Introduction to Federal Private Offering Exemptions

In this article I give a brief overview of the federal exemptions that are most commonly used for private, limited offerings and private placements in California.

I intend this article as a brief introduction only.  I narrow down to more detail in other articles – for example, my discussion of Regulation D spans a number of articles.  Consider also taking a step back for a bird’s eye view of private offerings – see my article “Introduction to Private Offerings.”

Generally, companies look to four federal exemptions when offering securities in California:

1. Section 4(2) of the Securities Act.
2. Regulation D.
3. The intrastate exemption in Section 3(a)(11) of the Securities Act.
4. Rule 1001 in combination with Section 25102(n) of the California Corporate Securities Law of 1968. 

Section 4(2)

Section 4(2) of the Securities Act exempts from federal registration any transaction by an issuer not involving a public offering.  This is the traditional exemption for private offerings.  Companies use Section 4(2) for offerings that are obviously private, for example, a private placement of securities with institutions or the promotion of a business venture by a few closely related persons.  Section 4(2) is not available for offerings of speculative ventures to unrelated and uninformed persons. 

The boundaries of Section 4(2) are not well defined.  The SEC and courts have consistently taken the position that whether Section 4(2) applies depends on the circumstances of the offering, including the issuer’s relationship with the investors, and  the nature, size and manner of the offering.

When in doubt about any of these factors, do not use Section 4(2).  Instead rely on Regulation D.

Regulation D

Most issuers rely on Regulation D when conducting their private offerings of securities.  Within Regulation D, most issuers use the Rule 504 exemption for offerings up to $1 million, and the Rule 506 exemption for all other offerings. 

All Regulation D offerings are private offerings, meaning that the issuer may not sell securities by any general solicitation or advertisement.  A large scale offering under Regulation D also might require the delivery of a disclosure documents (also called a private placement memorandum, or an offering circular) to unaccredited investors.  Lastly, all securities issued through Regulation D are “restricted” securities, meaning that the investor is restricted in its resale of the securities.

In the interests of brevity, however, I stop my discussion of Regulation D here.  For more information, please see my article, “Introduction to Regulation D” and my follow-on, detailed articles about Regulation D.

Intrastate Offering

Section 3(a)(11) of the Securities Act exempts from registration any offering made solely to persons residing in a single state or territory, where the issuer is incorporated and doing business in the same state.  The rationale is that a wholly intrastate transaction is adequately policed by the laws of the state, hence there is no need for an additional layer of federal law.

Under Rule 147, an issuer does business in a state if (1) at least 80% of its gross revenues (including subsidiaries) is derived from operations or assets in-state; (2) at least 80% of its assets (including subsidiaries) is located in-state; (3) at least 80% of the offering's net proceeds is used in-state; and (4) its principal office is in-state.  During the offering period and for nine months from the last sale by the issuer, purchasers may only resell their stock to other persons living in-state. 

Courts have narrowly construed the Section 3(a)(11) intrastate exemption, and you should use it with caution.  For example, an offer to even one out-of-state resident will blow the exemption.  The risk is higher because the doctrine of integration applies – the intrastate exemption can be integrated with prior and future offerings thereby causing an almost certain loss of the intrastate exemption. 

Even assuming that you can use the intrastate exemption, this does not mean that you get a free pass from securities regulation.  Remember that the exemption is at the federal level, and you must still comply with a state exemption.  This task will require more or less work depending on the complexity of the state exemption. 

Rule 1001 in Combination with California Section 25102(n)

Federal Rule 1001 gives an exemption for offerings up to $5 million that comply with § 25102(n) of the California Corporation Code.

California § 25102(n) is limited to issuers that are California companies (with some minor exceptions).  Investors must be “qualified purchasers.”  This means, generally, accredited investors and natural persons with a net worth specified in the statute.

For the most part, Section 25102(n) has only one feature that might be interesting – a “test the waters” disclosure.  In brief, issuers may publicly disseminate a limited written announcement of the offering.  Potential investors may then respond to the announcement by contacting the issuer.  The issuer may not telephone a prospective investor until it has determined that the investor is a qualified purchaser.  Issuers must provide disclosure documents to unaccredited investors at least 5 days prior to sale. 

The issuer must file a notice of transaction in California at the first to occur of the publication of the general announcement or the initial offer of securities.  The issuer will lose the exemption if it misses its initial filing deadline.  A second filing is required within 10 business days after the close or abandonment of the offering, and in no case later than 210 days after the filing of the initial notice.

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This article only gives a brief introduction to the federal private offering exemptions.  I have only scratched the surface.  I strongly urge you to get competent legal, accounting and tax counsel when you offer securities.

Call me to schedule a legal consultation: 510-796-9144