Securities:
Registration Exemptions
     Contents



Overview:
  • People planning to start a small business sometime want to raise capital by selling stock or having investors purchase interests in an LLC (both of which are considered to be "securities").  Such people, however, are often not knowledgeable about either the registration requirements or the "fraud by omission" booby-traps.

  • The general rule is that offers to sell securities must first be registered. Certain limited exemptions are available. In every case, whether or not there is an exemption, full disclosure of the potential risks should be given to the buyers in order to protect the sellers from liability in the event the buyers loose money on their investments.  For that reason the first step before approaching potential investors is ALWAYS to create an "offering memorandum" (see below)
Discussion of General Concepts
    WHAT IS A SECURITY?:  The term "securities" is broadly defined in the Security Exchange Act of 1933 to mean not only stock but also virtually any other instrument that is being sold as an investment.  In short, a "security" is anything that an investor buys with the expectation that it will increase in value as a result of the efforts of the entrepreneurs who created it.

    FULL BLOWN REGISTRATION REQUIRED BUT THERE ARE EXEMPTIONS   The general rule is that all securities being offered for sale must first be registered with the Securities and Exchange Commission (SEC) and with the relevant agency of state government unless the transaction is exempt. This type of registration can be expensive. Here is a brief summary of some of the requirements:

    • The issuer must submit to the SEC detailed information about the offering including audited financial statements

    • The issuer must submit (and the SEC must approve) a "prospectus" that contains detailed information about the offering including a comprehensive disclosure of all the risks. After the offering has been registered the prospectus is the primary disclosure document that must be given to all prospective purchasers.

    • After registration the company must submit periodic reports to the SEC.

    • Click here to go to a page on the SEC website which explains the registration process in detail.

    • BUT NEVER FEAR - EXEMPTIONS ARE AVAILABLE:  The available exemptions are outlined below.  For many small offerings the "intrastate exemption" and the "Regulation D - Rule 506" exemption are sometimes the easiest to obtain and comply with

    "FRAUD BY OMISSION" RULES APPLY EVEN IF EXEMPT:   All securities transactions, including exempt transactions, are subject to the antifraud provisions of the federal securities laws. The issuer can be held liable for damages suffered as a result of false (or misleading) statements or failure to disclose material facts ("fraud by omission"). Thus, there can be liability, even if no lies were told, simply because the issuer "forgot" to tell the buyers that they might lose money on their investment. See SEC Rule 10b. To protect themselves promoters should ALWAYS provide detailed written disclosures (called an "offering memorandum" or a "prospectus") describing the business and the potential risks (however remote).

    OFFERING MEMORANDUM RECOMMENDED EVEN IF SECURITY IS EXEMPT:  Almost all potential investors will expect to see an offering memorandum.  Beyond that an offering memorandum can help provide protection against liability arising out of "fraud by omission".  For that reason an offering memorandum is recommended even if is not expressly required by the particular exemption that is being used. This document should contain a detailed description of the business and a clear disclosure of the risk factors. This should include a disclosure of all the possible ways that the company could lose money (failure to do so would be an "omission of material fact" resulting in liability under the Securities Act).

    • CLICK HERE for an article entitled "How To Create an Offering Memorandum".

    FLORIDA REGISTRATION: Regardless of whether or not a security is exempt from federal registration it MUST still be registered with the Florida Office of Financial Regulation unless it qualifies for a state exemption. The State's registration procedures can be found at Chapter 517.081 FS and Rule 69W-700.001 FAC. Dealer registration requirements can be found at Chapter 517.12 FS,.


    EXEMPT SECURITIES MIGHT BE HARD TO RE-SELL:  The exemptions discussed below are "transactional exemptions", that is, they apply only for the original transaction between the issuer and the buyer. The exemption does not somehow attach to the security making a resale automatically exempt. If the buyer wants to later resell the security he or she must either have it registered or make sure that it is qualified for an exemption at the time of the re-sale. For this reason most securities issued under an exemption are considered "restricted".

    "ACCREDITED INVESTORS":  With some types of exemption offers can be made only to "accredited investors". The definition of "accredited Investor" is found at 17 CFR 230.501. It includes persons and institutions with a documented level of wealth and/or income and, as such, are presumed to have the sophistication to decide for themselves whether a particular security is a good investment. It includes the principals of the company issuing the securities but it also includes certain institutional investors, persons with a net worth of over $1,000,000, and persons with an annual income of over $200,000.

    "SOPHISTICATED INVESTORS":   Some types of exemption allow securities to be offered to people who do not necessarily meet the technical definition of "accredited investor" but who none the less are "sophisticated". To qualify such an investor must have the sophistication to be able to evaluate the risks and merits of the investment and be able to bear the investment's economic risk. Unlike the case of "accredited investors" there is no specific definition of "sophisticated investor" in the regulations (thus, there can be uncertainty as to whether or not a particular offeree qualifies).

TYPES OF EXEMPTIONS:


Statutory Inta-State Offering Exemption    - (back to the top)
    Section 3(a)(11) of the Securities Act -15 USC 77c (a)(11) - is generally known as the "intrastate offering exemption." To qualify:

    • The company must be organized in the state where it is offering the securities;

    • The company must carry out a significant amount of its business in that state;

      • If the company holds some of its assets outside the state, or derives a substantial portion of its revenues outside the state where the offer is being made it may be difficult to qualify for the exemption.

    • Offers and sales can be made ONLY to residents of that state (it would be wise to get a written representation from each purchaser as to his or her residence).

    • There is no requirement that investors be either "accredited" or "sophisticated"

    • There is no limit to the size of the offering or the number of purchasers

    The company must determine and document the residence of each offeree and purchaser. If any of the securities are offered or sold to even one out-of-state person, the exemption may be lost and the issuer wouild be in violation of the Act. To be safe the offering should be made only to persons that the issuer actually knows. The issuer should personally negotiate directly with those persons.

    Precautions must be taken against re-sale. If a purchaser resells any of the securities to a person who resides outside the state within a short period of time after the initial sale (usually nine months), the entire transaction, including the original sales made within the required state, might be in violation of the Securities Act. Transfer restrictions should be printed directly onto the security documents.

    FEDERAL REGULATORY SAFE HARBOR:    Rule 147 provides a "safe harbor" for intrastate offering.   However, transactions not meeting all the requirements of Rule 147 may still qualify for the exemption under the statutory exemption (riskier because going with Rule 147 adds a level of certainty).

    FLORIDA EXEMPTION. The State of Florida has a registration exemption for securities that are offered purely to instate buyers. Click here to view the exemption statute. The main requirements are as follows:

    • No more than 35 purchasers
    • No general solicitation or general advertising in this state.
    • Prior to sale purchasers are given "full and fair disclosure of all material information"
    • No commissions paid to dealers

Statutory Private Placement Exemption    - (back to the top)
    Section 4(a)(2) of the Securities Act - 15 USC 77d (a)(2) - exempts from registration "transactions by an issuer not involving any public offering (sometimes referred to as a "private placement"). To qualify for this exemption:

    • Purchasers must have enough knowledge and experience in finance and business matters to be "sophisticated investors" (able to evaluate the risks and merits of the investment) and be able to bear the investment's economic risk.

      • Investors in privately placed securities typically include insurance companies, pension funds, mezzanine funds, stock funds and trusts but not individuals.

      • As for individual investors, there is no bright line that tells you when "enough" knowledge and experience is truly enough to guarantee the availability of the exemption. It would be prudent to limit the offering only to persons meeting the statutory definition of "accredited investor". Issuers who intend to rely on this exemption should include in their files documentation regarding each offerees sophistication such as a fully completed financial questionnaire showing experience with the same kind of investment or business risk that the issuer is offering, and a net worth that can easily withstand the loss of the entire investment.

    • Purchasers must be given the same type of information that would be provided in a prospectus for a registered securities offering; and

    • Purchasers must agree not to resell or distribute the securities to the public. As safety precaution, the restriction should be printed on the face of the stock certificate or other document evidencing the security.>

    • The issuer must not use a general solicitation or general advertising to attract purchasers.

    • The maximum number of offerees is not defined by rule.

    • These securities are "restricted securities" (meaning resale is restricted unless it has been registered or an exemption applies).

    • There is a "safe harbor" for this exemption found in Regulation D - Rule 506 - see the discussion below

Regulation D - Private Placement Exemptions    - (back to the top)
CLICK HERE to view the full text of Regulation D
    Exemption under Regulation D - Rule 505:

    • This is the regulatory "safe harbor" for the statutory "accredited investor" exemption (which is discussed below). It is a safer alternative because it allows for inadvertent sales to non-accredited investors.

    • No federal registration required BUT "Form D" must be filed with the SEC immediately after the first sale.


    • The issuer can only offer and sell up to $5 million of its securities in any 12-month period;

    • The issuer may sell to an unlimited number of "accredited investors" and up to 35 other persons. There is no requirement that unaccredited investors be "sophisticated" as is the case with the safe harbor under Rule 506 (discussed below).

    • The issuer must inform purchasers that they receive "restricted" securities, meaning that the securities cannot be sold for six months or longer without registering them or an exemption applies. The restriction must be printed on the face of the security document.

    • No required disclosures need to be given to "accredited investors", so long as it does not violate the anti-fraud prohibitions of the federal securities laws. But "non-accredited investors" must disclosure documents that generally are equivalent to those used in registered offerings.

    • The issuer must provide the offerees with financial statements certified by an independent public accountant.

    • Unlike securities exempt under Rule 506 (see below), securities exempt under Rule 505 must register with the State of Florida (unless exempt under state law)

    Exemption under Regulation D - Rule 506 -

    • Rule 506 is the regulatory "safe harbor" for the Private Placement exemption of Section 4(a)(2) of the Securities Act (see the discussion, above)

    • For securities qualified under Rule 506 registration with the State of Florida is NOT required (because of the preemption provisions of National Securities Markets Improvement Act of 1996). For this reason it is the most popular of all the exemptions.

    • There is no limit on the amount of funds that can be raised.

    • No federal registration required BUT "Form D" must be filed with the SEC immediately after the first sale.


    • The issuer must not use general solicitation or advertising to market the securities;

    • The securities may be sold to an unlimited number of "accredited investors" but to no more than 35 unaccredited investors who must be "sophisticated". See the sub-headings above for a discussion on the topics of "accredited investors" and "sophisticated investors".

    • The issuer must give non-accredited investors the same types of disclosures that would be required to be given if the securities were registered offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well);

    • The issuer must be available to answer questions from prospective purchasers who are non-accredited investors; and

    • The issuer must provide the offerees with financial statements certified by an independent public accountant.

    Exemption under Regulation D - Rule 504

    • Amount raised is limited to $1 million in a one-year period. To prevent abuse, a second offering cannot be made for six months after the first 12 months expire.

    • A company can use this exemption so long as it is not a "blank check company" and does not have to file reports under the Securities Exchange Act of 1934.

    • The issuer is not free to advertise the securities and to solicit potential investors from the general public unless registration statement has been filed with the State of Florida and substantive disclosure documents have been delivered to the investors.

    • No restrictions on the number or type of investors.

    • No specific disclosure requirements mandated (other than those required in the Florida registration process and those required in order to stay out of trouble with the "fraud by omission" provisions of the federal Securities Act)

    • No resale restrictions provided that a publicly filed registration statement has been filed pursuant to a Florida Registration and there has been delivery of a substantive disclosure document to investors

    • Form D must be filed with the SEC after the first sale giving notice that the issuer has used the exemption.

    • Unlike securities exempt under Rule 506 (see above), securities exempt under Rule 504 must register with the State of Florida (unless otherwise exempt under Florida law). If it is to be sold in other states each state's registration requirements must be complied with

Statutory "Accredited Investor" Exemption    - (back to the top)
    Section 4(a)(5) of the Securities Act 15 USC 77d (a)(5) exempts offerings of up to $5 million made to "accredited investors" as defined in the regulations. No particular disclosures are required to be given to the offeree.

    The requirements are

    • An offers or sales by an issuer solely to one or more accredited investors
    • The aggregate offering price of an issue of securities can not exceed $5 millon
    • There can be no advertising or public solicitation in connection with the transaction
    • The issuer must file a notice with the SEC Commission

    This exemption is mostly used for transactions with "legitimate" institutional investors, like banks or large insurance companies. The exemption is much more risky when any of the offerees are individuals because the statute leaves no possibility of error in determining "accredited investor" status. Every offer must be to an "accredited investor" (as defined in the regulations) in order to effectively invoke the exemption.

    As with other securities issued with an exemption but without formal registration, these are "restricted securities" (meaning resale is restricted unless it has been registered or an exemption applies).

    The safer bet would be to qualify the security under the the "safe harbor" of Rule 505 (discussed above) which imposes similar conditions but where the inadvertent inclusion of some unaccredited investors would not be fatal.

Crowdfunding Exemption    - (back to the top)
    Crowdfunding is a relatively new and evolving method of using the internet to raise capital to support ventures. An entity or individual raising funds through crowdfunding typically seeks small individual contributions from a large number of people. Title III of the JOBS Act of 2012 provides an registration exemption for qualified crowdfunding transactions.

    Qualification for Exemption:

    • Investors do NOT need to be "accredited" (see the dicussion above in other sections of this article)

    • Issuers are be allowed to raise a maximum of $1 million a year from individual investors without registering with the SEC

    • Investors with annual income or net worth of less than $100,000 would be limited to contribute only $2,000 or 5 percent of their net worth or income, whichever is greater.

    • Investors with a higher net worth or income would be able to invest 10 percent of the lesser of their annual income or net worth in these transactions, with a cap of $100,000 over a 12-month period

    • The crowdfunding transaction also must be conducted through a intermediary registered with the SEC (either a broker or a funding portal)

    • The issuer must provide regular updates to the SEC regarding the issuer's progress in meeting the target offering amount.

    • This exemption preempts any conflicting Florida securities regulations and/or registration requirements.

    Required Disclosures:  The following disclosures must be made to the the public and the SEC

    • Information about its business and business plan.

    • Description of the purpose of the offering and intended use of the offering proceeds. The disclosure must provide a sufficiently detailed description of the intended use of proceeds to permit investors to evaluate the investment. If an issuer did not have definitive plans for the proceeds, but instead had identified a range of possible uses, then the issuer would be required to identify and describe each probable use and factors affecting the selection of each particular use. In addition, if an issuer indicated that it would accept proceeds in excess of the target offering amount,the issuer would be required to provide a separate, reasonably detailed description of the purpose and intended use of any excess proceeds with similar specificity.

    • The targeted amount of the offering and the deadline to reach the target offering amount. The issuer must disclose whether it would accept investments in excess of the target offering amount, and, if so, the maximum amount it would accept. The issuer must also disclose, at the commencement of the offering, how shares in oversubscribed offerings would be allocated. Issuers must must describe the process to cancel an investment commitment or to complete the transaction once the target amount is met.

    • The issuer's name and legal status, including its form of organization, jurisdiction in which it is organized and date of organization;

    • its physical address and its website address

    • the names of the directors and officers, including any persons occupying a similar status or performing a similar function, all positions and offices with the issuer held by such persons, the period of time in which such persons served in the positions or offices and their business experience during the past three years, including each person’s principal occupation and employment, including whether any officer is employed by another employer

    • a detailed description of the issuers ownership and capital structure.

    • A narrative discussion of the issuers financial condition. The description must include, to the extent material, a discussion of liquidity, capital resources and historical results of operations.

    • The financial statements specified in the Rule must be provided to both the SEC and the public (they do not need to be audited)

    CLICK HERE to view the federal regulations governing this exemption (Part 227 CFR)