Restricted securities are stocks, bonds, LLC units, limited-partnership interests, and other securities that were sold without registration under the Securities Act of 1933. Typically restricted securities are first sold in private placements under Regulation D, Rules 505 or 506. Restricted securities may not be resold absent an exemption or registration with the SEC.
Prior to an initial public offering, startup securities are restricted. The rules around restricted securities make it difficult for outsiders to acquire and insiders to sell equity in even the hottest non-public companies.
Regulation D contains the rules that apply to the overwhelming majority of private securities sales in the United States. As previously discussed, Regulation D is a safe harbor under Section 4(a)(2) of the Securities Act, which permits offers and sales of securities “not involving any public offering.”
Regulation D consists of eight rules with four specific exemptions.
Rule 501 defines the key terms used throughout Regulation D.
Rule 502 sets out general conditions that apply in varying degrees to all of the Regulation D Exemptions.
Rule 503 describes the procedure for filing notice with the SEC that your company is making a private offering under Regulation D. Private placements are private in the sense of “invite only,” not in the sense of “secret.” A notice filing on Form D is required and will be made available to the public once processed. You may also have to file the Form D with any state where you’re selling securities, but that’s a topic for another post.
Rules 504, 505, and 506 set out the four safe-harbor exemptions from registration.
Rule 504 exempts transactions under $1,000,000 while Rule 505 exempts transactions under $5,000,000.
The big drawback to both Rule 504 and 505 is that neither rule supersedes state laws. So any transaction under 504 or 505 must also be registered or exempt under the laws of each individual state in which an offer or sale is made. This can get complicated, and in some situations may preclude reliance on Rule 504 or 505.
Rule 506 is more broad, and was amended by the JOBS Act to include two exemptions.
Rule 506(b) is the most commonly used of all the private placement exemptions. It permits sales of an unlimited dollar amount to an unlimited number of accredited investors, provided, among other things, that the offerings were private–that is, not generally solicited. A Rule 506(b) offering may also include up to 35 non-accredited investors. But additional requirements under Rule 502 apply to any deal involving non-accredited investors.
Rule 506(c) was created by the JOBS Act, and provides for private placements by general solicitation—a new concept to the world of securities. Rule 506(c) allows issuers to publicly promote and advertise their “private placements,” so long as all of the actual investors are accredited. Under this approach, the issuer is obligated to ensure that all investors really are accredited. This may require extensive verification measures that will make some investors uncomfortable.
Rule 506(d) contains “bad actor” provisions which preclude reliance on Rule 506 if any issuer, or any director, officer, or 20% vote holder of the issuer, has ever been enjoined from, or prosecuted for, a range of securities and fraud infractions.
Rule 507 blocks an issuer that has been enjoined for failure to make a notice filing under Rule 503 from using Regulation D at all.
Rule 508 provides that if an issuer makes a small mistake in an otherwise good-faith Regulation D offering, the offer won’t be shot. But the SEC can still bring an action. Rule 508 excludes a lot of what ordinary business folks would consider “minor.” It is narrow relief.
Every securities transaction is registered, exempt, or illegal. The most common exemption for issuing securities without registration is found in Section 4(a)(2) of the Securities Act of 1933. As discussed in another post on that topic, Section 4(a)(2) exempts any issuance of securities “not involving any public offering.”
Unfortunately the language in Section 4(a)(2) is rather vague. It is often not clear whether a sale of securities involves a public offering, or is entirely private. To add clarity, the Securities and Exchange Commission issued Regulation D as a safe harbor for compliance with Section 4(a)(2).
(Technically certain parts of Regulation D were not issued under 4(a)(2), but under Section 3(b) of the Securities Act. Section 3(b) gives the SEC additional authority to exempt from registration securities issuances under $5,000,000.)
If you follow the rules of Regulation D when selling securities, the SEC will not deem your offer and sale to be an unregistered public offering. If you don’t follow the rules, you lose the safe harbor. You can still fall back on the vague language of 4(a)(2) to argue that your sale of securities did not involve a “public offering,” but that’s not always so easy. It’s wise to conform any sale of securities–whatever type of securities you are selling–to the rules of Regulation D whenever possible.
The fundamental rule of U.S. securities law is that every transaction involving securities must be registered or exempt from registration. Otherwise it’s illegal.
For a reminder of what exactly constitutes a security, see What is a Security?
Registration is a presumed requirement in every securities transaction. Section 5 of the Securities Act of 1933 makes it illegal to sell, offer to sell, or offer to buy any security unless a registration statement has been filed for the transaction. Sections 3 and 4 of the Act set out the exemptions to the registration requirement. Unless one of those exemptions applies, registration is required. It is the issuer or offeror’s responsibility to prove that an exemption applies.
The primary transactional exemptions are found in Section 4 of the Securities Act.
Section 4(a)(1) exempts transactions by “any person other than an issuer, underwriter, or dealer.” That covers the millions of unregistered re-sales that take place between investors every day. Transactions by dealers, other than those in conjunction with a sale by an issuer, are exempt under Section 4(a)(3) and 4(a)(4). That leaves transactions by issuers—the company issuing the securities—and underwriters.
Section 4(a)(2) exempts “transactions by an issuer not involving any public offering.” This is the private-placement exemption. It enables angel investment, venture capital, private equity, and most hedge-fund transactions. It applies when a startup sells stock to friends and family, or issues stock to the company founders. Section 4(a)(2) enables around $1 billion of private-company investment every year.
Section 4(a)(6) is the “crowdfunding” exemption. This exemption is not yet effective because the SEC is still working on finalizing its rules. When the crowdfunding exemption goes into effect it will permit an issuer to make a limited public offering of securities without registration. Section 4(a)(6) imposes sharp limits on the amount of funds that can be raised by crowdfunding, and creates substantial logistical challenges.
While Section 4 exempts a wide range of transactions from the Securities Act registration requirements, Section 3 excludes certain securities themselves from Securities Act coverage. The reason that Section 3 securities are excluded is that they are all subject to other regulatory regimes, political oversight, or fall outside the jurisdiction of the Securities Act. Examples include some types of bank securities, government securities, and securities issued exclusively within a single state by a resident of the state.
Section 3 is an abnormality in that it exempts securities from the Act, where the act otherwise applies only to transactions. This is an important distinction. Remember that unless you are running a government or a bank, securities themselves are never registered or exempt. It is only a specific transaction in those securities that is registered or exempt from registration. And every single transaction must be reviewed under this rubric of registration and exemption.
If an offering does not fit within an exemption, it must be registered with the SEC. Since registration is often impractically expensive and time consuming, Section 4 is vital to the flow of capital to startups, investment funds, and closely held businesses.
The primary risk in attempting an exempt offering—an unregistered re-sale or a private placement—lies in failing to fit the transaction within an exemption. Once an offer is made, if not properly exempt, it is already too late to register. The transaction is illegal. It must be stopped, unwound, and tried again after a lengthy cooling-off period. This process can be fatal to a shoestring startup.
Proceeding with a broken transaction is even worse. Because the unregistered offering is illegal, the SEC or any state regulator may order it stopped, fine the offeror, and even bring criminal charges. Even if the regulators leave it alone, any buyer or investor may rescind an illegal transaction, even years later, after seeing how the deal plays out. In a rescission, the offeror must come up with the cash to unwind the sale, even if the original cash was all spent on business expenses like salaries and overhead.
Faced with these options, there is no good solution. The only way to avoid the Scylla and Charybdis of killing the offering or breaking the law is to ensure that every securities transaction is registered or soundly within an exemption–like the safe-harbor rules of Regulation D.
We’re past the holidays and catch-up chaos. It’s time to focus on new projects. These are the top five legal issues that your business should be focusing on in the new year. By addressing these issues, you will avoid over paying on taxes, reduce business uncertainty, and unlock value.
1. Make an S Corporation Election & Pay Less Tax
Making an S Corporation election is easy. You can do it yourself or with the help of a lawyer or accountant. It is for most people, but not everyone. Read this information on how and when to make the S election. If it makes sense for you, go ahead and make the election. Save a lot of money in taxes. But be sure to act fast. The deadline to file is March 15th.
2. Hold an Annual Meeting & Take Minutes
If your business is organized as a corporation, you need to hold at least one shareholder meeting each year. If your business is organized as a limited liability company or partnership, you don’t have to hold an annual meeting, but it’s a good idea. The annual meeting can be held in person, or by phone, email, or entirely in writing if your bylaws or operating agreement permit. Creating a trail of meeting minutes showing the election of directors or managers and approval of major company decisions will reduce the odds that a judge will let company a creditor “pierce the corporate veil.” And it will help your company appear more competent, credible, and attractive to banks and investors.
3. Clean up Your Contracts—or Write Them
Weak or non-existent contracts are a major source of uncertainty, risk, and stress. Courts resolve disputes first and foremost by looking for contractual coverage. Eliminate uncertainty and risk by committing important ongoing relationships to writing, and cleaning up your cobbled-together contracts—you know, the ones you found on the internet. You’ll get a lot out of basic payment, delivery, and scope terms, a method for resolving disputes, and a warranty or disclaimer.
4. Protect your Intellectual Property
Your business is built on its intellectual property. Your brand name identifies you in the marketplace. Your creative output provides unique value. Inventions and designs are the core of many businesses. Your methods, processes, and techniques give you a competitive edge. Isn’t it about time that you protected your trademarks, copyrights, patents, and trade secrets from competitors? Not only will carefully planned registrations and contracts protect your IP from infringement, they will increase the value of your business, and may even unlock new streams of licensing revenue.
5. Start Talking with Potential Investors
If your company is in growth mode, and in need of outside capital, there has never been a better time to raise money. Investors have record amounts of dry powder on hand. And angels are more accessible than ever. But before you get started selling, take some time to plan your offering. Figure out exactly what you need. Prepare offering documents. And make absolutely sure that you are in compliance with federal and state securities laws before you make a single sale. Otherwise a great opportunity could turn into a costly headache.