COMPLIANCE WITH FEDERAL AND STATE SECURITIES LAWS

In any private offering, it is critical that the founders consider and comply with state and federal securities laws and regulations. Founders often believe -- incorrectly -- that an offering to "friends and family" is exempt from compliance with securities laws and regulations. In fact, friends and family are still investors and must be evaluated and treated as such. Although several exemptions from registration exist under the Act, the law and regulations still require that the founders pay close attention to the status of their investors and how they are solicited.

The private offering exemption under section 4(2) of the Act exempts from registration "transactions by an issuer not involving any public offering." 15 U.S.C. § 77d(2). To qualify for this exemption, the purchaser of the securities must:

  1. Qualify as a sophisticated investor or be able to bear the investment's economic risk;
  2. Have access to the type of information normally provided in a prospectus; and
  3. Agree not to resell or distribute the securities to the public.

In addition, the company may not use any form of public solicitation or general advertising in connection with an offering under Section 4(2) of the Act. The larger the investor pool, the more difficult it will be to show that the transaction is exempt. If one person does not meet the requirements, the exemption may be destroyed, potentially putting the offering in violation of the Act.

Regulation D of the Act provides important exemptions from registration for private offerings. A key feature of each exemption is the prohibition against general solicitation and advertising. Additionally, investors who purchase subject to a Regulation D exemption are buying "restricted" securities and may not resell them without registration or an applicable exemption. Two of the Regulation D exemptions are:

Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any twelve (12) month period. Under this exemption, a company may sell to an unlimited number of "accredited investors" and up to thirty five (35) other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must be purchasing for investment only and not for resale, and the issued securities must be "restricted." Consequently, the company must inform investors that they may not sell for at least one (1) year without the shares being registered.

Rule 506 is a "safe harbor" for the private offering exemption under Section 4(2) of the Act. If the company satisfies the following standards, the company will be assured of satisfying the Section 4(2) exemption:

  1. An unlimited amount of capital may be raised;
  2. No general solicitation or advertising to market the securities;
  3. An unlimited number of accredited investors and up to thirty five (35) other purchasers; and
  4. All non-accredited investors, either alone or with a purchaser representative, must be sophisticated - that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.

The definition of an "accredited investor" is the same for each of the above exemptions:

  1. A director or executive officer of the company;
  2. A person with a net worth, together with a spouse, of more than $1.0 million; or
  3. A person who has had income greater than $200,000 for the past two years or joint income with a spouse greater than $300,000 for the past two years.

When dealing with accredited investors, a company is not required to provide a Confidential Private Placement Memorandum ("PPM"). The company must, however, provide adequate financial statements prior to beginning the offering. What is essential is that there be full and fair disclosure of all relevant information regarding the company. This can be achieved through a PPM, a Business Plan, an executive summary, or Powerpoint presentation. The more written information that the company provides the less chance there is for misunderstandings by the investors.

To ensure that the sale will only be to accredited high-net worth individuals, appropriate Subscription Agreements and Investor Questionnaires should be used. An investment should be accepted only after those documents have been completed, reviewed and accepted by the company. A form of a Subscription Agreement and Investor Questionnaire is available for download from Evelexa.

It is important to consider state securities laws or "Blue Sky" regulations. While exemptions vary from state to state, there is some degree of coordination. Typically, if the offering is exempt from registration under federal securities laws, the offering will often require only a notice filing in the states where the offering is done -- sometimes accompanied by payment of a fee. The company must evaluate the impact of the state securities laws in each state in which an investor resides.

Finally, when dealing with restricted securities, Rule 144 is important. Rule 144 provides for the public sale of restricted and control securities in limited quantities without the requirement that such securities become registered. As discussed above, restricted securities are securities acquired in unregistered, private sales from a company or from an affiliate of the company. Control securities are those held by an affiliate of the company. When an individual purchases securities from an affiliate there are resale restrictions even if the securities were not restricted in the affiliate's hands. As a general matter, under Rule 144, restricted securities may be sold to the public if the following conditions have been met:

  1. The securities have been owned and fully paid for at least one year. The holding period only applies to restricted securities. Because securities acquired in the public market are not restricted, there is no holding period for an affiliate who purchases securities of the issuer in the marketplace. But an affiliate's resale is subject to the other conditions of the rule.
  2. Current financial information is made available to the purchaser.
  3. The seller files a Form 144, "Notice of Proposed Sale of Securities," with the SEC no later than the first day of the sale. If the sale involves more than 500 shares or the aggregate dollar amount is greater than $10,000 in any three-month period. The sale must take place within three months of filing the Form and, if the securities have not been sold, the seller must file an amended notice.
  4. If the securities were held for between one and two years, the volume of securities sold is limited to the greater of 1% of all outstanding shares, or the average weekly trading volume for the preceding four weeks. If the shares have been held for two years of more, no volume restrictions apply to non-insiders. Insiders must always abide by volume restrictions.
  5. The sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission. Neither the seller nor the broker can solicit orders to buy the securities.

The last step in selling restricted securities under the Rule 144 safe harbor is to be certain that the restricted legend is removed from the stock certificate(s). Only a transfer agent can remove the legend, but a transfer agent must first obtain approval from the company -- usually in the form of an opinion letter from the company's counsel.

ABOUT THE AUTHOR:

Peter B. Finn, Esq., Senior Partner, Rubin and Rudman LLP.

Mr. Finn is a Senior Partner with Rubin and Rudman LLP in Boston, MA, where he chairs the firm's Biotechnology Practice. He focuses his practice on representing start-up biotechnology and medical device companies, the development licenses, collaborations, and joint venture agreements, and all aspects of corporate finance. He is a member of the Technology Transfer Committee of the Beth Israel Deaconess Medical Center and equity subcommittee and the Editorial Board of the Biolaw and Business Journal. Mr. Finn has authored and published: Material Transfer Agreements, A Battle of Forms, Negotiating and Drafting Confidentiality Agreements, and Structuring a Start-up for Venture Capital Financing. He is a graduate of Syracuse University and Boston College Law School. Mr. Finn can be reached at pfinn@rubinrudman.com.

ABOUT RUBIN AND RUDMAN, LLP.

Rubin and Rudman LLP is a business oriented firm with seventy five (75) attorneys. The areas of concentration include, business and corporate finance, regulatory and environmental, litigation, and general real estate matters. For more information about the firm, visit www.rubinrudman.com.

This chapter was derived from an article originally published by Mr. Finn in the Journal of BioLaw and Business, 2002.