ALI-ABA Course of Study Fundamentals of Securities Law June 12-13, 2008 Savannah, Georgia

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1 55 ALI-ABA Course of Study Fundamentals of Securities Law June 12-13, 2008 Savannah, Georgia Exemptions From the Securities Act Registration Requirements Non-Public Offerings and Regulation D By Thomas Lee Hazen University of North Carolina School of Law Chapel Hill, North Carolina

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3 57 EXEMPTIONS FROM THE SECURITIES ACT REGISTRATION REQUIREMENTS NON-PUBLIC OFFERINGS AND REGULATION D Fundamentals of Securities Law Savannah, GA June 12-13, 2008 Thomas Lee Hazen Cary C. Boshamer Distinguished Professor of Law The University of North Carolina at Chapel Hill -- I. Statutory Exemptions A Act 4(2) and SEC Rule 506 (part of Regulation D) -- nonpublic offerings by issuers. 1. In SEC v. Ralston Purina, 346 U.S. 119 (1953), the Supreme Court rejected the suggestion that the applicability of the 4(2) should depend on the number of persons to whom the offer was made, or the limitation of the offer to a defined class of persons (in that case, "key" employees of the issuer), and held that it should depend on whether the class of persons to whom the securities are being offered "need the protection of the Act." In the situation before it, the Court found that the employees involved "were not shown to have access to the kind of information which registration would disclose" and were therefore "entitled to compliance with 5." 2. The SEC subsequently amplified the test enunciated by the Supreme Court, indicating that it would consider, among other things, the identity of the offerees and their relationship to the issuer, the size of the offering and of the units in which it was made, the use of investment bankers or stock exchange facilities, and the length of time for which the original purchasers held the securities. Sec. Act Rel. No (1962). However, two restrictive decisions by the Fifth Circuit in 1971 and 1972 (including one in which the SEC took an extremely narrow view of the exemption) led to doubts as to whether the exemption would ever be available for offerings to small numbers of people to raise the initial capital for new ventures, unless the offerees had access to all material information about the issuer by virtue of their status as "insiders." Hill York v. American Int'l, 448 F.2d 680 (5th Cir.1971); SEC v. Continental Tobacco, 463 F.2d 137 (5th Cir.1972). These decisions intensified pressure for development of a more "objective" test of what constitutes a "private" offering exempt from 1933 Act registration requirements.

4 58 3. Summary of the 4(2) exemption: a.. No limitation on the aggregate dollar amount of the securities to be offered. b. Limitation on the number of purchasers. (a) (b) Under the statutory exemption there is no limit on the number of purchasers; however, too many purchasers may mitigate in favor of a finding that a public offering has taken place. A safe harbor offering under rule 506 (of Regulation D) is limited to 35 sophisticated unaccredited investors plus an unlimited of accredited investors. (i) (ii) An unsophisticated unaccredited investor can nevertheless qualify through the use of a purchaser representative. (See Rule 501(h)). See Rules 215, 501(a) for the definition of who is an accredited investor. c. General solicitation of potential purchasers is not permitted. (See Rule 502(c)). d. There are restrictions on resale. (See Rules 144, 502(d)). B Act 3(b) exemptions (see also 4(6)) 1. Permits exemptions for offerings up to $5 million. 2. 3(b) is not self-executing and needs enabling rules promulgated by the SEC. a. Regulation A (Rules 251 et seq.) -- up to $5 million); b. Rules 504 (Regulation D) up to $1 million; c. Rule 505 (Regulation D) up to $5 million; d. Rule exemption for certain compensation plans but is no longer subject to 3(b) s $5 million ceiling.

5 59 C. Other statutory exemptions: 1. 4(l) of the 1933 Act (transactions by persons other than issuers, underwriters, and dealers); 2. 4(3) of the 1933 Act (certain dealer transactions occurring more than 40 to 90 days after a registered offering); 3. 4(4) of the 1933 Act (unsolicited brokers' transactions). 4. 4(6) of the 1933 Act (offerings of no more than $5 million, made only to accredited investors).

6 60 II. Regulation D A. THREE EXEMPTIONS 1. Regulation D consists of three exemptions with a series of common definitions and core concepts. 2. The three separate exemptions are contained in Rules 504, 505, and 506: a. Rule 504 is promulgated under section 3(b) of the Securities Act of 1933 and provides an exemption for certain offerings up to one million dollars. b. Rule 505 is also promulgated under section 3(b) and provides an exemption for certain offerings up to five million dollars. c. Rule 506 is a safe harbor for certain transactions trying to qualify for the exemption under section 4(2) of the Act that exempts transactions by an issuer that do not involve a public offering. 3. There is a proposal to amend Regulation D to exempt certain certain offerings of pooled investments to a newly defined category of large accredited investors. See Proposed Revisions of Limited Offering Exemptions in Regulation D, Sec. Act Rel. No , Inv. Co. Act Rel. No. IC-27922, 2007 WL (SEC Aug. 3, 2007). B. KEY CONCEPTS IN REGULATION D 1. There are a number of key concepts that apply to Regulation D offerings. 2. Accredited Investors - defined in Rule 501(a). See also Securities Act of (a)(15) and Rule 215. Rule 501(a) defines accredited investor to include: a. Institutional investors b. Individuals with a net worth (or joint net worth) of $1,000,000 c. Individuals with annual income in excess of $200,000 ($300,000 joint income with spouse) in each of the two most recent years d. Directors, executive officers, and general partners of the issuer 3. Number of Purchasers - Offerings under Rules 505 and 506 can be made to no more than thirty-five unaccredited purchasers.

7 61 4. General Solicitation of Offers - Offerings under Rules 505 and 506 cannot be made pursuant to a general solicitation of purchasers. General solicitations in Rule 504 offerings generally will require registration under state securities laws. 5. Required Disclosures - Offerings under Rules 505 and 506 will require the furnishing of information to investors if there are any unaccredited purchasers. Offerings under Rule 504 may require the dissemination of information under state law. 6. Restrictions on Resales - Rules 504, 505, and 506 each require that there be limitations on the resales of securities acquired in connection with an exempt offering. C. OVERVIEW OF REGULATION D RULES 1. Rule 50l Definitions applicable to Regulation D. 2. Rule 502(a) - Integration There is a safe harbor from integration for offers more than 6 months before the beginning of the Regulation D offering and 6 months after the offering has been completed. 3. Rule 502(b) - Informational Requirements: a. Under Rules 505 and 506 information must be given to all unaccredited investors. b. Formerly, the SEC required information to all investors if there were any unaccredited offerees. c. Currently, the SEC suggests that the information be given to all investors. d. If the issuer is not a reporting company under the Securities Exchange Act of 1934, the larger the offering, the more information is required. e. If the issuer is a 1934 Act reporting company, then the required disclosure is geared to the 1934 Act filings (Rule 502(b)(2)(ii)). 4. Rule 508 provides that insignificant deviations from a term, condition, or requirement of Regulation D will not destroy the exemption for a transaction which was structured in good faith. 5. Rule 503 requires the filing notice of sales of securities made in reliance on Regulation D. a. A failure to make the required filing does not automatically destroy the exemption.

8 62 D. RULE 504 b. However, Rule 507 provides that Regulation D is not available to persons who have been enjoined from violating Rule 503's notice of sales requirements. c. Rule 502(d) sets forth the precautions that an issuer must take to assure that there are no improper after market resales of the securities offered and sold in a transaction relying on the Regulation D exemption. 1. Limitation on Amount - Rule 504 is available for offerings up to $1,000,000 and is limited to issuers that are not 1934 Act reporting companies. Rule 504 is not available for "blank check" companies (penny stock rules). a. Note the method of calculation of the dollar limit: Include all securities offered within the past 12 months under a 3(b) exemption (i.e. Reg. A or Rule 505) plus all securities offered in violation of section 5 of the Securities Act of 1933 within the past 12 months. b. Examples of calculating the dollar limit: i. Can you have a $1,000,000 Rule 504 following within one year of a $4 million Regulation A offering? No, since Rule 504 puts a $1 million ceiling on 3(b) offerings within the preceding 12 months. ii. Can you have a $1,000,000 Rule 504 followed by a $4 million Regulation A offering? Yes, since Rule 254 would permit the $1,000,000 + $4,000,000 as within Regulation A's $5 million ceiling on 3(b) offerings within 12 months. 2. General Solicitation Not Permitted - In a Rule 504 transaction, no general solicitation of offerees is permitted unless the offering is registered under applicable blue sky laws. 3. Regulation A s bad boy provisions that disqualify certain bad actors from participating in Regulation A offerings do not apply to Rule 504.

9 63 E. RULE Limitation on Amount - Rule 505 is available for certain offerings up to five million dollars. The method of calculation is similar to Rule 504. In calculating the five million dollar ceiling, you must include all securities offered within the past 12 months under a 3(b) exemption (e.g. Regulation A or Rule 504) plus all securities offered in violation of section 5 of the Securities Act of 1933 within the past 12 months. 2. Limitation on Number of Purchasers - Rule 505 offerings can be made to no more than 35 purchasers but the following are not counted in the 35 purchaser limit: a. Relatives living with purchaser b. Trusts, corporations, partnerships, and other entities controlled by purchaser c. Accredited investors 3. General Solicitation Not Permitted - A general solicitation of purchasers is not permitted in a Rule 505 offering. a. The concept of general solicitation includes but is not limited to advertising, general meetings, general letters and circulars. b. There is no bright-line limit on number of offerees. c. Care must be taken in drumming up investor interest in the business. 4. Required Disclosures - Information must be provided to any unaccredited purchasers. 5. Restrictions on Resales - Resales of securities sold in a Rule 505 offering are subject to restrictions (Rule 502(d)). See also SEC Rule Unlike Rule 506 (see below), Rule 505 does not impose any limitations on nature of purchasers. 7. Rule 505 offerings are subject to Rule 252`s "bad boy" disqualifications that disqualify certain bad actors from participating in Regulation A offerings. 8. Rule 505 is not available to offerings by investment companies. 9. Compare the exemption provided by section 4(6) of the Securities Act of 1933 for offerings up to five million dollars made only to accredited investors.

10 Is the offering part of a single plan of financing? (integration) - Under Rule 502(a) - Offers within 6 months preceding and subsequent to the 505 offering are subject to the SEC s integration doctrine. F. RULE Rule 506 provides a safe harbor for certain offerings made under the exemption provided by section 4(2) of the Securities Act of 1933 for transactions by an issuer that do not involve a public offering. Although it is possible to secure a section 4(2) exemption without relying on Rule 506 s safe harbor, this course of action is not recommended. 2. Limitation on Amount - Unlike Rules 504 and 505, there is no limitation on the dollar amount of a section 4(2) or Rule 506 offering. 3. Limitation on Number of Purchasers - Rule 506 offerings can be made to no more than 35 purchasers but the following are not counted in the 35 purchaser limit: a. Relatives living with purchaser b. Trusts, corporations, partnerships, and other entities controlled by purchaser c. Accredited investors 4. Nature of Purchasers - Since Rule 506 is a safe harbor for the section 4(2) exemption, it is subject to the statutory limitations. 1 a. In order to qualify for the Rule 506 safe harbor, purchasers must be knowledgeable, sophisticated, and able to evaluate risks and bear the risk of the investment. Rule 506(b)(2)(ii). i. Rule 506 s predecessor (former Rule 146) required that all offerees meet the required sophistication or wealth thresholds. ii. Rule 506 does not require qualification of each offeree. However, the presence of unqualified offerees in the offering pool can result in a determination that there has been a general solicitation, thus making Rule 506 unavailable. 1 See SEC v. Ralston Purina Co., 346 U.S. 119, 73 S.Ct. 981, 97 L.Ed (1953); Van Dyke v. Coburn Enterprises, 873 F.2d 1094 (8th Cir.1989; See Lawler v. Gilliam, 569 F.2d 1283 (4th Cir.1978); Doran v. Petroleum Management Corp., 545 F.2d 893 (5th Cir.1977); SEC v. Continental Tobacco Co., 463 F.2d 137 (5th Cir.1972); Hill York Corp. v. American International Franchises, Inc., 448 F.2d 680 (5th Cir.1971). See also, e.g., SEC v. Murphy, 626 F.2d 633 (9th Cir.1980); Bowers v. Columbia General Corp., 336 F.Supp. 609 (D.Del.1971).

11 65 b. An unsophisticated unaccredited investor can nevertheless qualify for a Rule 506 offering through a qualified purchaser representative. See Rule 501(h). 5. General Solicitation Not Permitted - A general solicitation of purchasers is not permitted in a Rule 506 offering. a. The concept of general solicitation includes but is not limited to advertising, general meetings, general letters and circulars. b. There is no bright-line limit on number of offerees. c. The presence of unqualified offerees in the offering pool may establish that a general solicitation has taken place. d. Care must be taken in drumming up investor interest in the business. 6. Required Disclosures - Information must be provided to any unaccredited purchasers. If the issuer is a public company that is subject to 1934 Act periodic reporting requirements, the issuer must make new developments available. See Rule 502(b)(ii). a. An issuer which is not a reporting company should have the types of information that would be in a 1933 Act registration. Also, the issuer must be available for questions and answers. See Rule 502(b)(i). The detail of the required disclosures varies according to the size of the offering. b. Affirmative disclosure is required to any non-accredited purchasers but the SEC recommends that if there are any non-accredited purchases then the accredited investors should also receive the disclosure document (this used to be a requirement, now it is only a suggestion). 6. Restrictions on Resales - Resales of securities sold in a Rule 506 offering are subject to restrictions (Rule 502(d)). See also SEC Rule Is the offering part of a single plan of financing? (integration) Under Rule 502(a) - Offers within 6 months preceding and subsequent to the 506 offering are subject to the SEC s integration doctrine. 8. Note that like section 4(2) of the Securities Act of 1933, Rule 506 is limited to sales by issuers and thus does not apply to sales by shareholders. 9. Transactions exempt under Rule 506 are automatically exempt from registration under state securities laws. Note that this preemption does not apply to section 4(2) offerings not protected by Rule 506 nor does it apply to transactions exempt under Rule 504 or Rule 505. See Section 18(a) of the Securities Act of 1933.

12 66 G. OTHER EXEMPTIONS THAT MAY BE USEFUL 1. There is an exemption for totally intrastate offerings Act 3(a)(11); SEC Rule 147. a. The intrastate exemption has limited utility. b. The intrastate exemption requires that the company be incorporated in the same state where it conducts most of its business and all offerees must also be residents of that state. 2. SEC Regulation A provides an exemption for offerings up to five million dollars. a. There are no limitations on the nature or number of offerees. b. Extensive disclosures may be required. 3. SEC Rule 701 provides an exemption for offerings by nonpublic company employee and consultant compensation plans. 4. Secondary transactions i.e. resales of securities are governed by section 4(1) and SEC Rule 144.