Private Placement

Private Placements - No More Than 35?

Regardless of your practice area, it is likely that you may have advised your clients on certain aspects of securities law. Syndicating a real estate project, obtaining seed capital from friends and family for a new venture or establishing a partnership or limited liability company wherein some of the partners merely contribute capital are just some examples where securities are issued. In each of said situations, the issuance of the security, whether it be an interest in the real estate project, shares in a corporation or partnership or membership interests, must comply with applicable securities laws. Accordingly, the objective of this article is to provide a general overview of certain exemptions from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act") so you can be sensitive to federal and state securities laws.

Securities Act of 1933

The Securities Act is designed to protect investors by requiring full and fair disclosure by the issuing company so that potential investors can make intelligent investment decisions. All offers and sales of securities, whether an original issuance by the issuer or a sale or transfer of a security by a holder thereof, must be registered with the Securities and Exchange Commission (the "SEC") under the Securities Act and in each state where the transaction occurs. Courts, including the Supreme Court, generally have been liberal in defining what is a "security" - a franchise, an orange grove, a condominium, gold and silver bullion, diamonds, beavers and minks have been held to constitute a security protected pursuant to the provisions of the Securities Act. Generally, (1) any arrangement under which one invests money (2) in a common enterprise (3) with the expectation of deriving a return (4) primarily through the efforts of others must be analyzed to ascertain whether such arrangement constitutes an offer and sale of a security. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

Failure to comply with the registration requirements of the Securities Act and applicable state securities, or blue-sky, laws could result in a right of the part of the buyer to demand his money back at any time, and personal civil and criminal liability to the offeror or seller.

Registration is an expensive and lengthy process that involves preparing a registration statement (of which a so-called prospectus is a part) which is filed with the SEC for review and comment. The registration statement describes, among other detailed information, the company, management, the securities offered, the holdings of the insiders, as well as audited financial statements. Only after the registration statement is declared "effective" by the SEC can the company and/or the selling security holders be permitted to offer and sell the securities covered by the registration statement.



Regulation D

The private placement exemption contained in Section 4(2) of the Securities Act provides that the registration requirements do not apply to "transactions by an issuer not involving any public offering". The legislative history of Section 4(2) indicates that the exemption would apply where there is no practical need for the protection of the Securities Act; courts have interpreted the vague statutory language as contemplating situations where the financial sophistication of the offerees or the limited manner of the offering render the protective function of the registration provisions of the Act inapplicable.

In 1982, the SEC adopted Regulation D, which contains several safe harbors to ensure that the entity issuing the security is not engaged in a public offering. Under these regulations, there are provisions relating to the manner of the offering, including a prohibition against any general solicitation and advertising, restrictions on the resale of securities purchased in a private placement and regarding the information that the company is required to provide to potential investors. In addition, a Form D must be filed with the SEC within 10 days after the first sale in the offering is completed - such form provides the SEC with information about the issuing company, those involved in selling the securities, the type of offering and the use of proceeds from the private placement.

There are actually three different categories of private placements under Regulation D.

Rule 504 - A Rule 504 offering is available to all issuers other than companies which are SEC reporting companies, investment companies or companies with no specific business plan (commonly known as blank check companies). Under such an offering, the issuer can offer and sell up to $1,000,000 of securities during each 12-month period. There is no limit on the number of offerees or the number of purchasers under a Rule 504 private placement. Furthermore, under a Rule 504 offering, no information needs to be given to the prospective investors.

Under certain limited situations, 504 offerings can even be advertised and the securities purchased in such an offering will not contain the typical Securities Act restrictive legend (that states that no transfers of the shares can be made without registration). This limited situation would exist if the 504 offering is done exclusively in a state which provides for the registration of the securities and requires the public filing and delivery to investors of a substantive disclosure document (like a private placement memorandum) which is reviewed by the applicable state securities authorities of such state.

Rule 505 - Under a Rule 505 offering, an issuer can raise up to $5,000,000. Such an offering can be made to an unlimited amount of offerees, as long as no more than 35 non-accredited investors purchase the securities. Stated differently, an unlimited number of accredited investors can purchase the securities. This point is worth repeating - an unlimited number of accredited investors and up to 35 accredited investors can invest in the entity.

So what constitutes an "accredited investor"? Pursuant to Rule 501 (a), individuals are deemed accredited investors if (1) they have a net worth in excess of $1,000,000, (2) their income for the past 2 years and a reasonable expectation of income for the current year is in excess of $200,000 or (3) their joint income with their spouse is in excess of $300,000. Directors and officers of the issuing company are also considered accredited investors. Corporations and other entities are considered accredited investors if all the equity owners are accredited or the entity has assets in excess of $5,000,000 and was not formed for the purpose of making the particular investment. Rule 501(a)(3) defines non-profit tax exempt organizations with $5,000,000 or more in assets as accredited investors.

Rule 506 - A Rule 506 is similar to a Rule 505 offering, except that there is no dollar limitation to the amount of securities sold in a Rule 506 offering. In addition, in a Rule 506 offering, the non-accredited investors, either alone or with the assistance of a purchaser representative, must have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment.

If sales made pursuant to Rule 505 or Rule 506 are made exclusively to accredited investors, no specified disclosure document has to be used. Rule 502(b)(1)(i).

Offers made to non-accredited investors under either Rule 505 or 506 require the delivery of a private placement memorandum. In the case of a SEC reporting company making the private placement, this essentially involves delivering copies of the appropriate filings under the Securities Exchange Act of 1934 to the investors - the company's annual and quarterly reports. The information required by non-public companies, which must be delivered at a reasonable time prior to the sale, must be material to an understanding of the issuer, its business and the securities being offered. The financial information required depends on the issuer and the amount of the offering.

David Lubin, Esq. is currently an adjunct professor at Queens College and principal in David Lubin & Associates, PLLC, a securities and corporate boutique law firm located in Valley Stream.

Published in the Nassau Lawyer December 2006, Vol. 56, No. 4