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By Mark J. Astarita, Esq.
Introduction
This document is not legal advice, and
is intended solely for information and educational purposes.
If you are contemplating a private placement, or any legal
transaction, you should consult an attorney who can provide
you with the advice that you need, for your specific circumstances.
Securities law, and corporate finance, is not the area for
novices to play. Incorrect documentation can have serious
ramifications for all involved parties.
The term "private placement" as used
in this text refers to the offer and sale of any security
by a brokerage firm not involving a public offering. Private
offerings are not the subject of a registration statement
filed with the SEC under the 1933 Act. Private placements
are done in reliance upon Sections 3(b) or 4(2) of the 1933
Act as construed or under Regulation D as promulgated by the
SEC, or both. Regulation D, promulgated in 1982, sets forth
certain guidelines for compliance with the Private Offering
Exemption. Any registered representative who are involved
in the private placement process are expected to have a working
familiarity with Regulation D.
To qualify as a private placement, an offering
by an issuer must meet either the requirement of Sections
3(b) or 4(2) of the 1933 Act as developed through SEC interpretation
and court decisions or must follow the conditions set out
under Regulation D of the 1933 Act. Persons claiming the exemption
from the 1933 Act carry the burden of proving that its activities
came within that exemption.
Regulation D
Overview
Regulation D is a series of six rules, Rules 501-506, establishing
three transactional exemptions from the registration requirements
of the 1933 Act.
Rules 501-503 set forth definitions, terms and
conditions that apply generally throughout the Regulation.
Specific exemptions are set out in Rules 504-506.
Rule 504 applies to transactions in which no
more than $1,000,000 of securities are sold in any consecutive
twelve-month period.
Rule 504 imposes no ceiling on the number of
investors, permits the payment of commissions, and imposes
no restrictions on the manner of offering or resale of securities.
Further, Rule 504 does not prescribe specific disclosure requirements.
Generally, the intent of Rule 504 is to shift the obligation
of regulating very small offerings to state "Blue Sky"
administrators, though the offerings continue to be subject
to federal anti-fraud provisions and civil liability provisions
of the Exchange Act.
Rule 505 applies to transactions in which not
more than $5,000,000 of securities is sold in any consecutive
twelve-month period. Sales to thirty-five "non-accredited"
investors and to an unlimited number of accredited investors
are permitted. An issuer under Rule 505 may not use any general
solicitation or general advertising to sell its securities.
Rule 506 has no dollar limitation of the offering. Rule 506
is available to all issuers for offerings sold to not more
than thirty-five non-accredited purchasers and an unlimited
number of accredited investors. Rule 506, however, unlike
504 and 505, requires an issuer to make a subjective determination
that at the time of acquisition of the investment each non-accredited
purchaser meets a certain sophistication standard, either
individually or in conjunction with a "Purchaser Representative."
Like Rule 505, Rule 506 prohibits any general solicitation
or general advertising.
"Accredited Investor" is defined in
Rule 501(a). The principal categories of accredited investors
are as follows: (1) Directors, executive officers, and general
partners of the issuer, including general partners of general
partners in two-tier syndications. (The term "executive
officers" is more fully defined in the Regulation.) (2)
Purchasers whose net worth either individually or jointly
with their spouse equals or exceeds $1 million. It is important
to note that while there is no definition of "net worth"
in Regulation D there similarly is no requirement of liquidity
in the calculation of net worth for this accreditation standard.
Thus, a purchaser's home, furnishings, etc. are includable
in the determination of net worth. (3) Natural person purchasers
who have "income" in excess of $200,000 in each
of the two most recent years and who reasonably expect an
income in excess of $200,000 in current year (or $300,000,
jointly with their spouse). (4) A business entity will be
treated as a single accredited investor unless it was organized
for the specific purpose of acquiring the securities offered,
in which case each beneficial owner of the security is counted
separately.
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Additional Compliance Considerations Under Regulation
D
The SEC has pointed out the following regarding
Regulation D:
1. Regulation D does not exempt offerings from
the anti-fraud and civil liability provisions of the various
federal securities laws.
2. Further, Regulation D in no way relieves issuers
of their obligation to furnish to investors whatever material
information may be needed to make any required disclosures
not misleading.
3. Similarly, notwithstanding exemption from
registration at the federal level, Regulation D in no way
obviates an issuer's obligation to comply with applicable
state law.
4. Regulation D is interpreted as providing "transactional"
exemptions to issuers only. An investor whose purchase was
exempt from registration cannot resell his or her interest
without establishing an independent basis of exemption.
5. The three exemptions are not intended to be
mutually exclusive, that a reliance on one exemption is not
deemed to be an election to the exclusion of any other applicable
exemption.
6. Finally, the exemptions of Regulation D may
not be claimed with respect to any plan or scheme to evade
the registration provisions of the act.
Existing state securities regulations at times
impose substantially more onerous limitations on issuers than
Regulation D. Issuer's counsel must be consulted regarding
the requirements of the securities law of each state in which
an offering is going to be sold.
Form D
Notices, on Form D, are due within fifteen days
after the first sale of securities in an offering under Regulation
D. It will be prepared by Issuer's counsel.
Private Placement of Restricted Securities Outside
Regulation D
The specific requirements to be satisfied in
establishing an exemption under Section 4(2) for a private
placement are not stated in that section of the Securities
Act of 1933. By studying SEC interpretations and court decisions
dealing with Section 4(2), the basic requirements which a
private placement must meet can be determined. They are summarized
below:
1. All the offerees and purchasers must have
access to the same kind of information concerning the issuer
which would appear in an SEC registration statement, and these
persons must be able to comprehend and evaluate such information.
It must be kept in mind that any offer to an offeree who would
not qualify, as well as a sale to a purchaser who would not
qualify, may destroy the private placement exemption and result
in a violation of Section 5 of the 1933 Act.
2. The issuer and any parties acting for the
issuer, including the broker-dealer, must take all reasonable
steps to insure that the information given to the offerees
and purchasers is complete and accurate. This is "due
diligence." All information passed on in the course of
the private placement, either orally or by memorandum (or
offering circular), is subject to the anti-fraud provisions
of the federal securities laws. The fact that the offering
memorandum is not reviewed by the SEC does not lower the standards
for accuracy which would be applicable to any registered offering.
3. All of the offerees must have access to meaningful
current information concerning the issuer. The fact than an
offeree has considerable financial resources or is a lawyer,
accountant or businessperson, and thus may be considered sophisticated,
does not eliminate the need for appropriate information to
be made available.
4. While there is no specific limitation on the
number of offerees, the greater the number of offerees, the
greater the likelihood that the offering will not qualify
for the exemption. In this connection, a private placement
cannot be the subject of advertising, general promotional
seminars or public meetings in connection with the offering.
This limitation does not preclude meeting with offerees to
discuss the terms of the offer or to present information concerning
the issuer or the offer. After the private placement has been
completed, a general announcement (such as a tombstone ad)
concerning it may be made if this is desired.
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5. Purchasers in a private placement must acquire
the securities for investment and not for the purpose of further
distribution. If the purchaser acts in such a manner so as
to participate in distribution of the securities to the public,
either directly or indirectly as a link between the issuer
and the public, he or she will be deemed to be an underwriter
and the selling broker-dealer and other participants in the
distribution, including the issuer, will be in violation of
Section 5 of the 1933 Act. Each of the purchasers must intend
to acquire for investment at the time the securities are purchased.
Whether or not investment intent was present will be determined
from all the circumstances surrounding the acquisition. Such
circumstances would include the financial capability of the
purchaser to hold the securities for the long term and whether
the purchaser signed a letter of investment intent. The amount
of time the securities have been held (the holding period)
is one of the factors in a hindsight determination that an
investment intent existed at the time of purchase. A two-year
holding period is deemed to be the bare minimum. What is readily
apparent from the foregoing is that current and accurate information
about the offerees in a private placement transaction is absolutely
essential for the making of judgments as to suitability, ability
to evaluate an offering, and investment intent.
Private Placement Offering Memorandum
To meet the requirement of Regulation D or the
requirements of Section 4(2) of the 1933 Act (the private
placement exemption), the issuer is almost always required
to make extensive disclosures regarding the nature, character
and risk factors relating to an offering. The disclosure document
often is labeled"Offering Memorandum" or given a
similar title, which, in the normal course, is based upon
information provided to counsel to the issuer. While a properly
executed private placement is exempt from the registration
provisions (i.e. Section 5 of the 1933 Act) of the federal
securities laws, the transaction (and the disclosures made
or a lack thereof) is subject to the anti-fraud provisions.
If the offering memorandum is a particular private placement
turns out to be materially misleading in terms of disclosures
which have been made (or which should have been made), the
broker-dealer and its principals may be deemed to have violated
or aided or abetted violations of the anti-fraud provisions
of the federal securities laws.
Supplementary or Corrective Material
During the course of private placement activities
on a particular issue, or prior to the closing, it may become
necessary to update or correct information supplied in the
private placement memorandum as originally prepared. The corrected
information must be brought to the attention of the offerees
by means of a cover or transmittal letter which describes
the changes or additions. Depending upon the information transmitted,
reconfirmation of an investors desire to invest may be required.
The files maintained with respect to a particular offering
must contain a record of what has been done. Prior to closing
an offering, meaning the acceptance of investors in a transaction,
a brokerage firm Principal must verify that all such amendments
have been sent to all subscribing offerees and that the files
are accurate and complete.
Offeree Access To Information
In most private placement offering memoranda,
it is therein stated that the memorandum has been prepared
by counsel to the issuer (i.e., the corporation) from documents
which have been provided by representatives of the issuer.
Offerees are invited to meet with representatives of the issuer
to make an independent investigation and verification of the
matters disclosed in the offering memorandum. Courts, reviewing
private placements when challenged, weigh investor access
to underlying information about the transaction very heavily
in the determination of whether there has been compliance
with the private placement exemption. The brokerage firm's
designated Principal should obtain a commitment from the Issuer
that potential purchasers and their representatives shall
be given access to underlying information about the transaction
if they desire to pursue such information. The fact that information
is available to offerees should be specifically disclosed
to the offerees at a conspicuous point in the offering documents.
Private Placement Offering Process
Offering Commencement and Termination
The commencement date of private offerings is
fixed generally at the date of the availability of the approved
offering documents, for distribution to sales personnel.
The termination date for a private offering is
dependent on the type of offering being made. An "all
or nothing" offering contains, by its terms, a fixed
or defined date for the termination of the offering. A "best
efforts" offering may have an indeterminate termination
period meaning that the offering continues until the full
number of Securities is placed and the subscribers are formally
accepted by both the issuer (or a duly authorized representative)
and by a Principal of the brokerage firm.
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The sales objectives in a best efforts offering,
of course, is that all securities will be placed with suitable
investors. However, short of all securities being placed,
it is required that a minimum amount of money need be raised
which shall be sufficient, after the funding of all of the
organizational and offering expenses, and giving consideration
to the fixed contractual obligations of the issuer, without
changing the nature of the investment called for by the general
terms of the offering. The issuer may be given the option
of funding required issuer obligations by the making of loans
or deferral of fees. In such a case where the issuer funds
financial requirements prior to the placement of all of the
securities, it is the obligation of the brokerage firm to
assure itself that appropriate disclosure to all offerees
(and subscribers) be made and to assure itself that the basic
nature and character of the transaction called for by the
terms of the offering are maintained. If it appears that they
cannot be maintained, then the transaction must be rescinded
and monies paid by subscribers must be refunded.
Possible Need for a Purchaser Representative
A judgment must be made as to the business sophistication
of a purchaser. If it is determined that a particular purchaser
is not sufficiently sophisticated in business matters to effectively
evaluate the investment opportunity, then he or she must be
assisted by a "purchaser representative," i.e.,
a person possessing the requisite sophistication (chosen by
the purchaser) who is able to and does assist in evaluating
the investment opportunity and who is not an affiliate of
the issuer, not the brokerage firm. Also, State Blue Sky laws
impose additional requirements for their investors. Only customers
known to registered representative personally should be sent
only brokerage firm approved offering materials. If there
is doubt about the individual's need for a purchaser representative,
the subscriber should be required to obtain one.
No General Solicitation
1. Cold Calling is not permitted.
2. Advertisements, articles, notices or any other
communication cannot be published in any newspaper, magazine,
newsletter or similar media or broadcast on TV, radio or cable.
3. No seminars or meetings may be held with regard
to any current offering unless each invitee is known and qualified
in advance.
4. No mention of any specific offering or past
performance may be made at generic seminars (i.e. seminars
to discuss the general concept of such investments).
No Fee Sharing
Fees may not be split with non-registered persons
such as lawyers, accountants or investment advisers.
Investment Intent
Purchasers of private placement securities must
purchase for investment purposes and not for the purpose of
resale. The typical subscription documents used in private
placements contains what is called "investment letter
language." This representation should be personally verified.
Consideration should be given as to whether the investment
representation makes sense in view of the surrounding circumstances
of the proposed purchaser.
Oral Representations
Offerees, having received private placement offering
documents, frequently request oral explanations or supplements
to the information presented. Great care should be taken in
making oral disclosures regarding a private placement. Deviation
from the printed material is prohibited. Written notes of
conversations with offerees (and their representatives) should
be made, dated and placed in the client's file.
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Acceptance Of Offerees As Purchasers
In all private placement offerings, the subscribers
must be formally accepted by the issuer. The acceptance of
subscribers is based upon a subscriber questionnaire and,
possibly, the customers account information (a document signed
by the client). A review of the contents of this form by a
representative of the firm who is qualified to make such determinations
is imperative.
Following the acceptance of the subscribers in
an offering by both the issuer and the principal, the offering
shall be terminated by notification to all involved sales
persons or entities.
Mechanics of Offering Process
1. The offering documents should be numbered.
Unnumbered copies should be marked "For Information Only",
"File Copy" and other appropriate notation.
2. A distribution control sheet will be created,
and monitored. As offering documents are assigned to particular
registered representatives, the number of the offering documents,
together with the registered representative's name, should
be placed on the control sheet.
3. A sales control sheet will be maintained reflecting
current sales.
4.Incoming checks, subscription agreements, and
executed suitability documents will be logged on the Sales
Blotter on a daily basis.
5. Checks should be reviewed for acceptability
by the firm, recorded on the brokerage firm's receipts blotter,
and forwarded to the individual bank escrow agent, and
where appropriate to the Issuer, together with the purchaser's
name, address, social security number, and number of shares/units.
6. Incoming subscription agreements should be
approved by the firm, recorded on the sales blotter and forwarded
to the Issuer for acceptance. A copy must be maintained
for the brokerage firm files.
7. Confirmations should be sent immediately to
the subscriber upon acceptance, to the registered representatives,
and a file copy should be retained (e.g. a copy of the Subscription
Documents.)
8. Form D will be filed, on a timely basis, by
counsel to the Issuer, with the SEC and with those states
that require it.
9. Care should be taken that any other forms
necessary to comply with the state Blue Sky authorities will
be timely filed. Counsel to the issuer or brokerage firm counsel
should generally be consulted as to the required forms in
the states where the securities have been sold. Generally,
this is accomplished by counsel to the issuer. (Some states
require no forms.)
10. A complete file containing the above-described
documents for each private placement should be maintained
as part of the brokerage firm's records.
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Escrow Account - Private Placements Only
The federal securities law (the Exchange Act)
is very specific with respect to the required treatment of
an escrow account maintained in an "all or none"
or "part or none" offering.
The rules applicable to "all or none"
or "part or none" offerings relating to the maintenance
of an escrow account for a given offering are Rules 10b-9
and 15c2-4 of the Securities Exchange Act of 1934. Rule 10b-9
requires, in general, that in an "all or none" or
"part or none" offering (as opposed to a "best
efforts" offering) monies paid for the purchase of securities
must be returned to the investors if the specified number/dollar
amount of securities is not sold within a specified time.
In other words, the "all or none" or "part
or none" offering requires specification of the number
of securities and the time of the selling period. Both terms
must be adhered to.
Rule 15c2-4 requires, in general, that the monies
received from investors be deposited into a separate segregated
bank account (Independent Bank as Escrow Agent) and held for
the investors' benefit until the "all or none" or
"part or none" terms have been complied with. If
the terms of the offering are met, the money is to be transmitted
to the issuer. If not, the monies are to be returned to subscribers.
The specific procedures to be followed in the
handling of escrow accounts for "all or none" or
"part or none" transactions are as follows:
1. When an "all or none" or "part
or none" offering is commenced, an escrow agreement shall
be created. This document should be executed by the brokerage
firm and the bank. The brokerage firm is required to keep
a copy of all escrow agreements on file to demonstrate compliance
with Rule 15c2-4.
2. An escrow account should be opened by the
bank. The escrow account is governed by the escrow agreement.
The account typically requires signatures of representatives
of both the brokerage firm and the Issuer before any checks
can be issued from the account.
3. Incoming monies should be deposited immediately
into the escrow account, along with the purchaser's name,
address, social security number and number of shares/units.
4. Upon the completion of the "all or none"
or "part or none" terms of the agreement or upon
the expiration of the specified time period, the escrow agent
verifies that the terms of the escrow agreement have been
or have not been met by the designated date and that the funds
should be released from escrow.
5. The issuer then transmits written confirmation
stating that a determination has been made that the conditions
of the escrow have or have not been complied with and request
a release of the funds.
6. Upon receipt of the written confirmation described
above, the funds are transmitted to the proper entity or persons.
7. The documentation created by these procedures
is then retained in a segregated file for audit or regulatory
review.
8. In a "best efforts" offering, the
brokerage firm is contractually bound to use its "best
efforts" to place the securities with suitable investors.
The brokerage firm will follow the procedures as outlined
above regarding placement of subscriber's funds in an independent
bank escrow account.
Hopefully, this introduction has provided you
with an overview of the legal requirements of a private placement,
and the importance of every step of the process. For information
on the practical side of the process, try CorpFiNet or other
sites listed in our Financial Resources page.
Copyright © 1996 Mark Astarita. Nothing contained
herein should be construed as legal advice. Please see our
disclaimer for further information. Mark J. Astarita is an
attorney who represents financial professionals, small businesses
and public companies in a wide variety of matters from his
office in New York City. He is also the sponsor of The Securities
Law Home Page, a web site devoted to the legal aspects of
investments and corporate finance.
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