By Elliot Weiss
In the realm of corporate finance, Regulation D of the Securities Act of 1933, as amended, plays a pivotal role in enabling companies to raise capital through private placements of securities. This regulation provides issuers of securities with safe harbor exemptions from registration requirements under the Securities Act that would otherwise apply to public offerings. As otherwise stated, Regulation D lets companies doing specific types of private placements raise capital without needing to register the securities with the U.S. Securities and Exchange Commission. That being said, for company management, a comprehensive understanding of Regulation D is essential to navigate the complexities of fundraising while staying compliant with securities laws. Here, some of the most significant rules and implications of Regulation D are summarized.
Regulation D: A Brief Overview
Section 5 of the Securities Act requires all offers and sales of securities to be registered with the SEC unless there is an available registration exemption. Failure to comply with these requirements grants the purchaser a right to sue to rescind the purchase or seek damages against the issuer.
The two most common exemptions provided for in the Securities Act are Section 4(a)(2) and Regulation D. Regulation D is a set of rules and safe harbor exemptions that allow companies to raise capital through sales of securities without the need for a full-scale registration process with the SEC. Of note, any type of security can be offered to investors through a private placement under Regulation D including promissory notes, SAFE notes or equity interests (e.g. common stock, preferred stock or membership interest in a limited liability company, etc.).
Rules 504 and 506 of Regulation D set forth different qualification requirements and restrictions with respect to an offer and sale by an issuer. As a safe harbor mechanism, Regulation D is non-exclusive, which means where it does not provide an exemption, Section 4(a)(2) still may. Pursuant to both Regulation D and Section 4(a)(2), securities sold under pursuant to these exemptions are considered restricted securities and cannot be resold without registration with the SEC or qualification under another exemption.
Types of Offerings under Regulation D
Regulation D provides three main types of exemptions for private placements:
(i) Rule 504. The exemption under Rule 504 allows companies to offer and sell up to $10 million of securities to any type of investor within a 12-month period. Rule 504 is often used by smaller companies and may be subject to state securities laws, which can vary significantly.
(ii) Rule 506. According to the SEC, the exemption under Rule 506 is by far the most widely used under Regulation D, accounting for an estimated 90 to 95% of all Regulation D offerings and the overwhelming majority of capital raised in transactions thereunder. Rule 506 offers two distinct options:
- Rule 506(b): This rule allows an issuer to raise an unlimited amount of capital from up to 35 non-accredited investors and an unlimited number of accredited investors. Pursuant to Rule 506(b), issuers must provide specific disclosure documents to non-accredited investors and must have a pre-existing relationship with them. General solicitation is prohibited under Rule 506(b) offerings.
- Rule 506(c): Rule 506(c) permits companies to broadly solicit and advertise their offerings to the public, but all investors must be accredited. This option does not have a specific limit on the amount of capital that can be raised. Rule 506(c) is especially helpful for rolling and other private investment funds since it allows management to engage in general solicitation. The SEC has confirmed that privately offered pooled investment vehicles relying on the qualified purchaser (Section 3(c)(7)) or 100-holder (Section 3(c)(1)) exclusions under the Investment Company Act of 1940 may engage in general solicitation under Rule 506(c).
Taking advantage of any registration exemptions through a Regulation D offering requires that all sales of securities of the same class or for the same purpose within the six months preceding and following a reported Reg offering must be integrated. Essentially, these types of offerings will all be considered a single offering, and as such, any limits on the sale price or number of purchasers is cumulative; however, any offers and sales will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering either complies with the registration requirements of the Securities Act or that an exemption from registration is available for the particular offering (including four specific safe harbors for non-integration). The concept of integration seeks to prevent issuers from improperly evading registration with the SEC by artificially dividing a single offering into multiple offerings.
Accredited investors play a central role in many Regulation D offerings. These investors are deemed to have the financial sophistication and capacity to assess the risks associated with private placements. Examples of accredited investors include individuals with high income, institutions with substantial assets, holders of certain professional certifications, and certain knowledgeable employees of the subject company. In recent years, the SEC has modernized the definition of "accredited investor” by including new groups given accredited investor status.
Company management must take steps to confirm that an investor qualifies as an accredited investor in each offering. These steps differ depending on the type of Regulation D offering being conducted. Under Rule 506(b), all accredited investors participating in a 506(b) private placement offering may self-verify that they qualify as an accredited investor, generally, by completing an accredited investor questionnaire issued by company management.
Issuers wishing to solicit or advertise under 506(c) must also take reasonable steps to verify the accredited investor status of purchasers. Rule 506(c) sets out a principles-based method for accredited investor verification, requiring an objective determination by the issuer as to whether the steps taken in verification were “reasonable” in context of the particular facts and circumstances of each purchaser and transaction. Note that the verification standard is heightened under Rule 506(c). The non-exhaustive list for accredited investor verification from Rule 506(c) includes:
- Reviewing IRS documentation (e.g., tax returns) that state income levels and obtaining a written representation that the investor has a reasonable expectation of reaching the same income level necessary to qualify as an accredited investor during the current year;
- Reviewing bank statements, brokerage statements, and other similar reports to determine net worth; and
- Obtaining written confirmation of the investor’s accredited investor status from one of the following persons: a registered broker-dealer, an investment adviser registered with the SEC, a licensed attorney, or a CPA.
Even though Regulation D offerings are exempt from full SEC registration, issuers are still required to provide accurate disclosure of material information to non-accredited investors (there are no specific disclosure requirements for offerings sold only to accredited investors). If an offering is sold to any non-accredited investors, Rule 502(b) requires disclosure similar to that which would be required for a public offering. For example, if an offering is sold to any non-accredited investors under Rule 506(b), Rule 502(b) disclosure requirements are required to match Regulation A’s disclosure mandates (e.g., the disclosure of unaudited financial statements, as long as the offering amount is no more than $20 million, and in the case of Rule 506(b) offerings over $20 million, disclosures in Article 8 of Regulation S-X instead of the disclosures required in a registration statement).
Compliance and Investor Protection
While Regulation D provides valuable exemptions, companies must remain vigilant about compliance with stipulated rules. Missteps can lead to serious legal consequences and damage to a company's reputation. Investors are still afforded a certain level of protection, and any fraudulent or misleading practices can result in legal action.
Navigating State Securities Laws
Companies engaging in Regulation D offerings must also consider state securities laws, often referred to as "Blue Sky Laws." These laws vary by state and may impose additional filing requirements and regulations that could impact the offering.
Seeking Legal Counsel
Given the complexity of Regulation D and its potential legal ramifications, it is highly advisable for companies looking to avail themselves of Regulations D’s safe harbors to seek the expertise of legal professionals with experience in private financings and securities law. An attorney can help guide company management through the compliance process, draft necessary documents, and ensure that the company's interests are protected.
Without questions, Regulation D presents a valuable framework for companies seeking to raise capital through private placements. By understanding Regulation D and similar exemptions, investor qualifications, disclosure requirements, and compliance obligations, company management can navigate the intricacies of fundraising while adhering to securities laws.
This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.