The Basics of Regulation D Private Placements

By Stuart A. Ober, CFE, AIFA ®

The American Law Institute – American Bar Association Securities Law Committee of the Federal Bar Association sponsored the “Regulation D Offerings and Private Placements” seminar on March 17-19, 2011, for which I am grateful for much of the materials contained in this paper.

The Securities Act of 1933 (the “Securities Act”) was the first major federal legislation to regulate the offer and sale of securities in the United States and its Territories. Prior to the Securities Act, state laws primarily governed the regulation of securities, and were commonly known as blue sky laws.When Congress enacted the Securities Act, it left in place a patchwork of existing state securities laws to supplement federal laws in part because there were questions as to the constitutionality of federal legislation.

Under the Securities Act, offers and sales of securities must either be registered with the Securities and Exchange Commission (the “SEC”) or meet an exemption.The theory behind this exemption was that capital formation will be facilitated if a more simplified and flexible registration process (and thus less burdensome with red tape) were available when making a securities offering.

Found in Section 4(2) of the Securities Act is the registration exemption:“The provisions of Section 5 (of the Securities Act) shall not apply to – 2.transactions by an issuer not involving any public offering.”   While the statute does not define “public offering,” the SEC and the courts have developed standards to distinguish private from public offerings.

Those standards include:

1. Sophisticated persons with access to the same kind of information that would be provided in a registration statement;
2. The number of offerees; and
3. The lack of special selling efforts.[1]

The SEC has adopted a safe harbor[2] under Section 4(2) in its Rule 506 of Regulation D (often known as Reg D).If a party follows the provisions of Rule 506 of Regulation D, then its offering will be exempt from registration.

Under Section 3(b) of the Securities Act, the SEC has granted special exceptions to securities offerings not exceeding $5 million.  This authority is found in Regulation D Rules 504 and 505, Regulation A,[3]  Rule 701,[4] and Rule 1001.[5]

There is also an exemption from SEC registration for intrastate offerings, which is provided by Section 3(a)(11) of the Securities Act.These offerings must be made by an issuer who resides or is incorporated, and does substantial operational business, in the same state as the offeree residents of that single state.   The SEC, under Section 3(a)(11), has adopted Rule 147 as a safe harbor from registration for these types of offerings.One restriction is that no resales of these securities may be made outside of the state for at least nine months after the date of the last sale.These intrastate offerings have no filing requirement.

Section 28 of the Securities Act was added by the National Securities Markets Improvement Act of 1996 (“NSMIA”).Under this section, the SEC was provided general rulemaking authority to exempt any person, security, or transaction from registration to the extent that the exemption was appropriately in the public interest and was consistent with investor protection.The SEC, however, was not given the power to grant exemptions from the anti-fraud provisions of the Securities Act.

With the adoption of Section 28, all the exemptions under Section 3(b) could be adopted under Section 28, without the $5 million size limitation of the offering.Thus, the SEC could raise the dollar limits on Rules 504 and 505, Regulation A, and Rule 701.However, the SEC, pursuant to its powers under Section 28, has not yet adopted any new rules, except for some changes to the dollar limitation under Rule 701.[6]

Regulation D

Regulation D contains three rules (Rules 504, 505, and 506) that provide exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the securities with the SEC.

Rule 504 of Regulation D

Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $1,000,000 of their securities in any 12-month period.

This exemption can be used by a company provided it is not a blank check company[7] and does not have to file reports under the Securities Exchange Act of 1934 (i.e., an investment company).   Also, the exemption from registration generally does not allow companies to solicit or advertise their securities to the public.Purchasers of these investments receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption.

Rule 504 does allow companies to sell securities that are not restricted, if one of the following circumstances is met:

1.      The company registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;

2.      A company registers and sells the offering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or

3.      The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to "accredited investors" (please see “Accredited Investors” section below).

A company should provide sufficient information to investors to avoid violating the antifraud provisions[8] of the securities laws, even if the company makes a private sale where there are no specific disclosure delivery requirements.   This means that any information a company provides to investors must be free from false or misleading statements.  Similarly, a company should not exclude any information to investors if the omission could be construed to be false or misleading.

Rule 505 of Regulation D

Rule 505 of Regulation D allows companies, who meet the following requirements, to have their securities offerings exempted from the registration requirements of the federal securities laws:

·         Can only offer and sell up to $5 million of its securities in any 12-month period;

·         May sell to an unlimited number of "accredited investors" (please see section below) and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions;

·         Must inform purchasers that they receive "restricted" securities, meaning that the securities cannot be sold for six months or longer without registering them; and

·         Cannot use general solicitation or advertising to sell the securities.

This rule allows a company, so long as it does not violate the antifraud prohibitions, to decide what information to give to accredited investors.   But companies must give non-accredited investors disclosure documents that generally are equivalent to those used in registered offerings.  And if a company provides information to accredited investors, it must make this information available to non-accredited investors as well.  The company must also be available to answer questions by prospective purchasers.

Here are some specifics about the financial statement requirements applicable to this type of offering:

·         Financial statements need to be certified by an independent public accountant;

·         If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company's balance sheet (to be dated within 120 days of the start of the offering) must be audited; and

·         Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.

Rule 506 of Regulation D

Rule 506 is considered a "safe harbor"[9] for the private offering exemption of Section 4(2) of the Securities Act.   Companies using this exemption can raise an unlimited amount of money.   A company can be assured it is within the Section 4(2) exemption by satisfying the following standards:

·         The company cannot use general solicitation or advertising to market the securities;

·         The company may sell its securities to an unlimited number of "accredited investors" (please see section below) and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative,[10] must be sophisticated;[11]

·         A company must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws.  But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.  If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;

·         The company must be available to answer questions by prospective purchasers;

·         Financial statement requirements are the same as for Rule 505; and

·         Purchasers receive "restricted" securities, meaning that the securities cannot be sold for at least a year without registering them.

Accredited Investors

Who or what is an accredited investor?We have seen that to qualify for some of the exemptions, such as Rules 504, 505, and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors."

Accredited investors are defined in Rule 501 of Regulation D as:

1. a bank, insurance company, registered investment company, business development company, or small business investment company;
2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
3. a charitable organization, corporation, or partnership with assets exceeding $5 million;
4. a director, executive officer, or general partner of the company selling the securities;
5. a business in which all the equity owners are accredited investors;
6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;[12]
7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Thus, an accredited investor is any person or entity who falls within one of the enumerated eight categories, or who the issuer reasonably believes[13] falls in one of these categories.  

It should be noted that an investor is considered to be accredited who falls into one of the categories “at the time of the sale of securities,” even if, at a later date, there is a change in status, after the sale of securities.

A Compliance Guide for Small Entities and Others from the SEC for Regulation D

Regulation D Filing Requirements

While a company using a Regulation D (17 CFR § 230.501 et seq.) exemption does not have to register its securities and usually does not have to file reports with the SEC, it must file what’s known as a "Form D" after it first sell its securities.Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

In February 2008, the SEC adopted amendments to Form D, requiring that electronic filing of Form D be phased in during the period September 15, 2008 to March 16, 2009.   Although as amended, the electronic Form D requires much of the same information as the paper Form D, the amended Form D requires disclosure of the date of first sale in the offering.   Previously, disclosure of the first date of sale was not required.

SEC rules require the Form D notice to be filed by companies and funds that have sold securities without registration under the Securities Act in an offering based on a claim of exemption under Rule 504, 505 or 506 of Regulation D or Section 4(6) of that statute.   Commission rules further require the notice to be filed within 15 days after the first sale of securities in the offering.For this purpose, the date of first sale is the date on which the first investor is irrevocably contractually committed to invest.  If the due date falls on a Saturday, Sunday or holiday, it is moved to the next business day.  The SEC does not charge any filing fee for a Form D notice or amendment.

State Form D Filings Information for Issuers

Many states also require the filing of Form D notices and amendments, and most of them charge a filing fee.  For information on state Form D filing requirements, visit www.NASAA.org to get links to the proper state web sites.State web sites contain bulletins providing details on filing requirements and a contact person for specific questions.At the present time, all states that require Form D filings accept paper filings only; none permit online filings.A state’s Form D paper filing requirements may be satisfied using a printout of the SEC online Form D filing retrieved from the EDGAR Company Search page and submitting it along with the appropriate fee.  Such requirements may be satisfied by completing and submitting a paper version of Form D along with the appropriate fee.

Additional Information on Form D Processing

The staff of the SEC's Division of Corporation Finance is available to assist small companies and others with questions on filing and amending Form D notices.   The publication Guidance on Form D Filing Process may answer questions on the EDGAR Form D filing process. Additional questions on the process may be directed to SEC personnel by telephoning (202) 551-8900.

Additional Information on Form D Legal Requirements

The staff of the SEC's Division of Corporation Finance has published interpretations of Rule 503, 17 C.F.R. § 230.503, which imposes the SEC Form D filing requirement in most instances, in Section 257 of its Securities Act Rules Compliance and Disclosure Interpretations, and interpretations of the requirements of Form D itself, in Section 130 of its Securities Act Forms Compliance and Disclosure Interpretations.   Answers to other interpretive legal questions relating to Form D may be obtained by contacting the SEC's Office of Small Business Policy at smallbusiness@sec.gov or (202) 551-3460.

How to Determine If a Regulation D Filing Was Made?

If an investor is thinking about investing in a Regulation D offering, it is recommended to search the EDGAR[14] database to determine whether the entity has filed Form D.   If a copy of a Form D filed as a paper filing is needed (which will include any Form D filed before September 15, 2008) that has not been scanned into EDGAR, request a copy using the SEC online form.  If the company has not filed a Form D, this should alert the investor that the offering might not be in compliance with the federal securities laws.

Also, always check with state securities regulator to see if they have more information about the company and the people behind it.   Be sure to ask whether the state regulator has cleared the offering for sale in the investor’s state.  Get the address and telephone number for of state securities regulator by calling the North American Securities Administrators Association at (202) 737-0900 or by visiting its website, http://www.nasaa.org/home/index.cfm. This information is also found in the state government section of the local phone book.