Overview of US federal securities law exemptions available for raising capital

Every offering of securities must be registered with the SEC unless it qualifies for an available exemption and I am often asked to describe various types of exemptions and regulations that are available to private companies raising capital.  I go over Regulation D, Regulation CF, Regulation A+ rules with clients about once a week.  I also teach the same at Fordham Law School.  Below I am posting a summary that I hope you will find helpful.  Note that the table does not include all available exemptions and regulations.  Email me if you'd like a nice pdf version.

Regulation CF (Crowdfunding):

Amount to be Raised:	Up to $1,070,000 in a 12-month period
Type of Issuers:	US entities only Other limitations apply
Investors:	Any investor (accredited[1] and non-accredited).  However, there are limits as to how much non-accredited investors can invest depending on their net worth or income.
Marketing Limitations:	Issuers can only communicate and market through a registered crowdfunding portal.  Any type of marketing and communication is permitted through the portal (so long as not misleading).  Outside of the portal platform, only very limited factual communications are permitted.
Resale Limitations:	These are restricted securities that generally cannot be resold for one year unless (i) back to the issuer, (ii) to an accredited investor, (iii) as part of a registered offering, or (iv) to a family member or for estate planning purposes.
Filing Requirements:	Issuers must file Form C with the SEC and update it annually so long as, generally, securities issued in Regulation CF offering are outstanding.
Information Requirements:	In addition to providing disclosures about the company and the offering, the issuers must provide financial statements (which have to be audited if the offering exceeds $535,000 and the issuer has sold securities in reliance on Regulation CF before).
General comments:	Although cheaper than conducting a Regulation A+ offering, the $1.07 million cap on the gross proceeds makes it a relatively expensive undertaking.  Also, the issuer must conduct its offering through one of the registered crowdfunding portals.

Regulation D Rule 506(b):

Amount to be Raised:	Unlimited
Type of Issuers:	Any issuer, including foreign issuers Certain limitations apply (such as that the issuer cannot be a “bad actor”)
Investors:	Unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors.
Marketing Limitations:	No general solicitation or advertising is permitted.  Offers and sales should be made only to those investors with whom the issuer has pre-existing relationship.
Resale Limitations:	Restricted securities (i.e., not freely tradeable generally for at least one year)
Filing Requirements:	Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.
Information Requirements:	If the issuer accepts money from non-accredited investors, it must provide a private placement memorandum with specific mandated disclosures specified in Rule 502 of Regulation D.
General comments:	This exemption may not be suitable for those offerings that are conducted online through unrestricted web portals because of the restriction on solicitation and advertising (because posting offering details on a website is generally considered to be advertising).

Regulation D Rule 506(c):

Amount to be Raised:	Unlimited
Type of Issuers:	Any issuer, including foreign issuers Certain limitations apply (such as that the issuer cannot be a “bad actor”)
Investors:	Accredited investors only
Marketing Limitations:	General solicitation and advertising are permitted.
Resale Limitations:	Restricted securities
Filing Requirements:	Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.
Information Requirements:	None
General comments:	Many issuers rely on this exemption.  The issuer has to take reasonable steps to verify that purchasers of securities sold in any offering under Rule 506(c) are accredited investors.

Regulation A+ (Tier 1):

Amount to be Raised:	Up to $20 million per year
Type of Issuers:	US and Canadian entities only Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible
Investors:	Accredited and non-accredited investors
Marketing Limitations:	Generally marketing and advertising are permitted, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit.
Resale Limitations:	Unrestricted securities, but limitations on trading exist
Filing Requirements:	Issuers must file Form 1-A with the SEC and get qualified.  Companies need to count their shareholders for the purposes of Section 12(g) registration.
Information Requirements:	Form 1-A requires detailed disclosures about the issuer, including financial statements which need not be audited unless audited financial statements already exist.  Generally, the level of disclosure is similar to that required in an initial public offering.
General comments:	Issuers raising money in a Regulation A+ Tier 1 offering must comply with the individual "blue sky" laws of each state where they plan to sell their securities.

Regulation A+ (Tier 2):

Amount to be Raised:	Up to $50 million per year
Type of Issuers:	US and Canadian entities only Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible
Investors:	Any accredited and non-accredited investor.  However, there are limits on how much non-accredited investors may invest depending on their net worth or income.
Marketing Limitations:	Generally marketing and advertising is allowed, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit.
Resale Limitations:	Unrestricted securities (at the federal level)
Filing Requirements:	Issuers must file Form 1-A with the SEC and get qualified.  After the offering, the issuer has ongoing reporting obligations. Tier 2 offerings are exempt from complying with state “blue sky” laws (although states can (and generally will) still require that information provided to the SEC also be filed with the state, and that the issuer pay filing fees.
Information Requirements:	Form 1-A requires detailed disclosures about the issuer, including audited financial statements.  The level of disclosure is similar to that required in an initial public offering. Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC on an ongoing basis.
General comments:	Companies are required to engage the services of a transfer agent.

Regulation S:

Regulation S is an exclusion from the registration requirements of the Securities Act for offerings made outside of the United States by both U.S. and foreign issuers.  A compliant Regulation S offering must follow two general conditions: (i) the offer or sale must occur in an “offshore transaction” and (ii) there be no “directed selling efforts” into the United States. 

Regulation S transactions are divided into three categories.  Category One, which includes offers and sales by “foreign issuers” for which there is no “substantial U.S. market interest” or offerings of securities in “overseas directed offerings” is the least restrictive, with no resale limitations.  Category Two securities, which include securities issued in equity offerings by reporting foreign issuers and offerings of debt securities, non-participating preferred stock by reporting issuers or non-reporting foreign issuers, may not be resold to U.S. persons during a 40-day distribution compliance period.  Category Three is typically the most relevant for the smaller private issuers.  Category Three includes offerings of all other securities, including equity offerings by domestic non-reporting issuers (i.e., private companies with no reporting requirements with the SEC).  Resales to U.S. persons of securities issued in Category Three offerings are restricted for one year unless they are done in compliance with an available resale exemption. 

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[1] Rule 501(a) of the Securities Act defines accredited investors (in the case of natural persons) as those whose individual net worth (alone or with a spouse) exceeds $1 million (excluding the value of their primary residence) or those whose annual income exceeded $200,000 (or $300,000 together with their spouse) in each of the two most recent years and they reasonably expect reaching the same income level in the current year.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

Fundraising Startups and their Associated Persons - Can They Be Broker-Dealers?

Continuing with the theme of broker-dealer registration, I now switch to the issuer safe harbor.  As you know, a broker is "any person engaged in the business of effecting transactions in securities for the account of others."  The key phrase here is "for the account of others".  Since many startup companies cannot attract the attention of broker-dealers to help them secure funding, the companies do it themselves.  Raising funds on the company's own behalf is not considered to be a broker-dealer activity.  However, even if the issuer itself is not a broker, anyone working for it may be because they would be selling securities of the issuer for the account of the issuer, not their own.  This brings into question the fundraising activities of issuer associated persons: its partners, officers, directors or employees. Note that Rule 3a4-1(c)(1) definition of "associated persons of the issuer" does not include independent contractors.

Whether such persons have to register as broker-dealers depends on facts and circumstances of each case.  In 1985, the SEC adopted Rule 3a4-1 that acts as a narrow nonexclusive safe harbor for associated persons.  Complying with the requirements of this Rule means that such associated person will not be required to register as a broker-dealer while engaging in fundraising activities.  First, the person needs to meet all three general requirements:

1. Not be subject to a statutory disqualification at the time of his participation; AND
2. Not be "compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities"; AND
3. not at the time of his participation be an associated person of a broker or dealer (ie, its partner, officer, director or employee).

With respect to the second requirement, the SEC noted in the Proposing Release that "This prohibition is intended to preclude compensation arrangements which vary with or depend upon the success of the sale efforts by associated persons."  This does not seem to prohibit compensating the associated person for the participation in the capital raise but precludes varying the amount of compensation based on the amount raised.  One needs to be very careful with structuring the compensation of persons engaged in fundraising for the company.

If the three general conditions are satisfied, the associated person then needs to meet one of the following three criteria:

1. Participate only in transactions involving offers and sales of securities to institutional investors, including broker-dealers, banks, investment companies or in connection with mergers, asset sales or certain other transactions (not really applicable to startups) - Rule 3a4-1(a)(4)(i)(A, B, C, D); OR
2. Limit activities to (i) preparing written offering materials subject to approval by a partner, officer or director of the issuer, while not engaging in oral solicitation, (ii) responding to investor inquiries, provided that responses are limited to information in the offering document, or (iii) ministerial and clerical work in effecting the transaction; - Rule 3a4-1(a)(4)(iii); OR
3. Perform (throughout the offering or starting at the end of the offering) substantial duties on behalf of the issuer other than marketing the securities, provided that this person is not a broker-dealer or its associated person within the prior 12 months and does not participate in the sale of securities of the issuer more than once every 12 months - Rule 3a4-1(a)(4)(ii). 

The issuer's founders, directors, officers, and employees would most likely rely on the third criterion when raising capital for their company.  However, it is important to remember that such fundraising efforts cannot happen more than once every 12 month period and that their compensation cannot depend on the success of their fundraising activities.

As I previously mentioned, this Rule is a nonexclusive safe harbor.  However, it is difficult to judge what activities would be permissible if you step outside of the strict confines of the Rule.  The SEC has repeatedly brought actions against associated persons of the issuers for failure to register (although often in connection with other charges such as fraud).

In conclusion, all startup founders should carefully structure their fundraising efforts so that their team is not deemed to be unregistered broker-dealers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  

International Brokers - Do They Have to Register with the SEC?

Due to the globalization of business dealings, issues often arise with respect to the proper registration of foreign persons as "brokers" or "dealers" under the U.S. federal securities laws (colloquially referred to as "broker-dealers").  Sometime, it is a U.S. person soliciting outside of the United States.  Other times, it is a non-U.S. resident who may be reaching out to the U.S. persons.  Below is a brief analysis of how the U.S. federal registration requirements apply to such international brokers.

First, the basics.  Section 15(a)(1) of the Securities Exchange Act of 1934 (the "Exchange Act") makes it unlawful for any "broker" or "dealer" to use interstate commerce to "effect any transactions in, or induce or attempt to induce the purchase or sale of, any security." The term "broker" is defined in Section 3(a)(4) of the Exchange Act to mean any "person engaged in the business of effecting transactions in securities for the account of others." Through numerous no-action letters, we know that the hallmarks of broker activity are: solicitation of potential investors, negotiation of deal terms, handling securities and/or funds, settling transactions, and receiving compensation that is tied to the success of the offering.  Further, the courts look at whether this person is "in the business" of doing so, i.e., certain degree of regularity.

There are several exemptions to the registration requirements for municipal securities brokers, government securities brokers, associated persons of the issuer (more on this in the next blog post), and online investment portals.  There is also a narrow common law exception for "finders" that with time has become so narrow that I am not certain it still exists.

B-Ds located in the U.S.

The approach with respect to broker-dealers that are located in the United States but work only with foreign investors is unsettled.  The SEC's general position was to require registration of broker-dealers physically located in the United States even if their activities were only directed at foreign investors located outside of the United States.  This broad extraterritorial approach was limited by the U.S Supreme Court holding in Morrison v. National Australia Bank Ltd. in 2010, that held that Section 10(b) of the Exchange Act only applied to conduct in connection with the domestic securities transactions (note that the case was about a different section of the Exchange Act, but courts later extended the analysis to broker-dealer registration provisions).  In particular, the Court held: "When a statute gives no clear indication of an extraterritorial application, it has none."

Section 929P of the Dodds-Frank Act, enacted into law less than one month after the Morrison decision, supported the SEC extraterritorial approach by amending the Securities Act and the Exchange Act to provide that the U.S. courts have jurisdiction over "(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors, or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States."   However, certain courts still applied the Morrison approach where the matters required interpretation of U.S. securities laws.  For example, in SEC v Benger (2013), the court held that the broker-dealer registration requirements did not apply to a person located in the United States that solicited foreign investors to invest into foreign securities.  It was unclear how to reconcile the Morrison case with the Congressional intent until the Tenth Circuit's decision in SEC v. Charles D. Scoville and Traffic Monsoon LLC that just became available in January 2019.  The heart of the case was the SEC civil enforcement action against defendants running a worldwide ponzi scheme.  The Court affirmed that the SEC correctly used the conduct-and-effects test to reach a securities transaction outside of the United States.  So, while the conduct-and effects test brought back by the Dodd-Frank Act will be used in governmental actions, as stated here, private actions under the antifraud provisions will continue to be governed by the Morrison test.  Another great analysis that supports the above can be found here.

Foreign B-Ds located outside of the U.S.

Foreign brokers that operate outside of the United States generally have to register with the SEC if they use any interstate commerce to effect securities transactions with persons in the United States.  This would include the use of the Internet and advertising materials.  There are, however, several significant exceptions for this general rule codified in Rule 15a-6 under the Exchange Act.

Although repeating the entire Rule here is beyond the scope of this blog post, I would like to draw your attention to several of its provisions.  The first one exempts from registration requirements those foreign broker-dealers that engage in "unsolicited transactions" in the United States.  As the SEC clarified in its FAQ (Question 9), there could be more than one such transaction. However, the focus should be on the foreign broker-dealer activities to determine whether solicitation had occurred.  The SEC warned that it interprets "solicitation" broadly to include phone calls encouraging use of such broker-dealer's services, advertising materials, and trading recommendations.

Another exception allowed foreign broker-dealers to forego registration in the U.S. for direct solicitation of securities transactions (and the effecting of such transactions without involving a U.S. broker-dealer) so long as such  solicitations were directed at foreign persons temporarily present in the United States.  The SEC noted in FAQ Question 1 that, although the question of "temporary presence" was a factual one, it was the overall intention of the SEC to exclude from the registration requirements those foreign broker-dealers who effected transactions with a foreign person located in the U.S. with whom they had a "bona fide, pre-existing relationship before the foreign person entered the U.S., so long as such person: (1) is not a U.S. citizen and (2) is not a lawful permanent resident of the U.S. (i.e., a “Green Card holder”)."

There are several more exemptions included in the Rule that are beyond the scope of this summary blog post.

In conclusion, as you can see, the broker-dealer registration requirements are quite complex as they apply to foreign broker-dealers soliciting and effecting transactions with U.S. persons or on U.S. soil.  Foreign broker-dealers, whether they are in the U.S. or not, should carefully consider application of the U.S. securities laws to their broker-dealer activities as they interact with their clients.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.