This blog covers the following topics:
Feel free to scroll down to the topic that interests you most.
Definition of a security
Securities must be registered with the SEC
Rules exempting securities from registration
Review of Regulation D Rules
Argument: Filing Form D is not optional
Consequences of failing to file Form D
How to file Form D
As many of my readers know, I have spent the greater part of my 17 years of law practice working with technology startups. Invariably, these startups are thirsty for capital from investors to fund their brilliant and innovative ideas. While acceptance of investor funds triggers questions related to securities compliance, there are often misunderstandings about how to comply. In particular, there is a pervasive misbelief that the action of filing Form D as prescribed under Regulation D is optional. The purpose of this blog is to dispel this belief.
Definition of a Security
We begin our analysis with a short discussion of what constitutes a “security”. Whenever a person makes an investment of value into a common enterprise with an expectation of profits derived from the efforts of others, the investment constitutes a securities transaction that triggers regulatory oversight and compliance from the Securities and Exchange Commission. It is this broad approach to defining what is a security that has captured initial coin offerings (ICOs), initial exchange offerings (IEOs), and even air-drops of cryptocurrencies into the securities regulatory framework. Incidentally, convertible notes, SAFE agreements, and SAFT agreements are also recognized securities instruments under the same Howey analysis.
Securities Must be Registered with the SEC
Continuing, it’s important to recognize that “… every offer and sale of securities, even if it is just to one person, must either be registered with the SEC or conducted under an exemption from registration.” When the SEC says all securities much be registered, it means registered with a public stock exchange. Consequently, the idea that there is some exception for a “friends and family round” is a myth. Of course, startups cannot afford to take-on the cost of a public registration, nor is a public registration always advisable for larger privately-held companies. Thus, in order to conduct a private offering of securities, the company doing the fundraising has to rely on some available exemption from the requirement to register all securities offerings.
Rules Exempting Securities from Registration
To facilitate small business capital formation, the SEC has developed several exemptions from the securities registration mandate. Among them are the original 4(2) exemption (now 4(a)(2) under the JOBS Act), Regulation D, Regulation Crowdfunding, Regulation A, intrastate offerings, and employee benefit plans. Historically, securities lawyers helped businesses accept investor funds through the use of 4(a)(2) that exempts from registration “… transactions by an issuer not involving any public offering.” Under this law, whether an offering constitutes a public offering largely depends on a number of variables, including the number and sophistication of the investors, the size and manner of the offering, and the relationship of the investors to the issuer. While a 4(a)(2) offering provides exemption from public registration, it does not grant automatic compliance with the individual state securities regulations called Blue Sky Laws. Consequently, any private issuer relying on this exemption from registration must also comply with the securities regulations of each state where the securities are offered. Further, investors must be given access to the type of information that would be included in a public registration statement. It makes sense then that due to inconsistencies in how courts have interpreted and applied these factors, the SEC later adopted Regulation D as a non-exclusive safe harbor that allows issuers to conduct limited offerings and sales of securities without registration under the Securities Act of 1933.
Review of Regulation D Rules
Regulation D can be found in the electronic Code of Federal Regulations (eCFR) sections 230.500 – 230.508. Following is a summary of each of the rules contained in Regulation D which is helpful to the determination that filing Form D is mandated in each and every offering made in reliance on Regulation D as the available registration exemption.
Rule 500 gives the reader background information about Regulation D, noting with particularity that while compliance with Regulation D provides companies safe harbor from varying state securities regulations, it does not exempt companies from compliance with the antifraud, civil liability, or other provisions of the federal securities laws. Thus, issuers must disclose, disclose, disclose!
Rule 501 provides definitions and terms as they are used throughout Regulation D. For example, the definition of an accredited investor can be found here.
Rule 502 gives information about general conditions that must be met with relying upon Regulation D in private offering. For example, rules regarding the integration of concurrent offerings can be found here, as well as the kind of information a securities issuer is required to provide to investors depending on the size and nature of the offering, and whether it involves unaccredited investors. Spoiler alert, the issuer must always provide to the investor all of the information about the company that an investor would find material to their decision of whether to invest. Yes, this is vague and ambiguous. So, if you are aren’t sure whether something is required to be disclosed, the best course is usually to error on the side of disclosure