Securities Offerings Compliance with State and Federal Securities Law

Transcription

1 (Shmalo Lang) LLP PO Box Atlanta, Georgia Daniel A. Shmalo, Esq. Steven H. Lang, Esq office fax MEMORANDUM TO: FROM: Clients and Friends of DATE: January 8, 2010 RE: Securities Offerings Compliance with State and Federal Securities Law We have prepared this memorandum in order to provide our clients and friends with a summary of how best to navigate through the private capital raising process from a securities law perspective. Our goal is to help ensure that you do not inadvertently do anything that might expose you to liability. Careful securities law planning on the front end is one of the best ways to meet this objective. A. OVERVIEW: How & Why to Avoid Registration of a Securities Offering Why is this memorandum even necessary? The answer is because every company in the United States is faced with a regulatory gauntlet that starts with the requirement that every sale of securities (even the sale of a single share!) is required to be registered at both the federal level (with the Securities and Exchange Commission - the SEC ) and with each state in which the securities are offered or sold. Registration of a securities offering is an extraordinarily complex, expensive and time consuming endeavor. Given this hurdle, you might naturally ask how any small company raises capital. The answer is because state and federal securities laws provide multiple exemptions from registration as long as the offer or sale of securities meets certain criteria. The objective of most companies is to always stay within one or more of these exemptions from registration. Unfortunately, finding an exemption does not mean the securities offering is now magically legal, that the work is done, or that the stock sale will be successful. Finding an applicable exemption is good, but it really just means we have to go down a different regulatory path. It would be nice if all companies could look to one national rule book to plan a stock offering. Unfortunately, only in a very limited situation do the federal securities laws preempt or trump the various state securities laws (commonly called the Blue Sky Laws for reasons beyond this memo). State securities registration exemptions differ dramatically from state to state, and, again, a federal exemption does not guarantee a state exemption (or vice versa). However, if you can qualify for a federal exemption under Rule 506 (discussed below) you can avoid the application of (most) state registration requirements (this is called preemption ). Consequently, careful advance planning is necessary to ensure that any proposed sale of securities qualifies for an exemption from federal registration requirements and either an exemption from, or preemption of, state registration requirements. Please bear in mind that exemption from securities registration will not relieve you of your obligations under the anti-fraud provisions of both state and federal securities laws (see Section E below). Page 1 of 8

2 The anti-fraud provisions require you to provide investors with access to all material information about your company and their investment in order to allow them to make an informed investment decision. These mandatory disclosure requirements are discussed in greater detail below. Securities law theology In general, the securities laws in the U.S. are drafted with the following regulatory themes: the very wealthy and/or financially sophisticated investor is deemed to be able to fend for himself (absent fraud by the company selling the securities), the lower the number of offerees/purchasers, the lower is the opportunity for abuse of investors, and the smaller the amount of money being raised, the lower is the magnitude of potential damage to investors. It follows that the time, cost, complexity and general headaches involved in the capital raising process increase directly with the increase in the number of offerees and/or purchasers, and the decrease in the level of wealth and/or sophistication of the investors. Also, since each state has its own laws, the fewer the number of states where the securities are offered, the lower is the total burden of regulatory compliance. B. COMPLIANCE WITH FEDERAL SECURITIES LAWS FEDERAL EXEMPTIONS. On the federal level, there are a number of exemptions from registration available. The most important are the 3 safe-harbor exemptions in Regulation D promulgated under the Securities Act of 1933 ( Reg D ). 1. Rule Regulation D The preferred exemption from the standpoint of saving time, avoiding costs and reducing the complexity of offering mechanics is Rule 506 (of Reg D, promulgated pursuant to Sec 4(2) of the Securities Act of 1933). The most attractive feature of this exemption is that it preempts the application of blue sky laws requiring registration of securities [see discussion of NSMIA below]. This means that except for certain abbreviated notice filings with the states, you need not worry about structuring your offering to fit within any state registration or exemption. It also reduces the concerns over offering integration (a concept discussed below). The features of the Rule 506 exemption are relatively straightforward: a. No dollar limit on offering amount; b. Unlimited number of accredited investors (defined below), but no more than 35 nonaccredited investors; c. No required disclosure format. The Company must prepare a formal offering prospectus (following Part II of Form 1-A) ONLY if the Company sells to any nonaccredited investors (but a minimum level of disclosure is always warranted under the applicable anti-fraud laws); d. each UNaccredited investor must be a sophisticated investor (defined below); e. No general advertising/solicitation by the Company of potential investors; and f. a Form D (only a few pages) must be filed with the SEC (and with each state in which sales were made) within 15 days after the first sale (some states may require one or two Page 2 of 8

3 additional short-form filings, such as consents to service of process). NOTE: As of March 15, 2009, the SEC requires that all Form D reports be filed electronically on the EDGAR system. In order to file the Form D electronically you will need to obtain EDGAR filer codes (a Central Index Key ( CIK ) number and CIK Confirmation Code. In structuring your offering under Rule 506 (or Rules 505 and 504 discussed below), an understanding of the following terms or concepts will be very important: Accredited Investor. Generally, an accredited investor is any director or executive officer of the Company, or any individual who, individually or jointly with his or her spouse, has a net worth (i.e. total assets in excess of total liabilities) in excess of $1,000,000 at the time of purchase, or individually (without his or her spouse) has had an annual income in excess of $200,000 for each of the two most recent calendar years or jointly (with his or her spouse) has had an annual income in excess of $300,000 for each of those years and reasonably expects an income of at least the same level in the current calendar year [Rule 501(a) of Reg. D]. Corporations and partnerships can also qualify as accredited investors. Any corporation or partnership not formed for the specific purpose of acquiring the securities offered and with total assets in excess of $5 million will qualify as an accredited investor. Banks, insurance companies, other institutional investors and certain employee benefit plans with institutional managers might also qualify as accredited investors. In addition, any entity in which all of the equity owners are themselves accredited investors will qualify as an accredited investor. The determination of an investor s status as accredited investor is generally accomplished through representations made in a subscription agreement or through the use of an offeree questionnaire. Sophisticated Investor: A sophisticated investor is any investor who either alone or with his purchaser representative has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the Company reasonably believes immediately prior to making the sale that the purchaser comes within this description. As with the accredited investor, the determination of an investor s status as a sophisticated investor is generally accomplished through representations made in the subscription agreement or through the use of an offeree questionnaire. No General Solicitation/Advertising. Under Rule 506 you must be very careful that neither the company, nor any person acting on its behalf, offers or sells the securities by any form of general solicitation or general advertising. For example, you cannot advertise in any media (i.e. newspapers, TV, radio, or the Internet), engage in a mass mailing, conduct informational meetings with potential investors, spam the Internet, or issue a press release that discusses the existence of the private placement until after the offering has been concluded and all sales to investors have been finalized. The SEC s position on solicitation guidelines is that all offerees should be people with whom your company, its directors, officers, full-time employees, or any licensed selling agents engaged by your company has a substantial and pre-existing relationship. That relationship should generally be of a nature and involve interaction that is sufficient to enable the Company (or its licensed selling agent(s)) to determine the financial well-being and investor sophistication of the offeree. The relationship should also be in place before the terms of the offering are developed and the offering of securities commences. The longer the term of the pre-existing relationship, the better, however, the SEC has stated that a period of 30 days may be long enough to establish a preexisting relationship. Accordingly, making offers to individuals who are merely friends of a friend is not encouraged, but will not, by itself, defeat the exemption. However, the circumstances of the situation and the nature of the prospective investor and friend will be relevant to the general solicitation determination. Page 3 of 8

4 2. Rule Reg D This exemption is substantially similar to the Rule 506 exemption discussed above except that accredited investors in a Rule 505 offering need not be sophisticated, and the aggregate offering amount can not exceed $5 million (less the amount of any securities sold within the prior 12 months in reliance on Rule 505 or Rule 504). As compared to Rule 506, however, the major disadvantage of Rules 505 and 504 is that the use of either of these latter two Rules does NOT preempt the application of state registration requirements, meaning that you must still structure the offering to fit within an exemption in each state in which offers (not just sales) are made. In addition, avoidance of offering integration (discussed below) becomes very important. 3. Rule Regulation D Under Rule 504, the SEC basically takes a hands off approach to any offerings under $1,000,000. In order to qualify for Rule 504, a company must not already be registered with the SEC, and the aggregate offering price for all securities issued by the company within 12 months before the start of and during the offering of securities must not exceed $1,000,000. You are required to file a Form D with the SEC no later than 15 days after the first sale of stock. General solicitation and advertising is permitted under Rule 504 if, and only IF, the offering is registered with one or more states that have a regulation that permits general solicitation or advertising. As a practical matter, this option rarely makes sense for a new company because the costs and restrictions of state registration is usually prohibitive. As with Rule 505, avoidance of offering integration becomes very important. Given the usual capital and flexibility needs of any new company, the exemption under Rule 504 is typically not a very attractive option. 4. Intra-state Exemption If an issuing company limits its offering and selling activity exclusively to residents of the state of the company s incorporation (the Home State ), compliance with federal regulations is not required by virtue of Section 3(a)(11) under the Securities Act of 1933, and Rule 147 promulgated thereunder. This exemption can be attractive if a company s investors, its operations and its intended application of offering proceeds are all in the same state. The intra-state offering exemption requires no formal disclosure document and no filings with the SEC. It is important to note, however, that in the example above, if even one offer is made to anyone outside of the Home State, the exemption will be lost and another exemption or full compliance with federal and state securities laws will be required. The basic conditions of this exemption are the following: i.the company and all offerees must be residents of the Home State; ii.the company must be organized in, must have its predominant financial presence in, and must plan to use the proceeds of the offering in the Home State; and iii.resale of the securities must be restricted to only residents of the Home State for at least nine (9) months following the termination of the offering. 5. Section 4(2) of the Securities Act of 1933 Exempted Transactions This exemption is set forth under Section 4(2) of the Securities Act of It is defined only by case law, and therefore, is seldom relied upon, except as a fall-back position if the Regulation D safe harbors are not available. Essentially, the conditions are the following: a. limited number of offerees/purchasers (generally five or fewer offerees/purchasers have qualified under this exemption); Page 4 of 8

5 b. all offerees must be sophisticated investors as described above under Rule 506; c. all offerees must have access to detailed information regarding the Company and its operations; d. each purchaser must demonstrate his/her investment intent (i.e. that the purchaser is not purchasing with a view toward making unregistered public resales of the securities); e. resales of the securities must be restricted for a period of at least one year after completion of the offering; and f. no general advertising or solicitation of prospective investors is permitted. As you might imagine, very few modern companies can legitimately fit within the single state exemption. Georgia s Limited Offering Exemption is found at O.C.G.A (14). It says that an offering is exempt from registrations, if, in a single issue: i. Not more than 15 purchasers in Georgia ii. iii. iv. No general solicitation or general advertising No commission is paid for soliciting purchasers Issuer reasonably believes all GA purchasers are purchasing for investment. 6. Exemption for Sales of Securities through Employee Benefit Plans - Rule 701 The SEC's Rule 701 exempts sales of securities if made to compensate employees, directors, general partners, trustees (where the issuer is a business trust), officers or consultants and advisors. This exemption is available only to companies that are not subject to Exchange Act reporting requirements. Under Rule 701, a company can sell at least $1,000,000 of securities under this exemption, no matter how small the size of the company. The company can sell even more if it can satisfy certain formulas based on company's assets or on the number of its outstanding securities. If a company sells more than $5 million in securities in a 12-month period, it will need to provide limited disclosure documents to its employees, directors, consultants, etc.. The state exemption for stock incentive plans was significantly enhanced in Georgia pursuant to the Georgia Uniform Securities Act of Unlike the prior Georgia statute, current law O.C.G.A (21) now allows consultants and advisors to participate in stock option plans. This law does require that consultants and advisors be: a) natural persons and b) provide services to the issuer at the time of offering. 7. SEC Rule 1001 SEC Rule 1001 (17 CFR ) recognizes state exemptions that are based upon a "qualified purchaser" exemption. Currently, only California has adopted a qualified purchaser exemption that qualifies under SEC Rule California companies or companies with business in California are exempt from federal and state registration of offerings of up to $5 million if the sales are made only to "qualified purchasers" as defined by paragraph (n) of section of the California Corporation Code. Page 5 of 8

6 This California law exempts from California state securities law registration offerings made by California companies to "qualified purchasers" whose characteristics are similar to, but not the same as, accredited investors under Reg D. This exemption allows some methods of general solicitation prior to sales based on a form of tombstone or barebones advertisement. California 25102(n) has not been a very useful exemption despite early high hopes. C. COMPLIANCE WITH BLUE SKY LAWS STATE EXEMPTIONS. Each state also regulates the offer and sale of securities (the District of Columbia, oddly, does not). Seeking and receiving a blessing from each state applicable to your offering is known as "Blue Skying." Some states use full disclosure regimes (similar to the SEC) and some use a merit review system; however, in administration of the laws, the shades of difference tend to blend. Merit review usually requires a finding by the state that the offering is "fair, just and equitable" to the purchaser. The National Securities Markets Improvement Act of 1996 ("NSMIA") was enacted in October, 1996 in response to the states' failure to uniformly regulate certain types of national securities offerings. Among other changes, NSMIA amended Section 18 of the Securities Act of 1933, as amended (the "Act"), thereby creating a class of securities - referred to as "covered securities" - the offer and sale of which (through licensed broker-dealers) are no longer subject to state securities law registration requirements. Covered securities include: securities listed (or approved for listing) on the NYSE, AMEX and the Nasdaq, and securities of the same issuer which are equal in rank or senior to such listed securities; mutual fund shares; securities sold to certain qualified purchasers (as yet not defined by the SEC); certain securities exempt under Section 3(a) of the Act (including government or municipal securities, bank securities and commercial paper); and securities exempt from registration under the Act if sold in transactions complying with Rule 506 of Reg D under the Act. Although NSMIA preempts state securities registration requirements, NSMIA preserves the right of the states to investigate and prosecute fraud. PRACTICAL ADVICE: Given the tremendous break in complexity, time and cost afforded by avoiding state blue sky registration, most companies should give very careful consideration before considering adding any feature to its offering that would destroy its ability to rely on the Rule 506 exemption. D. OFFERING INTEGRATION. The integration doctrine is used by securities law regulators to prevent issuers of securities from breaking up one large securities transaction that would not otherwise qualify for a registration exemption into several smaller transactions in order to avoid the reach of federal and state securities laws. Under both federal and state securities laws, the concept of integration is used to aggregate together as one transaction what would ordinarily be considered to be a series of separate transactions. While each of the separate sales of securities would qualify for a federal and state exemption, the aggregated securities transactions might fail to qualify. As a general rule, securities transactions that occur with six months of one another will automatically be integrated together by the SEC and by most state securities regulators. E. DISCLOSURE OBLIGATIONS ANTI-FRAUD RULES. Although certain of the state and federal exemptions discussed above do not require that a standard form of documented disclosure (e.g. PPM) be delivered to accredited investors, the anti-fraud rules under both federal and state securities laws generally prohibit any company (or agents acting on its behalf) from making any untrue statement of a material fact or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading (Rule 10b-5 of the Exchange Act of 1934) [emphasis added]. This basically means that if the average prudent investor would consider a matter to be material in making his Page 6 of 8

7 investment decision, the matter should be disclosed to him in advance. There is no exemption from the disclosure, or anti-fraud, obligations of state and federal securities laws. Consequently, some form of meaningful disclosure to purchasers is always advisable. PRACTICAL ADVICE: In offerings of a relatively small size under exemptions that do not prescribe an SEC disclosure format, recommended disclosure can generally consist of an executive summary of the offering features and risk factors, a business plan, copies of your organic documents, along with any material contracts you have entered into, as well as any financial information available. You should be careful in making any financial forecasts, and should not make any representations with which you are not completely comfortable and willing to legally stand behind. In the subscription agreement used for the purchase of securities, each purchaser should be asked to represent that he or she has been given full access to your books and records and has had adequate opportunity to ask questions about your company and receive responses sufficient to satisfy the purchaser. Very importantly, if there are any material proposed transactions or specific risks on the horizon, you should make complete disclosure of the status of these transactions and risks to all purchasers. IMPORTANT: As a general rule, if offers are made to any non-accredited investors, then a formal, SEC-type prospectus (following Part II of Form A) may be required (and is often advisable even when not required) to qualify for the applicable exemption. Thus, the inclusion of non-accredited investors will often substantially increase the costs, complexity, and regulatory risk of the offering. F. RESTRICTIONS ON RESALE SECONDARY TRANSFERS. Because all of the securities sold in reliance upon the federal and state exemptions will have been issued without registration under federal securities laws, such shares are considered restricted securities, the transfer of which is restricted absent the availability of some exemption. The offering documentation and the subscription agreement in any private offering should recite this restriction, and the fact that certificates representing shares, if any, will bear a restrictive legend to the same effect. We hope that the information in this memorandum is helpful to you in your capital raising planning process. Should you have any questions regarding these or any related matters, please do not hesitate to contact us: Daniel A. Shmalo, x101, dshmalo@360vlaw.com. Steven H. Lang, x102, slang@360vlaw.com. NOTE: This publication is designed to provide clients and contacts of with information they can use to more effectively manage their business and determine when to seek legal counsel. The contents of this publication is for informational purposes only, and only speak as of the date of this publication. Neither this publication nor the lawyer(s) who authored them are rendering legal or other professional advice or opinions on specific facts or matters. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader s specific circumstances. assumes no liability in connection with the use of this publication. Page 7 of 8

8 COMMON EXEMPTIONS FROM FEDERAL SECURITIES LAWS REGISTRATION REQUIREMENTS Exemption Rule 504 (Reg D) Dollar Limit Number Of Investors Manner Of Offer $1,000,000 No limit No general advertising or solicitation unless securities registered in states that require delivery of disclosure document. Resale Disclosure Filing Restricted, unless registered in state requiring delivery of disclosure document. None required, but state laws may apply and anti-fraud rules dictate disclosure. Form D with SEC 15 days after first sale; every 6 months; 30 days after last sale. Rule 505 (Reg D) $5,000,000 No limit on accredited investors, < 35 nonaccredited investors. No general solicitation permitted. No restrictions on paying commissions and other transaction-related compensation. Incorporates bad boy provisions of Reg. A. Restricted None if offers only to accredited investors; if nonaccredited involved, disclosure document required for all investors. Form D with SEC 15 days after first sale; every 6 months; 30 days after last sale. Rule 506 (Reg D) No limit No limit on accredited investors < than 35 nonaccredited investors. Nonaccredited investors must be sophisticated. No general solicitation permitted. No restrictions on paying commissions and similar transaction-related compensation. Restricted None if offers only to accredited investors. If offering to even 1 nonaccredited investor detail technical requirements for disclosure apply. Form D with SEC 15 days after first sale; every 6 months; 30 days after last sale. Rule Intrastate Offers No limit L:imited by state law Only to residents of state of issuer; legends and stop-transfers on certificates. GA law see OCGA (14) Resales during offer period and for nine months after last sale are limited to residents of same state or territory None required None required