Following up on my last post to the topic of securities law primer, I wrote that the registration requirement is cost prohibitive for small businesses, and that small business owners therefore need to resort to the possible exemptions. Today I address the “catch-all” statutory exemption known as a “private offering” or a “private placement.”
Section 4(2) of the Securities Act of 1933 provides simply that “transactions by an issuer not involving a public offering” are exempt from the requirement of registering the sale prior to the offering. The Supreme Court addressed the obvious question of what Congress meant by that clause in the case SEC v. Ralston Purina Company, 346 U.S. 119 (1953). The case involved a company that had offered shares of stock to its own employees without first registering the sale with the S.E.C.
In answering the question, the Court explained:
The design of the statute is to protect investors by promoting full disclosure of information thought necessary to informed investment decisions. The natural way to interpret the private offering exemption is in light of the statutory purpose. Since exempt transactions are those as to which “there is no practical need for [the bill’s] application,” the applicability of 4 (1) should turn on whether the particular class of persons affected needs the protection of the Act. An offering to those who are shown to be able to fend for themselves is a transaction “not involving any public offering.”
Since that case, S.E.C. interpretations and additional court cases have developed various criteria for determining whether those offered a security need the protection of the registration requirement or not. These criteria essentially boil down to whether the purchasers of the securities:
- are reasonably sophisticated in business and financial matters and are therefore able to evaluate and understand the risks and merits of the proposed investment;
- can bear the consequences of a potential loss of the investment;
- have access to the type of information they would normally find in a prospectus; and
- explicitly agree not to resell or distribute the securities to the public.
The test applies to each purchaser, meaning that the entire offering potentially violates the Securities Act if even a single investor fails to satisfy every one of the foregoing factors. Moreover, the inquiry doesn’t simply end there, for the manner in which the offering is made is also relevant. Thus, a court considering whether a company can rely on Section 4(2) for its failure to register the sale of securities will also consider whether:
- any form of public solicitation or general advertising was made in connection with the offering; and
- the number of purchasers who do not have some sort of pre-existing relationship with or a connection to those responsible for managing the issuer.
Unfortunately, no single factor is particularly decisive, and some, like an excessive number of disconnected purchasers, is simply a “know-it-when-I-see-it” kind of consideration. A Section 4(2) exemption thus amounts to a “facts-and-circumstances” test that leaves considerable doubt to those who rely on it in all but the most obvious of situations, such as when a small group of founders first organize the business entity and divvy up shares among themselves.
But businesses thrive best with certainty in how to manage their affairs, and perhaps nowhere is this more critical than in the process of raising capital. The S.E.C. recognized this when it issued its Regulation D “safe harbor” rules in 1982. We will explore “Reg D” in our next segment.