Private Placement Memorandum and Regulation D
Private Placement Memorandum And Regulation D: The §4(2), or private-offering,
exemption is the basis on which most emerging business enterprises are able
to sell securities in the United States. (The term refers to that section
in the '33 Act that contains the exemption.) Because of a series of fundamental
miscues when the legislation was first drafted, the '33 Act reads backwards.
Instead of postulating a definition of exempt private offerings, or defining
the offerings which must be registered, the Act suggests that all sales of
securities are to be registered and then exempts various transactions, including
ones "not including any public offering" of securities. Since by
far the great bulk of transactions are of the exempt variety, the tail is
wagging the dog.
For many years, the corporate bar urged the SEC to define the entire process
by which securities move from the issuer to the investors so that private
transactions could go forward with certainty. Until relatively recently, the
Commission stoutly resisted these pleas. The SEC repeatedly denied the persistent
notion that sales to twenty-five or fewer persons constituted a private offering
and clung to the conceptually immaculate view that "offerees" were
the key indicator. Faced with a variety of devices calculated to mask disguised
offers, the SEC's announcements are replete with language suggesting that
the mere hint could constitute "indirect solicitation."
During the period of uncertainty, practitioners worked out their own guidelines,
with little help from the SEC, to determine when a placement was exempt. This
body of learning continues to be marginally pertinent, since the new rules,
while providing a "safe harbor" for certain issues, do not replace
the less certain parameters of §4(2) for offerings that cannot fit under
the black-letter rules of Regulation D, described hereafter.
Thus, in 1982, after almost forty years of tugging and hauling, the law came
to a sensible resting place; the Commission-promulgated Regulation D, or "Reg.
D" as it is called, which provides a practical "safe harbor"
without a host of difficult traps for issuers and their counsel.
Reg. D is not exclusive. For placements unable to fit within the black-letter
rules of Reg. D, §4(2) continues to be available. However, the thrill
has largely gone out of this area of practice. We are dealing now with private
offerings with thousands of offerees and hundreds of purchasers; some such
private offerings result in instant public companies, required to register
(because they have more than 500 shareholders) under §12(g) of the Securities
Exchange Act of 1934.
Reg. D, which covers solely primary, or issuer, transactions, breaks down
into six sections. Rule 501 is a definitional rule; most important is the
definition of "accredited investor," which is any person within
one of following categories:
- Institutional investors: banks, insurance companies, investment companies,
broker/dealers, thrift institutions, business development companies, SBICs,
certain employee benefit plans, and certain 501(c)(3) charitable corporations.
- Insiders: directors, executive officers, and general partners of the issuer.
- "Rich individuals": natural persons whose joint net worth at
the time of purchase exceeds $1 million or whose individual net income was
over $200,000 ($300,000 if joint) for each of the preceding two years, coupled
with a reasonable expectation of that income level for the current year.
- "Rich" entities: any corporation, business trust, or partnership
with total assets in excess of $5 million if not organized for the purpose
of making the investment, plus any private trust with assets in excess of
$5 million, not organized for the purpose and directed by a sophisticated
- Aggregates of the above: any entity whose equity owners are entirely accredited
investors under any category.
Rule 501's other key provision relates to the calculation of the number of
allowable purchasers in an exempt transaction. Accredited investors are excluded
from the count, meaning that there may be, with limitations explored in this
article, an unlimited number of accredited investors.
Rule 502 sets forth the general terms and conditions to be met if Reg. D
is to apply. It specifically addresses integration of contemporaneous offerings,
the information to be provided investors, and limitations on the "manner"
of the offering and/or resale. Rule 503 adds the notice requirements on Form
D, to be filed by the issuer with the SEC no later than fifteen days after
the "first sale" of securities.
The exemptions are contained in §504 (issues of $1 million or less),
§505 (issues of $5 million or less), and §506 (all other issues).
The antifraud provisions still apply to all transactions, and therefore Reg.
D does not do away with the necessity for disclosure (although disclosure
requirements are relaxed in some instances). It is also important to note
that the burden of qualifying for the exemption has not been shifted; it is
still up to the issuer and its advisers to make certain that each of the requirements
of Reg. D has been complied with. However, the SEC has caved in to the argument
that substantial compliance should be enough to maintain the exemption's applicability.
In brief, not only is Reg. D help to issuers and their counsel, but the SEC
has also been forthcoming in explaining the rule. In a release published on
March 3, 1983, the staff issued an extensive interpretation in question-and-answer
format. A number of no-action letters have further fleshed out the bar's insights
into the staff's views. Reg. D itself is quite specific; it's possible for
a layman to understand the major provisions of the rule simply by reading
it. Since its original promulgation in 1982, there have been a number of relaxing
improvements. Thus, in 1988 the definition of "accredited investor"
was enlarged, and the Rule 504 exemption ostensibly increased from $500,000
to $1 million. In 1989, the SEC de-emphasized the filing of Form D (no longer
a condition to the exemption, although still required to be filed); adopted
a change to the effect that, in Rule 505 and 506 offerings with both accredited
and non-accredited investors, the specified information need only be supplied
to the non-accredited investors; and finalized Rule 508, the "excuse
me" or "innocent and immaterial" (I & I) rule, which allows
issuers to be forgiven for committing violations of Reg. D which are "insignificant"
and occur despite a "good-faith attempt" to comply. And, in 1992,
as part of the Small Business Initiative, the limit on the Rule 504 exemption
was effectively raised to $1 million, and securities issued in Rule 504 transactions
are no longer "restricted" securities.
The rules ostensibly allow for the issuance and sale of securities to an
unlimited number of purchasers (culled from an unlimited list of offerees)
if they qualify as accredited investors, meaning people who are rich or otherwise
qualified in the eyes of the SEC. Contrary to all prior learning, Reg. D (with
exceptions having to do with the way prospects are identified) is not technically
offended if the placement is made available to an unlimited number of offerees,
a significant departure from the SEC's former view. Given a pool of "rich"
people and a pre-sanitized prospect list, an issuer can make what amounts
to a public offering-with perhaps as many as a thousand or more purchasers
of the security and some multiple of that number as offerees-without technically
running afoul of Reg. D.
A critical caution is in order at this point. Regardless of the number of
purchasers or offerees, if the placement is made on the basis of either "general
solicitation" or "general advertising," then an unregistered
public offering may have occurred. Obviously, it's hard to get a deal in front
of even a limited number of potential purchasers without participating in
some kind of activity reasonably viewed as "solicitation." The problem
facing a founder approaching Reg. D is how to keep from running afoul of the
ban on "general" solicitation and yet get his business plan out
widely enough so that he has a chance of raising the money.
The first rule of thumb in this area is almost a banality, but it is one
that bears constant repetition: keep careful records. An analysis of the cases
in which issuers were held to have gone beyond the bounds of §4(2) will
show varying fact patterns, as one might expect, but, in the author's view,
one consistent theme pops up: the issuer and its agents did not keep careful
records and, therefore, were unable to state with certainty when challenged
in court how many people had been offered the opportunity. Continuing that
tradition, in a 1985 SEC enforcement proceeding under Reg. D involving an
illegal general solicitation, the order prominently reflected the fact that
the number of persons solicited was not known because the issuer's records
were so inadequate.
Secondly, it goes without saying that the ban on advertising, even though
stated in terms of "general advertising," really means no advertising
at all; since it is difficult to conjure up a practical scenario involving
"nongeneral" advertising. Thus, announcements of the offered opportunity
in the newspapers, on the radio, on television, and so forth, are not in order.
One would think that this constraint was clear enough; either you trumpet
the investment opportunity in the media or you don't-but nothing in life is
simple when the securities laws are involved. An ambiguity is likely to arise
if, for example, the technology being exploited is interesting and the press
wants to do an interview with a founder who has come up with a scientific
breakthrough. In theory, if the founder limits his conversation with reporters
to the technology and makes no mention of the fact that he's looking for funding,
the media have not been used "in connection with" the sale of a
security. The problem is that one hasn't control of what a reporter will actually
publish; a single mention in the press of the pending offering could inadvertently
blow Reg. D's safe harbor. In a 1985 no-action letter commenting on so-called
tombstone advertising (an ad which does no more than give the barest of information),
the staff restated its view that materials designed to "condition the
market" for the securities constituted an offer even though the tombstone
did not specifically mention the transaction in question. (The risk, I hasten
to add, is not likely to be SEC enforcement, as the discussion below indicates;
the danger is that a disgruntled investor will initiate a civil action based
on an allegation that the "safe harbor" is unsafe.)
Even with the most careful records, a forbidden solicitation may still be
alleged because the word "general" is not susceptible of a precise,
objective test. For example, a founder may want to mail to a list of all venture-capital
funds named in Pratt's Guide to Venture Capital Sources, the most common reference
book in the field. If a mailing does go out to a thousand names, is that a
general solicitation? The SEC has helped illuminate the issue in a series
of no-action letters. Taken together, the letters indicate a staff view that
general solicitation does not occur when the solicitor and his targets have
a nexus: as the SEC puts it, a "substantial preexisting" relationship.
The learning comes largely from the tax-shelter syndication area, where placement
agents with long lists of previously screened prospects are the norm, because,
at least prior to 1987, tax-shelter "junkies" (as they were called)
tended to be repeat buyers. Thus, in a factual pattern that runs through the
no-action responses most often cited as influential, it is typically brokers,
not the founder, who are soliciting individuals to invest in limited-partnership
products. In order to establish a meaningful "preexisting business relationship"
between the broker and the prospect, the brokers send out "cold"
mailings well in advance of the deals-questionnaires asking individuals to
fill in certain financial information and to establish a record of their "sophistication"
in such transactions. Reading the requests together, the staff's view is that
an offering not in existence at the time the questionnaire was mailed can
be sent out widely without running afoul of the general-solicitation constraint.
However, a founder doing his first, and perhaps the only deal of his lifetime
has no access to a list of prior prospects. Absent such a list, the founder
is left to soliciting his friends, business acquaintances, and parties with
whom he can conjure up a prior relationship of some kind. Presumably, that
list can be expanded vicariously, by asking his lawyer, accountant, and/or
banker to make the material available to potential purchasers with whom they
are acquainted. How much further he can go is still unclear. Parenthetically,
as was earlier indicated, it is critical to keep careful records identifying
all offerees, even though the names do not appear on a master mailing list.
If an intermediary is asked to help, it is important to memorialize the intermediary's
While the foregoing discussion exemplifies the law, the rules, and the reported
precedents, there has appeared in recent years a phenomenon, which
this writer on occasion has jokingly labeled a "crime wave,"
which needs to be taken into account. That is to say, for years
the classic view among practitioners was that there could be no
mention in the public press or in public forums of a pending private
offering. The term "gun jumping" is sometimes applied
in this context, although it appears in other legal contexts as
well. When confronted with an inadvertent leak to the press about
a private offering, the more cautious law firms would insist that
the placement come to halt, a cooling off period ensue, and the
solicitation efforts be not restarted until the effect of the
unauthorized and unfortunate public announcement had been vitiated
by the passage of time. There has been no explicit from that notion.
That is to say, there appear routinely in the trade press (such
as The PE Analyst) issuer-generated reports of private placements
in process, sometimes specifying the amount of the capital being
solicited. Moreover, at the venture-capital clubs and other public
forums in which companies seeking private equity present themselves,
obviously the potential investors are attracted by public media
announcements, mass mailings, ads in newspapers, bulletin-board
presentations, and the like. The SEC appears to be looking the
other way, except perhaps in the event of blatant fraud; therefore,
since no law firm can appear to be "holier than the Pope,"
experienced counsel are themselves overlooking public announcements
and presentations which otherwise would qualify as general solicitation
and advertising and disqualify the placement.
Source: VC Experts, Inc.