We find that many founders and executives do not fully appreciate that raising capital and other transactions often involves the sale or issuance of securities, bringing them under the jurisdiction of the Securities and Exchange Commission (SEC) and requiring specific filings and compliance measures. It is important for businesses to understand when they fall under SEC jurisdiction and the options they have for SEC compliance.

What is a “Security?”

A primary role of the SEC is to screen security offerings for inaccurate claims and prevent “bad actor” promoters of securities from engaging in fraudulent schemes. Thus, in the most basic terms, if a company issues, sells or trades a “security,” it will be subject to SEC regulation. Whether a particular financial instrument is a “security” is very clear in the case of stocks or bonds issued by a company to many passive investors, but the analysis is trickier in other cases.

The long-used test to determine whether the instrument being sold is a security comes from the 1946 U.S. Supreme Court case SEC v. W.J. Howey Co and is referred to as the Howey Test. For something to be deemed a security, it must involve:

1. An Investment of Money: The investor provides capital (money, assets, or other value).
2. In a Common Enterprise: The investor’s funds are pooled with others or tied to the success of the promoter’s efforts.
3. With an Expectation of Profits: The investor anticipates a financial return.
4. Solely from the Efforts of Others: The profits are derived primarily from the managerial or entrepreneurial efforts of a third party (not the investor).

If any one of these four Howey prongs is not met, the instrument in question would not be deemed a security. Certain arrangements may fail the Howey Test and thus fall outside SEC regulation. As an example, if an LLC is selling its equity to a new partner, and the partner will take on an officer or similar managerial role in the company, that LLC equity is not a security in this case and typically would not require SEC filings because the investor will have an active role in the business. Conversely, if the LLC offered equity to passive investors with no managerial control over the business, then those equity interests would be deemed securities under the Howey Test. If there is any ambiguity about whether a certain right or interest issued by a company is a security under the Howey Test, it is best to consult with an attorney experienced in securities law.

The Way to Avoid “Registration: Regulation D

Even if an instrument is deemed a security, that does not necessarily mean that security needs to be “registered” with the SEC. “Registration” describes the process of filing information about the security and issuer with the SEC for approval and public viewing. This is generally perceived to be an onerous and expensive process, especially for a startup, and something to avoid if at all possible.  A “registered security” usually is a corporation’s stock that has been qualified to be publicly traded on exchanges such as the NYSE or Nasdaq, but any capital-raising campaign or transaction that hasn’t been designed to fall within an exemption from registration will need to be registered.

Fortunately, for the types of private offerings most considered by small to medium-sized private companies, the sale of securities will be exempt from registration, because of an SEC regulation called “Regulation D.” Regulation D, usually referred to as “Reg D” refers to a set of SEC rules which allows companies to issue securities privately with much fewer disclosure requirements than registered securities (see 17 C.F.R. § 230.500 et seq). The avenues to such relief are discussed in greater detail below.

Key Terms Under Reg D

In exchange for Reg D’s reduced disclosure obligations, issuers must adhere to restrictions, such as selling to a defined pool of investors and, in some cases, limiting how they solicit investors. Two terms of art are especially important to understand. The following is a high-level summary of the importance of these restrictions:

• The default rule under Regulation D is that the investors in a Reg D securities offering must be Accredited Investors.
• A company can only employ General Solicitation in certain tightly constrained situations.

Accredited Investors

An “accredited investor” is a person or entity that meets certain SEC requirements which demonstrate the investor’s financial sophistication. In turn, an issuer has fewer and more lenient requirements when issuing securities to accredited investors. The rationale of this classification of investor is that limiting an offering to only or mostly accredited investors is a way for the offering to be regulated by its own exclusiveness without extensive SEC disclosures and requirements. Given their qualifying criteria, accredited investors are more likely to be savvy and knowledgeable when evaluating investments. They also meet certain minimum financial requirements, meaning that a loss will generally impact them less than a non-accredited investor.

While there are multiple ways to qualify as an accredited investor, the primary way individuals qualify is through their income or net worth. Specifically, an individual is an accredited investor if he or she: (i) has an income of $200,000 individually or $300,000 with a spouse for the last two years and is expected to earn the same in the current year; or (ii) has a net worth of at least $1,000,000, individually or with a spouse, excluding a primary residence. Other ways to qualify as an accredited investor include certain qualifications for individuals (e.g. having certain professional certifications such as a Series 7 license, being an executive officer or director of the issuer, etc.) and entities (e.g. broker-dealers, banks, registered investment companies, employee benefit plans, etc.)

General Solicitation

“General Solicitation” refers to an issuer publicly advertising or offering securities to a broad audience. Where general solicitation is prohibited (such as Rule 506(b) offerings), the issuer must take care not to advertise its offering to the general public or a general audience. Instead, it must target potential investors with whom the issuer has pre-existing relationships. Although “general solicitation” is not exhaustively defined in Regulation D, SEC guidance and precedent suggests it includes broad-reaching actions like public seminars, mass emails, and online advertising aimed at attracting investors.

Reg D’s Most Commonly Used Exemptions    

Although there are some additional, rarer exemptions issuers can utilize under the SEC rules, the most common Reg D exemptions are Rules 506(b), 506(c), and 504. Each of these three exemptions have various trade-offs, each of which may suit one issuer or offering over another. It is especially important to consult a securities attorney before trying to commence an offering under these rules, because often it isn’t clear which rule, if any, will apply and how one should conduct the offering.

The table below summarizes the key characteristics of each offering, followed by a description of a few notable trade-offs for each offering:

• Rule 506(b) is the most commonly used exemption under Reg D. Even though it permits sales to non-accredited investors, many issuers choose to only sell to accredited investors to avoid extra disclosure requirements. Rule 506(b) minimizes state-level compliance and allows the issuer to rely on reasonable belief (often via investor self-certification) of accredited investor status. The downside to Rule 506(b) offerings is that general solicitation is prohibited. Issuers who rely on general solicitation or may be prone to inadvertently engage in general solicitation should weigh this restriction against the more lenient requirements of Rule 506(b).

• Rule 506(c) requires more diligence on the part of the issuer to vet accredited investors. Issuers must take reasonable steps to verify accredited investor status, which may include requesting tax returns, bank statements, or third-party confirmation. In exchange for this additional verification, the issuer may engage in general solicitation. For issuers who need general solicitation to make sales, Rule 506(c) may be a better option than Rule 506(b).

• Under Rule 504, issuers do not need to limit the offering to accredited investors, and unlike Rule 506(b) offerings, they do not need to provide additional disclosures to non-accredited investors. There is a $10 million limit on the offering size within a 12-month period, so Rule 504 is only suitable for companies who are looking to raise small to moderate amounts of capital. The major downside to Rule 504 is the lack of full state-level preemption. Issuers using Rule 504 will need to find other rules to exempt them from state regulation or otherwise register the securities with each state where sales and offerings are made. Rule 504 is most beneficial to issuers who want to sell to non-accredited investors in a limited number of states.

Form ID, Form D and Blue Sky Filings

Federal Filings

Once an issuer decides which rule to use for its offering and launches its offering, it is required to file a Form D with the SEC. Prior to filing the Form D, however, it needs to first register with the SEC’s Electronic Data Gathering, Analysis and Retrieval (“EDGAR”) by filing its Form ID. The Form ID contains some basic information about the issuer and must be notarized by a principal of the issuer. After the issuer files its Form ID, EDGAR will issue it a set of unique codes to log into the EDGAR Filer Management Dashboard.

From here, the issuer can file its Form D for its offering. The Form D can be filed before the first sale of the offering takes place, but no later than 15 days after the first sale. Form D requires the issuer to disclose certain limited information about the issuer and offering, which will be available for public viewing through EDGAR. Most notably, among other information, the issuer must disclose any “related persons” of the issuer (namely directors and executive officers), the issuer’s industry type, the type of security being offered, the date of the first sale of securities under the offering, the number of investors to date, the minimum investment amount and maximum size of the offering, and broker-dealer information and commissions or management fees, if any. Compared to public offerings or other types of offerings (such as Regulation A offerings), this information is minimal and largely keeps the details of the offering private.

Blue Sky Filings and State-Level Preemption

In addition to the SEC’s federal-level regulation, each state also has its own securities laws and compliance procedures, also called “blue sky laws,” which need to be considered for any offering. A major advantage of Rules 506(b) and (c) is that the federal SEC exemptions preempt any state law requirements, provided that the issuer fully complies with such federal exemption requirements. For Rule 506(b) and (c) offerings, the issuer merely needs to submit a notice of the offering to the respective state regulator along with a filing fee, which varies by state. States require these filings to be made within 15 days of the first sale in the respective state. These filings and fee payments can be made in every state electronically via the North American Securities Administrators Association (NASAA) Electronic Filing Depository (https://nasaaefd.org). If the offering has more than one closing, these blue sky filings will be made on a rolling basis as securities are sold in new states for the first time. As mentioned earlier, Rule 504 offerings do not enjoy full preemption from blue sky laws. Thus, issuers using Rule 504 will need to research the rules of each individual state they plan to sell in and comply accordingly.

GreeneHurlocker is happy to assist companies of varying sizes and needs structure their private placement offerings under Reg D and comply with federal and state securities requirements. Please contact us with any questions regarding which type of offering is right for your business.