Does your business need additional capital to realize its full potential? Raising capital often involves issuing securities and can create complex legal responsibilities. “Securities” include stocks, bonds, debentures, notes, and most other forms of investor participation. Both the federal and state governments have enacted comprehensive securities laws to protect investors. Failure to comply with these laws can result in civil, administrative and even criminal penalties.
At the federal level, a securities offering often must be registered with the Securities and Exchange Commission (SEC). The registration process is extremely complex, expensive and time-consuming. Federal law, however, also provides several exemptions from the registration requirements. The “intrastate” exemption, for example, applies to an issuer that offers securities only to residents of the state in which it is organized or has its principal office, derives at least 80% of its revenues from operations in that state, has at least 80% of its assets located in that state, and intends to spend at least 80% of the offering proceeds in connection with operations in that state. Another example is the “Regulation A” exemption, which allows an offering of up to $5 million to an unlimited number of investors with only a limited SEC filing.
Perhaps the most often-used exemption is Section 4(2) of the Securities Act of 1933, which exempts securities offerings “not involving any public offering.” These non-public offerings are frequently referred to as private placements. Factors determining whether an offering is public or private include the number of offerees and their sophistication, the relationship of the offerees to the issuer, the aggregate dollar amount of the offering, and the manner of the offering.
To give an issuer some certainty whether its offering will qualify for this private placement exemption, the SEC adopted Rule 506 of Regulation D. This Rule is a “safe harbor” because an issuer who satisfies its requirements will qualify for the Section 4(2) exemption. Regulation D contains two other rules, Rule 504 and Rule 505, which also provide "safe harbor" exemptions from registration for certain smaller offerings. Rule 504 covers offerings of up to $1 million during a 12-month period. The Rule allows issuers to offer and sell securities to an unlimited number of investors, regardless of their sophistication or financial means. In most cases, however, the Rule prohibits any general solicitation or advertising to attract investors and will require the issuer to take steps to ensure that the securities will not be resold in violation of the securities laws. The Rule does not require the issuer to provide investors with any specific disclosure information. But the issuer must file a notice (Form D) with the SEC within 15 days after the first sale.
Rule 505 covers offerings of up to $5 million during a 12-month period. Like Rule 504, it prohibits any general solicitation or advertising to attract investors and requires a Form D to be filed with the SEC. Unlike Rule 504, a Rule 505 offering is limited to 35 nonaccredited investors but an unlimited number of accredited investors. Accredited investors include institutional investors; certain business and nonprofit entities; directors, executive officers and general partners of the issuer; and certain high net-worth and high-income individuals. Rule 505 issuers must disclose certain information to the nonaccredited investors and take steps to ensure that the securities will not be resold in violation of the securities laws. Rule 505 may not be used by issuers who are subject to certain “bad boy” disqualification provisions, which include conviction of certain offenses involving the offer or sale of securities.
Rule 506 offerings do not have a dollar limit. In addition to the requirements of a Rule 505 offering, the issuer must reasonably believe that each of the nonaccredited investors, either personally or with the assistance of an adviser or other representative, has sufficient knowledge and experience in business and financial matters to weigh the merits and risks of the securities being offered.
Even if an issuer exempts an offering of its securities from the federal registration requirements, other SEC requirements, most notably the antifraud provisions, will still apply. Accordingly, an issuer is required to disclose all material information to the purchasers, even in an exempt offering. Information is “material” if a reasonable investor would consider the information important in making an investment decision.
In addition to the federal requirements, securities are subject to state registration requirements under state securities laws (known as “blue sky” laws). Michigan has several registration exemptions for offerings to a limited number of investors. In some cases, Michigan exemption provisions are preempted by federal law. In some cases, they are not. Limited Offering Exemption (ULOE), which exempts offerings that satisfy the requirements of Rules 505 and 506 under Regulation D. Michigan's version of ULOE, however, imposes its own suitability requirements for nonaccredited investors in Rule 505 offerings that are in addition to any requirements in Regulation D. The Michigan ULOE does not exempt Rule 504 offerings, which must meet one of the other Michigan statutory exemptions to avoid state registration.
The securities laws contain many complexities not fully addressed in this newsletter. Only a consultation with a qualified securities expert can determine the best way to raise new capital for your emerging business. If you have any questions, feel free to contact your WN&J attorney.