A previous article in this series contained an overview of the private placement exemptions under Regulation D of the Securities and Exchange Commission (SEC), including such key concepts as accredited investors and integration of separate offerings. It also listed several key factors to consider when deciding which exemption to use:
- The dollar amount of capital sought to be raised
- How many investors will be participating in the offering and whether any will be non-accredited investors
- Whether the investors and the issuer will reside in a single state
- Whether the offering will be limited to officers, employees and consultants of the issuer
Another article in this series discussed the discussed advertising and general solicitation in private placements, including the important changes made by the Jumpstart Our Business Startups (JOBS) Act that for the first time permit advertising general solicitation in private placements to accredited inventors.
In this article I will go through the three distinct exemptions provided by Regulation D: Rule 504, Rule 505 and Rule 506. A separate post discusses several other exemptions outside of Regulation D that can used for private placements as well.
1. Use of Regulation D
A few preliminary matters on Regulation D appear in Rule 501.
(1) Regulation D only exempts transactions form the requirement to register the securities offering with the SEC. Qualifying transactions will not be exempt from the antifraud, civil liability, or other provisions of the federal securities laws. The Rule specifically admonishes issuers of their obligation to provide such further material information, if any, as may be necessary to make the information required under Regulation D, in light of the circumstances under which it is furnished, not misleading.
(2) Attempted compliance with any rule in Regulation D does not act as an exclusive election; the issuer can also claim the availability of any other applicable exemption. For instance, Rule 506 was specifically adopted as a rule implementing the statutory exemption under Section 4(2) of the Securities Act of 1933 (Securities Act) for transactions “by an issuer not involving any public offering.” However, if a securities offering does not meet all of the requirements of Rule 506, the issuer may still rely on Section 4(2) directly (and all of the court cases interpreting its application). For this reason Regulation D is often referred to as a “safe harbor”: while compliance with the rules will provide an exemption form SEC registration, the failure to comply does not necessarily mean that registration is required–another exemption may still be relied upon.
(3) Regulation D is available only to the issuer of the securities and not to any affiliate of that issuer (such as an officer, director or substantial shareholder) or to any other person for resales of the issuer’s securities. Regulation D provides an exemption only for the transactions in which the securities are offered or sold by the issuer, not for the securities themselves. As will be discussed, securities issued under Regulation D (except for certain types of Rule 504 offerings) are restricted securities, and even if the issuer were subsequently to go public they would be subject to the resale limitations of SEC Rule 144.
(4) Regulation D applies only to the Federal securities laws and the laws of each state in which a sale is made must also be complied with. Most states have adopted laws that are similar to Regulation D, and in many cases other provisions of Federal law preempt state regulation in this area; this is discussed in a separate article in this series.
(5) Regulation D may also be used for securities issued in merger and other business combinations under SEC Rule 145.
(6) In view of the objectives of Regulation D and the policies underlying the Securities Act, Regulation D is not available to any issuer for any transaction or chain of transactions that, although in technical compliance with Regulation D, is part of a plan or scheme to evade the registration provisions of the Act. In such cases, registration under the Act is required.
(7) Regulation D offerings may be made simultaneously with offerings under SEC Regulation S, which provides an exemption for securities offered and sold outside the United States. Thus, for example, persons who are offered and sold securities in accordance with Regulation S would not be counted in the calculation of the number of purchasers under Regulation D. Similarly, proceeds from such sales would not be included in the aggregate offering price. However if the issuer elects to rely solely on Regulation D for offers or sales to persons made outside the United States, then it must comply with all of the provisions of the Regulation D.
2. Advertising and General Solicitation
In a Rule 505 or 506 offering, neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising. The same is true of Rule 504 limited offerings, except those that are registered with one or more state securities (blue sky) regulators. The topic of advertising and general solicitation is covered by a previous article in this series.
JOBS Act: Advertising and General Solicitation Permitted in Rule 506 Offerings to Accredited Investors
Title II of the JOBS Act implemented the first significant relaxation on the prohibition on general advertising and general solicitation since the adoption of the Securities Act in 1933, by allowing general advertising and general solicitation in Rule 506 offerings to accredited investors. The Act directed the SEC to revise Rule 506 within 90 days of the JOBS Act’s enactment to allow general advertising and general solicitation in Rule 506 offerings to accredited investors, and to “ require the issuer to take reasonable steps to verify the purchasers of the securities are accredited investors, using such methods as determined by the [SEC].” The SEC issued proposed rules were issued on August 29, 2013. (Securities Act Release No. 33-9354). The proposed rules essentially follow the statutory wording, and when enacted will open Rule 506 offerings to accredited investors to advertising and general solicitation. The Release also provides considerable guidance for determining what actions constitute reasonable steps to verify the purchasers of the securities are accredited investors under a variety of circumstances. Final rules were adopted on July 10, 2013, and become effective on September 23, 2013. The final rules are discussed in detail in a separate article on general solicitation and general advertising in private placements to accredited investors under Rule 506 of Regulation D.
3. Information Requirements
If an issuer sells any securities under Rule 505 and 506 to any purchaser that is not an accredited investor, the issuer must furnish the information specified in Rule 502(b) of Regulation D. There is no required disclosure for offerings under Rule 504 or for a sale to any accredited investor.
The type of information that must be furnished depends on several factors. In this article, I will focus on offerings made by domestic (U.S.) private issuers. The disclosures for public companies are based on their filed disclosure documents, and are detailed in Rule 502(b).
Disclosure of Non-Financial Information
For private issuers, at a reasonable time prior to the sale of securities the issuer must furnish to the purchaser, to the extent material to an understanding of the issuer, its business and the securities being offered both financial and non-financial information. If the issuer is eligible to use Regulation A, it must provide the same kind of information as would be required in Part II of Form 1-A. If the issuer is not eligible to use Regulation A, it must provide the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the issuer would be entitled to use.
Disclosure of Financial Information
Offerings up to $2,000,000. The information that must be provided is that required in Article 8 of Regulation S-X, except that only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.
Offerings up to $7,500,000. The financial statement information that must be provided is that required in Form S-1 for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.
Offerings over $7,500,000. The financial statement information that must be provided is that which would be required in a registration statement filed under the Securities Act on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.
In addition, at a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under Rule 505 or Rule 506, the issuer shall furnish to the purchaser a brief description in writing of any material written information concerning the offering that has been provided by the issuer to any accredited investor but not previously delivered to such unaccredited purchaser. The issuer shall furnish any portion or all of this information to the purchaser, upon his written request a reasonable time prior to his purchase.
The issuer shall also make available to each purchaser at a reasonable time prior to his purchase of securities in a transaction under Rule 505 or Rule 506the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of information furnished.
At a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under Rule 505 or Rule 506, the issuer shall advise the purchaser of the limitations on resale in the manner discussed above.
4. Resale Restrictions
Except for qualifying Rule 504 offerings that are registered at the state level, securities acquired in a transaction under Regulation D “have the status of securities acquired in a transaction under section 4(2) of the [Securities] Act and cannot be resold without registration under the Act or an exemption therefrom.” Since Section 4(2) is only available to issuers, another exemption must be sought if a purchaser of securities that were not registered with the SEC (known as “restricted securities”) wishes to resell them. The obvious exemption is Section 4(1) of the Securities Act, which exempts “transactions by any person other than an issuer, underwriter, or dealer.” The reseller of restricted securities is usually not the issuer or a dealer; however, the case of an “underwriter” is more difficult.
An underwriter is defined in Section 2(11) of the Securities Act to include “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking . . . .” The SEC has issued no-action letters in a variety of contexts that in effect apply many of the requirements for private placements under Section 4(2) to resales of securities under Section 4(1); this is often informally known as the Section 4(1½) exemption. Some of these are now codified in Rule 502(d) of Regulation D, which requires the issuer to exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of Section 2(11). This reasonable care may be demonstrated by the following:
(1) Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons;
(2) Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and
(3) Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities.
While taking these actions will establish the requisite reasonable care, it is not the exclusive method to demonstrate such care. Other actions by the issuer may satisfy this provision. In addition, the issuer is required to deliver to non-accredited investors in a Rule 505 or 506 offering written disclosure of the limitations on resale to investors.
5. Rule 504: Limited Offerings of up to $1 Million
Rule 504 was adopted under Section 3(b) of the Securities Act, which exempts certain offerings of less than $5 million under regulations adopted by the SEC. Because it was not adopted under the private placement exemption under Section 4(2), which exempts offerings by an issuer not involving a public offering, securities offerings under Rule 504 are usually referred to a “limited offerings” rather than “private placements.”
Rule 504 is not available to (1) public companies, (2) investment companies, or (3) blank-check companies. Public companies are those whose securities are registered under the U.S. Securities Exchange Act of 1934 (Exchange Act), and include companies with a class of securities trade on a U.S. stock exchange, Nasdaq and the “pink sheets” and similar over-the counter markets for public securities. Investment companies include mutual funds, closed funds and other similar entities, which generally must register under the U.S. Investment Company Act of 1940. A blank-check company is a development stage company that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person.
Aggregate Offering Price: May Not Exceed $1 Million
The aggregate offering price for an offering of securities under Rule 504 may not exceed $1,000,000, less the aggregate offering price for all securities (1) sold within the twelve months before the start of and during the offering of securities under Rule 504, (2) in reliance on any exemption under section 3(b), including Rule 505, or (c) in violation of section 5(a) of the Securities Act.
Number and Qualification of Purchasers
There is no limitation on the number of purchasers that may participate in a Rule 504 limited offering. There is no requirement of business knowledge or sophistication imposed on purchasers.
Interestingly, unlike the case for Rules 505 and 506, in a Rule 504 limited offering, there is no specified level of information disclosure that the issuer must provide to non-accredited investors. While many Rule 504 offerings are registered at the state level, and therefore must comply with the state’s disclosure regulations and, often a review by the state’s securities regulatory body, for those that are not there is no disclosure protection for investors other than the general antifraud provisions of the Federal securities laws. As a matter of policy, this does not make much sense, as investors in smaller companies arguably require as much disclosure as do investors in larger offerings.
Manner of Offering and Resale Restrictions
Rules 505 and 506 contain limitations on advertising and general solicitation, and the securities issued are restricted securities subject to resale restrictions. These provisions apply to Rule 504 limited offerings as well, unless the offering is made:
(i) Exclusively in one or more states that provide for the registration of the securities, and require the public filing and delivery to investors of a substantive disclosure document before sale, and are made in accordance with those state provisions;
(ii) In one or more states that have no provision for the registration of the securities or the public filing or delivery of a disclosure document before sale, if the securities have been registered in at least one state that provides for such registration, public filing and delivery before sale, offers and sales are made in that state in accordance with such provisions, and the disclosure document is delivered before sale to all purchasers (including those in the states that have no such procedure); or
(iii) Exclusively according to state law exemptions from registration that permit general solicitation and general advertising so long as sales are made only to accredited investors.
Thus, there are really two types of Rule 504 offerings: (1) those that are registered at the state level, and are not subject to resale restrictions and the information disclosure requirements of Regulation D, and (2) those that are true private placements under Regulation D. a number of states have adopted uniform registration procedures, known as SCOR filings, to facilitate multi-state Rule 504 offerings.
It should be noted that before 1999, Rule 504 offerings were exempt from the resale restrictions even if not registered at the state level. This permitted issuers to issue up to $1 million of securities that could trade in the open market on the “pink sheets.” These were usually penny stocks, and were subject to abuse. In order to close down these practices, the SEC tightened the rule in 1999 to provide that stock issued under Rule 504 was restricted and thus can not trade in the open market, unless the offering were registered at the state level. (Securities Act Release No. 33-7644.)
6. Rule 505: Limited Offerings of up to $5 Million
Like Rule 504, Rule 505 was adopted under Section 3(b) of the Securities Act, which exempts certain offerings of less than $5 million under regulations adopted by the SEC.
Rule 505 is available to any issuer, public or private, other than an investment company (i.e., a registered mutual fund or other entity governed by the Investment Company Act of 1940).
Rule 504 also incorporates the so-called “bad-boy” disqualifications of Rule 262 of Regulation D. These make the Rule inapplicable to issuers who have been subject to various types of court orders, administrative orders and similar matters involving securities issuances and related matters. Issuers who have any officer, director, general partner or 10% shareholder that has been convicted of certain offences or administrative proceedings involving securities transactions, fraud and the like are also disqualified.
Aggregate Offering Price: May Not Exceed $5 Million
The aggregate offering price for an offering of securities under Rule 505 shall not exceed $5,000,000, less the aggregate offering price for all securities sold within the twelve months before the start of and during the offering of securities under Rule 505 in reliance on any exemption under Section 3(b) of Securities the Act or in violation of Section 5(a) of the Securities Act. Other Section 3(b) offerings would include those made under Rule 504 and Regulation A.
Number and Qualification of Purchasers
Rule 505 offerings are limited to no more than 35 non-accredited investors. There is no requirement of business knowledge or sophistication imposed on purchasers.
Manner of Offering and Resale Restrictions
No general advertising or general solicitation is permitted in Rule 505 offerings. Securities sold are restricted securities, subject to the resale restrictions discussed above.
7. Rule 506: Private Placements with no Dollar Limitation
Rule 506 was adopted under Section 4(2) of the Securities Act, which exempts offerings by an issuer not involving a public offering. Thus, unlike Rules 504 and 505, it is a true private placements exemption.
There is no restriction on the type of issuer that may rely on Rule 506.
Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act required the SEC to adopt rules that disqualify securities offerings involving certain felons and other bad actors from reliance on Rule 506. In Securities Act Release No. 33-9211 (May 25, 2011), the SEC proposed implementing amendments to Rule 506. The list of disqualifying matters is similar to but not exactly the same as that applicable to Rule 505 and Regulation A offerings.
No Limitation on Aggregate Offering Price
Unlike Rules 504 and 505, there is no limitation on the aggregate offering price. Thus Rule 506 is the most flexible of the Regulation D exemptions.
Number and Qualification of Purchasers
Rule 506 offerings are limited to no more than 35 non-accredited investors.
Unlike the case with Rule 504 and Rule 505 offerings, in a Rule 506 offering, each purchaser who is not an accredited investor either alone or with his purchaser representative(s) must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.
A purchaser representative must be unaffiliated with the issuer and its officers, directors and 10% shareholders, and meet the following additional criteria:
(a) The purchaser representative must have such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment;
(b) The purchaser representative must be acknowledged by the purchaser in writing, during the course of the transaction, to be his purchaser representative in connection with evaluating the merits and risks of the prospective investment; and
b) The purchaser representative must disclose to the purchaser in writing a reasonable time prior to the sale of securities to that purchaser any material relationship between himself or his affiliates and the issuer or its affiliates that then exists, that is mutually understood to be contemplated, or that has existed at any time during the previous two years, and any compensation received or to be received as a result of such relationship.
Manner of Offering and Resale Restrictions
As discussed above, Rule 506 offerings to accredited investors are now permitted to be made using general advertising and general solicitation. As I discuss in a separate article, on July 10, 2013, the SEC adopted final rule changes permitting general solicitation in Rule 506 offerings solely to accredited investors, which become effective on September 30. Among other things, the rules require the pre-filing of solicitation materials with the SEC.
Rule 506 offerings that include non-accredited investors continue to be prohibited from making use of general advertising and general solicitation.
8. Filing of Form D
An issuer relying on a Regulation D exemption must file a form D with the SEC within 15 days of the first sale. Rule 503 details requirements for amending Forms D and related matters.
Under Rule 507, no exemption under Rules 504, 505 or 506 is available for an issuer if such issuer, any of its predecessors or affiliates have been subject to any order, judgment, or decree of any court of competent jurisdiction temporarily, preliminary or permanently enjoining such person for failure to comply with the filing requirements of Rule 503, unless the SEC determines, upon a showing of good cause, that it is not necessary under the circumstances that the exemption be denied.
9. Insignificant Deviations From a Term, Condition or Requirement of Regulation D
Rule 508 provides that the Regulation D exemptions will not be lost for insignificant deviations from a term, condition or requirement of Regulation D made in good faith or otherwise as detailed in the Rule.