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Securities Overview

The purpose of this memorandum is to provide a brief overview of some issues that may arise in connection with the offer or sale of securities, such as stock, promissory notes, and investment contracts.

In the United States, the offer and sale of securities are subject to both federal and state securities laws.  Securities subject to such regulation include both equity securities (stocks, for example) and debt securities (promissory notes, for example).  Thus, whenever stock, notes or other securities (warrants, e.g.) are offered or sold, the issuer must check both the federal security laws and the applicable state securities laws to verify compliance.  Typically, the domicile state of the purchaser will be the applicable state.  Thus, if an issuer offered or sold securities to purchasers in different states, the securities laws of the US government and of each state where a purchaser was located would need to be reviewed to ensure compliance with the applicable laws.

Both state and federal securities laws usually begin with a general prohibition of the offer or sale of securities unless the securities are registered with (i) the SEC, to satisfy the federal regulations, and (ii) the applicable state agency, to satisfy the requirements of the applicable state laws.  The general prohibitions are then subject to various exemptions. 

Federal Exemptions

The most common exemption is one allowing “private” sales.  The general prohibition against the offer and sale of securities is usually limited to “public” offerings or sales.  The courts have made clear that whether an offering is “public” or not may not be determined solely based on the number of offerees or purchasers (although this may be a significant factor).  Nevertheless, there are a number of exemptions that are referred to as “limited offering exemptions.”  (Such an appellation may be misleading because, while a central condition for qualifying for the exemptions so named, the limited number of offerees or purchasers is only one of the conditions that need to be met.  It is necessary, but not sufficient.) 

The private offering exemption found at Section 4(2) of the Securities Act of 1933 (hereafter, the “Securities Act”), exempts “transactions by an issuer not involving any public offering.”  But, as noted on the SEC’s website, “[t]he precise limits of this private offering exemption are uncertain.  As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption.  You should know that if you offer securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act” (emphasis added).  It should also be noted that the wording of the SEC’s comments above may themselves be misleading.  It cannot, for example, be assumed that employees of an issuer will fall within a Section 4(2) exemption because “the relationship to the company” is not remote.

On the contrary, the courts have held that offerings to employees are not necessarily “private.”

One of the problems with relying simply on the exemption at Section 4(2) of the Securities Act is the very fact that “the precise limits . . . are uncertain.”  Among other issues raised, this uncertainty means that it may be difficult, if not impossible, to obtain a requested legal opinion in various transactions.  For this reason, and to otherwise resolve the inherent uncertainty of reliance solely on Section 4(2), it is common for issuers to use the “safe harbor” exemptions promulgated by the SEC.  Such safe harbors include the exemptions under Regulation D promulgated under the Securities Act.

Regulation D

Reliance on Regulation D is useful not only to resolve some of the uncertainty as to whether an offering will be deemed “private” or “public,” a determination always made in hindsight, but also to assist with compliance with state securities laws.  The Securities Act provides that if an issuer complies with the requirements of specified exemptions, then state securities laws are pre-empted.  An offering under Rule 506 of Regulation D (a common exemption) is subject to the benefits of such pre-emption.

Generally, Regulation D requires that (i) the number of offerees and/or purchasers be limited in number  and (ii) certain information about the issuer be provided to a purchaser prior to the purchase.  The informational requirements may not apply to “accredited investors” and any “accredited investors” may not be included in determining the number of offerees or purchasers.  The definition of “accredited investor” is attached. 

A further complication in determining the number of offerees or purchasers is the concept of “integration.”  Under this concept, one offering may be included with another to form one offering.  Once again, the “precise limits” of the rules as to whether any offering will be integrated with any other are “uncertain”.  Rather there are a number of factors to consider in a “facts and circumstances” analysis and no specific guidance is given as to how those factors are to be weighed in making the determination regarding integration of different issuances.  In short, once again there is no certainty.  Once again, however, under Regulation D there is a “safe harbor”.  Under Regulation D, if a six-month interval during which no offerings are made, separates two offerings, then the two offerings will not be integrated.  The rules concerning integration found in Rule 502 of Regulation D are attached.  

This is sometimes referred to as “10b-5 liability.”  (Although that reference is really to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder rather than to any section of or rule promulgated under the Securities Act, the Securities Act has its own prohibitions against sales using fraud or deceptive practices.)

In order to try to limit “10b-5” liability, offerings are frequently accompanied by disclosure documents (offering circulars, etc.).  Such documentation allows the issuer to make a record of the nature and scope of the information and disclosures provided to the offerees and purchasers.  However, such documentation may be costly to create.  It is common for such documents to mirror a substantial amount of the disclosures required by a registration statement.  Further, such a disclosure document is not absolute protection against a claim of fraud.

¹Reg D offerings under Rules 505 and 506 limit the number of purchasers to 35.  Offerings under Rule 504, being exempt under a different section of the Securities Act than Rule 505 and 506 offerings, do not limit the number of purchasers.  Other limitations apply to Rule 504 offerings.

Accredited Investors

Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors." 

The federal securities laws define the term accredited investor 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;
  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.


Integration. All sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D.  Offers and sales that are made more than six months before the start of a Regulation D offering or are made more than six months after completion of a Regulation D offering will not be considered part of that Regulation D offering, so long as during those six month periods there are no offers or sales of securities by or for the issuer that are of the same or a similar class as those offered or sold under Regulation D, other than those offers or sales of securities under an employee benefit plan as defined in Rule 405 under the Act [17 CFR 230.405].

Note: The term “offering” is not defined in the Act or in Regulation D.  If the issuer offers or sells securities for which the safe harbor rule in paragraph (a) of this § 230.502 is unavailable, the determination as to whether separate sales of securities are part of the same offering (i.e., are considered “integrated”) depends on the particular facts and circumstances.  Generally, transactions otherwise meeting the requirements of an exemption will not be integrated with simultaneous offerings being made outside the United States in compliance with Regulation S. See Release No. 33-6863.

The following factors should be considered in determining whether offers and sales should be integrated for purposes of the exemptions under Regulation D:

  1. whether the sales are part of a single plan of financing;
  2. whether the sales involve issuance of the same class of securities;
  3. whether the sales have been made at or about the same time;
  4. whether the same type of consideration is being received; and
  5. whether the sales are made for the same general purpose.

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