When buying a car, consumers are afforded the opportunity to kick the tires, read reviews and safety ratings and test drive the car in order to make an informed decision about their purchase. In order to provide investors purchasing stock or other securities with a similar opportunity to make an informed decision about their purchase, federal securities laws were enacted that require companies to disclose
important financial and other information through the registration of securities. As a result, any offer of securities must either be registered with the Securities and Exchange Commission or exempt from registration.
The two most relevant federal securities laws with respect to the registration of securities and disclosure of information are the Securities Act of 1933 and the Securities Exchange Act of 1934. According to the SEC, the 1933 Act has two primary objectives. First, it requires that investors receive financial and other significant information concerning securities being offered for public sale, and second, it prohibits deceit, misrepresentation and other fraud in the sale of securities. The 1934 Act established the SEC and, among other things, empowers the SEC with authority over all aspects of the securities industry, including the power to require periodic reporting of information by companies with publicly traded securities.
The basic exemption from registration under the 1933 Act is through Section 4(a)(2) of the 1933 Act, which states quite simply that transactions by an issuer not involving a public offering are exempt from registration. In true legal fashion, Section 4(a)(2) does not define or provide any explanation or clarification of what constitutes a public offering. As a result, most companies turn to Regulation D (and most often Rule 506 of Regulation D) to understand whether their offering of securities is exempt from registration under Section 4(a)(2) of the 1933 Act.
Regulation D of the 1933 Act is comprised of Rules 500 through 508 and generally includes three exemptions from registration, two of which are found in Rule 506. Most companies utilize the exemptions afforded by Rule 506 because, unlike other available exemptions, the Rule 506 exemptions have no restriction on the dollar amount of the offering of securities by companies. Therefore, companies are free to raise any amount of money in offerings of securities under these exemptions so long as they satisfy applicable requirements.
Under Rule 506(b), companies can be assured they are within the Section 4(a)(2) exemption from registration if they satisfy certain requirements. First, companies cannot use general solicitation or advertising to market the securities being offered for sale. This means companies cannot market the offering through advertisements or articles published in newspapers, over television or radio, or through similar media or broadcasts. In addition, companies cannot hold general seminars or meetings where persons attending those meetings have been invited through similar mediums. Second, companies may sell securities to an unlimited number of accredited investors (described below) and up to 35 other purchasers. All non-accredited investors must be what is known as sophisticated investors, which means they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of a prospective investment in securities. Third, companies must give the accredited investors standard information to make the investment in the companies’ securities not misleading, and such information cannot be fraudulent. There is no specific requirement as to what information must be provided by the companies. In fact, the companies themselves determine what information is required in order to make the investment not misleading. Oftentimes, but not always, companies provide potential investors with a private placement memorandum, which includes information about the company, potential investments by the company, company management and other information. Information given to non-accredited investors is more expansive and includes financial statements, possibly audited, which for some companies can be costly or time-consuming. Any information given to one potential investor must be given to all potential investors, regardless of accredited investor status and even if not required under the Rule.
Unlike Rule 506(b), Rule 506(c) permits general solicitation and advertisement and permits companies to be in compliance with the private placement exemption so long as all investors in the offering are accredited and the companies take reasonable steps to verify the investors are in fact accredited. Such steps may include reviewing Form W-2s, tax returns and other information. Relying on representations in a subscription agreement alone may be insufficient. Many companies require potential investors to complete an investor questionnaire prior to making an investment in the companies’ securities, which questionnaire contains questions aimed at ensuring such investors satisfy the definition of being accredited investors. Such questionnaire may also be insufficient by itself to satisfy the verification requirement under the Rule. Companies are permitted, however, to take into account their relationship and knowledge of potential investors, as well.
Rule 501 of Regulation D sets forth the requirements of what constitutes an accredited investor. Generally, individuals qualify as accredited investors if their individual net worth or joint net worth with their spouse exceeds $1 million (excluding the value of such individual’s primary residence), or if such individual’s income exceeds $200,000 in each of the two most recent years or income with such individual’s spouse exceeds $300,000 in each of those years, and the individual has a reasonable expectation of reaching the same income level in the current year.
Bad Actor Disqualification
Even if companies would otherwise satisfy the requirements under Rule 506 and be eligible for one of the exemptions from registration thereunder, companies are disqualified from using such exemptions if they fall into the bad actor disqualification pursuant to Rule 506(d). Rule 506(d) disqualifies an issuer if the issuer, any director or executive officer of the issuer, any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities or certain others have engaged in one of many specified acts set forth in the Rule. Such acts include having been convicted of a felony or misdemeanor within certain specified timeframes in connection with the purchase or sale of any security, making false filings with the SEC and similar acts.
Form D and Blue Sky Laws
If companies comply with either exemption offered under Rule 506(b) or Rule 506(c) and are therefore exempt from the registration requirements under the 1933 Act and not disqualified pursuant to the bad actor disqualification under Rule 506(d), the companies do not need to register their offering of securities with the SEC. They are, however, still required to make a notice filing on Form D within 15 days of the first sale of securities. A Form D is a short public filing alerting the SEC that an offering and sale of securities has been made pursuant to an exemption from registration. In addition, companies should ensure that they have satisfied all applicable state securities laws, often referred to as blue sky laws, with respect to their offerings. Oftentimes, states will not require separate state filings to be made after a Form D is filed with the SEC, but will require a copy of the Form D or electronic notice of the offering be provided to the applicable state.
Due to the registration exemptions offered by Rule 506, companies can successfully raise a significant amount of money through private placements without having to endure the costly and time-consuming process of registering their offerings.
Jeffrey B. Morlend is a partner in the Corporate Department of Sullivan & Worcester LLP. Jeff advises both public and private clients in a range of corporate matters with a focus on securities law compliance, financing transactions and private equity investments. He counsels domestic and international companies in public equity and debt offerings and general disclosure matters, and represents financial institutions and public and private companies involved in a variety of industries in secured and unsecured credit facilities.