Securities Laws

The following is a summarization of basic US securities laws, rules, and regulations. However, though we have made Regulation A+ available through Financial Architect® Expansion Capital Producer™ to go further than a private placement under Regulation D, you really should hire a team of professionals who understand what they are doing.

 

To conduct a securities offering in the United States, legally, you must:

 

A.     Produce and pre-file a registration statement with the Securities and Exchange Commission (SEC)—and up to fifty states (Blue-sky law). This is considered a “Registered Offering,” such as an S-1 for an Initial Public Offering (IPO)—it’s expensive. However, you may raise an unlimited amount of capital, advertise the securities—with certain content constraints—and the securities will be freely traded on a securities exchange. Cannot be sold by your management team only through FINRA Member (stockbrokerage) firms. (Very Expensive).

Or

B.     Produce and pre-file form 1-A under Regulation A+ (Tier 1 or Tier 2) (and or CA (1001) with the state of California) with the Securities and Exchange Commission (SEC) and the state securities bureau, which allows Regulation A securities to be sold in their state. This is considered a “qualification” for an exemption from registration under Regulation A, CA (1001) and the California Corporations Code 25102. This is more cost-effective than pre-filing a registration statement with the SEC and up to fifty states. The CA (1001) and the California Corporations Code 25102 has a $5 million maximum limitation within a twelve-month period. You may advertise the securities—with certain content constraints. The securities may be freely traded on a securities exchange—subject to additional constraints—and the investor qualifications are less stringent that Reg. A+. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Expensive).

 

Or

 

C.     Produce and pre-file form U-7 under the Small Corporate Offering Registration (SCOR) with the state(s), which allow SCOR (not all states do) and where the securities will be solicited and sold. This is considered a “qualification” for an exemption from registration under the SCOR. This is more cost-effective than pre-filing form 1-A Regulation A and CA (1001) statement with the SEC and any of the fifty states. It has a $1 million maximum limitation within a twelve-month period. You may advertise the securities—with certain content constraints—and the securities may be freely traded on a securities exchange and are subject to additional constraints. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Moderately Expensive).

 

Or

 

D.     Produce a Private Placement Memorandum (PPM aka an Offering Circular), which “claims” an exemption from registration under Regulation D 506(b) (private placement), where no general solicitation or advertising is allowed or under Regulation D, Rule 506(c) (restricted public placement), as long as you restrict the offering to accredited investors only. Third party verification of accreditation for each investor is required. The private placement of securities—under Regulation D, Rules 504, 506, and/or 4(a)(5) of the Securities Act of 1933—cannot be advertised to the general public through general solicitation. However, it will generally be exempt from registration if the document provides for sufficient disclosures and disclaimers—and where compliance requirements for “Notice of Sales” filings requirements are met. Both offerings must be accompanied by a securities-offering document, which complies with the various federal and state laws, rules, and regulations. Both offerings can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Relatively Inexpensive).

 

Or

E.     Claim the Accredited Investor Exemption 4(5) where compliance requirements for “Notice of Sales” filings requirements for private placements are met. One must restrict the offering to $5,000,000 in any given 12-month period and to Accredited Investors only that have a pre-existing relationship to bona fide members of the company’s management team. No pre-filing required. No securities offering documentation is required, however there are no Safe Harbor provisions against claims of fraud without the proper disclosures. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Inexpensive, but potentially dangerous).

 

Remember, these lessons are based on soliciting and selling securities effectively to US Investors under US Securities law. Regulation S is available for US Companies to solicit and sell securities to foreign investors. All the securities offering document templates, that you can use in Financial Architect™ are written and designed to comply with both; Regulation D-Rules 504, 505 and 506, as well as Regulation S, enabling you to solicit and sell securities to foreign investors.

 

Claiming and Exemption from Registration.

 

Each Financial Architect® program defaults to the commensurate exemption to claim; so you have only to understand the rules of solicitation, which are further defined throughout the programs in the End-User Instructions. However, you should know:

 

  1. Regulation D, Rule 504 allows up to $5 million to be raised in a twelve-month period and does not need to have an audited balance sheet. Up to thirty-five non-accredited investors are allowed in the deal. Only direct solicitation to current management team members of only pre-existing relationships is allowed, unless its run through a broker dealer. What constitutes pre-existing relationships? Check with your legal counsel, as this dynamic is a continually changing due to social media’s reach.
  2. Regulation D, Rule 506(b) allows unlimited dollar amounts to be raised privately in a twelve-month period and does need to have an audited balance sheet, if your Company has any operating history and if you will be allowing ANY non-accredited investors in the deal. Up to thirty-five (35) non-accredited investors allowed in the deal with the audited balance sheet. The audited balance sheets must not be older than 120 days, so keep that in mind when you establish the expiration date of the PPM. Once the balance sheet is older than 120 days, the document will not qualify for exemption from registration. You will need to make the above changes in different areas throughout the PPM that reference these regulations. Only direct solicitation to current management team members of only pre-existing relationships is allowed, unless its run through a broker dealer. What constitutes pre-existing relationships? Check with your legal counsel, as this dynamic is a continually changing due to social media’s reach.
  3. Regulation D, Rule 506(c) allows unlimited dollar amounts to be raised publicly in a twelve-month period and does not need to have an audited balance sheet. No non-accredited investors allowed in the deal, period. Third party verification of accreditation for each investor is required. The non-audited balance sheets must not be older than 120 days, so keep that in mind when you establish the expiration date of the PPM. Once the non-audited balance sheet is older than 120 days, the document will not qualify for exemption from registration. You will need to make the above changes in different areas throughout the PPM that reference these regulations. Regulation D, Rule 506(c) allows public solicitation of a private placement. It is not deemed a public offering.
  4. Public Solicitation—Unlimited Amount—Within California only. Under California’s 25102(n), you can issue securities through a public placement to an unlimited number* of investors who reside in the state of California, using the general solicitation through the general media within the state. However, as a practical matter, we suggest limiting the offering to accredited investors only. It’s better to have those who can sustain a loss—just in case your Company fails. In order to qualify, one can either form their Corp. or LLC in the state of California if they have yet to form the entity in another state or register their Corp. or LLC in the state of California as a foreign Corp. or LLC if the entity is already formed in another state. Neither you nor your Company needs to move to California, to use this exemption.

 

*NOTE: Although your Company has the ability for inclusion of an unlimited number of accredited investors, once you’ve passed the 2,000-investors mark, your Company becomes an SEC-Reporting Company—whether your Company’s securities are publicly traded or not.

 

At this point, your Company’s choice of securities offering should be relatively easy—whether the offering is registered or claiming or qualifying for an exemption (not the deal structure). When thinking of pre-existing prospective-investor relationships, do not forget friends, family, customers, suppliers, professional advisors, or any other pre-existing personal relationships of the company’s management-team. Under Regulation D, soliciting and selling only to pre-existing relationships further your claim from registration.

 

We know securities laws, rules and regulations can be confusing—not only from a regulatory-legality perspective but more importantly from the perspective of practicality. If this process is just too costly and/or burdensome, most simply won’t go through with it. That has been the case for quite some time. With the creation of Financial Architect®, we’ve  attempted to simplify the process and greatly reduce the cost of engagement.

Therefore, along with us having been in the financial world since 1985, the following chart hopefully clarifies the difficulty of engagement with the capital-raising probability.

Exemption Decision Matrix

We’ve denoted the areas in green for go and yellow for caution. The red text denotes activities that can be extremely time intensive and costly and therefore should be avoided, if possible, until you are capitalized enough to hire the necessary professionals, if possible.

The ban on General Solicitation for Regulation D Rule 506 ended on September 23, 2013 and it is now known as Regulation D 506(c) under Title II of the JOBS Act of 2012.  In conjunction with the effects of other laws, you can sell up to 2,000 equity investors and an unlimited number of debt investors so long as all of the investors can prove their accredited status, without the need to register with the SEC as a fully reporting company. The final requirements and procedures are included within the Commonwealth Capital Club and are to be reviewed by your legal counsel once you’ve produced the Regulation D, Rule 506(c) document—included within all of the Financial Architect® Programs.

* As of January 20th 2017, Regulation D: Rule 504 enables you to sell up to $5,000,000 in securities over a 12-month period. However, if you self-limit the amount to $1,000,000 offering in a 12-month period, you can use the disclosure for FORM C a Title III “Crowdfunding” through a Registered FINRA Member portal. Also this could be used for a SCOR offering, which is registered at the state level as an Intrastate Offering. In conjunction with the effects of other laws, you can sell up to 2,000 equity investors and an unlimited number of debt investors with non-accredited status, without the need to register with the SEC as a fully reporting company. If the offering is registered at the state level, and depending on the particular state, you may be able to advertise through general solicitation.  SCOR can be registered in more than one state, but the $1,000,000 total amount holds fast. All 50 states accept SCOR except: Alabama (under consideration), Delaware, District of Columbia (has no securities laws), Florida, Hawaii, and Nebraska.

^ If you solicit and sell the securities only to accredited investors under Regulation D Rule 506(c), you will not need audited balance sheets. Under all Regulation D Exemptions, you may solicit and sell up to 35 non-accredited investors; however, if you do not limit the total amount to $5,000,000 and claim Regulation D, Rule 506(b) (as the exemption) you may need to provide at least an audited balance sheet that is no older than 120 days—unless you can prove it would be cost prohibitive to produce and provide the audited balance sheets.

# If you solicit and sell the securities only to accredited investors under Regulation D, Rule 506, you will be able to advertise nationally.

~ This applies to California Corporations only, or Corporations that are registered as for Foreign Corporations in the state of California. For more information, see California Secretary of State’s website.

~~ This applies to California Corporations only, which must be registered in the state—not necessarily headquartered or operating there. See CA 25102(n).

 

The information below provides further clarification to clearly understand the available options, especially if the Exemption Decision Matrix above creates any further confusion.

 

PRIVATE OFFERINGS:

 

Regulation D Rule 504: for $5,000,000 or less in capital over a twelve-month period.

– No Audited Financial Statements Required.

 

If your company is at the point where:

  • you need to allow non-accredited investors in the deal;
  • you do not need to advertise your company’s securities, because you may have ample personal and professional investor contacts;
  • you are not willing to spend the money on creating audited financial statements at this juncture, and;
  • Your company’s securities offering will be for less than or equal to $5,000,000 then Regulation D 504 would be the exemption you would claim. [1]

 

Regulation D Rule 506(b): for an Unlimited Amount in capital over a twelve-month period.

– Audited Balance Sheet May Be Required.

 

If your company is at the point where:

  • you need to allow non-accredited investors in the deal;
  • you do not need to advertise your company’s securities, because you may have ample personal and professional investor contacts;
  • you qualify (normally start-ups) to be exempt from producing an audited balance sheet and are not willing to spend the money on creating audited financial statements at this juncture, and;
  • Your company’s securities offering will be for any amount greater than $5,000,000 then Regulation D 506(b) would be the exemption you would claim.

 

The Accredited Investor Exemption 4(5): for $5,000,000 or less in capital over a twelve-month period:

– No Audited Financials Required.

 

If your company is at the point where:

  • you allow only accredited investors in the deal;
  • you do not need to advertise your company’s securities, because you may have ample personal and professional investor contacts;
  • you are not willing to spend the money on creating audited financial statements at this juncture, and;
  • Your company’s securities offering will be for more than $1,000,000 but less than $5,000,000 then 4(5) the Accredit Investor Exemption would be the exemption you would claim.
  • No securities offering documentation is required, however there are no Safe Harbor provisions against claims of fraud without the proper disclosures, as provided for in most securities offering documents.

 

PUBLIC OFFERINGS:

Small Company Offering Registration (SCOR): for $1,000,000 or less in capital over a twelve-month period.

– No Audited Financials Required.

 

If your company is at the point where:

  • you need to allow non-accredited investors in the deal;
  • you need to advertise your company’s securities, because you do not have ample personal and professional investor contacts;
  • you are not willing to spend the money on creating audited financial statements at this juncture, and;
  • your company’s securities offering will be for less than or equal to $1,000,000 then a Small Company Offering Registration (SCOR) would be the exemption you would pre-file with the state(s), where the securities are to be solicited and sold, to “qualify” for the exemption from registration.

 

 

Regulation D, Rule 506(c) Public solicitation of a Privately Placed Security

– No Audited Financial Statements Required.

 

If your company is at the point where:

  • you allow only accredited investors in the deal;
  • you do need to advertise your company’s securities, because you do not have ample personal and professional investor contacts;
  • you’re willing to obtain 3rd party verification of accreditation on each and every investor.
  • you are not willing to spend the money on creating audited financial statements at this juncture, and;
  • your company’s securities offering will be for any amount then Regulation D Rule 506(c) would be the exemption you would claim, because under Title II of the JOBS Act of 2013 you can now solicit and sell securities across state line with the use of the general media.

                        See page 112 of SEC Final Rules.

 

Regulation A (Tier 1 & Tier 2).

Audited Balance Sheet May Be Required for Tier 1.

Audited Financial Statements Required for Tier 2.

 

If your company is at the point where:

  • You need to allow non-accredited investors in the deal;
  • You need to advertise your Company’s securities, because you do not have sufficient personal and professional investor contacts;
  • You are willing to spend the money to create, or you already have available, current audited financial statements; and
  • Your Company’s securities offering will be for more than $5,000,000 but less than $50,000,000.

 

Referencing Regulation A. U.S. and Canadian companies, that are not required to file reports under the Exchange Act, can raise up to $50 million. The final rules create two tiers: Tier 1 for smaller offerings raising up to $20 million in any 12-month period, and Tier 2 for offerings raising up to $50 million in any 12 month period, as well. The new rules also make the exemption available, subject to limitations on the amount, for the sale of securities by existing stockholders. The new rules modernize the existing framework under Regulation A by, among other things, requiring that disclosure documents be filed on EDGAR, allowing an issuer to make a confidential submission with the SEC, permitting certain test-the-waters communications, and disqualifying bad actors. The final rules impose different disclosure requirements for Tier 1 and Tier 2 offerings, with more disclosure required for Tier 2 offerings, including audited financial statements. Tier 1 offerings will be subject to both SEC and state blue sky pre-sale review. Tier 2 offerings will be subject to SEC, but not state blue sky, pre-sale review; however, investors in a Tier 2 offering will be subject to investment limits (except when securities are sold to accredited investors or are listed on a national securities exchange) and Tier 2 issuers will be required to comply with periodic filing requirements, which include a requirement to file current reports upon the occurrence of certain events, semi-annual reports and annual reports.

 

Regulation A Tier 1 or Tier 2 is highly inappropriate for start-up and early stage companies, because of: 1.) The amount of legal and accounting work required for preparation is often cost prohibitive and 2.) The large amounts allowed to be raised, inherently position the start-up and early stage company to sell too much of the company too early for too little capital.  Think of it this way. What do you think you need to give up, in ownership percentage (through conversion rights or otherwise and voting control, to attract $50 million dollars for a young company?  When you think about it, its absurd.

 

Public Exchange Listing SEC Form S-1 (S-11 for Funds/REITS). Form S-1 (or S-11) would be the registration statement you would file with the SEC and the state(s) where solicitation and sales would occur if the following apply:

Audited Financial Statements Required.[2]

 

If your company is at the point where:

  • You need to allow an unlimited number of non-accredited investors in the deal;
  • You need to advertise your Company’s securities, because you do not have sufficient personal and professional investor contacts;
  • You are willing to spend the money to create, or you already have available, current audited financial statements; and
  • Your Company’s securities offering will be for more than $5,000,000.

 

Like Regulations A & A+, registration of an S-1 (or S-11) is highly inappropriate for start-up and early stage companies, because of: 1.) The amount of legal and accounting work required for preparation is often cost prohibitive and 2.) The large amounts allowed to be raised, inherently position the start-up and early stage company to sell too much of the company too early for too little capital.

 

The First Two Rounds:

Let’s make this part of the decision-making process as simple as can be. Consider the following deal structure and claim of exemption from registration.

Round One:

The vast majority of Start-Up or Early Stage Companies will do well to conduct a seed capital securities offering by:

  1. Selling Seed Capital Convertible Bridge Notes.
  2. Limiting the maximum dollar amount to $1 million for the first [seed capital] round.
  3. Allowing thirty-five (35) Non-accredited investors and an unlimited amount of accredited investors in the offering.
  4. Not needing the company’s financial statements to be audited.
  5. Not needing to advertise the offering to the general public.
  6. Claiming Regulation D, Rule 504 as the exemption from registration to solicit privately to pre-existing contacts, then converting the Regulation D, Rule 504 (constructed to only $1,000,000) into a SCOR offering, if allowed in the state where your Company resides, to advertise the securities to the general public. Or using the disclosures afforded under Regulation D, Rule 504(constructed to only $1,000,000) to fill out Form C on a Regulated Crowdfunding Portal for general solicitation to the crowd—general public, under Title III of the Jobs Act of 2012.


Round 2:

The vast majority of Start-Up, Early Stage, and Middle-Stage Companies will do well to conduct a development or expansion-capital securities offering by:

  1. Claiming Regulation D, Rule 506(c) as the exemption from registration.
  2. Selling convertible, participating preferred equity.
  3. Not limiting the total dollar amount.
  4. Not allowing any non-accredited investors and an unlimited number of accredited investors in the offering.
  5. Not needing the company’s financial statements to be audited.
  6. Needing to advertise the offering to the general public.
  7. Willing to obtain 3rd party verification for each investor’s accreditation

 

After those rounds, one should hire a team of professionals to handle future securities offerings, because, structured correctly, your financing options increase; but if they’re written incorrectly, your financing options decrease.

 

LEGAL PERSPECTIVE – by Russell C. Weigel, III, Esq.

 

Certain Officers and Directors

Only officers and directors authorized by their corporation may communicate with prospective investors. Lower-level employees, equity holders who are not officers, directors, attorneys, or other corporation agents may not do so unless they are registered as securities broker-dealers.

Indeed, no officer or director may be specially compensated directly or indirectly for communicating with prospective investors. They cannot receive commissions.

They cannot receive success fees. No officer or director may have as his/her full-time job the position of communicating with prospective investors to obtain capital, unless that person is registered as a broker-dealer.

 

Officers and Directors May Be Required to Register as “Brokers”

Generally, the federal and state definitions of a “securities broker” are purposefully broad to include persons who are not compensated for introducing an investor to an investment opportunity. Anyone who engages in the activity of finding potential investors is a broker. Thus, corporate officers and directors who communicate with prospective investors are also brokers. Federal law, however, provides an issuer-employee exemption for participation in one offering per year. Also, most states exempt these persons from being required to register as securities brokers, provided they are not compensated for their services as securities brokers—and so long as it is not their full-time duty to raise funds for the corporation.


Persons with Disqualifying Histories

Some people with histories of relevant, criminal convictions, injunctions, cease-and-desist orders, bars from the securities industry, or from being a public-corporation officer or director, or a penny-stock bar are automatically barred under federal law and the laws of most states from participating in some but not all categories of unregistered-securities offers. However, these same persons (unless they are barred from the industry or have been barred from offerings of penny stock) may participate in registered securities offers. This is because registration statements require material-facts disclosure, and disclosure of criminal convictions, injunctions, and findings of violations in investment-related litigation are matters requiring disclosure—not preclusion.

 

Friends and Family

Contacting anyone (including friends and family) for interest in funding your venture is illegal unless a statute or administrative-agency rule provides an investment-offer registration exemption (and the ability to solicit funds). How large is your family? How many friends do you have on Facebook? As stated above, many states have a limited-offering exemption of approximately twenty-five (25) purchasers. Federal law, under Regulation D, Rules 504 and 506(b), permits up to thirty-five (35) non-accredited purchasers in a single offering. Communications using interstate commerce with friends and family under these thresholds are permissible; but in both the state and federal exemption schemes, you must have a pre-existing relationship with the offerees. If you do not actually know the “friends” or “family” before contacting them, and you communicate with them with the ultimate goal of seeking their investment interest, that is an unregistered non-exempt public offering. It only takes a single stranger in the mix to void the ability to claim the exemption.

There is more to this restriction. You are permitted to contact friends, family, and others with whom you have a relationship, provided you are knowledgeable of whether they are accredited or unaccredited investors. This point is very important. If you contact too many unaccredited investors, and/or you (or the other officers or directors or broker agents of the issuer) do not actually know them, you can void the ability to conduct a private offering and subject yourself and everyone involved in the offering to liability.

Prior to enactment of the JOBS Act of 2012, under the federal-securities laws, Regulation D prohibited general solicitation and advertising in connection with private-investment offerings. The basic idea is registered; public offerings are examined by the SEC for compliance with disclosure requirements. These registered-securities transactions can then be offered and sold to the general public. On the other hand, private offerings are not reviewed by the SEC; therefore, there is greater risk disclosures will be inadequate for certain types of investors—especially if the amount of persons solicited to invest is numerous or the cash sought to be raised exceeds $1,000,000. As defined by Regulation D, Rule 502(c), among other things, general solicitation or general advertising includes “(1) [a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media,” and “(2) [a]ny seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

Title II of the JOBS Act directed the SEC to amend Rule 506 of Regulation D to release the ban on general solicitation and advertising provided that only accredited investors were permitted to invest in the advertised offering. Title III of the JOBS Act (crowdfunding) contains a similar concept. Title III permits a maximum, capital raise of $1,000,000, but any number of investors with any degree of business knowledge can invest. In this respect, crowdfunding is similar to Rule 504, however it has no limit to the number of non-accredited investors who may participate in the offering. Although the total dollar amount is limited to $1,000,000, crowdfunding investments are based upon an income and net-worth scale, hence Title III imposes restrictions on how much money each investor can invest.

 

However, the big news is general solicitation and capital-raise advertising is legal for Rule 506(c) offerings—it will be legal for crowdfunding and Regulation A+ offerings.

 

Since advertising and general solicitation connotes a lack of pre-existing relationship and a generalized form of communication, the issuer may be able to hold a meeting with a small number of prospective investors provided the issuer can demonstrate that it did not create the invitation list from a generic source—a list of attorneys licensed in a particular jurisdiction. The SEC advises “[t]he types of relationships with offerees that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists or that otherwise are of some substance and duration.” A permissible example of this is where a securities broker-dealer sends out fifty monthly questionnaires to local businessmen and professionals using lists created by the sender where the proposed solicitation is generic in nature, does not reference a specific securities investment offered or contemplated to be offered, and a procedure is in place to ensure that no one who receives a mailing is able to invest in a security that was being offered while at the time of the mailing. The business relationship is substantiated with responding persons for a period of at least forty-five days before any of them are provided materials concerning a particular investment.

 

Thus, a substantive relationship may be established with a person who has provided a satisfactory response to a questionnaire that enables the sender to have sufficient information to evaluate the prospective offeree’s sophistication and financial circumstances.

Engaging in general solicitation and advertising violates the “private” nature of private-securities offerings. Unless such securities offerings are registered or are offered in compliance with new rules promulgated by the SEC pursuant to the requirements of the JOBS Act, such offerings will violate the federal and possibly state-securities laws.

[1] NOTE: On October 26, 2016 the SEC adopted the final rules to Rule 504. Rule 504 retains the existing framework, while increasing the aggregate amount of securities that may be offered and sold under Rule 504 in any 12-month period from $1 million to $5 million and disqualifying certain bad actors from participation in Rule 504 offerings.  The $1 million aggregate offering limit in Rule 504 has been in place since 1988. The final rules repeal Rule 505, as well.

[2] Be sure to check with your attorney before conducting the actual offering of securities, as securities, organizational structures, tax, procedural laws, and rules & regulations can change at any time.