We previous considered the nonpublic offering exemption from federal registration. The focus of this article is on another type of offering that can be accomplished without registration under the federal securities laws (and thus in a less costly manner by small companies) -- the intrastate offering.
This exemption, although technically falling under what the federal securities laws consider an "exempt security" (as opposed to an exempt transaction), is really enabled by virtue of the geographic limitations of the offering.
The theory underlying the exemption is simple -- the federal government takes no regulatory interest (except under its antifraud rules) in offerings which are inherently local in nature. In other words, the SEC yields to state regulators to police this type of offering. No filing need be made with the SEC and the contents of any disclosure document will not be directly regulated by the SEC.
More particularly, Section 3(a)(11) of the Securities Act of 1933 exempts an offering involving "any security which is part of an issue offered and sold only to persons resident within a single state... where the issuer of such securities is... a corporation incorporated by and doing business within such state".
Thus, the criteria for the intrastate exemption are threefold -- (1) all offers and sales to investors must be made only to bona fide residents of a single state, (2) the state where offers and sales are made must be the state in which the company was organized, and (3) the company making the offering must be "doing business" within that state.
The elements of the intrastate exemption are seemingly few and straight forward; however, as is the case with most securities regulation, subtle nuances abound. For example, the "doing business" requirement mandates that the company have its principal place of business (e.g., headquarters) in the state in which the offering is conducted and that the company apply most of the offering proceeds within that state. This "doing business" requirement also mandates that certain numerical standards be satisfied if the company generates significant operating revenues out-of-state.
It is important to note that a single offer or sale to a non-resident will defeat the availability of the exemption. Therefore, a company which is unsure of whether it wishes to conduct a private placement across state lines may not "test the waters" by making offers to non-residents and thereafter switch to the intrastate offering exemption.
The availability of the exemption may be lost under certain circumstances if securities offered on an intrastate basis are resold to non-residents. In other words, the federal securities laws require that the intrastate-offered securities "come to rest" in the hands of residents.
Due to the amorphous nature of what constitutes "coming to rest", the SEC promulgated a safe harbor rule which allows the company to assume that its securities have "come to rest" if no resales occur within nine months of the last sale made in reliance on this exemption. Any subscription documentation related to the intrastate offering should prohibit the resale or transfer of securities to non-residents for a period of nine months after the offering closes.
The small businessman conducting an intrastate offering should not forget that the antifraud provisions of the federal securities laws still apply. As a result, extreme caution should be taken to ensure that investors are not misled in any verbal or written communication concerning the affairs of the company or the attributes and risks of the investment.
Due to the absence of direct federal regulation, a state's interest in this type of offering becomes paramount. Thus, the company must independently analyze whether an exemption from registration is available on the state level or whether registration with state authorities will be necessary.
The requirements for exemption and registration vary among the states. State antifraud provisions, on the other hand, generally conform to the federal regulatory scheme. The specific requirements under Michigan law will be discussed in a forthcoming article.
Although there are no limitations on the amount of capital which can be raised or the number of investors which may invest strictly in reliance upon this federal exemption, most state regulations will impose these limitations. From a practical standpoint, the greater the number of investors, the greater the risk that securities may "come to rest" or be transferred out-of-state -- thereby destroying the exemption.
The company has the burden of complying with the exemption's requirements -- not the individual investor. If the elements of the exemption are not satisfied, the company may become subject to civil liability or may be required to return invested money. To minimize the significant risk of destroying the availability of the intrastate offering exemption, offering documentation should be carefully drafted by the company, with the assistance of an experienced attorney.
In summary, an intrastate offering may be attractive to small businesses and entrepreneurs in view of the cost savings associated with avoiding direct federal regulation. Moreover, if the company's products and business have local appeal, investors may be more inclined to invest in the offering. Clearly, if entrepreneurs don't have the resources or contacts to conduct a successful out-of-state offering, the intrastate offering exemption may be the preferable alternative.