Securities Regulations: Exemptions Under Reg D & Limited Offerings

Under Section 5 of the Securities Act of 1933, as amended (the “Securities Act”), all securities must be registered unless an exemption applies to those securities.  This article will give a brief summary of Regulation D and the limited offering exceptions found within it.  Please note this summary and explanation is by no means exhaustive, and you should consult with an experienced securities attorney as to your individual situation to ensure that your needs are met and are compliant with all applicable securities regulations.

Regulation D contains some of the most important registration exemptions under the Securities Act.  Furthermore, since the inception of the Jumpstart Our Business Startups (“JOBS”) Act was created, which granted additional leniency in regards to the general solicitation requirements of Rule 506, Regulation D has become even more important in relation to registration exemptions.

The exemptions set forth by Regulation D are found in Rule 504, 505, and 506.  Rules 504 and 506 were formed based upon Section 3(b)(1) of the Securities Act.  Rule 3(b)(1) allows the Securities and Exchange Commission (the “SEC”) to authorize exemptions from registration for transactions up to $5,000,000.  Rule 506, however, is considered a nonexclusive safe harbor as they relate to the private offerings exemption of Section 4(a)(2).  Section 4(a)(2) will be discussed in a later post.  All three are nonexclusive safe harbors, and as such, issuers can rely on one or more of these exemptions as well as the other nonexclusive exemptions to avoid having to register the securities with the SEC.  However, Regulation D is not available to non-issuers, so secondary sales of the securities will not be exempt under Regulation D.

Preliminary Discussion: Accredited Investors, Aggregation and Integration

Any discussion of Rules 504, 505, and 506 will undoubtedly include the term, “accredited investor.”  To qualify as an “accredited investor” an individual must be: (i) an officer, director, or 10% shareholder of the issuer; (ii) anyone with a net-worth of $1,000,000 exclusive of their primary residence; or (iii) in receipt of an annual income greater than or equal to $200,000 for the prior two years and expected to be so for the current year, unless the investor is investing with their spouse, in which case the annual income raises to $300,000.  Accredited investors also include institutional accredited investors, banks, insurance companies, employee benefit plans, qualified trusts, registered broker-dealers, and other large financial institutions, all who are financially sophisticated enough to have a reduced need for the protection provided by disclosure requirements.  Aggregation and integration will be discussed next.

Often, the terms “aggregation” and “integration” are confused.  Aggregation refers to the maximum limit on offering prices under Rules 504 and 505 within any 12-month period (each rules limits are discussed in their respective section, below).  The maximum aggregate offering price for these rules means that the amount of any offerings relied upon by these rules within a 12-month period must be equal to or less than the maximum price set forth in the regulation.  So if an issuer has two offerings under Rule 504 within a 12-month period, but each offering amount, when combined, goes above the maximum aggregate offering price allowed by Rule 504, the issuer will lose the exemption under Regulation D.  Furthermore, any securities sold in reliance upon any Section 3(b) exemption within the previous 12-month period before a Regulation D offering will reduce the aggregate offering price limitations for that Regulation D exempt offering.  So the amount of the offering on reliance of the Section 3(b) exemption within the 12-month period will aggregate with the Regulation D exemption, causing the maximum amount that can be offered and still be in compliance with Regulation D to be lowered.  Similar to integration, if you lose an exemption due to the offers being aggregated and the offering price of the Regulation D offering is higher than the aggregate offering amount allowed by the exemption, the issuer will lose the right to use the exemption and any securities sold under such exemption without being registered with the SEC can be returned by the investors for a full refund of their purchase price.

As it relates to integration, it is important to note that an issuer cannot use Regulation D exemptions without considering the issue of integration of offerings.  The Securities Act sets forth standards for the SEC to make the decision as to whether two offers made by the same issuer should be considered “part of the same issue,” or what is known as being “integrated.”  If the SEC determines that the two offers are in fact part of the same “issue,” and one offer violates a requirement of one of the Registration D safe harbors in any way, even the offer in compliance will lose its exempt status allowing the investors to return their securities and get a refund on their purchase price.  However, Rule 502 sets forth a safe harbor for Regulation D offerings and integration:

“Offers and sales made more than six months before the start of a Regulation D offering or 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 and sold under Regulation D.”

However, it is important to remember that offers and sales that occur within that six-month period are not automatically going to be considered integrated.  Examinations of transactions and whether they will be considered integrated are undertaken on a case-by-case basis, as every transaction differs in some way.  The SEC has released notes stating that any one or more of the following may determine a transaction is integrated:

  1.        Are the offerings part of a single plan of financing;
  2.        Do the offerings involve issuance of the same class of securities;
  3.        Are the offerings made at or about the same time;
  4.        Is the same type of consideration to be received; and
  5.        Are the offerings made for the same general purpose

If the issuer can show the SEC that they are not in fact integrated, then the issuer can move forward with the offer and sale, so long as the offer and sale complies with all other securities regulations that may apply.

The Safe Harbors of Reg. D: Rules 504, 505, and 506

Rule 504

Rule 504 has a maximum aggregate offering price of $1,000,000 during any 12-month period.  However, an exemption under this rule is not available for reporting or investment companies.  Unlike some other rules, there are no limitations on the number of purchasers, and no sophistication requirements.  Another positive attribute of this exemption is there are no affirmative disclosure obligations.  However, the resale of the securities after initial issuance is restricted.

Rule 505

Rule 505 has a maximum aggregate offering price of $5,000,000, during any 12-month period.  Once again, this exemption does not apply to investment companies.  Under Rule 505, the issuer may sell to an unlimited number of accredited investors, but may only sell to a maximum of 35 non-accredited investors.  If the offer includes non-accredited investors, the issuer does have affirmative reporting requirements as set forth in Rule 502 Section (2).  Once again, the resale of the securities after the initial issuance is restricted.  The issuer must have a preexisting relationship with the investors under Rule 505, and using general solicitation or general advertising to find investors is prohibited.

Rule 506

Rule 506 will be broken into two separate sections as the Rule 506 exemption can actually be broken down into two separate exemptions, Rule 506(b) and Rule 506(c).

Rule 506(b)

Under Rule 506, there is no maximum aggregate price limit on the offering.  Under 506(b), an issuer may offer to an unlimited number of accredited investors, and up to 35 sophisticated investors.  506(b)(2)(ii) defines the requirements for the issuer to offer the securities as it relates to the non-accredited investors, being the investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”  This safe harbor is available to reporting companies, as well as non-reporting companies, but once again the issuer must have a preexisting relationship with the investors and cannot rely on general solicitation or general advertisement to find them.

Rule 506(c)

Rule 506(c) was created by the JOBS act and allows the issuer to use general solicitation and general advertising to find investors, but 506(c) prohibits the offer and sale of securities under this exemption to non-accredited investors. Furthermore, under 506(c) the issuer must take reasonable steps to verify the investors accredited investor status.

Check back soon as LSK will be providing more information on other registration exemptions in the weeks to come. Please keep in mind that you should always consult an experienced securities attorney before undergoing any offer, offer to sell, or sale of securities, as there are other regulations that these exemptions must be read in conjunction with to ensure compliance and that every transaction is driven by the transaction’s individual circumstances.  Contact Lee Shome & Kennedy, LLP today to schedule a consultation with one of our experienced securities law, business law and corporate law attorneys.