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Securities
 
Copyright © 2004 Zegarelli Law Group. All rights reserved.
Written by Gregg R. Zegarelli, Esq.

 


  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.

Background

 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 the exemption.

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 determine suitability. 

Any questions concerning what might constitute general advertising or general solicitation should be discussed with counsel.

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"?

Specifically, "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:

[i]-501(a)(l)-Certain Institutional Investors.

(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 investors.

[ii]-501(a)(2)-Private Business Development Companies.  Any private business development company as defined in Section 202(a)(22) of the Investment Advisers Act of 1940.

 [iii]-501(a)(3)-Entity with 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.

[iv]-501(a)(4)-Directors, 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.

[v]-501(a)(5)-$I,000,000 Net Worth Individuals.  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.

[vi]-501(a)(6)-Income Test.  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.

[viii]-501(a)(7)-Certain 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 person. 

[ix]-501 (a)(8)-Entities 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 35-Person Limitation?

Certain purchasers are excluded from the 35-purchaser limitation contained in Rule 506, as follows:

(1)        Accredited investors;

(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 Disclosed?

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 Purchasers Possess?

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 Prepared?" below.

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 Agreement.

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 Laws Considerations?

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.

Broker-Dealer Issues

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 Be Prepared?

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 securities laws.

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 Only."

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 investor.

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 registered representative.

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 activities.

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 Required?

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.


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