CHAPTER 12
Federal Regulation of Private Offerings of Securities Prior to the JOBS Act
Prior to the twentieth century, offerings of securities in the United States were not regulated by government at any level. The prevailing laissez-faire philosophy of the time dictated that government should interfere with commercial activities only when absolutely necessary to protect the public interest. Investors were held strictly accountable for their own mistakes, negligence, and bad investment choices under the maxim of caveat emptor, or “buyer beware.”
Early 1900s: The States Get the Ball Rolling with Blue-Sky Laws
That changed in the early twentieth century, largely as the result of several panics (today we call them recessions) in which many investors lost their shirts by putting money into thinly capitalized start-up companies launched by promoters who in many cases were little better than thieves.
During the Progressive Era of the early 1900s, a number of states, including New York, enacted securities laws designed to protect investors against these unscrupulous promoters. These were called blue-sky laws in a 1917 U.S. Supreme Court opinion, which described the purpose of these laws as preventing “speculative schemes that have no more basis than so many feet of ‘blue sky.’”
Blue-sky laws vary from state to state but have traditionally focused on the registration of broker-dealers and securities offerings. With respect to the registration of private offerings, most states impose some sort of merit review (state regulators tear apart the offering documents, offer comments, and suggestions, and generally make a nuisance of themselves). States also typically have in place antifraud provisions that make actionable false statements made in connection with securities offerings. These antifraud provisions apply regardless of whether registration is required.
Absent an exemption, blue-sky statutes typically require registration in each state where the offering occurs. Registration, therefore, may be required in multiple states. Researching each individual law and completing the registration process can add delay and cost to an offering and discourage capital raising.
State blue-sky laws still play an important role in the regulation of private offerings. Under the U.S. Constitution, the states and the federal government have the concurrent power to regulate offerings of securities. That means the federal government and the states can pass laws affecting private offerings. Unless the federal government expressly preempts or prohibits the states from passing laws in a particular area, the states are free to pass laws of their own as long as they are at least as restrictive as federal law and do not allow behavior that is prohibited by federal law.
So, for example, if federal law says you can’t have more than thirty-five nonaccredited investors in a private offering of securities, State X is free to pass a law saying, “Yes, but for this type of offering you can’t have more than ten nonaccredited investors who are residents of this State without filing an offering statement with the State X Department of Securities.” A number of states have such rules, and companies planning offerings of securities need to be aware of the limitations that apply in the states where their investors reside.
While Title III of the JOBS Act expressly prohibits (or preempts) states from passing laws to regulate Title III crowdfunded offerings, there is no such blanket preemption for Title II accredited investor offerings, which may still require notice filings in some states. Also, as discussed in Chapter 2, a number of states have amended their intrastate offering rules (for offerings of securities that take place entirely within state borders) to allow for limited crowdfunding of these offerings. Therefore, companies looking to make Title II crowdfunded offerings (offerings to accredited investors only) or intrastate offerings (offerings of securities that take place entirely within state borders) may still have to comply with blue-sky laws in the states where they are physically located or where their investors live.
1933: The Federal Government Wades into the Securities Markets
Fast-forward to the early 1930s, after the 1929 stock market crash, followed by the Great Depression, followed by President Franklin D. Roosevelt and his New Deal.
One of the most important pieces of New Deal legislation Congress passed during this period was the Securities Act of 1933, the first federal statute regulating the offerings of securities.
The Securities Act imposed rules for offerings of several types of securities: stocks, bonds, notes, debentures, certificates of interest, participations in profit-sharing agreements, preorganization certificates, preorganization subscriptions, voting trust certificates, and investment contracts. A piece of paper may be a security, even if not denominated as a share of stock or a note, if it is deemed to fit within one of a group of other less clear-cut categories such as “investment contract.”
In a 1946 opinion, the U.S. Supreme Court defined a security, subject to regulation under the Securities Act, as “an investment of money in a common enterprise with the profits to come solely from the efforts of others.”
The heart of the Securities Act is Section 5, which prohibits the offer of securities to anyone unless a “registration statement” (including a prospectus or business plan describing the securities and the company issuing them) is on file with and has been declared “effective” by the SEC. Section 5 also prohibits the delivery of the securities to a purchaser or investor unless accompanied or preceded by a prospectus that complies with the requirements of the Securities Act.
The Securities Act, like all securities laws, is basically a consumer protection law. The idea is that securities should not be sold to anyone unless the company issuing them educates the purchaser about the company, the business, the securities, and the risks involved in an investment. Failure to do so, or false or misleading statements in the offering documents, are severely punished under the Securities Act. The investor, of course, does not have to read all the documentation but must be given a reasonable opportunity to do so before the rule of caveat emptor kicks in and he is faulted for making a bad investment.
Section 5 basically says that if you want to make a public offering of securities in the United States, you must—must—go through the public offering process: you must prepare a registration statement and prospectus, file it, have it approved (or “declared effective”) by the SEC, and deliver it to prospective investors. The size of the offering or the company issuing the securities do not matter. Under the Securities Act, every offering of securities is a “public” offering unless it is specifically exempted from the registration requirements of Section 5.
From the beginning, it was recognized that the requirements of Section 5 would be too onerous for many small companies making small or limited offerings of securities to people they knew well who could handle the risks of investing in an unproven, early-stage company. Thus the Securities Act contains several exemptions from the Section 5 registration requirement, two of which are especially important when dealing with crowdfunded offerings:
1.Section 3(b) of the Securities Act gives the SEC authority to exempt small offerings of securities (defined by the SEC as offerings that do not exceed $1 million during a rolling twelve-month period, less other offerings by that same company during the same period).
2.Section 4(a)(2) of the Securities Act, which exempts from Section 5 “any transaction by an issuer not involving any public offering.”
In determining whether an offering is nonpublic under Section 4(a)(2), the Supreme Court has looked at whether the class of people being offered the securities needs the protection of the Securities Act or otherwise is sophisticated and has access to the type of information that would be contained in a registration statement filed with the SEC.
Thus, for an offering of securities to be other than a public offering requiring compliance with the Securities Act’s registration requirements, the offering must:
Not be made “publicly” or in a public manner (for example, by a general solicitation or general advertising)
Not be made “to the public” (that is, the crowd, the hoi polloi, aka “the great unwashed”) indiscriminately but only to selected people who by virtue of their sophistication and wealth do not need the protection of the federal securities laws
In 1934, Congress passed the Securities and Exchange Act of 1934, containing rules for companies that have registered one or more public offerings with the SEC and have thereby become “public companies.” Various sections of the 1934 act require public companies to file annual and quarterly financial reports with the SEC, regulate how public companies can be governed, describe illegal “market manipulation” activities, and contain detailed rules for broker-dealers and other players in the securities markets.
Section 12 of the 1934 act provided that even if a company had not registered a public offering with the SEC, it could become a public company subject to the act’s requirements if it had more than five hundred shareholders or more than $10 million in total assets at the end of its last fiscal year. Title V of the JOBS Act (discussed in Chapter 13) raised those limits to two thousand shareholders, five hundred shareholders who are not accredited investors, and $25 million in total assets.
1964: The SEC Adopts Regulation A
Fast-forward to 1964, the era of Camelot, the rise of Madison Avenue, and colossal tail fins (on automobiles). In that year, the SEC issued Regulation A, consisting of thirteen rules that make up, in effect, a shortened form of registration for a securities offering. Regulation A exempts from Section 5 of the Securities Act an offering of securities in an aggregate amount of $1,500,000 in any twelve-month period, reduced by the amount of any other securities that the issuer sold during that period under any other exemption.
Relatively few companies over the years have taken advantage of a Regulation A offering, but two aspects of Regulation A are still relevant for crowdfunded offerings:
1.Regulation A contains provisions disqualifying “bad” companies from using the regulation; these are basically companies whose owners, key executives, or promoters have been convicted of securities offenses, been subject to SEC disciplinary proceedings, or been involved in certain other types of proceedings (these are commonly referred to by securities professionals as “bad boy” provisions, sexist language notwithstanding).
2.Compliance with Regulation A requires the filing, generally in the regional SEC office where the issuer has its principal place of business, of a notification and an offering circular on SEC Form 1-A, which must be approved by the SEC prior to the offering.
Also, companies that are subject to the bad boy disqualification rules are not eligible to make crowdfunded offerings under Title III.
Title IV of the JOBS Act and SEC Release No. 33-9741, adopted March 25, 2015 (the text can be found online at www.sec.gov/rules/final/2015/33-9741.pdf), made numerous amendments to Regulation A designed to make it a more attractive option for early-stage companies than previously, with mixed results. Issuers interested in Regulation A should also consult the SEC’s “Small Entity Compliance Guide” (available at www.sec.gov/info/smallbus/secg/regulation-a-amendments-secg.shtml).
1970: The SEC Adopts Rule 146 for Private Placements
Fast-forward to 1970: Richard Nixon, tie-dyed shirts, Vietnam, and “All you need is love.” In that year, the SEC adopted Rule 146 in an attempt to create a “safe harbor” under Section 4(a)(2). Safe harbor means that if a company issuing securities complied with all of the rule’s requirements, it was engaged in a “private placement” that did not have to be registered with the SEC under Section 5 of the Securities Act.
If a company substantially complies with the safe harbor rules in Rule 146 but fails to nail them 100 percent, it might still be exempt from registration under the Securities Act by virtue of the Section 4(a)(2) private placement exemption, but it might have to prove it in court if challenged by angry investors, the SEC, or state securities regulators. Securities lawyers refer to this as the “residual” Section 4(a)(2) exemption. Of course, whether a company has “substantially complied” with a rule is often a matter for the courts to decide, an expensive and time-consuming proposition for any early-stage company.
Rule 146 imposed a number of hoops for companies to jump through in order to qualify for the safe harbor, but three specifically are relevant to crowdfunded offerings:
1.The offering must be limited to thirty-five purchasers overall.
2.The offering must not be made by “general solicitation” or “general advertising.”
3.The company must have “reasonable grounds to believe” prior to making an offer that (1) either the offeree or her investment representative has such knowledge and experience in financial and business matters that she is capable of using the information contained in the company’s offering statement to evaluate the risks of the prospective investment and of making an informed investment decision, and (2) the offeree is a person who is able to bear the economic risks of investment.
In other words, for an offering to qualify as a private placement under Rule 146, it must be made discreetly to a limited number of people who are both sophisticated and rich—people who do not need the protection of the federal securities laws because they can fend for themselves.
1982: The SEC Adopts Regulation D, Adding More Exemptions
Fast-forward to the early 1980s: Ronald Reagan, Michael Jackson, Madonna, MTV, big hair for men, and bigger shoulder pads for women. After a decade of wrestling with the “sophistication” and “rich” definitions to determine which investors qualify as offerees under Rule 146, the SEC decided to throw the rule out and start from scratch. Also, there was a growing consensus in the securities industry and the SEC that exemptions from the Securities Act’s registration requirement should be available for offerings under $1 million that don’t deserve the federal government’s time and attention (and/or which could be more easily regulated by state governments under their blue-sky laws).
What emerged was Regulation D, containing three separate exemptions from the registration requirements in Section 5 of the Securities Act: two (Rules 504 and 505) under Section 3(b) of the Securities Act dealing with small offerings, and one (Rule 506) under Section 4(a)(2) of the Securities Act dealing with private placements to accredited investors (and some others).
Rule 504 exempts an offering of securities not in excess of $1 million in any twelve-month period (less all other exempt offerings during that period by the same company).
Rule 505 exempts an offering of securities not in excess of $5 million in any twelve-month period (less all other exempt offerings during that period by the same company).
Rule 506 exempts the sale of an unlimited amount of the securities if the company issuing them reasonably believes the sale is being made to not more than thirty-five nonaccredited investors. Sales under Rule 506 may also be made to an unlimited number of people whom the issuer reasonably believes are accredited investors. In addition, the issuer must reasonably believe that each nonaccredited investor, alone or with a purchaser representative, has such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risk of the investment (in other words, is a sophisticated investor).
Rule 501 of Regulation D defined “accredited investors” as:
Certain institutional investors, such as banks, employee benefit plans, and venture capital firms
Insiders, such as directors, executive officers, or general partners of the issuing company
Wealthy individuals—people who have a net worth, or a joint net worth with a spouse, in excess of $1 million, or who had an individual income in excess of $200,000, or a joint income with a spouse in excess of $300,000, in each of the last two years and anticipated in the current year
Entities—all of whose beneficial owners meet the above three criteria of “accredited investors”
Whether an offering of securities is made under Rule 504, 505, or 506, it must also meet a number of other conditions under Regulation D. For example:
Rule 502(b) requires that specific information be made available to nonaccredited investors in a Rule 505 or 506 offering (for offerings up to $2 million, the information required is the same as would be required by Part II of SEC Form 1-A), and copies of that information be given as well to all accredited investors in the offering.
Rule 502(c) requires that a Regulation D offering be made with no “general solicitation” or “general advertising.”
Rule 502(d) requires the issuing company to make reasonable inquiry to determine if the purchaser is acquiring the securities for his or her own account, generally by requiring the investor to sign an investment-intent letter or subscription agreement that contains a representation that the purchaser is buying for his or her own account for investment and not with a view to distribution or for resale to others.
Rule 503 specifies that five copies, one manually signed, of a notice of sale on SEC Form D be filed with the SEC not later than fifteen days after the first sale of the securities.
Although issuers may be disqualified from using Rule 505 if there is a violation of the bad actor disqualification provisions set forth in Regulation A, there is no such disqualification procedure in connection with Rule 504 or 506 offerings.
Regulation D is still the dominant rule for determining whether an offering of securities is exempt from the registration requirements of Section 5 of the Securities Act. If an offering qualifies for exemption under Title II or Title III of the federal JOBS Act of 2012 and the SEC regulations contained in Regulation Crowdfunding, it does not have to qualify separately for exemption under Regulation D. An offering that does not meet all of the conditions of Title II or Title III may, however, still be exempt from registration under the Securities Act if it separately meets the conditions of Rule 504, 505, or 506 of Regulation D.
Thus a Title III crowdfunded offering that closes with twenty-five accredited investors and five nonaccredited investors, all of whom had access to the offering documents prepared by the issuing company and posted to the funding portal, but one of whom invested more than $2,000 in private offerings of securities during the past year, may still qualify for exemption under Rule 506 if all the nonaccredited investors who purchased securities in the offering meet the “sophistication” criteria of that rule. Of course, the offering of the securities via a crowdfunding portal constituted a general solicitation or general advertising that might deny the offering exemption under the Rule 506 safe harbor, but the offering may still qualify under the residual exemption in Section 4(a)(2) of the Securities Act (for offerings that substantially comply with the safe harbor rules). That will be a case for the courts to decide if and when the time comes.
1996: The National Securities Markets Improvement Act
Fast-forward to 1996: Bill and Hillary Clinton, corduroys and grunge music, and the dawn of the Internet. Congress passes the National Securities Markets Improvement Act (NSMIA), which eliminates state registration requirements for “covered securities,” including shares sold in a private placement under Rule 506 of Regulation D.
The NSMIA, however, left the other exemptions untouched. Offerings relying on Regulation A, Rules 504 and 505 of Regulation D, and private placements under Section 4(a)(2) of the Securities Act that do not meet the requirements of the Rule 506 safe harbor remained subject to state registration requirements.
The states also retained the power to enforce the antifraud provisions in their blue-sky laws, bringing actions against fraudulent offerings and establishing registration violations for offerings improperly made under Rule 506.
2012: The Jumpstart Our Business Startups Act
Fast-forward to today: Barack Obama, Lady Gaga, the Great Recession, social media networks, reality television, and Kickstarter. And the Jumpstart Our Business Startups (JOBS) Act of 2012, discussed in the next chapter.