Securities Laws Regulations And Exemptions

Securities – Governing Laws And Regulation

Securities law is a broad area of law that includes several areas of the economy that deal with stocks, including

• Stocks and bonds issued by companies in private and public offerings;
• The resale of stocks and bonds between existing holders and third parties;
• Stock exchanges;
• Investment companies;
• Broker-dealers;
• Mutual funds.

The primary laws that impact companies issuing securities to investors and employees are the Securities Act of 1933 (commonly referred to as the “1933 Act”) and the Securities Exchange Act of 1934 (“1934 Exchange Act”). Rules and regulations promulgated by the SEC under the 1933 and 1934 Acts, including Regulation A and Regulation D, and the state securities laws of the fifty states, are often referred to as state “blue sky” laws. These Acts are critical when navigating the securities laws regulations and exemptions world.

Registration Of Securities

Since the 1933 Act was adopted, all securities issued by a company, including common stock, preferred stock, promissory notes with a maturity date of over nine months, and bonds, must be registered with the SEC unless the securities or the sale transaction fit into an exemption. In addition, the laws of the 50 states also require registration unless an exemption applies.

This should make most sellers of securities shudder due to the complexity of registering securities. First, registration of securities requires disclosures of detailed information about the company and its business, intellectual property, management, industry, and capital stock. These disclosures go as far as requiring a description of the shares already issued, the percentage that has been issued to management, a description of the shares being registered, and detailed financial information set out in financial statements that comply with GAAP (generally accepted accounting principles) and other accounting standards that go back at least two years.

These financial statements must include a balance sheet, statement of operations, statement of stockholder equity, and statement of cash flows presented in accordance with GAAP. In addition, they must be audited by an independent accounting firm. Finally, the registration statement that requires all this information, generally prepared by third-party professionals, namely lawyers and accountants, must be submitted to the SEC and state regulators in the relevant state.

Companies can sometimes avoid registration on both the state and federal levels. This is possible if an exemption to the offering or sale of securities is available. In very few cases are the securities sold by a company exempt securities. However, there are increasing transactional exemptions from registration available to companies who wish to sell their common stock or other securities.

Registration Exemptions

Federal securities laws generally require registration for public securities offerings but exempt transactions deemed private issuances. The statutory exemption set out in Section 4 of the 1933 Act is seemingly straightforward: securities issuance transactions that are “not involving any public offering” are exempt. While this seems clear-cut, the 1933 Act does not clearly define the meaning of “public offering.”

The SEC has fortunately promulgated regulations that set out so-called “safe harbors” to exemption from registration over time. More simply put, if a company’s stock issuance meets specific criteria, the sale of its stock is exempt from federal securities laws. The requirements of a particular exemption relate to the type of investor sold to, the amount of stock sold relevant to the company’s outstanding stock, the amount of money raised, and the type of disclosures made to investors.

Section 4(a)(2)

Section 4(a)(2) is part of the original text of the 1933 Act. It states that “transactions by an issuer not involving any public offering” are exempt from registration.

Early in my career, one of the first securities lawyers I had the privilege of working closely with was Norm Johnson. Mr. Johnson had served as one of the four commissioners at the SEC. While at the SEC, Mr. Johnson had a hand in making the Section 4(a)(2) exemption “self-executing.” The significance of a self-executing exemption is that, so long as the issuing company is not engaged in a public offering, Section 4(a)(2) automatically applies and exempts the stock issuance transaction under federal law without the company doing anything. However, making Section 4(a)(2) self-executing did little to comfort a company that wanted to ensure that its offering was not public and to make the offering transaction exempt under the laws of the states where the offering was made.

Fortunately, the SEC has since created more specific regulations. The most widely used are under Regulation D and increasingly under Regulation A.

SEC Regulation D

Regulation D is important when considering securities laws regulations and exemptions. It contains several SEC rules that allow for an exemption to a company’s sale of its stock to investors. These rules include Rule 504, 505, and 506.

Rule 504 is for offerings of $1,000,000 or less and sold only within a single state.

Rule 505 is limited to offerings of $5,000,000 and still must be qualified with the securities regulator in each state where the offering is sold.

Because of the limitations of Rules 504 and 505, Rule 506 is by far the most commonly used rule under regulation D. It allows an unlimited number of shares of stock to be sold to an unlimited number of investors for an unlimited amount of money, so long as the investors are “accredited investors.” Rule 506 also allows selling stock to sophisticated but non-accredited investors, assuming the many disclosures required in a registration statement are provided. The required disclosures include information about the company, including its management, products and services, and financial statements audited by an independent accountant.

Accredited Investors

An accredited investor has both reasonable sophistication and a certain minimum wealth of $1,000,000 in net assets, excluding the equity in their primary residence. A person with less than $1,000,000 in net assets can qualify as an accredited investor if their salary is at least $200,000 per year or totals $300,000 per year when combined with a spouse’s salary.

The income threshold for accredited investors requires that the minimum income be met in each of the two preceding years. In addition, there is an expectation that the income threshold will also be met in the year in question.

As of 2020, knowledgeable employees at some investment funds and registered investment advisors can be deemed accredited investors even if they lack the traditional net asset and salary qualifications. Many commentators note that the $1,000,000 net asset and salary thresholds are less significant than when the accredited investor rules were established due to inflation. However, even as of the date of this book, the number of American adults that qualify as accredited investors on the basis of assets or income is only around ten percent, which excludes the vast majority of the population.

Using Regulation D

Any company can sell its securities under the regulation D exemption, so long as it sells only to accredited investors, provides the appropriate information to non-accredited investors, and no “bad actors” are involved. “Bad actors” include large stockholders and members of the issuing companies’ management that have been found guilty of fraud or securities law violations of both a civil and criminal nature. There is a five-year look-back period that prohibits a company that has anyone with a history of fraud or securities law violations involved from making use of Regulation D.

Filing Requirements For Regulation D Offerings

So long as a company qualifies for an exemption, it will receive the exemption. However, a company that relies on a Regulation D exemption for its securities offering is required to file a notice with the SEC on Form D. It is a reasonably simple filing that discloses the company, the date of the offering, the exemption that is relied upon, the expected number of investors, the expected offering size, address of the company, and the states where the offering will be sold. Most states also require notice of issuers selling securities in their state under Regulation D Rule 506.

Under federal law, states can require companies to make a notice filing but are prohibited from requiring the issuer of securities relying on Rule 506 exempt transactions to go through any other qualifying process with the state. Therefore, Regulation D, Rule 506 is the most widely used securities offering exemption.

Selling Regulation D, Rule 506 Offerings To Non-Accredited Investors

Regulation D, Rule 506 offerings of securities can be sold to up to 35 non-accredited investors. However, if a company sells to non-accredited investors, it is required to provide registration statement-type disclosures about the company. These requirements include the company’s business, intellectual property, management, industry, and capital stock. The capital stock disclosure must include a description of the shares already issued, the percentage of shares issued to management, a description of the shares being registered, and detailed financial information set out in financial statements that comply with GAAP and other accounting standards that go back between one and two years.

“Gaming” The 35 Non-Accredited Investor Requirement

There have been several instances where companies have attempted to “game” the 35 non-accredited investor limit to a Rule 506 offering. They would generally do this by opening a new Rule 506 offering as soon as they hit the 35 non-accredited investor mark.

SEC rules prohibit this tactic.

Under Securities Act Rule 152, an issuer must wait 30 days between the closing of one Rule 506 offering and the commencement of a subsequent offering in order for the exemption to be available. If consecutive offerings occur within 30 days, they are integrated into a single offering, causing the 35 non-accredited investor limit to be exceeded, rendering the exemption null.

The primary exemption used under Regulation D is Rule 506, subsections Rule 506(b) and Rule 506(c). All offerings under Rule 506 allow for an unlimited number of securities to be sold to an unlimited number of accredited investors and to raise an unlimited amount of money so long as the offering is only made to accredited investors.

As a result of the JOBS Act, Rule 506 was broken into two subsections. The traditional Rule 506 procedures were assigned to subsection 506(b), and new procedures were assigned to subsection 506(c).

Rule 506(b)

The traditional Rule 506, now commonly referred to as Rule 506(b), does nothing to relieve companies selling their securities from the general prohibition of “generally” soliciting investors. This means that the company may not advertise the investment opportunity in question online, in flyers, via cold calls, or in other forms of media. The company is only allowed to raise money from qualified accredited people with whom it already has relations or individuals brought to it by brokers with whom they already have relations.

Rule 506(c)

The codification of Subsection 506(c) was a dramatic departure from the securities laws in the United States prior. It allows for offerings to be sold by general solicitations to investors that have not been reviewed or cleared by the SEC.

There is a “catch,” however. All investors must not only be accredited, but the investors’ accredited status must be verified by the company or an agent hired by the company to conduct the verification. The verification can include a review of the investors’ tax returns and a letter from a CPA or lawyer familiar with the investor’s financial condition.

Rule 506(c) is the exemption that allows investment opportunities to be made in radio ads and other media. This did not exist at all before Rule 506(c). While many practitioners and companies were excited about Rule 506(c), data in the years following its adoption show that the vast majority of Rule 506 money continues to be raised by people already known to the companies and their brokers through a non-generally solicited Rule 506(b) offering.

Restrictions On Offerings After Regulation D Exemptions

Once a company has sold shares to an investor, there continue to be securities laws restrictions on the stock. For instance, if the investor wishes to resell their stock, they must either have the shares registered with the SEC or find another exemption.

The primary exemption for the resale of securities by investors is section 4(a)(1) of the 1933 Act. There is a relatively well-known safe harbor to section 4(a)(1) called Rule 144, which allows investors to resale their common stock subject to holding the shares for six months or twelve months, depending on whether the company files reports with the SEC. However, there are restrictions to the use of Rule 144. For example, holders of more than ten percent of a company’s outstanding stock, officers, or directors of the company may still use Rule 144 with additional limitations and disclosure requirements.

For more information on Securities Laws Regulations And Exemptions, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (801) 355-7878 today.