United States: Issuing Securities In Private Transactions

In the context of issuing securities, the federal and state securities laws have the following common basic tenet: every issuance of securities must be registered or exempt from registration. Issuing securities that have been registered under the applicable securities laws is known as a public offering, whereas issuing securities pursuant to exemptions from the registration requirements of applicable laws is known as a private offering or private transaction. Generally speaking, the federal and state securities laws operate independently of each other. In the context of a private transaction, this means that an issuer of securities must be sure that an exemption is available under federal law as well as under the law of each state in which securities are being offered. Failing to register, in the absence of an applicable exemption, may have many consequences, not the least of which is absolute liability to a purchaser for the purchase price. That is to say, until the applicable statute of limitations runs, the purchaser is entitled to a return of his purchase price and does not need to demonstrate any injury to be entitled to it. Obviously, the loss of capital raised, even without further penalty, could be devastating to a company’s business plan. The availability of an exemption is an all or nothing proposition. Under federal law either the entire offering is exempt or the entire offering must be registered. One could expect each state to take a similar position with respect to offerings within its jurisdiction. Additionally, the burden of proving that an exemption is applicable is on the issuer. Therefore, it is important to get it right from the beginning.

Part of getting it right is recognizing that the securities laws are applicable. Although it is clear that stock in a corporation is a security, the fact that an issuance of securities is involved may not be foremost on the minds of family members or friends that decide to start a new business (or their attorneys). That could result in a lack of planning that could potentially hinder growth of the business or result in violations of the securities laws. For example, under a concept known as integration, two "apparently" separate offerings of securities may be combined into one offering. Although an exemption might be available for the earlier offering, when the later offering is "integrated" with the earlier offering no exemption is available. Because the availability of an exemption is an all or nothing proposition, the entire "integrated" offering violates the securities laws. Other examples of situations where it is easy for the unwary to stumble are the formation of limited partnerships and the borrowing of money.

Getting it right was more difficult prior to 1996 than post-1996. Exemptions from state securities registration requirements are often more restrictive than those available under federal law. For example, state exemptions might be limited with respect to the number or the sophistication of purchasers for which the exemption is available, either in the state or for the offering as a whole, and might be conditioned upon the filing of certain materials. The passage of the National Securities Markets Improvements Act of 1996 ("NSMIA") made it considerably easier, in many instances, for issuers to secure both federal and state exemptions from registration.

NSMIA designated a category of securities known as "covered securities." Included in the category of "covered securities" are securities offered pursuant to the Securities and Exchange Commission’s Rule 506. NSMIA preempts state laws regarding the registration of securities offered pursuant to Rule 506, with the exception that states may continue to require issuers to make notice filings of substantially the same documents filed with the Securities and Exchange Commission under Rule 506 and may continue to charge a fee in connection with the filing. Under Rule 506, an issuer may sell securities to an unlimited number of "accredited investors" and up to 35 other persons whom it is reasonably believed have the experience and knowledge necessary to understand the risks of the investment ("Sophisticated Persons"). It should be noted that, with respect to the concept of integration mentioned above, Rule 506 offerings will not be integrated with other offerings occurring more than six months following the end of the offering.

Accredited investors include officers and directors of the issuer, individuals whom meet certain net worth or income requirements and businesses and other entities that meet certain asset requirements. As with most exemptions for private transactions, the issuer in a Rule 506 offering cannot use any general solicitation or advertising. If an issuer is selling only to accredited investors, it is not necessary to provide potential investors with an offering memorandum, although they must be given access to the company books and records. If an issuer is selling to Sophisticated Persons as well as accredited investors, each Sophisticated Person must be given substantially the same information as would be required in a prospectus for a public offering. The issuer must make sure that all investors are purchasing for investment purposes only and do not intend to distribute the securities. All certificates or other documents evidencing the securities issued must contain a legend specifying that they are not registered under the Securities Act of 1933 and are therefore subject to restrictions on transfer. Finally, the issuer must file a notice of sales on Form D with the Securities and Exchange Commission no later than 15 days following the first sale of securities. Most states have a similar notice filing requirement and additionally require a consent to service of process and a filing fee.