Under the federal securities laws a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. A securities offering exempt from registration with the SEC is sometimes referred to as a private placement or an unregistered offering. Exempt private placements are done in reliance upon Sections 3(b) or 4(2) of the 1933 Act as constructed or under Regulation D as promulgated by the SEC, or both. Section 4(a)(2) of the Securities Act, sometimes referred to as the “private placement” exemption, exempts from registration transactions by an issuer involving sophisticated investors. Additionally, Regulation A+ and Regulation Crowdfunding ,although are allowed to be publicly advertised, are also considered private placements as they both are exempt from registering with the SEC for publicly advertised offers. However, this blog will focus solely on private placements under Regulation D, including those that fall under Section 3(b) and Section 4(b) of the Securities Act of 1933.
Generally speaking, private placements are not subject to some of the laws and regulations designed to protect investors, such as disclosure requirements that apply to registered offerings. Issuers often provide a document called a private placement memorandum or offering memorandum that introduces the investment and discloses information about the securities offering and the issuer. A private placement memorandum complies with securities laws outlined by the SEC. However, the rules under Regulation D do not require a private placement memorandum. Private placement memorandums differ from a registration or offering statement in that registration statements filings with the SEC. All that is required under Regulation D of the filling of Form D no later than 15 days after the first sale of securities or an agreement to sell.
What is Regulation D, and How does it apply?
Regulation D includes SEC rules—Rules 504 and 506—often relied upon to sell securities in unregistered offerings. The entity selling the securities is commonly referred to as the issuer. Each rule has specific requirements that the issues must meet. Rules 501-503 set forth definitions, terms, and conditions that generally apply throughout the Regulation. Specific exemptions are set out in Rules 504-506. Purchasers in a private placement offering receive “restricted securities.” Restricted securities are generally acquired in unregistered, private offerings. In a private placement offering, purchasers should not expect to easily and quickly resell their restricted securities.
Rule 504 of Regulation D exempts from registration the offer and sale of up to $10 million of securities in a 12-month period. Prior to this recent change, issuers conducting a Rule 504 offering from 2017-2021 could only raise up to $5 million and only up to $1 million back in 2015. A company undergoing an exempt Rule 504 offering today is still required to file a notice with the SEC on Form D within 15 days after the sale of securities in the offering. Form D will include brief information about the issuer, its management and promoters, and the offering itself. In addition, a company must comply with state securities laws and regulations in the states in which securities are offered or sold. In general, issuers relying on Rule 504 may not use general solicitation or advertising to market the securities and purchasers will receive restricted securities.
Rule 506(b) provides objective standards that a company can rely on to meet the exemption requirement. Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(b), the states still have authority to require notice filings and collect state fees.
Under Rule 506(b), issuers may not use general solicitation or advertising to market the securities. A company may sell its securities pursuant to Rule 506(b) to an unlimited number of accredited investors. (See our previous blog on The Accredited Investor Standard). However, issuers may not sell securities to more than 35 non-accredited investors. All nonaccredited investors must be sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment. In Securities and Exchange Commission v. Ralston Purina Co., the Court required that all persons to whom offers are made have the requisite financial sophistication (or be advised by one who has such sophistication) persons have access to the kind of information contained in a registration statement. As defined by case law, this sophistication requirement may be satisfied by having a purchaser representative for the investor who satisfies the criteria. An investor engaging a purchaser representative should pay particular attention to any conflicts of interest the representative may have.
Under the current accredited investor definition, individuals are accredited investors if their income exceeds $200,000 in each of the two most recent years (or $300,000 in joint income with a person’s spouse) and that individual reasonably expects to reach the same income level in the current year. All that is required for verifying “accredited investor” status is a review of financial information such as bank statements or a written verification from the investor’s attorney, accountant or financial advisor, or broker.
Under Rule 506(b) – financial sophistication is presumed with accredited investors but must be shown, or at least the issuer must “reasonably believe ” that each non accredited investor, either alone or with a “purchaser representative, “has such knowledge or experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment. A purchaser representative is defined as any person who meets, or who the issuer reasonably believes, has such knowledge and experience in financial and business matters that they can evaluate the merits and risks of the prospective investment.
The availability of the Rule 506(b) exemption is conditioned upon the disclosure of specified information to nonaccredited purchasers. The relevant disclosure provision governing issuances is Rule 502(b)(2). Rule 502(b)(2) requires that issuers provide both financial and non-financial information. Companies must disclose financial business information via the financial statements of the business. The extent of disclosure, which can be extremely detailed, depends on the size of the offering. Non-financial information 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. It is important to note that the information disclosure or delivery requirements outlined in Rule 502(b) are only applicable to offerings under certain exemptions, such as offerings to non-accredited investors 506 have to provide extensive information while offerings under Rule 504 do not. Offerings to accredited investors do not require furnishing this type of information under a Rule 506(b) offering.
Rule 506 (c)
Rule 506(c) permits issuers to solicit and generally advertise an offering broadly. General advertising may involve advertising through the Internet, social media, print, radio, or television. However, only accredited investors are allowed to purchase in a Rule 506(c) offering that is widely advertised. Issuers must also take reasonable steps to verify purchaser’s accredited investor status. In order to verify a purchasers’ accredited investor status, an issuer must obtain financial information such as bank statements or a written verification from the investor’s attorney, accountant or financial advisor, or broker. A company is also required to file a notice with the SEC on Form D within 15 days after the first sale of securities in the offering. Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(c), states still have the authority to require notice filings and collect state fees.
Private placements may be pitched as a unique opportunity being offered to select investors. However, private placements can be very risky. Thus, it is essential for an issuer to provide the necessary information that will help investors make informed investment decisions. In fact, issuers relying on Rules 506(c) and 506(b) must provide non-accredited investors an opportunity to ask questions and receive answers regarding the investment. Investors need to fully understand and fully appreciate the risks involved before taking on a private placement offering.
Despite not being subject to the same disclosure obligations as registered offerings, private placements are subject to the federal securities laws’ antifraud provisions. Any information provided must be accurate and may not omit any material facts to prevent any misrepresentation, which is a severe offense.
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*with edits by Elizabeth L. Carter, Esq., Managing Attorney