Although the SEC has several exemptions from registration, among the more popular exemption rules are rules promulgated pursuant to Regulation D and other related rules, which I will cover in this part; in the next part I will discuss other registration exemptions.
Before I begin discussing the exemptions pursuant or related to to Reg D, it is necessary to have a brief discussion about one of the important concepts of Reg D, the accredited investor. The accredited investor is a wealthy individual or institution that are irrefutably presumed to have access to the type of information about a company normally provided in a registration statement and the financial sophistication necessary to understand that information in a format other than the S-1 or other registration form. The individual requirements for an accredited investor are a person whose net worth exceeds $1 million and those whose individual income exceeded $200,000 ($300,000 in joint income for married couples) in each of the previous two years and is reasonably expected to exceed that amount in the current year. Recently, the SEC changed the definition of an accredited investor’s net worth to exclude the value of their primary residence. Under the Reg D exemptions, companies are not required to deliver financial information to accredited investors, as accredited investors are assumed to have the financial position and accumen to fend for themselves when investing in these companies and don’t necessarily need the full protection of the securities laws.
Perhaps the most popular exemption under Reg D is Rule 506. The primary attraction of Rule 506 is that, unlike other Reg D rules, there is no limit on the amount of money that can be raised by the offering. Another important attraction of Rule 506 is that, pursuant to federal legislation enacted in 1996, state regulation of Rule 506 offerings is preempted (although states may continue to require notice filings and collect fees pursuant to the offering, and may also continue to police fraudulent actions in respect to the offering). Rule 506 permits sales to an unlimited number of accredited investors; however, under a Rule 506 offering sales may only be made to a maximum of 35 non-accredited investors. In addition, general solicitation or advertising of the offering is not permitted; while there is no limit on the number of people the offering may be advertised to, too great a number could lead to a determination that a general solicitation occurred. Furthermore, companies must provide specific disclosures (pursuant to Rule 502(d)) to all non-accredited investors who make purchases; companies must also make a sophistication determination that each non-accredited investor who makes a purchase is capable of bearing the economic risk of the investment and either alone or in conjunction with an investment advisor has the business and financial knowledge necessary to evaluate the investment. Finally, companies offering under Rule 506 must take steps to prevent resale, generally by obtaining investment letters from purchasers and making special disclosures about limitations on resale to non-accredited purchasers.
The other Reg D related exemption rules are Rule 504 and 505. Rule 504 permits, in essence, a “mini public offering” — although companies (which cannot be investment companies or companies that already report to the SEC) are limited to raising a maximum of $1 million in any 12 month period, there is no limit on the number of investors of any type or any need to make a sophistication determination regarding nonaccredited investors or otherwise provide special disclosures to them. General solicitation and resale are permitted under one of two conditions: 1) the securities are registered in a state requiring public filing and delivery of disclosure documents and the disclosures are delivered to all purchasers before sale; or 2) the offering qualifies for a state exemption and sales are made only to accredited investors.
Rule 505 permits an offering of a maximum of $5 million over a 12 month period. Sales may be made to an unlimited number of accredited investors, in addition to a maximum of 35 nonaccredited investors; there is no need to make a sophistication determination, but like Rule 506 special disclosures must be made to nonaccredited investors. Like Rule 504, investment and reporting companies are not permitted to use the Rule 505 exemption; issuers who have previously engaged in securities misconduct (so-called “bad boys”) are also barred from using Rule 505. Finally, unlike Rule 506, offering under Rule 505 are fully subject to state regulation (indeed, some states place additional restrictions on Rule 505 offerings).
Under any Reg D offering, an issuer must file Form D with the SEC. Previously, Form D was required as a condition of exemption; under Rule 507, the SEC eliminated having filed Form D as a condition of exemption, but the SEC still ultimately requires the filing of Form D in connection with a Reg D offering. In addition, the SEC issued Rule 508, which provides Reg D issuers with a substantial compliance “safe harbor” — a Reg D exemption is not invalidated simply for a technical defect in the offering.