|The first question is always, "what is a security"? Sometimes it's
intuitive based upon your experience, such as stock in a corporation, sometimes
it is not so intuitive, such as selling interests in an orange grove.
In almost every instance, the
sale of common stock, preferred stock, debentures, or limited partnership
interests involves the sale of securities. The significance of an interest
being deemed a security is that comprehensive federal and state regulatory
provisions become applicable to the offer and sale of the security unless
exemptions from the registration requirements of applicable laws are available.
Registration of the sale of a
security with the Securities and Exchange Commission (the "SEC")
is an expensive and time-consuming process. Therefore, an exemption from
registration is often critical, especially for start-up and emerging companies.
Two of the most important exemptions from the registration requirements of the
federal securities laws are the private placement exemption contained in
Section 4(2) of the Securities Act of 1933, as amended (the "Act") and the safe
harbor thereunder provided by Rule 506 of Regulation D. This memorandum
discusses the Rule 506 exemption and the procedural steps advisable in
attempting to perfect the exemption.
Section 4(2) of the Act exempts
from the registration requirements of Section 5 of the Act "transactions by an
issuer not involving any public offering." This section usually is referred to
as the private placement exemption, but the statute does not define what
constitutes a non-public offering. The SEC and the courts have interpreted the
exemption to be available for offerings involving sophisticated offerees and
purchasers who have access to or are provided the same kind of information that
a registered offering would provide, who are able to "fend for themselves" as
knowledgeable investors, and where the offerings are conducted in a non-public
manner. Section 4(2) also provides that the sophistication level of both
the offerees and the purchasers are important in determining the availability of
Because of the great
uncertainty in determining when the private placement exemption was available
under Section 4(2), the SEC adopted Rule 506, which provides a "safe harbor"
under Section 4(2). Section 4(2) is sometimes used when an offering is made to
a small number of sophisticated investors. However, most issuers attempt to
employ the Rule 506 exemption, and use the Section 4(2) exemption as a back-up
in the event one of the conditions of the rule is not met.
The issuer attempting to invoke
the exemption has the burden of proving its applicability. The failure to
satisfy even one element could destroy the availability of the exemption for the
entire offering and could result in rescission n of the offering at the election
of the investors, even one unaffected by the rule violation. In 1989, the SEC
adopted Rule 508 which allows for the availability of the exemption despite
failure to comply with a requirement of Regulation D if the requirement is not
designed to protect specifically the complaining person, the failure to comply
is insignificant to the offering as a whole and there has been a good faith and
reasonable attempt to comply with all the requirements. The failure to comply,
however, would still be actionable by the SEC under the Act. Further, it is
important to note that an exemption from registration does not exempt the offer
or sale of the securities from the anti-fraud provisions of the securities laws,
which require the disclosure of material information so that an investor may
make an informed investment decision.
The key elements of Rule 506
are discussed below, but are qualified in their entirety by reference to the
complete Rule attached hereto.
What Limitations Exist on the
Manner of the Offering?
Neither the issuer of the
securities nor any person acting on its behalf can offer or sell the securities
by any form of general solicitation or advertising. Such exclusion
includes, but is not limited to, any advertisement, article, press release, mass
mailing, notice or other communication published in a newspaper, magazine, or
similar media or broadcast over television or radio. Realistically, this
provision requires that the issuer control the number and kind of offerees so as
to show that no general solicitation occurred. Practical steps include a
determination that (a) the prospective investor is an "accredited investor," or
otherwise meets the standards established by the issuer and (b) investment in
the securities would be suitable investment for the prospective investor.
Ideally, each prospective investor should have a pre-existing relationship with
the issuer, its officers, directors, or affiliates of sufficient contact to
Any questions concerning what
might constitute general advertising or general solicitation should be discussed
How Many Offerees and
Purchasers May there Be?
Rule 506 places no limitation
on the number of persons to which the issuer may offer the securities.
However, offers to significant number of persons may be deemed a prohibited
general solicitation. Rule 506 does restrict the number of purchasers. The
issuer must reasonably believe that no more than 35 "sophisticated" investors
(as discussed in more detail below), plus a theoretically unlimited
number of "accredited investors," become purchasers. However, some transactions
are structured for sale only to accredited investors as certain
additional protections from potential liability are obtained thereby.
Who Is An "Accredited
investor" means any person who comes within any of the following categories or
who the issuer reasonably believes comes within any of the following categories
at the time of the sale of the securities to that person:
(a) Any bank, savings
and loan institution, or other institution as defined in Section 3(a)(5)(A) of
the Act, whether acting in its individual or fiduciary capacity;
(b) Any broker or dealer
registered pursuant to Section 15 of the Securities Exchange Act of 1934;
(c) Any insurance
company as defined in Section 2(13) of the Act;
(d) Any investment
company registered under the Investment Company Act of 1940, or a business
development company as defined in Section 2(a)(48) of that Act;
(e) Any Small Business
Investment Company licensed by the U.S. Small Business Administration under
Section 301(c) or (d) of the Small Business Investment Act of 1958;
(f) Any plan
established and maintained by a state, its political subdivisions, or any
instrumentality of a state or its political subdivisions, for the benefit of its
employees, if the plan has total assets in excess of $5,000,000; and
(g) Employee benefit
plans within the meaning of Title I of ERISA, if the investment decision is made
by a plan fiduciary, as defined in Section 3(21) of ERISA, which is either a
bank, insurance company, or registered investment advisor, or if the employee
benefit plan has total assets in excess of $5,000,000, or, if a self-directed
plan, with investment decisions made solely by persons that are accredited
Any private business
development company as defined in Section 202(a)(22) of the Investment Advisers
Act of 1940.
Total Assets in Excess of 5,000,000.
Any organization described in
Section 501(c)(3) of the Internal Revenue Code (dealing with tax-exempt
organizations), any corporation, Massachusetts or similar business trust, or
partnership not formed for the specific purpose of acquiring the securities
offered, with total assets in excess of $5,000,000. Any corporation, whether
public or privately held, will be accredited under this section if it has total
assets (not net worth) in excess of $5,000,000.
Executive Officers, and General Partners. Any director, executive officer, or general partner of the
issuer of the securities being offered or sold, or any director, executive
officer, or general partner of a general partner of that issuer.
Any natural person whose individual net worth or joint net worth with that
person's spouse, at the time of purchase exceeds $1,000,000. Net worth of a
spouse may be included even when the property is held solely by that spouse.
Partnerships, corporations or other entities may not take advantage of this
category. Note that person's primary residence is deducted from the
$1,000,000 net worth.
Any natural person who had an individual income 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 and who reasonably expects
at least the same income level in the year of purchase.
Trusts. Any trust
with total assets in excess of $5,000,000 not formed for the specific purpose of
acquiring the securities offered whose purchase is directed by a sophisticated
Made Up of Accredited Investors. Any entity in which all of the equity
owners are accredited investors.
The SEC staff, in Release No.
33-6455 (Mar. 10, 1983), has issued a number of interpretations as to whether a
person may fall into one of the accredited investor categories discussed above.
This release is available upon request
Who Is Excluded From the
Certain purchasers are excluded
from the 35-purchaser limitation contained in Rule 506, as follows:
(2) Non-United States
citizens and residents;
(3) Any relative,
spouse, or relative of the spouse of a purchaser who has the same principal
residence as the purchaser;
(4) Any trust or estate
in which a purchaser and any of the persons related to him as specified in (3)
above or (5) below collectively have more than 50% of the beneficial interest
(excluding contingent interests); and
(5) Any corporation or
entity of which a purchaser and any of the persons related to him under (3) or
(4) above are beneficial owners of more than 50% of the equity interests.
For the purposes of counting
purchasers, each corporation, partnership, or other entity is generally counted
as one purchaser (unless such entity was organized for the specific purpose of
acquiring the securities and is not an accredited investor under 501(a)(8)
above, and then each beneficial owner of an equity interest in the entity is
counted as a separate purchaser).
What Information Must Be
If securities are sold to any
nonaccredited investors, certain information must be delivered to all
purchasers. Although the specifics of such disclosure are outside the scope of
this memorandum, the issuer should often attempt to prepare a Private Placement
Memorandum containing substantially the same information as would be required in
a registration statement filed with the SEC. The Private Placement Memorandum
is intended to inform prospective investors of all material facts and rules
associated with the investment.
State and federal securities
laws require the issuer to provide the purchasers with full, fair and complete
disclosure of all "material" facts about the offering and the issuer, its
management, business, operations, finances, and most importantly, the risks
associated with the same. Information is deemed "material" if a reasonable
investor would consider the information important in making an investment
decision. Omissions, even inadvertent, of material facts can lead to liability.
Lastly, all purchasers must be
given the opportunity to ask questions and receive answers about the offering
and to obtain information reasonably obtainable by the issuer to verify the
information furnished. Private Placement Memorandums frequently contain legends
covering the latter point.
Offers generally should be made
only by a Private Placement Memorandum and only after the procedures set
forth in this memorandum have been satisfied. Generally, the issuer or its
agents should not furnish in connection with the offering (whether for review in
the office, review by the offeree's advisors, or otherwise): (a) any written
information (such as additional projections, analyses, or other reports or
documents) relating to the issuer or its operations other than what is contained
in the Private Placement Memorandum or (b) any information contrary to that
contained in the Private Placement Memorandum. If it is discovered that the
Private Placement Memorandum contains inaccurate information or there is a new
material information that should be disclosed, the issuer should immediately
amend the Private Placement Memorandum to reflect these changes and provide the
amendment to prospective investors.
What Sophistication Must the
The issuer must reasonably
believe immediately prior to making any sale that each purchaser (except for
accredited investors) either alone or with a purchaser representative has such
knowledge and experience in financial and business matters that the investor is
capable of evaluating the merits and risks of the prospective investment. Note,
however, that if all of the requirements of Rule 506 are not met and Section
4(2) is to be relied upon, the fact that offers were made only to sophisticated
offerees may be important.
How does the issuer determine
that a prospective purchaser is capable of evaluating the merits and risks of
the investment? A commonly used approach is to require that the prospective
investor complete a questionnaire that elicits responses concerning education,
investment background, net worth, investment experience, and other matters.
Only after review of the completed questionnaire and a determination that the
person qualifies is the person accepted as a purchaser. As a precautionary
measure, the questionnaire is sometimes included as part of the Subscription
Agreement and the answers from the prospective investor are stipulated to be
representations and warranties of said person. The Subscription Agreement can
also contain an appropriate indemnification agreement.
Since the burden of proof is on
the issuer to show that the exemption was available, detailed records should be
kept of the manner of solicitation, the process of accepting purchasers, and the
disclosure of information to offerees. See "What Back-Up Documents Should be
When Should a Purchaser
Representative Be Employed?
As noted above, Rule 506
requires the issuer to reasonably believe that each purchaser who is not an
accredited investor either alone or with his purchaser representative has such
knowledge and experience in financial and business matters that he is capable of
evaluating the merits and risks of the prospective investment. In instances
where it is uncertain whether the prospective investor meets this sophistication
level, it will be advisable that a purchaser representative be used who meets
the requirements of Rule 506. Certain special rules and requirements are
imposed when purchaser representatives are used.
Under the California private
placement exemption of Section 25102(f) of the Corporations Code, the purchaser
representative must be unaffiliated with and not be compensated by the issuer or
any affiliate or selling agent of the issuer, directly of indirectly.
What Are the Limitations on
Resale of the Securities?
Securities acquired in a
transaction under Rule 506 must be acquired for investment purposes and may not
be resold for an indefinite period, which for persons not closely associated
with the issuer is generally not less than two years. These securities will be
deemed restricted, and cannot be resold without registration under the Act or an
exemption therefrom. The issuer must exercise reasonable care to assure that
the purchasers of the securities do not intend to immediately redistribute the
securities acquired. Such reasonable care includes, but is not limited to, an
inquiry as to whether the purchaser is acquiring the securities for his or her
own account; written disclosure to each purchaser prior to the 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 is available;
and the placement of a legend on any certificate or document that evidences the
security stating that the security has not been registered under the Act and
setting forth the restriction on transferability and sale of the securities.
In order to comply with such
standards, the issuer will typically discuss such matters in the Private
Placement Memorandum and may include a legend to the effect that the securities
were acquired pursuant to an exemption from registration under the Act.
Furthermore, a covenant from the purchaser that the securities will not be sold
in violation of the Act's registration requirements, and an acknowledgment of
the transferability limitations, is usually contained in the Subscription
What SEC Filings Are Necessary?
The issuer should file with the
SEC five copies of a notice on Form D no later than 15 days after the first sale
of securities in a Regulation D offering, although the failure to file the Form
D on time may not affect the availability of the exemption. A notice is deemed
filed with the SEC as of the date on which it is received by the SEC, or as of
the date on which the notice is mailed by means of United States registered or
certified mail to the SEC at its Office of Small Business Policy. One copy of
every notice must be manually signed by an authorized person of the issuer.
The SEC staff has noted that
the receipt of the first Subscription Agreement and the acceptance of
subscription funds into an escrow account pending receipt of minimum
subscriptions would trigger the filing requirements. In such instances, the
issuer should file its first Form D no later than 15 days after the receipt of
the first Subscription Agreement.
What Are the State Securities
An exemption from federal
registration pursuant to Rule 506 does not generally exempt offerings from the
qualification requirements of state securities laws (often referred to as "blue
sky laws"). The blue sky laws of every state where the securities are being
offered must be reviewed to determine the effect and applicability of such laws
on the transaction. State blue sky laws may have a different focus from the
requirements of the Act, which is primarily disclosure oriented.
Many blue sky statues provide a
statutory transactional exemption modeled in some manner on Section 4(2) or
portions of Regulation D. Variations in the state statutes include: (1)
limitations on the number of offerees within the state and/or total offerees;
(2) similar limitations on the number of purchasers within a 12-month period;
(3) affirmative filing requirements with the state securities administrator
before and/or after the offering; (4) possible limitations on commissions paid;
(5) merit review of the offering to determine if the offering is fair, just or
equitable, which may entail compliance with the regulations governing the
substantive terms of the offering; (6) limitations on the manner of the offering
and prohibitions on general solicitation and advertising; (7) requirements
concerning minimum amount of investment; and (8) use of state registered
broker-dealers in connection with the offering.
As an example, California
securities law imposes substantive requirements separate from federal law.
Section 25110 of the California Corporate Securities Laws makes it unlawful for
any person to offer or sell a security for the direct or indirect benefit of an
issuer in California, unless the offer and sale is qualified or is exempt from
qualification. However, California law provides a type of private offering
exemption codified in Section 25102(f) of the Corporations Code, and the
California Administrative Code provides regulations and interpretations of the
exemption. Although similar to Rule 506, Section 25102(f) does contain some
differences that should be reviewed in connection with a particular offering.
A notice of a transaction
relying on the Section 25102(f) exemption must be filed. The notice must be
filed with the California Commissioner of Corporations within 15 calendar days
after the completion of the transaction, or if the issuer has failed to file the
notice, within 15 business days after demand by the Commissioner. For the
purposes of the' California law, a transaction is completed when the issuer has
obtained the contractual commitments to purchase the securities or when it
terminates the offering, whichever first occurs. The federal Form D can be
filed to satisfy this filing requirement.
Persons or entities selling the
issuer's securities, and particularly where commissions or compensation is
received in connection therewith, may be required to register as "brokers,"
"dealers" or "agents" under federal or state securities laws.
However, if the issuer is going
to sell the stock without a broker-dealer then the issuer and related
individuals may fall within a federal exemption and avoid having to register as
"brokers," "dealers" or "agents." Directors and officers of the issuer may
qualify for an exemption from broker-dealer registration if they: (1) have not
relied on the issuer exemption in the preceding twelve months; (2) are not
subject to a "statutory disqualification;" (3) are not compensated (directly or
indirectly) by paying commissions or other compensation based on sales of the
securities; and (4) are not at the time of the sales of the securities, an
"associated person of a broker or dealer," nor were they "a broker or dealer, or
an associated person of the broker or dealer" within the prior twelve months,
all as defined under applicable SEC rules.
What Back-Up Documents Should
An issuer claiming an exemption
from the securities laws has the burden of proof in showing that the exemption
was in fact available. It is therefore important that a compliance program be
established so as to document the availability of the exemption, which will be
referred to herein as the "Burden of Proof" file. The purpose of the Burden of
Proof file is to have available supporting documentation in the event of any
litigation or regulatory enforcement inquiry. Issuers and promoters have been
subjected to liability for violation of the securities laws because they were
unable to sustain their burden of proof in court that the offering was in fact
conducted in a manner warranting an exemption. The properly maintained Burden
of Proof file (when the mandates of the exemption have been met) will help
insulate the promoters from violation of the registration requirements of the
The Burden of Proof file will
typically contain many documents in connection with the offering. Of primary
importance is a Control Sheet for Private Placement Memorandums (sample
attached). This form is designed to provide recordation of the distribution of
Private Placement Memorandums, and to show that offerings were only made to a
limited number of individuals who met the suitability standards established by
the issuer. This form should typically contain a numbered listing of all
Private Placement Memorandums issued, the names of the recipients and their
addresses, and the dates of transmittal to the recipients. Prior to delivery of
a Memorandum to a prospective investor, the prospective investor's name should
be inserted in the upper right-hand corner of the cover of the numbered
Memorandum. That copy must be delivered only to the named person. If the
Memorandum is being furnished to non-prospective investors (such as to counsel
or the issuer's accountants), the right hand comer should be marked "Information
Subscription documents should
not be sent to an investor unless accompanied by a Private Placement Memorandum
or unless a Private Placement Memorandum has previously been sent to the
A procedure for determining
qualification of offerees and whether they merit inclusion in the offering is
advisable to establish. The procedure should identify that a prospective
offeree has sufficient experience, business knowledge, and investment
sophistication to allow the offeree to make a reasonable informed investment
decision before any offer is made to such person. Although offeree
qualification is not per se present under Rule 506, it is still nevertheless
important in the event that the issuer needs to rely on the Section 4(2) private
placement exemption and to show that the offering was conducted in a limited
manner without general solicitation. Such a procedure will obtain basic
information about the proposed investor, such as financial sophistication, net
worth, investment experience, and other relevant information. If it is
determined that the prospective offeree should be included in the offering,
then a numbered Private Placement Memorandum is provided to the offeree or the
All broker-dealers, registered
representatives, or other persons connected with the offering should be
instructed as to the limitations on the manner of the offering. All selling
agreements with participating broker dealers should obligate the broker-dealer
to comply with the requirements of Rule 506 of Regulation D applicable to its
In the event a purchaser
representative represents the prospective investor, a number of additional
documents will be required. An acknowledgment that the purchaser representative
is acting as such for the offeree will be necessary, as well as a disclosure of
any material relationships between the purchaser representative and the issuer.
The issuer should have supporting documentation showing the purchaser
representative satisfied the conditions required by Regulation D.
To determine that subscribers
are in fact suitable investors, a confidential questionnaire soliciting
financial, investment, and educational information about the subscriber should
generally be required to be completed by each prospective investor. These
should be reviewed to determine if all questions have adequately been answered,
and whether the investor meets both the financial standards and investment
sophistication levels established by the issuer and required under Rule 506.
In the event that the offeree
or a purchaser representative has requested additional information, written
records should be kept of the information provided. If there have been any
meetings with the offeree or a purchaser representative, a record of such
meeting should also be kept detailing who was present, the meeting agenda, and
the matters discussed.
All compliance with and filings
under blue sky laws should be carefully documented.
What Additional Steps May Be
Other steps or documents may be
necessary or advisable in a given transaction so as to qualify for an exemption
from the registration and qualification requirements of federal and state
securities laws. This memorandum is intended for general reference purposes
only, as a particular transaction may mandate additional and/or different
procedures. As the state of the law in this area is constantly changing, this
memorandum speaks only as of its date, and no obligation is undertaken to update
or supplement this memorandum.
Contact us for more information:
Z e g a r e l l i
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Zegarelli Law Group
Upper St. Clair Administrative and Postal Office:
2585 Washington Road, Suite 134
• Summerfield Commons Office Park
301 Grant Street, Suite 4300 • One Oxford Centre
Pittsburgh, PA 15219-1407 USA
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