Exemption from Securities Registration
Regulation D, or Reg D, refers to a group of “safe harbor” exemptions from securities registration requirements, both federal and state, which is contained in the Securities Act of 1933. Reg D is the most frequently used of all securities registration exemptions because it is not only cost effective, but is also useful in a variety of situations and for a variety of businesses and joint ventures, small, medium, or large. This is not something that can be said of the other exemptions, which may require spending more money and time, making a securities offering economically inefficient. Reg D is made up of four exemptions, and an issuer’s choice in exemption is mainly based on the amount of funds sought, although the type of advertising the issuer wants to engage in also plays a part.
The Basics of Reg D
It is important for anyone who plans to utilize Reg D to understand what he or she can and cannot do under Reg D. At the end of the day, if there is a dispute, the burden is on the issuer to prove compliance with Reg D. The two major obligations a Reg D issuer has is to disclose material information to prospective investors and comply with the manner in which the offering is conducted. Additionally, in complying with Reg D, an issuer must refrain from misleading or lying to investors. If an issuer fails to abide by these basic rules under Reg D, the issuer may face fraud charges, civil liability, and sanctions.
Rule 504 is one of the basic exemptions listed under Reg D. This exemption is useful for issuers seeking less than $1,000,000 in funding. Under this exemption, the issuer cannot seek any more than $1,000,000 through any offering in reliance on any section 3(b) exemption under the Securities Act of 1933, for a twelve month period. There is no limit on the number of investors that may purchase securities under a Rule 504 offering. Additionally, in order to conduct a Rule 504 offering, an issuer cannot be any of the following.
SEC Reporting Company – An issuer would be considered an SEC reporting company if the issuer is subject to the reporting requirements of section 13 or 15(d) of the Securities Exchange Act of 1934. Brokers and investment advisors are included in those who are subject to these reporting requirements.
Investment Company—An investment company is a company whose primary business is investing securities and is not exempt from the Investment Company Act of 1940. There are many exemptions to the application of the Investment Company Act of 1940. The most used exemptions are (a) private fund with no more than 100 investors; (b) institutional investors – unlimited number of investors with $5mil or more in net assets; (c) real estate first mortgage liens and direct interests; and operating companies.
Additionally, securities under Rule 504 cannot be generally solicited or advertised to the public. What does this mean? Well, it means no radio ads, television ads, newspaper advertisements, web advertisements, or any other attempt to sell securities to the general public, which includes walking up to a stranger and asking them for money or soliciting at a trade show. Instead, investors must be sought through existing relationships or financial intermediaries, such as broker-dealers. There is an exception to the bar on general solicitation and advertising under rule 504. General solicitation is allowed under the following circumstances, but keep in mind that this does not mean every form of soliciting or advertising is available.
It is allowed if the issuer registers, exclusively, in one or more states that require a publicly filed registration statement and that a disclosure document be delivered to investors.
It is allowed if the issuer registers in one or more states that require a publicly filed registration statement and that a disclosure document be delivered to investors, in addition to states that do not have these requirements, if the issuer delivers the disclosure document delivered to investors in states that do have these requirements to all investors.
It is allowed if the issuer sells only pursuant to state law permitting general solicitation and advertising, but only if the securities are sold exclusively to what are called “accredited investors,” which is a special definition under the securities laws, consisting of eight categories of investors, which largely concerns income. In short, these “accredited investors” are not your everyday person. Accredited investors fall under a number of different categories with the most common being annual income of $300,000 for couples, $200,000 if single, or a net worth of $1mil.
Rule 505 is the second of the three exemptions listed under Reg D. This exemption is useful for those issuers seeking up to $5,000,000 in funds but is rarely ever used. Under this exemption, the issuer cannot seek any more than $5,000,000 through any offering in reliance on any section 3(b) exemption under the Securities Act of 1933, for a twelve month period. The limit on the number of investors is thirty five non-accredited investors and an unlimited amount of “accredited investors.” Once again, they can only mainly be sold to wealthy people.
This rule is rarely utilized because Federal Law has pre-empted State Law under rule 506. This means that under rules 504 and 505, the issuer still must abide by State laws. However, under rule 506, so long as the securities issuer meets Federal guidelines and State notice requirements, there are no additional registrations required of these securities.
Rule 506 includes the final two exemptions listed under Reg D. Rule 506 is very different in that, as of 2013, there are two separate exemptions under Rule 506, 506(b) and 506(c), in addition to there being an unlimited offering amount with both 506(b) and 506(c).
Rule 506(b)—Under 506(b), general solicitation or advertising is not allowed, like rule 504, except there are no exceptions under rule 506(b), as opposed to rule 504. Like rule 505, the limit on the number of purchasers is thirty five non-accredited investors and an unlimited amount of “accredited investors.” However, unlike rule 505, all non-accredited investors must be sophisticated, which essentially means these investors must have a substantial amount of knowledge about financial and business matters. These people are not wealthy enough to be considered accredited, but they are deemed to have enough prior knowledge to be able to make an informed decision. Subject to antifraud provisions, issuers can choose what information to give to investors, but the issuer must be available for investors’ questions, and accredited and non-accredited investors must receive identical information.
Rule 506(c)—The difference between rule 506(b) and 506(c) is pretty simple. General solicitation and advertising is allowed under 506(c), but only if certain conditions are met. All investors must be accredited, and reasonable steps must be taken to verify that investors are accredited, which includes reviewing the investors’ financial documents. Now what exactly is allowed with general solicitation is still a little murky. This is a relatively new change, and the limitations are not altogether clear yet, especially in light of the fact that reasonable steps must be taken to verify investors are accredited. Therefore, rule 506(c) must be used with caution.
Going With Reg D
There’s a good reason Reg D exemptions are used so much more frequently than other exemptions. For one thing, as you can see from this article, there are many options for those issuers who choose to sell securities pursuant to a Reg D exemption. There is a Reg D exemption for most scenarios. A Reg D offering is also incredibly economically efficient, especially as opposed to a full-fledged federal registration or a registration with the state, which is often more time consuming and costly than even a federal registration. We utilize Reg D exemptions on a frequent basis for our clients to help make sure they are getting the most out of their time and money.