Federal Exemptions Available for Private Placement of Securities – Part I

This posting is mostly geared towards securities attorneys who advise small and growing businesses on how to do a private placement.

This posting is a brief outline of requirements of federal private placement exemptions available to companies that would like to offer and sell their securities (I refer to them as the "issuers" of securities) to investors and should not be relied upon for choosing the exemption that is most appropriate for any given company and/or offering.

The following federal exemptions may be available:

• Section 4(2) of the Securities Act
• Rule 506 of Regulation D
• Section 4(6) of the Securities Act
• Rule 504 of Regulation D
• Rule 505 of Regulation D
• Rule 701
• Regulation A
• Section 3(a)(11)
• Rule 147

Part I discusses the first two exemptions: Section 4(2) and Rule 506 of Regulation D.

Section 4(2) private placement exemption

Courts look at the following factors in deciding whether this exemption is available, as discussed in the instrumental Ralson Purina case (Securities and Exchange Commission v. Ralson Purina Co., 346 U.S. 199 (1953):

1. All offers must comply with the exemption requirements. A single offer that does not qualify may invalidate the whole offering.
2. There should be a limited number of offerees (there is no exact limit, but it is clear that there is a limit depending on the circumstances).
3. Company issuing the securities cannot engage in general solicitation or advertising. For more information on this ban, see my earlier post “Rules relating to solicitation and advertising in Regulation D private placement of securities.”
4. The issuer has to restrict resales of securities by obtaining investment letters from investors, placing restrictive legends on stock certificates and issuing stop transfer instructions.
5. All offerees have to be financially sophisticated or have an advisor who has the required financial expertise. Wealth does not necessarily make investor financially sophisticated.
6. Offerees need to have access to the kind of information about the company and the offering that would be contained in a registration statement or actually receive such information. Certain offerees have access to this information because they are executive managers of the issuer, have family ties or special business/ economic bargaining power with the company that would allow them to have access to the required information.

In addition to satisfying all factors listed above, issuers also have to comply with state securities laws, as states may impose their own requirements for private offerings that are conducted under Section 4(2) of the Securities Act.

Rule 506 of Regulation D

Rule 506 was adopted by the Securities and Exchange Commission in 1982 as a “safe harbor” to the Section 4(2) exemption. This means that if the company issuing the securities complies with the requirements of Rule 506, such issuer has perfected the Section
4(2) private placement exemption. On the other hand, it is not necessary to comply with Rule 506 requirements in order to have a successful private placement.

Rule 506 contains the following requirements:

1. Rule 506 places no limit on the aggregate amount of the offering price.
2. Like in Section 4(2) private placements, no general solicitation or advertising is allowed. For more information on this ban, see my earlier post “Rules relating to solicitation and advertising in Regulation D private placement of securities.”
3. There may be only a maximum of 35 nonaccredited investors and an unlimited number of accredited investors (see more below).
4. Specified disclosure must be made to all nonaccredited investors.
5. The issuer must reasonably believe that nonaccredited investors (either alone or together with their investment representatives) have sufficient financial and business knowledge to allow them to evaluate the risks and merits of the investment.
6. The issuer has to restrict resales of securities by obtaining investment letters from investors, placing restrictive legends on stock certificates and issuing stop transfer instructions.
7. The issuer must provide disclosure to nonaccredited investors regarding limitations on resale.
8. The issuer must file Form D with the Securities and Exchange Commission within 15 days of the first sale of securities.

Accredited investors are defined to include those individuals whose net worth (or joint net worth) at the time of purchase exceeds $1 million and/or those who have over $200,000 income in the last two years (or $300,000 combined with a spouse) and reasonable expectation to have similar income in the present year. Accredited investors definition also includes directors, executive officers or general partners of the issuer, and certain institutional investors such as certain banks, insurance companies, employee benefit plan, charities, corporations, trusts and partnerships with assets in excess of $5 million.

The definition of accredited investors generally focuses on wealth, whereas the definition of sophisticated investors, used in Section
4(2) exemption, although not well defined, focuses primarily on whether such investors have sufficient experience in financial and business matters to be able to adequately evaluate the risks and merits of a proposed investment.

States are preempted from regulation of offerings made under Rule 506 but may set forth notice filing requirements and collect fees.

This posting will continue in Part II.