Slaying the Securities Regulation Dragon Part 3: Other Exemptions

In this final part I will discuss other registration exemptions under federal securities laws and SEC rules.

Perhaps the most significant exemption in this part, at least from a historical perspective, is Section 4(2) of the Securities Act, which is essentially the predecessor to Rule 506 under Reg D (today, Rule 506 can act as a “safe harbor” for defects in compliance with Section 4(2)). Under Section 4(2), which is still a valid exemption, the concern is whether the rules were followed in every offering, as opposed to every actual sale — courts have held that a violation of the rules in one offer to an individual may invalidate the entire offering. A Section 4(2) offering may only be made to a limited number of investors, although the actual limit is unclear as the limitation is a creature of case law. Like Rule 505 and 506 under Reg D, general solicitation and advertisement is prohibited in a Section 4(2) offering. Resale of the securities is also prohibited under a Section 4(2) offering; issuers must obtain investment letters and place appropriate transfer restrictions on the certificates. Section 4(2) offerings require that all offerees be sophisticated, that is, they have the financial ability to bear the economic risk of the investment and the knowledge (or be advised by one who has the knowledge) to evaluate the investment. Although accredited investors aren’t technically part of the Section 4(2) scheme, an individual who would be an accredited investor under Reg D would almost certainly meet the definition of a sophisticated investor for the purpose of Section 4(2). Issuers must make the type of information that would be included in a registration statement available to prospective investors (this is an important distinction with Rule 505 and 506, which require actual delivery of such information to investors — under Section 4(2) the information only needs to be made available, which nowadays is usually accomplished electronically, or often arises as a result of prior business dealing between the issuer and offeree). Finally, state regulation applies to offerings made under the Section 4(2) statutory exemption (although if an issuer uses Rule 506 as a safe harbor for defects in its Section 4(2) offering, state regulation no longer applies as it would under that rule).

Another statutory exemption from the Securities Act is the Section 4(6) offering. Section 4(6) permits an offering of no more than $5 million to an unlimited number of accredited investors (offerings to nonaccredited investors is not permitted). General solicitation and advertising is not permitted, nor is resale of the securities by the purchasers. Finally, an issuer making a Section 4(6) offering must file a notice of the offering with the SEC; the offering is still nonetheless subject to further state regulation.

Limited offerings of securities for employee compensation can fall under the Rule 701 exemption. The amount of the offering is limited to, over a 12-month period, the greatest of: 1) $1 million; 2) 15% of the company’s total assets; or 3) 15% of the outstanding securities of the class of securities being issued. The securities may only be offered as part of a compensation benefit plan to a company’s employees, officers, directors, consultants, and advisers. As long as the securities are only being offered to the preceding classes of individuals, general solicitation is permitted; however, resale is restricted. As long as the offering does not exceed $5 million, there are no specific disclosure requirements; furthermore, no notice of sales is required to be filed with the SEC.

Perhaps moreso than a Rule 504 offering, offerings made pursuant to the Regulation A exemption are very much “mini public offerings” — Reg A exempts from registration general interstate offerings of up to $5 million during a 12-month period. Reg A places no limits on the number or type of offerees, and even permits the use of broker-dealers and general solicitations. Reg A even permits resale of the securities by purchasers. Reg A requires issuers to file an “offering statement” (similar to a registration statement) with the SEC; however, the information required for an offering statement is not as extensive as is required for a registration statement, nor, since Reg A is an exemption from registration, does liability attach for materially false or misleading statements in the offering statement. Periodic reporting is also not required for securities issued under Reg A. Like Rule 505, the Reg A exemption is not available to investment or reporting companies, or issuers who have engaged in securities misconduct (“bad boy” issuers). And like Reg D exemptions, Reg A also has a “safe harbor” provision for substantial compliance with the regulation’s requirements. However, despite the great deal of simplification of requirements under Reg A, because Reg A offerings are subject to state regulation (unlike Rule 506 offerings), the Reg A exemption has yet to become as popular as other exemptions.