Raising Money and Securities Regulation

(a) Issuing a Security.
As described above, whether or not a particular instrument, arrangement or equity interest will be deemed a security or not can be complicated. In short, it is often safe to approach the question with the answer in mind: If you are asking yourself the question “Is it a security?” The answer is likely “yes.”

If you are raising money from third parties, you should approach the matter as the issuance of a security. Prior to offering or selling a security in Utah, the security or transaction must either be: (i) registered;

exempt from registration; or (iii) be a federal covered security.

Issuing Securities By Registration: For a company starting a business, it will rarely be recommended that funds be initially raised through the registering of such securities with applicable governmental authorities (i.e., the SEC or a State’s Division of Securities). The registration process is complicated, time consuming and expensive. The registration process will require the preparation of a registration statement, review and comment by state and/or federal securities regulators, significant legal and accounting review and assistance and continuing compliance requirements. Registering a security is a book unto itself and will not be discussed herein.

Issuing Securities Pursuant to an Exemption from Registration: The Utah Uniform Securities Act (Section 61-1-14) provides more than 30 exemptions from registration. Most of these exemptions, however, require filings with the state prior to or immediately after the offering. Any person that relies on an exemption has the burden to prove they qualify for the exemption. Most of these exemptions do not apply to a start-up company raising funds to operate a business. It should be noted that there are no exemptions from the anti-fraud provisions of securities laws. An exemption only permits a person to offer or sell a security without registering the security. Accordingly, individuals offering or selling exempt securities may have additional disclosure requirements to satisfy the anti-fraud provisions. The “anti-fraud” provisions of securities laws, in summary, make it illegal to make a misstatement or omission of a material fact in connection with an offering of securities.

The “exempt” offering that most people rely on is the “private offering exemption” specified in Section 4(a)(2) of the Securities Act of 1933 (“the 1933 Act”). In Utah, the applicable provision is Utah Code Section 61-1-14(2)(n) “a transaction not involving a public offering.” The “private offering exemption” exempts a transaction by an issuer not involving any public offering from having to register securities with the SEC or state securities divisions. Section 4(a)(2) exempts only an initial sale by an issuer, not resale. Any resale that follows an initial sale must be registered with the SEC or should satisfy an exemption to the 1933 Act. The SEC defined a private transaction under 4(a)(2) through two cases: Doran v. Petroleum Management Corp. and SEC v. Ralstson Purina. The two cases defined that a private transaction not involving any public offering involves offerees who do not need the protection of the 1933 Act. Therefore, the offerees must have both information and knowledge to understand the transaction that they are involved in. For an offeree to satisfy the standard, the offeree must possess sophisticated knowledge and either an access to information that a registration statement would normally provide or actual disclosure of the information by the issuer.

An issuer has to demonstrate that all offerees meet the test.

An issuer can show that each offeree is qualified to be in a private transaction by a number of different ways. In assessing sophistication of each offeree, the issuer must have pre-existing business relationships with an offeree so that the issuer is familiar with how sophisticated an offeree is, or question an offeree regarding their knowledge and previous business experiences to establish the offeree’s sophistication. In connection with access, an offeree is deemed to have access to information if the offeree serves as a director or an executive officer for the issuer or is a family member of an insider. If an offeree has economic bargaining powers big enough to demand access to information, an offeree is also considered as a transactional insider. If the issuer does not wish to provide access, it can always directly disclose relevant information to offerees.

The “private offering exemption” is the de facto exemption that most companies use upon formation. The parties organizing a business, contributing capital and being actively involved in the business are issued securities upon formation. Due to such organizers knowledge of the business, activity in the day to day operations and status as “active investors”, such individuals generally meet the information and knowledge requirements to satisfy the private offering exemption requirements. A private offering is referred to as a “self-effectuating exemption” in that no filings or information delivery requirements are necessary.

When a company seeks funds from investors that will not be active in the company and were not the “founders” or family members of insiders, then the private offering exemption becomes more difficult to meet. In such cases, a company should consider an exempt offering known as a Regulation D offering (described below).

Issuing Securities Pursuant as a Federal Covered Security: A Federal covered security is a security that is exempt from state registration because either it is registered with the Federal government under the 1933 Act or it is exempt from federal registration under the 1933 Act. Federal covered securities include securities listed or authorized for listing on the NYSE, AMEX, the National Market System of Nasdaq®, registered investment company securities; securities offered or sold to qualified purchasers; securities with respect to certain transactions exempt from Federal registration, including some private placements; and securities that are exempt from Federal registration (Regulation D, Rule 506).

A company raising money through the sale of securities will generally be best advised to issue those securities through a Regulation D (“Reg D”). Reg D is an exemption to the 1933 Act that spells out safe harbors that qualify as a private transaction under Section 4(a)(2) of the 1933 Act (described above). Reg D includes Rules 500 to 508 of the 1933 Act. Reg D exempts only issuers from Section 5 of the Securities Act of 1933, which requires a filing of a registration statement with the SEC and controls use of prospectus and an offer to sell or buy securities before a registration statement is filed. Therefore, issuers who rely on Reg D can issue securities without registering them with the SEC.

Three rules, Rules 504, 505, and 506 of Reg D provide for the bulk of the exemptions under Reg D while other rules deal with general conditions and requirements. Rules 504 and 505 are based on Section 3(b) of the 1933 Act. Section 3(b) grants the SEC the authority to issue rules exempting securities of the dollar amount less than 5 million dollars. Rule 506 arises from section 4(a)(2) of the 1933 Act, which exempts issuers’ private placement from registration with the SEC.

Rule 504 applies to issuers who do not have to file reports under the Securities Exchange Act of 1934 (“the Securities Act”). To rely on 504, a company must be a private entity that has not accessed the public capital market and has never been a reporting company under the Securities Act. Rule 504 does not apply to a blank check company, which is defined as a development stage company that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person. The 504’s aggregate offering price, including offerings made under any 3(b) exemption or in violation of section 5 of the 1933 Act in 12 months preceding the 504 offering, cannot exceed $1 million.

If a company is neither a reporting company under the Securities Act nor a blank check company, it can rely on Rule 504 given that the company satisfies Rule 501 and 502(a), (c), and (d). Rule 502(a) exempts all offers and sales “made more than six months before the start of a Reg D offering or made more than six months after completion of a Reg D offering” from being integrated with or being considered part of the Reg D offering. However, if a company has offered or sold securities that are of “the same or a similar class as those offered or sold under [Reg D], other than those offers or sales of securities under an employee benefit plan,” the company can no longer rely on the exemption to integration provided by Rule 502(a). Instead, the company has to consider five factors whether or not offers or sales should be integrated with a Reg D offering. The five factors include, (a) whether the sales are part of a single plan of financing, (b) whether the sales involve issuance of the same class of securities, (c) whether the sales have been made at or about the same time, (d) whether the same type of consideration is being received, and (e) whether the sales are made for the same general purpose. If two offerings are deemed to be integrated, then they have to satisfy a single exemption to the 1933 Act.

Rule 502(c) restricts manner of offering by prohibiting issuers or any person acting on behalf of issuers from using general solicitation or general advertising in selling or offering securities. General solicitation or general advertising is defined to include (1) an advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; (2) any seminar or meeting with whose attendees have been invited by any general solicitation or general advertising. Giving journalists access to press conferences held abroad, meetings with issuers or selling security holder representatives conducted abroad, or written-press-related materials released abroad, at or in which a present or proposed offering securities is discussed, will not constitute general solicitation or general advertising. Rule 502(d) imposes limitations on resale. Securities sold under

Reg D are treated as restricted securities, equivalent to ones issued in a private transaction under 4(a)(2) of the 1933 Act. When restricted securities are resold, they have to be registered with the SEC or satisfy an exemption to the 1933 Act. Therefore, in order to comply with Rule 504, an issuer has to exercise reasonable care to assure that purchasers of the restricted securities are not underwriters within the meaning of section 2(a)(11) of the 1933 Act. Reasonable care are defined as (1) reasonable inquiry to determine if the purchase is acquiring the securities for himself or for other persons, (2) written disclosure to each purchaser prior to sale that the securities have not been registered under the 1933 Act and, therefore, cannot be resold unless they are registered under the 1933 Act or unless an exemption from registration is available, and placement of a legend on the certificate or other document that evidence the securities stating that the securities have not been registered under the 1933 Act and setting forth or referring to the restrictions on transferability and sale of the securities.

However, Rules 502(c) and 502(d) do not apply if an issuer is one of the followings: (1) the company registers the offering exclusively in one or more states that requires a public filing of a registration statement and a delivery of a substantive disclosure document to investors before sale; (2) the company sells in a state which does not require registration and disclosure delivery when the company has already registered and sold the offering in a state with those requirements; or (3) the company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to accredited investors. Issuers who satisfy any one of the three conditions can freely conduct general advertising or general solicitation and do not have to place any restriction on the resale of the securities.

Rule 501(a) defines who accredited investors are for purposes of Reg

The bar to be an accredited investor is not high. For example, if an individual had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year, according to Rule 501(a), that individual is an accredited investor. Rule 501(a) also provides a set of rules on how to calculate a number of accredited investors.
Rule 505 has a larger price cap of $5 million. Similar to Rule 504, Rule 505 does not apply to issuers that are either blank check companies or companies that are disqualified by Rule 262 of Regulation A. Also, the same aggregate offering rule to that of Rule 504 applies. However, Rule 505 has a stricter set of requirements, forcing issuers to satisfy both Rules 501 and 502. Hence, all the restrictions that applied to Rule 504, including restrictions on resale, manner of offering, and integration as well as 502(b), information requirement, have to be satisfied by issuers who rely on Rule 505. In addition, an issuer can have only up to 35 purchasers. The issuer can exclude accredited investors from the count. If the issuer sells to accredited investors only, it does not have to furnish the investors with the information required under Rule 502(b).

Rule 506 is similar to Rule 505. Issuers under Rule 506 have to satisfy Rules 501 and 502 as well as respecting the 35 purchaser cap. Accredited investors are excluded from the count. However, issuers have to ascertain that each purchaser who is not an accredited investor either alone or with his purchaser representative has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer has to reasonably believe immediately prior to making any sale that such purchaser comes within this description.

There are some advantages to Rule 506. The primary benefit is that a Reg D, Rule 506 offering is deemed to be a “covered security” and is exempt from state filing requirements (other than a simple notice requirements). There is no aggregate offering price limit for securities issued under Rule 506 because the rule stems from section 4(a)(2) of the 1933 Act. Section 4(a)(2) has no limitation on the amount of securities that can be issued under the exemption. The SEC also recently relaxed some requirements of Rule 506 by creating 506(c). Rule 506(c) allows issuers to evade certain requirements of Reg D if they sell only to accredited investors. An offering made under 506(c) has to satisfy Rules 501 and 502(a) and (d) but not (b) or (c). Therefore, issuers can conduct general advertising or general solicitation and offer freely without any restriction on manner of offering. Issuers still have to take reasonable steps to verify that purchasers of securities issued under 506(c) are accredited investors. Furthermore, issuers do not have to register securities but notices with states.

Rule 506 do not allow issuers that are “bad actors” as defined by Rule 506(d). Rule 506(d) disqualifies corporations that have a history of a crime related to the sale or offering of securities. Even a crime by any director or executive officer of a corporation makes the corporation a bad actor, disabling the corporation from relying on Rule 506.

Lastly, Rule 503 requires issuers who issue securities under Reg D to file Form D. However, filing Form D is not a condition to issuing securities under Reg D. Even if an issuer fails to file Form D, the issuer can still rely on Reg D. The failure to file Form D might still cause the SEC to take an action against an issuer. The bottom line is that the issuer should always file Form D with the SEC.

Active Versus Passive Investors.
As described above, the activity of the investors (are they founders, officers, third party passive investors, etc.,) will determine which exempt offering the company should consider as more appropriate. A “private offering” is generally only applicable to founders and active participants in the business with sufficient understanding of the business and financial resources to undertake the risks involved.

Passive investors are generally best suited for a Reg D, Rule 506 offering. In each case, individuals and companies seeking to raise capital should consult with an attorney.

Debt versus equity.
The Division of Securities sums up on its website the securities issues involved in raising capital through debt or equity succinctly as follows:

Essentially, businesses raise money through equity financing or debt financing. Equity financing is when businesses raise funds by selling an ownership in their business (e.g. stock, partnership interests, limited liability company interests). Debt financing is when businesses raise funds by selling debt in their business (e.g. bonds, notes). Whatever the instrument, if a business raises capital through equity or debt, they are likely issuing a security In short, whether a company raises funds via debt or equity is a business decision. The issues with respect to compliance with securities laws, however, are the same. Equity and debt are both securities.

Failure to Comply.
Failure to comply with the securities regulations can put both the company and its owners at significant risk of criminal and civil liabilities. Criminal penalties for each violation can be up to 15 years imprisonment. As a matter of practice, jail and criminal fines generally follow some sort of criminal intent – though the line can be very fine on what is deemed to be criminal intent.

One of the greatest, and more likely risks of failure to properly comply with securities laws are the civil liabilities. Intent to not comply is not required to be civilly liable. Under UCA 61-1-22, a person who issues securities in violation of applicable securities laws (both the company and the people in their individual capacities – no corporate veil protection), can be held liable for (1) a full return of all invested funds; (2) an additional 12% annual return on such funds; and (3) the reimbursement of attorneys’ fees of the investors who seek rescission. Additionally, if it can be shown that a person’s violations were reckless or intentional, triple damages can be imposed. An investor has five years after the act or transaction constituting the violation or the expiration of two years after the discovery by the investor of the facts constituting the violation, whichever expires first, to bring a claim.

Summary
Compliance with securities laws is complicated and the failure to comply can have a material adverse impact on the owners of a company as well as the company itself. Before issuing securities, one should consult with an attorney with experience in securities laws.