than an exemption for the particular issuance or transaction. The securities can be freely resold without worrying about registration.

• Benefits of Section 3 Exemptions – The exemption is attractive to issuers because it allows for:
⁃ an unlimited number of investors,
⁃ an unlimited amount of raised capital, and
⁃ general solicitation of investors may be allowed under the applicable state law.

• Coming to Rest – Purchasers cannot immediately resell the security, as that resale may involve out-of-state purchasers. If the securities have not “come to rest” then resale out of state destroys the exemption for the entire offering.

⁃ Note: The issuer must encourage purchasers to avoid immediate resale in order to avoid the appearance of a sham attempt to achieve a non-intrastate offering.

• Integration Doctrine – The “integration doctrine” applies to Section 3 issuances. This doctrine states that any offering of securities by the issuer within the last 12 months may be integrated into the current offering. Even if the other offerings were under another exemption, they may be “integrated” into a single transaction. If the issuances are integrated, it is possible that the prior offering will cause the loss of the registration exemption for the present and former transactions.

⁃ Note: The result of a failed exemption is that any purchasers in either offering may seek to rescind the transaction.
What is a Section 3(b) Registration Exemption?

• Section 3(b)(1) Exemption – Section 3(b)(1) of the ’33 Act is an exemption from registration of securities. It gives the SEC authority to define the types of exempt transactions where the value of securities issued does not exceed $5 million (“small issues” exemption).

⁃ Note: This statutory authority is the basis for an exemption under Rule 504 of Regulation D (discussed below).

• Section 3(b)(2) Exemption – Section 3(b)(2) allows the SEC to define a new “small issuance” class with a limit on the amount of funds raised of $50 million. These are unrestricted securities, which can be traded freely.

⁃ Note: This statutory authority is the basis for an exemption under Regulation A+ (discussed below).

• Discussion: Why do you think the securities laws allow an exemption from registration of securities sold strictly to residents of the state in which the issuer primarily does business? Why do you think the law exempted the security, rather than the transaction? Do the benefits of an intrastate offering make it compelling for issuers despite the geographical limitations?

• Practice Question: ABC Corp decides to sell shares to instate investors to raise $2.5 million in operating capital. ABC works diligently to make certain to offer the securities to only instate residents. What are the benefits of an intrastate offering? What is the risk to ABC Corp of purchasers immediately reselling the issued securities? This is ABC Corp’s third issuance of securities pursuant to an exemption? What information do you need to know to determine if the current issuance will cause a problem for ABC Corp?
What is “Rule 147” and how does it relate to a Section 3 exemption?

Rule 147 of the ’33 Act is a safe harbor for section 3(a)(11). It lays out the strict requirements that the issuer must meet to remain within the confines of the statutory exemption. To qualify for the intrastate offering exemption under SEC Rule 147:

• the issuer (company) must be incorporated in the state where the offering is made;
• at least 80% of the issuer’s revenues must come from business within that state;
• at least 80% of the issuer’s assets must be located in that state; and
• at least 80% of the proceeds of the offering must be used in that state.

As the name of the exemption implies, the issuer and all purchasers of the security must be primary residents of the state in which the securities are sold. As previously stated, a single offer or sale to an out-of-state individual destroys the exemption. Under the broad definition of an offer under the ’33 Act, any inadvertent contact with an out-of-state investor regarding the intended offering could be considered an offer to sell the securities. Lastly, a purchaser cannot resell the security to an out-of-state purchaser within 9 months of the issuance.

• Note: Ultimately, the issuer bears the burden of verifying the residency of each offeree or potential investor.

• Discussion: Why do you think the securities regulations allow for a rule-based exemption (regulation) that is a safeguard against violating the section 3(a)(11) statutory exemption? Do you agree that a purchase who meets the above-referenced characteristics should be considered an in-state purchaser? Why or why not?

• Practice Question: ABC Corp plans on an instate issuance of securities. They are worried about violating the section 3(a)(11) statutory exemption and losing the exemption. What options are available to ABC Corps to make certain they do not violate the statutory exemption?
What is a “Section 4” exemption from registration under the ’33 Act?

Section 4 provides for two statutory exemptions from registration of securities by an issuer. The exemptions available under Section 4 of the ’33 Act provide for transactional exemptions for the securities, rather than a blanket exemption for the security itself.

Private Offering Exemption – Section 4(a)(2) – Section 4(a)(2) provides that, “the provisions of section 5 shall not apply to transactions by an issuer not involving any public offering.” The SEC has deemed certain transactions to constitute “private offerings” and fall outside of the scope of a public offering. That is, the securities are not being sold in a public offering and, therefore, are exempt from the registration and reporting requirements of Section 5.

• Note: Rule 506, discussed in a separate lesson, is a “safe harbor” for the Section 4(a)(2) exemption. That is, if you follow the requirements of Rule 506, but fail to perfect the exemption, you may still qualify for an exemption under Section 4(a)(2). The requirements for exemption under Rule 506 are less stringent than those under Section 4(a)(2). For example, Rule 506 allows for purchase by non-sophisticated investors through an agent (purchaser representative). The main advantage of having this safe harbor provision is that, in the event the issuer fails to meet the requirements, it may still attempt to claim the exemption under Section 4(a)(2) or another exemption.

The characteristics of a section 4(a)(2) offering are as follows:

• Exempt Transactions – Section 4 provides for a long list of exempt transactions that include:

⁃ transactions falling under Section 4(2) and Reg. D and Rule 144A;

⁃ securities issued as compensation – Rule 701;

⁃ cross-border rights and exchanges for business combinations: Rule 800-802; and

⁃ foreign issuances: Reg. S (Rules 901-905).

• Benefits of Section 4(a)(2) – Section 4(a)(2) allows for the following benefits:

⁃ there is no geographical limitations on the issuance within the United States,

⁃ an unlimited number of offerees and investors, and

⁃ there is no limit upon the amount of money raised in the issuance.

• Limitations of Section 4(a)(2) – The following limitations apply to a section 4(a)(2) exemption:

⁃ Disclosure – Prospective purchasers must receive the pre-sale, statutory disclosures in the form of a private placement memorandum.

⁃ Sophistication Requirement – The issuer may offer or sell securities only to investors who are sophisticated and are not in need of the public protections afforded under the SEC’s regulations. Courts have interpreted this standard to mean that an investor must have the financial ability to bear the risk of loss in the investment or extensive business experience and open access to necessary information.

⁃ Note: There is no bright-line test for sophistication and financial ability to bear risk under the statute. If the potential investor does not meet the standard of “sophistication”, the exemption could be lost. If so, any investor who purchased securities within twelve months of the unauthorized offer will have an action to rescind the purchase of the security.

⁃ Integration – This offering may be integrated with prior offerings within the past 12 months.

⁃ General Solicitation – The offering cannot involve the general solicitation of purchasers. This concept is discussed further below.

⁃ Restricted Securities – These are “restricted securities”. They cannot be resold unless:

⁃ they are held for 6 months (reporting company) or 12 months (not a reporting company), or

⁃ they are registered prior to resale, or

⁃ the seller perfects another transactional exemption.


What is a “Section 4” exemption from registration under the ’33 Act?

Section 4 provides for two statutory exemptions from registration of securities by an issuer. The exemptions available under Section 4 of the ’33 Act provide for transactional exemptions for the securities, rather than a blanket exemption for the security itself.
Section 4(a)(5)

Statutory Exemption for Accredited Investors – Section 4(a)(5) -Section 4(a)(5) of the ’33 Act provides a statutory exemption for securities sold in accordance with its provisions.

• Note: The notable difference between Section 4(a)(5) and Regulation D exemptions is that Regulation D also allows for sales to non-accredited investors. Section 4(a)(5) is rarely used as a stand-alone exemption. The reason is because this statutory exemption generally fits within the rule-based exemptions of regulation D (Rules 505 and 506, for example), but does not contain many of the benefits.

The following limitations apply to a Section 4(a)(5) issuance:

• Disclosure – The issuer must provide a prospectus to purchases that complies with ’33 Act disclosure provisions;

• Accredited Investors – The issuer can only offer and sell securities to accredited investors;

• General Solicitation – The issuer cannot undertake any advertising or other forms of general solicitation of purchasers;

• Dollar Value – The maximum offering amount cannot exceed $5,000,000;

• Notice – The issuer must provide notice of sale to the SEC;

• Restricted Securities – Securities sold under section 4(a)(5) constitute “restricted securities” under Rule 144(a)(3) and cannot be resold in the future without registration or perfection of a separate exemption; and

• State Registration – Securities exempted under section 4(a)(5), like some other statutory exemptions, do not fall within the meaning of a federally covered security. The result is that federal law does not preempt state laws regulating the securities.

• Discussion: Why do you think the securities laws allow for a statutory exemption from registration of private offerings that meet the requirements of section 4(a)(2)? What about 4(a)(5)? Can you see how the restrictions on section 4(a)(5) make it a rarely-used exemption?

• Practice Question: ABC Corp is your employer and is considering a private issuance of securities. As a consultant for ABC Corp, you want to make certain that they understand the limitations and restrictions that apply to an issuance under Section 4. If asked, can you explain the limitations that apply to section 4(a)(2) and 4(a)(5)?
What is a “Regulation A” exemption?

Regulation A is a “conditional small issues” exemption from registration available for issuances that meet certain characteristics. Like Section 3(11), Regulation A provides for an exemption of the actual securities issued under the exemption. As such, the securities are not restricted from later sale.

• Note: The exemption is available for the issuer but is not available for broker-dealers offering the security for sale.

General Limitations – The following general limitations apply to all Regulation A exemptions:

• Private, Non-Reporting Company – The issuer cannot have stock registered with the SEC under Section 12 (i.e., cannot have stock that is traded on a public exchange) or be a reporting company under Section 15(d) of Securities Exchange Act of 1934 (’34 Act).

• US Company – The company must be a US or Canadian-based company.

• Operating Company – It cannot be an investment company, shell company, or involve fractional interests in oil or gas rights.

Types of Regulation A Exemption – Regulation A is actually divided into two classes of issuances, as follows:

• Tier 1 Issuance: The maximum amount of the issuance is $5 million in a 12-month period. There is no limit on the number of amount of securities purchased by any investors.

• Tier 2 Issuance: The maximum amount of the issuance is $50 million in a 12-month period. An investor may only purchase a number of securities valued at 10% of her annual income or 10% of her net worth, whichever is less.
Regulation A Disclosures

Regulation A is a middle ground between complying with the full registration and disclosure requirements of Section 5. The issuance requires review by the SEC prior to sale of the securities. The issuer must file an offering statement containing both non-financial and financial disclosures about the company and the issuance. This document has several components, including offering circular and financial statements. The issuer’s CEO, CFO, and majority board members, and any selling shareholder must sign the offering statement certifying the information contained therein. This certification subjects these individuals to liability for any material omissions or misstatements. While this exemption does entail a filing requirement, the filing is far less demanding than those completing the entire registration process.

• Note: The issuer cannot solicit investors, make any binding commitments for sale, or sell any securities before the request for issuance and exemption is reviewed and approved by the SEC. There is, however, an exception that allows the issuer to “test the waters”.
Regulation A and General Solicitation

Regulation A allows the issuer of securities to “test the waters” for interested investors. That is, the issuer can use a written document or a radio or television broadcast to seek feedback from interested investors. The purpose of this provision is to allow the issuer to determine, prior to preparing the detailed offering disclosure documents, whether or not there is sufficient interest from investors to proceed with the issuance. The key limitations are that the test-the-waters communication must be filed with the SEC on the date of use.

• Note: Failing to file the “test-the waters” communication does not automatically forfeit the exemption, but it can prejudice future issuances under this provision.
Regulation A and State Regulations

Regulation A securities are not exempt from state regulation. This means that, even though the federal exemption applies, states may require that the issued securities be registered in the state and, in some states, undergo a merit review. Perhaps most importantly, many states do not allow general solicitation of investors unless the securities being sold are registered. This would strictly limit the open solicitation of purchasers in person or through television, radio, or Internet. So, even though Regulation A allows for testing the waters, the state may require state registration prior to doing so.

• Note: A prohibition against general solicitation requires that an issuer approach regular business contacts or professional brokers to generate interest in the issuance.

• Discussion: Why do you think Regulation A offers an exemption that accompanies a registration requirement? Given the extent of the disclosure requirements, do you think Regulation A is more or less attractive to issuers than full registration? Why?

• Practice Question: ABC Corp decides to issue securities in an effort to raise $45 million in financing. What are some of the restrictions that ABC Corp must understand when considering Regulation A?
What are “Regulation D exemptions”?

Regulation D is the most commonly used set of exemptions for private placement. It consists of Rules 501-508 of the ’33 Act. In addition to several statutory exemptions from registration, the SEC adopted Regulation D to provide “safe harbors” for issuers of securities. These exemptions are referred to as safe harbors because compliance with these rules will provide for an exemption from the standard disclosure requirements. Unlike the statutory exemptions, such as Section 4(a)(2) or Section 4(a)(5), failure to achieve or perfect an exemption is not completely detrimental to the validity of the securities offering. Rather, if the validity of the issuance under a Regulation D rule is challenged, the issuer can then attempt to assert a statutory exemption for the issuance. As such, Regulation D provides a safe harbor for pursing an exemption and leaves open other possibilities for seeking exemption if somehow the offering runs afoul of the Regulation D exemptions.

• Note: The statutory authority for exemptions under Regulation D are found in Sections 3 and 4. Pursuant to this authority, the SEC used its quasi-legislative authority as an administrative agency to pass these exemption rules.
Regulation D, Rule-Based Exemptions

Regulation D, rules 501, 502 and 503 provide definitions and conditions for the applicable exemptions. Rules 504, 505 and 506, are the substantive exemptions. Rules 507 and 508 lay out the consequences for failing to comply with the requirements of an individual exemption. Taken together, these rules provide for the most commonly employed exemptions to securities registration requirements.

• Note: Each of the rule-based exemptions are discussed in detail below. It is important, however, to remember that the general provisions of Rules 501- 503 apply to each exemption.
Limitations of Regulation D

• Issuer Protections – A notable limitation of Regulation D safe harbor provisions is that they only provide exemptions for the issuers of the securities during the original issuance of the security. The rules do not exempt individuals who later sell those same securities to third parties.

⁃ Note: This restriction is quite important, as some securities sold to equity investors are “restricted” and limit the investor’s ability to resell. The importance of this limitation will be become apparent as we review the available exemptions.

• General Solicitation – Another important limitation is the restriction on the ability to make offers to sell securities to individuals. Many Regulation D exemptions prohibit issuers from soliciting investors to purchase the securities.

⁃ Note: The ability to solicit investors by making offers to sell securities is dependent upon the assumed knowledge and personal wealth of the investor.

• Accredited & Sophisticated Investors – Some exemptions limit the ability to sell securities to a certain number of “accredited investors” or “sophisticated investors”. Accredited investors are individuals with a net worth (not counting their primary residence) of more than $1 million or an annual income of more than $200,000 or institutions (such as banks and insurance companies). A sophisticated investor is an individual who has sufficient knowledge or experience to assess the risks of an offering themselves.

⁃ Note: A sophisticated investor may also be an accredited investor and vice versa. However, it is possible that one may not qualify as the other.

• Discussion: Why do you think the SEC decided to offer rule-based exemptions as safe harbors for the statutory exemptions? Do you think that offering additional protections to issuers against challenges by purchasers is a good thing? Why or why not?

• Practice Questions: What are the primary rules under regulation D? What are the rule-based exemptions from registration of securities and how do these rules relate to the statutory authorizations?
What is a Rule 504 “small offerings exemption”?

Rule 504 is a transactional exemption from registration under Regulation D for small securities offerings. The statutory authority for the rule is pursuant to Section 3(b) of the ’33 Act. The general requirements and limitations on the exemption are as follows:

• Issuer Protections – The exemption is available to the original issuer. The exemption is available to any company that is not a “reporting company”, “investment company”, or a “blank check company” under the Securities Exchange Act.

• Dollar Limits – Rule 504 allows an issuer an exemption for small offerings of shares with an aggregate annual value of up to $1 million. The issuer may not split a single offering between Rule 504 and some other exemption. Any other offerings during the previous twelve-month period, even if under another exemption, will be integrated into the Rule 504 offering.

• Number of Purchasers – The issuer can make sales to an unlimited number of persons. It does not matter whether the purchasers are sophisticated or accredited investors.

• Restricted Securities – Securities are restricted. Affiliates and non-affiliates of an issuer who wish to resell securities must look elsewhere for a transactional exemption.

• General Solicitation – Rule 504 prohibits the issuer or anyone on the issuer’s behalf to “offer or sell the securities by any form of general solicitation or general advertising”. Rule 504 does allow for general solicitation in the following circumstances:

⁃ the offering is registered in the state where securities are sold, or

⁃ the state permits general solicitation and sales are only made to accredited investors in that state, or

⁃ Note: In these situations, the securities issued pursuant to either of these provisions are not restricted.

⁃ the state of issuance does not require registration, but the securities are registered in another state.

⁃ Note: This is a situation where the state allows the issuer to piggyback on the registration of securities in another state. The issuer must generally file an informational notice to the issuing state regarding the registration in another state.

• Private Placement Memorandum – To qualify for this exception, the state law must require “the public filing and delivery to investors of a substantive disclosure document before sale.” The disclosure document must disclose all material information to investors.

• State Regulation – A Rule 504 exemption does not preempt state regulations of securities under such an issuance. States may still regulate the issuance.

• Discussion: What do you think is the SEC’s purpose in allowing for the Rule 504 exemption? Who do you think this exemption best serves? What do you think is the greatest limitation on this exemption? Why do you think the SEC allows for exceptions to the rule against general solicitation?

• Practice Question: ABC Corp is a relatively new company that is growing quickly. ABC needs about $1 million in investment capital reach its growth goals for the next 18 months. In a brief letter, can you summarize the benefits and drawbacks of seeking an exemption from securities registration under Rule 504?
What is a Rule 505 “small offerings” exemption?

Rule 505 of Regulation D provides a transactional exemption from registration of a securities issuance.

• Issuer Protections – The exemption is generally available to all types of issuers (individuals, non-corporate businesses, corporations, as well as those reporting under the ’34 Act) but it is not available for investment companies or for issuers that are subject to any statutory disqualification provisions, such as companies formally sanctioned by the SEC for untrue statements or omissions in securities offerings.

• Dollar Limits – This exemption allows an issuer to raise up to $5 million within a 12-month period.

• Purchaser Requirements – The exemption allows for sale to an unlimited number of accredited investors and up to 35 non-accredited investors.

⁃ Note: Exceeding the number of non-accredited investors can forfeit the exemption.

• Restricted Securities – The securities exempted in the issuance are restricted from resale.

• General Solicitation – General solicitation of purchasers is prohibited in the same manner as under a Rule 504 exemption.

• Private Placement Memorandum – The issuer does not have to make specified disclosures to accredited investors, but it must make extensive disclosures to non-accredited investors. This is normally done through the private placement memorandum, a disclosure document similar in nature to the prospectus. Notably, the disclosures must include certified financial statements.

• State Regulation – Rule 505 does not provide an exemption from registration of securities under state law. This is similar to a Rule 504 offering.

• Discussion: The primary differences between a Rule 504 and 505 exemption is the dollar value of the issuance and classification of purchasers of securities. Why do you think Rule 505 separates classes of purchasers of securities into accredited and unaccredited investors?

• Practice Question: ABC Corp is an established company that is steadily growing. ABC needs about $5 million in investment capital reach its growth goals for the next 18 months. In a brief letter, can you summarize the benefits and drawbacks of seeking an exemption from securities registration under Rule 505?
What is a “Rule 506” exemption?

Rule 506 of Regulation D allows for two exemptions of securities issuances. The statutory authority for a Rule 506 is pursuant to Section 4(a)(2) of the ’33 Act. Rule 506 exemptions are the most commonly employed exemptions to securities registration.
Rule 506(b) Safe Harbor Exemption

• Issuer Protection – Rule 506 protections available for issuers are similar those of Rule 505. The notable exception is that the limitations for reporting companies under the ’34 Act, or the so-called “bad boy” disqualifications do not apply to this exemption.

• Dollar Limits – This exemption allows for an unlimited dollar value for issuances.

• Purchaser Requirements – An issuer may sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors.

• Restricted Securities – This is a transactional exemption. As such, this exemption applies only to issuers and does not cover later sales by investors.

• General Solicitation – Rule 506(b) does not allow for general solicitation, which means that the issuer cannot use general advertising methods to reach potential customers. Of note, this general rule applies only to actual sales of securities, rather than to both offers and actual sales.

⁃ Note: The issuer must also use reasonable care to assure that the purchasers of the securities are not statutorily considered to be underwriters of the securities, as this can cause general solicitation issuers.

• Private Placement Memorandum – Rule 506(b) information disclosures are divided between accredited and non-accredited investors. There is no information disclosure requirement for the accredited investors, but the non-accredited investors must receive extensive disclosures. These disclosures are similar to those required under other Regulation D exemptions. The issuer must provide a private placement memorandum containing the necessary disclosures. Also, all non-accredited investors must meet a sophistication requirement. More specifically, they must have the knowledge or resources necessary to evaluate the merits of the investment.

⁃ Note: As with a Section 4(a)(2) exemption, the issuer must ascertain that offers only happen to individuals who meet qualification requirements to be purchasers. These non-accredited investors must either have sufficient sophistication to evaluate the merits and risk of the prospective investment or be represented by a sophisticated agent.

• State Regulation – Section 18 of the ’33 Act exempts Rule 506 securities from registration requirements or a merits review under state law. As such, states cannot place additional registration requirements on the security issuance.
What is a “Rule 506” exemption?

Rule 506 of Regulation D allows for two exemptions of securities issuances. The statutory authority for a Rule 506 is pursuant to Section 4(a)(2) of the ’33 Act. Rule 506 exemptions are the most commonly employed exemptions to securities registration.
Rule 506(c) – Exemption Pursuant to JOBs Act of 2013

The JumpStart our Businesses Act of 2013 (JOBs Act) made extensive changes to the securities registration exemption regime. As a result, it allowed the SEC to develop Rule 506(c) exemption with the following characteristics:

• Issuer Protections – Rule 506(c) applies to issuers to the same extent as Rule 506(b).

• Dollar Limits – The exemption allows an issuer to raise an unlimited amount of funds.

• Purchaser Requirements – The most daunting requirement of Rule 506(c) offerings is the requirement that the issuer verify that each purchaser of securities is accredited. An issuer who fails to exercise reasonable care in making this determination risks losing the exemption. The standard for judging an issuer’s reasonable efforts to make this determination is uncertain. The SEC identified four primary methods of verifying that an individual is an accredited investor, including:

⁃ Annual Income – The issuer may examine proof of the purchaser’s income, such as IRS filings from the last two tax years.

⁃ Note: This may require a certification by the issuer that they expect to sustain the previous years’ earnings.

⁃ Net Worth – The issuer may examine bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessment, or appraisal reports, and consumer reports from a national agency, or obtain a written representation that purchaser has disclosed all liabilities.

⁃ Professional Certification – The issuer may receive a written representation from a registered broker-dealer or investment advisor, licensed attorney, or CPA that such person has taken reasonable steps to verify that the purchaser is an accredited investor as of the last three months.

⁃ Written Verification – If the prospective purchaser is a previously verified accredited purchaser, a written verification that such person is still accredited.

• Restricted Securities – The shares received by the investor under the exemption are “restricted”.

• General Solicitation – The rule allows for general solicitation in an issuance where all purchasers are accredited investors and the issuer takes reasonable care to determine that each investor is accredited.

• Private Placement Memorandum – Before consummating a sale, the issuer must provide the purchaser with adequate disclosures under Regulation D.

• State Regulation – Rule 506(c) are covered securities that are exempt from state regulation.

• Discussion: Why do you think Congress felt the need to provides for a specific exemption to accredited investors that also allows for general solicitation? Do you feel that the ability to generally solicit purchasers of securities undermines the purpose of public disclosure? Why or why not?

• Practice Question: ABC Corp is a wildly successful startup company that is growing by 300% per year. ABC needs about $100 million in investment capital reach its growth goals for the next 18 months. In a brief letter, can you summarize the benefits and drawbacks of seeking an exemption from securities registration under Rule 506? Specifically focus on the differences between rules 506(b) & 506(c).
What is a “Rule 502(d)” and “Rule 144 Safe Harbor”?

Rule 502(d) requires that issuers of securities pursuant to an exemption under Regulation D take the following three steps to make certain the shares are not resold during the restricted period:

• reasonable inquiry to determine if each purchaser is buying the security for himself or for someone else,
• written disclosure to each purchaser that the securities are restricted, and
• a legend on the securities noting the resale restriction.

The SEC promulgated Rule 144, which allows a “safe harbor” for purchasers to resell their shares after one or two years, depending on how much public information about the issuer is available. In any case, the issuer must make certain that the shares are not being purchased with the intent of immediate resale. This safe harbor rule provides additional comfort to a purchaser of the security. As such, it adds liquidity to the security by making it easier to later sell and trade in the market.

• Discussion: What do you think is the underlying purpose or rationale for Rule 502(d) and Rule 144? Do you think these rules are adequate to achieve their objectives? Why or why not?

• Practice Question: ABC Corp issues securities pursuant to Rule 505 registration exemption. Kerry is a purchaser of securities. He realizes that the shares are restricted for a substantial period. What should ABC Corp and Kerry do to make certain that later reselling the shares does not potentially violate the Rule 505 offering?
What are the general information disclosure requirements for companies seeking an exemption from registration?

The perfection of an exemption does not completely relieve an issuer’s disclosure requirements. The disclosure document that is generally used by businesses perfecting a registration exemption is the “private placement memorandum” (PPM). The issuer must disclose to potential investors at the time of the offer or prior to the business accepting any offer of investment funds. The PPM is very similar to the prospectus and is similarly demanding in its disclosure requirement. The PPM requirement requires extensive work and effort to prepare, but it is far less burdensome to the business than registering the issuance.
Types of Disclosure

Securities law breaks down the disclosure requirements for issuers of securities based upon the type of investor or purchaser of the securities. The relevant disclosure provision governing issuances is Rule 502(b)(2). It requires that issuers provide both financial and non-financial information. The company is required to provide the equivalent information as is required under SEC Form 1-A. It is important to note that the information disclosure or delivery requirements set forth in Rule 502(b) are only applicable to offerings under certain exemptions. Offerings to accredited investors do not require furnishing information.

• Example: Offerings under Rules 505 and 506 have to provide extensive information to non-accredited investors, while offerings under Rule 504 do not.

• Note: The issuer must always comply with state and federal anti-fraud laws, such as section 11(a), 12(a) and (b), and 10(b) under the ’33 Act. Information that is factually untrue or misleading in any form runs the risk of violating one of these provisions. Generally, if the issuer is not a company that routinely provides reports to the SEC under Sections 13 or 15(d) of the Securities Exchange Act of 1934, it must furnish the following information to the purchaser of the securities.
Non-Financial Information

Non-financial information required by Rule 502(b) includes: the management team; the industry; the type and characteristics of the securities offered; any third-party facilitators in the offering process; and the risks involved in the type of security being offered. More precisely, the required information is listed in Part 1 of the registration statement that the business would be required to use, absent the applicable exemption. This information is deemed necessary to allow the investor to make an informed decision about whether to undertake the investment.

• Note: There is some flexibility in this disclosure requirement, as the introductory language in Rule 502(b)(2)(i) requires the issuer to furnish the specified information “to the extent material to an understanding of the issuer, its business, and the securities being offered.”
Financial Information

Financial information about the business must be disclosed via the financial statements of the business. The extent of disclosure, which can be extremely detailed, depends on the size of the offering. The greater the dollar value the more extensive the disclosure requirements. The amount of required financial information varies between issuances below $2 million, between $2 million and $7.5 million, and above $7.5 million. Generally, the variation is the amount of financial data of the company and whether that information must be audited and certified by the company executives. The information requirement serves to provide the investor with information that may not be available because the business is not required to register the information with the SEC.

• Discussion: Why do you think the information disclosure requirements vary between accredited and non-accredited investors? Why do you think the rules separate the requirements for financial and non-financial disclosures? Why do you think the amount of issuance matters with regards to the amount of information required to be disclosed to investors?

• Practice Question: ABC Corp is attempting to sell securities pursuant to an exemption under Rule 506(c). ABC Corp wonders what actions it should take to remain within the confines of Rule 506(c). Can you explain the types of disclosures that ABC Corp must make?


What is the requirement to file “Form D”?

To claim an exemption from registering a securities issuance, the issuer must provide notice to the SEC of the issuance and claimed exemption. The entrepreneur provides notice by filing Form D with the SEC. Form D is currently filed in electronic format and must be filed within 15 days of the first sale of securities in the offering. The Form D is generally available through the SEC website (EDGAR). Form D makes basic disclosure about the issuance. This information includes the amount or value of the issuance and the names of company officers and directors.

• Note: The SEC disclosure requirement is less stringent than it sounds, as failure to file the Form D prior to the issuance will not hinder the ability of the issuer to claim an exemption. The negative side of failing to file is that, in the event of a challenge to the sale of securities, the SEC may stop the sale and deny the future use of exemptions due to the failure to file. Failure to file a Form D may also make it difficult for the issuer to comply with state securities laws.

• Discussion: Why do you think the SEC requires notification of a claimed exemption from registering a securities issuance? Based upon your conclusions, why do you think the failure to file Form D has very little negative repercussions?
What is the effect of failing to register an offering under Section 5 and failing to perfect an exemption to the registration requirement?

Violating Section 5 of the ’33 Act by failing to register an issuance or failing to carry out an issuance in accordance with an applicable exemption can subject the issuer to liability to purchasers of the securities. Specifically, Section 12(a)(1) allows any purchaser to bring a lawsuit to rescind the purchase of the securities (along with interest on the purchase funds) or, if the securities have been sold, to receive the damages suffered from the purchase. Rescinding the purchase transaction is often referred to as “buying a put,” because the purchaser will have the right to force the seller to repurchase the security. The SEC may also have a civil cause of action against the issuer who sells securities in violation of Section 5.

The result of failing to comply with failing to comply with a relevant exemption can be detrimental to an issuer. Rule 508 provides some relief from these effects if an anticipated exemption under Rules 504 – 506 fail because of an insignificant reason. That is, the issuer may be able to defend an action for rescission by demonstrating the following:

• the issuer’s deviation from the exemption requirement was insignificant with regard to the overall offering;

• the requirements were not specifically imposed to protect this type of purchaser’s interest; and

• the issuer honestly (in good faith) attempted to comply with the exemption requirements.

An issuer who successfully demonstrates these elements may be relieved from liability to plaintiff investors or the SEC.

• Discussion: How do you feel about the repercussions on an issuer for failure to comply with registration requirements or perfect an exemption? Is this provision overly advantageous to the purchaser or securities? Why or why not?

• Practice Question: ABC Corp sells securities to a small group of investors in several states. ABC did not seek legal counsel and is unaware that its sale of securities is subject to regulation under the securities law?

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