Under federal securities laws, a business 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 offering or an unregistered offering. Private placements generally include the following exemptions: (1) Section 4(a)(2) of the U.S. Securities Act of 1933 Act ("the 1933 Act"); and (2) Regulation D as promulgated by the SEC. Section 4(a)(2) exempts from registration transactions by an issuer involving sophisticated investors, which may include non-accredited investors. However, this blog will focus solely on private placements under Regulation D ("Reg D"), including those that fall under Section 3(b)(1) and Section 4(b) of the Securities Act of 1933.
Issuers of Reg D offers often provide a disclosure document called a private placement memorandum ("PPM") that introduces the investment and discloses material information about the securities offering and the issuer. A PPM should comply with both State and federal securities laws. Although good practice, a PPM is not required nor is it necessary to file such with the SEC. Instead, the SEC requires issuers of Reg D offers file disclosure form called Form D no later than 15 days after the first sale of securities or an agreement to sell. Form D requires brief information about the issuer, its management and promoters, and the offering itself. In addition to Form D, the SEC requires issuers to comply with Rule 10b-5 against fraud, misrepresentation, and omission. As such, an issuer of a Reg D offer should provide full disclosure to prospective investors in the form of a PPM or at least in the form of an exhibit to the offering that describes the particular risk factors of the offer.
What is Regulation D, and How does it apply?
Regulation D includes SEC rules—Rules 504 and 506—two exemptions 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 issuer must meet.
Rule 504 of Regulation D exempts from registration the offer and sale of securities up to $10 million in a 12-month period. Prior to this recent change in March 2021, issuers conducting a Rule 504 offer from 2017-2021 could only raise up to $5 million and only up to $1 million back in 2015.
By default, issuers relying on Rule 504 may not generally solicit or advertise the offer, and purchasers of this offer may not resell their shares or interests for a period of one year, unless one of the following are satisfied:
1. the issuer offers and sells the securities exclusively in one or more States that require registration, public filing and delivery to investors of a substantive disclosure document before sale (like a PPM);
2. the issuer offers and sells the securities in one or more States that do not require registration, public filing and delivery of a disclosure document before sale, so long as: (A) the securities have been registered in at least one other State that provides for such registration, public filing and delivery before sale; (B) the issuer offers and sells securities in that other State; and (C) the issuer delivers the disclosure documents to all purchasers in that State(s); or
3. the issuer offers and sells the securities exclusively in a State according to an exemption in such State that permits general solicitation and advertising, so long as sales are made only to accredited investors.
Lastly, an issuer of a Rule 504 offer must also comply with State securities laws in every State in which its securities are offered or sold.
Under Rule 506(b), issuers may raise an unlimited amount of capital from investors but may not use general solicitation or public advertising to obtain these investors. In addition, issuers of Rule 506(b) may obtain an unlimited number accredited investors. An accredited investor is an individual whose income exceeds $200,000 in each of the two most recent years (or $300,000 in joint income with a person's spouse). The issuer is required to verify that the investor is in fact accredited. This can be done through a review of financial information such as bank statements or a written verification from the investor’s attorney, accountant or financial advisor, or broker. Issuers of Rule 506(b) offers are able to sell to non-accredited investors, but no more than 35. In addition, these non-accredited investors must be financially sophisticated.
Financial sophistication is defined as having knowledge and experience in financial and business matters sufficient for properly evaluating the merits and risks of the offering. 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) akin to the information contained in a registration statement. Accredited investors are presumed to have financial sophistication. However, this presumption does not exist for non-accredited investors. Instead, an issuer must show that the non-accredited investors are sophisticated or otherwise have a purchaser representative who satisfies the "sophisticated investor" criteria or who the issuer reasonably believes satisfies this criteria. Lastly, the Rule 506(b) exemption preempts State securities laws. However, some States may still require these issuers to make notice filings and pay filing fees.
Rule 506 (c)
Rule 506(c) permits issuers to generally solicit and publicly advertise an unlimited amount of money from investors and publicly advertise more broadly. Under this rule, public advertising may include advertising through the Internet, social media, print, radio, or television. However, only accredited investors are allowed to purchase securities offered through a Rule 506(c) offering. Issuers of a Rule 506(c) offer must also take reasonable steps to verify that purchasers are accredited. This includes obtaining financial information such as bank statements or written verification from the investor’s attorney, accountant, financial advisor, or broker confirming such status. Like Rule 504, an issuer of Rule 506(c) is also required to file a notice with the SEC on Form D within 15 days after the first sale of securities. However, unlike Rule 504 offers, Rule 506(c) offers are not required to comply with State securities laws. Notwithstanding this preemption, issuers of Rule 506(c) offers will still have to comply with State antifraud laws.
Although a PPM or some other mandated disclosure form is not required for Reg D offers, it is essential for issuers of Reg D offers to provide investors with all necessary information in order for them to make informed investment decisions. In fact, issuers relying on Rules 506(c) and 506(b) are actually required to provide non-accredited investors an opportunity to ask questions regarding the investment. Furthermore, any information provided to prospective investors must be accurate and an issuer must not omit any material facts regarding the offer. Otherwise, the issuer risk a claim of fraud or misrepresentation by the SEC.
In conclusion, Reg D offers provides an unique opportunity for issuers to obtain investors for the launch and growth of their businesses. However, Reg D offers can be risky if not done properly. It is therefore important that an issuer of a prospective Reg D offer consult with a securities attorney prior to launching the offer. Schedule your consultation with us today!
*co-authored by Elizabeth L. Carter, Esq., Managing Attorney