Readers may recall generally that the federal securities laws make it unlawful to sell securities to investors absent either a registration with the SEC (Securities and Exchange Commission) or an exemption from registration.
A previous article considered the non-public offering exemption from federal registration as a viable approach towards raising money from a limited group of sophisticated investors. The basis of that exemption is found directly in the language of the Securities Act of 1933, hence its label as a statutory exemption.
In addition to statutory exemptions, the SEC is empowered to promulgate rules which further define and, in certain respects, create exemptions from registration. These are known as rule exemptions.
In 1982, the SEC promulgated an integrated series of rule exemptions for limited offerings of securities. These series of rules are cast under the collective rubric, Regulation D.
Since its inception, Regulation D has been generally heralded as a regulatory success story for the SEC. It has been touted as providing legal certainty in areas where it previously had been non-existent. This oft-cited benefit has enhanced the capital formation capabilities of small businesses.
Regulation D is a collection of eight separate rules providing so-called "safe harbor" protection. If an issuer satisfactorily demonstrates that it has substantially complied with the requirements of Regulation D, the SEC and disgruntled investors are presumptively prevented from asserting a registration violation.
This additional legal comfort is one of the most compelling reasons why, whenever possible, private issuers should attempt to satisfy the requirements of Regulation D. The price for this comfort is not cheap. Regulation D contains numerous stringent conditions, limitations and requirements. A brief summary follows.
Three of the eight rules comprising Regulation D set forth offering alternatives. These offering alternatives vary in terms of dollar size, disclosure requirements, the number and nature of permitted investors and the manner in which investors can be solicited. The remaining five rules in Regulation D set forth definitions and other terms and conditions of general application.
The first offering alternative, Rule 504, exempts offerings which do not exceed $1 Million during any 12 month period.
Prior to the SEC's adoption of its small business initiatives, offerings under Rule 504 were subject to the general terms and conditions applicable to all Regulation D offerings, i.e., securities were subject to restrictions on transferability and could not be offered or sold by means of general solicitation or advertisement. These restrictions were removed by the SEC in August, 1992.
The result is that companies are permitted under federal law to conduct a limited public offering up to $1 Million without limitation on the number or nature of investors or the requirement to deliver a prescribed disclosure document. However, state securities laws may curtail certain aspects of these types of offerings.
The next offering alternative, Rule 505, covers offerings not exceeding $5 Million during any twelve month period.
Unlike the Rule 504 exemption, there can be no more than thirty-five "non-accredited investors" purchasing the offered securities. An "accredited investor" is defined to include virtually every type of institution that typically participates in the private placement market as well as wealthy individual investors.
In particular, individual investors with a net worth exceeding $1 Million or with individual incomes in excess of $200,000 in each of the two most recent years (or joint income with that person's spouse in excess of $300,000 in each of those years) will be deemed "accredited" and thus counted towards the thirty-five "non-accredited investor" maximum. Stated differently, a company relying on Rule 505 can sell to an unlimited number of accredited investors and a maximum of thirty-five non-accredited investors. Rule 505 requires the delivery of a disclosure document to investors, the contents of which are detailed in the rule.
The final offering alternative under Regulation D is Rule 506, which exempts offerings without any limitation on the dollar amount of securities which can be sold.
The requirements of the Rule 506 exemption are substantially identical to Rule 505., including the thirty-five "non-accredited investor" limitation. The principal difference between the two rules is an additional requirement that Rule 506 "non-accredited investors" must also have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the proposed investment. This "sophistication" requirement together with the slightly more comprehensive disclosure requirements are the distinguishing features of Rule 506.
In sum, small businesses should find ample incentive to rely on Regulation D to offer their securities to private investors. By affording "safe harbor" protection, Regulation D offers an important, highly utilitarian avenue for private capital formation. Although the requirements for demonstrating substantial compliance with Regulation D may seem rigorous, it is a relatively small price to pay for the legal protection afforded by the regulation.