Understanding Regulation D (or “Reg. D”) exemptions is a must for investors who want to be able to make intelligent investment decisions and protect themselves (to the extent possible) from investment scams and fraud. In this quick guide to understanding Regulation D for investors, we will touch on some of the basic requirements of Rule 506 exemptions. We will also explain why being an accredited investor is so important and how you can become verified as an accredited investor.Finally, we’ll touch on what it means to purchase restricted securities pursuant to a Reg. D offering.
Investing in securities requires careful consideration and a basic knowledge of some of the legal requirements in the United States.
With this primary understanding of Regulation D, you can conduct your own research on any potential offering and evaluate whether it complies with all legal requirements before you invest. Plus, when you understand the federal laws, you will be better able to assess the risks you are undertaking when investing.
To be clear, this guide is a very basic overview of Regulation D. It is not (nor is it intended to be) a detailed exploration of the federal laws or of all factors an investor needs to understand when investing in securities.
The federal and state laws governing securities are extremely complicated. This guide is intended merely to provide a broad overview of the most commonly used federal exemptions to securities registration. Use it as a starting point, but conduct your own due diligence and consult with all legal, business, and other professionals as needed.
A Brief History of Regulation D.
In 1929, in the United States, the stock market crashed.
In the throes of the Great Depression, Congress passed the Securities Act of 1933 (“Securities Act” or “the Act”).
The Securities Act, also known as the “Truth in Securities” law, governs the sale and exchange of securities. The Act was passed to protect investors from fraud by requiring issuers to be honest and fair in their dealings with their investors.
The Act requires issuers to honestly disclose information about the securities they are selling, so investors have the information they need to properly evaluate the risks of investment. The Act also prohibits issuers from promising unrealistic returns on investments to entice investors to invest.
The year after Congress passed the Securities Act, it passed the Securities Exchange Act of 1934, (SEA) to govern securities transactions on the secondary market.
SEA, in turn, created the federal regulatory body, the Securities and Exchange Commission (SEC) to carry out this mission.
The Securities Act requires every public offering of a security (e.g., stocks, bonds, equity, and more) to be registered with the SEC. The SEC registration requirements are burdensome, time-consuming, and costly — especially for small businesses. Making a public offering, for example, by conducting an initial public offering (IPO), to raise capital is often well beyond the financial means of most small companies or start-ups.
Over time, lawmakers recognized the onerous burden that SEC registration imposed on small to medium-sized businesses trying to raise capital, so they carved out certain exemptions from the SEC registration process. These exemptions are embodied in Regulation D (or “Reg. D”).
Regulation D went into effect in 1982. It allows companies to raise capital through the sale of equity or debt security without having to register their securities with the SEC.
But only if the company meets the specific requirements of the exemption.
A Little Bit About Reg. D Exemptions.
The exemptions in Reg. D generally do not allow companies to advertise their securities publicly.
Instead, to qualify for a Reg. D exemption, the securities must be offered to private investors (whether individuals or entities) Guide for Issuers. In other words, a Reg. D offering is in the nature of a private placement.
In addition, securities purchased under a Reg. D offering are restricted securities.
For an investor, this means that the securities purchased pursuant to a Reg. D offering cannot be resold unless they are registered with the SEC or come within an exemption governing their resale.
Since its enactment, Reg. D and Form D (the form required to be filed with the SEC to apply for a Reg. D exemption) has been amended and changed — sometimes significantly.
Most notable was the effect the Jumpstart Our Business Startups Act (“JOBS Act”) had on the Reg. D exemptions.
Enacted in 2012, the JOBS Act required the SEC to amend existing exemptions and create new ones that would allow issuers to raise capital without having to register their securities with the SEC.
The JOBS Act effectively lifted the ban on general advertising of securities by amending Rule 506 of Reg. D and Rule 144A of the Securities Act.
Regulation D consists of three separate rules — Rule 504, 505, and 506.
In October 2016, the SEC amended Rule 504 and repealed Rule 505 — integrating many of Rule 505’s provisions into the amended Rule 504. Thus, investors who are considering investing in Reg. D offerings need to understand Rules 504 and 506.
Regulation D — A Few Basics Investors Need to Understand
Understand What it Means to Invest in Unregistered Offerings.
It may seem obvious, but as an investor, it is worth taking a minute to recognize what it means to invest in securities that are offered pursuant to a Reg. D exemption.
Importantly, you want to be aware of the fact that Reg. D offerings are unregistered securities. That means that some of the protective features provided by registering a security with the SEC are not present when you invest in a Reg. D security.
The two main issues of concern here are:
Disclosures, and
The resale of the security.
As to disclosures, there is a significant difference in the level of disclosures provided for registered securities, and those provided for unregistered securities.
When a security is registered with the SEC, the issuer is required to provide a detailed disclosure document — called a prospectus — to any potential investor.
In addition to the prospectus, the issuer must file a registration statement with the SEC. The registration statement provides extremely detailed information about the business and the intended equity offering. The SEC then reviews the registration statement before making it available to the general public.
These detailed documents — the prospectus and registration document — provide a lot of specific information about the offering. They are the documents an investor primarily relies on when deciding whether or not to invest in a given opportunity.
In contrast, offerings made under the Reg. D exemptions (Rule 504, Rule 506(b), Rule 506(c)), lack these informational protections.
The level of disclosure required for unregistered securities is either minimal or nothing at all.
That means that an investor must rely on his or her own knowledge and experience to evaluate the risks of investing in an unregistered security. Hence, the importance that the SEC places on an investor’s status as “accredited” or “non-accredited” in a Reg. D offering.
The other main issue to be aware of is that securities issued under Reg. D are generally “restricted securities.”
A restricted security is one that cannot be resold unless it either comes within an exemption or is registered with the SEC. Whether or not you can easily resell your security is a factor that can affect your investment. Therefore, it is a point any investor should consider carefully before purchasing securities under Reg. D.
Understand the Different Rules Under Reg. D.
Now let’s look more closely at the exemptions available under Reg. D.
Rule 504
In October 2016, the SEC repealed Rule 505. It was discontinued over time, and most of its provisions were wrapped into Rule 504 of Reg. D. The SEC’s final amendments to Rule 504 took effect in 2017.
Under the amended Rule 504, a company can raise up to $10,000,000 in any 12-month period without having to register those securities with the SEC. As amended, Rule 504 stipulates:
investors do not need to be accredited or sophisticated investors,
the offer can be to an unlimited number of investors,
the sale must comply with all federal and state anti-fraud laws, but there are no specific disclosure requirements for a Reg. D 504 offering.
BUT the Rule also mandates that:
general solicitation or advertising is allowed only if: (a) the securities are registered under state law or (b) sales are made to accredited investors only and advertising is allowed under state law,
a notice on Form D must be filed with the SEC,
the exemption is not available to “bad actors,”
companies that do not have specific business plan or that intend to merge with another company or be bought by one, cannot use the 504 exemption, and
if a “covered person” (someone able to influence the transaction) is involved in the transaction and they do not meet the requirements, the offering will be disqualified.
Importantly, under Rule 504, the state can still regulate the security.
While Rule 504 provides advantages and disadvantages for issuers, what investors need to understand about it are the following two (2) key factors:
Generally, the securities purchased under Rule 504 are restricted, and
Rule 504 does not require a company to provide any specific disclosure information to investors.
As mentioned above, the lack of disclosures and the fact that Reg. D securities are restricted securities are both important matters an investor should fully understand and carefully consider before investing.
Finally, because Rule 504 applies to only some companies, it is not used as frequently as Rule 506.
Rule 506
Rule 506 of Reg. D is the most commonly used exemption for companies raising capital without registering their securities with the SEC.
In 2012, Rule 506 was amended to implement requirements in the JOBS Act to allow small companies to advertise unregistered securities and solicit investors for private offerings. The result was 506(b) and 506(c).
Rule 506(b)
Rule 506(b) provides a “safe harbor” for companies under Section 4(a)(2). It does this by providing objective standards that a company can rely on to avoid violating the federal securities laws when making private placements.
Rule 506(b) provides that an issuer:
can raise an unlimited amount of capital under the exemption,
can sell to an unlimited number of accredited investors,
cannot sell to more than 35 non-accredited investors,
cannot advertise offerings or use general solicitation to market offerings, and that
all non-accredited investors must have sufficient knowledge and experience to evaluate the proffered investment and the company must provide non-accredited investors with certain limited disclosures such as financial statements and must be available to answer questions.
If a company meets all the requirements of 506(b), it may sell securities without registering them with the SEC. However, it is important to note that the securities sold are restricted securities.
Rule 506(c)
Rule 506(c) also allows a company to raise unlimited capital by selling unregistered securities. Unlike Rule 506(b), however, 506(c) allows a company to use advertisem*nts or general solicitation to offer its securities to investors — but only if all investors are accredited investors.
It also requires the issuer to take “reasonable steps to verify” each purchaser’s accredited investor status.
Plus, Rule 506(c) makes clear that while it preempts state registration, the states still have the authority to require the filing of notices and to collect fees related to securities. Thus, issuers must consider all state “blue sky laws” that may apply to their offering.
Understand Some of the Nuances in the Language and the Law.
With a basic understanding of the Reg. D exemptions, let’s now take a closer look at some of the specifics that investors need to know and understand.
What is “general solicitation”?
For example, what constitutes “general solicitation” for purposes of Rule 506 (b)?
As noted above, 506(b) does not allow an issuer to advertise or use “general solicitation” to market its offerings.
But what, exactly, is “general solicitation”?
Unfortunately, the law does not define it.
However, that does not mean there is no guidance available to tell you when an issuer may be running afoul of the Rule 506(b) prohibition.
There is.
According to the SEC, “general solicitation” includes, (but is not limited to) some or all of the following:
advertisem*nts published in newspapers and magazines,
advertisem*nts on public websites,
television or radio broadcasts,
seminars where attendees were invited by general solicitation or general advertising.
For investors, this means it is important for you to take note of how you became aware of a Reg. D offering. The manner in which you were approached by an issuer can give you some indication of whether a company is following the law or not. Good investors are wary of companies that fail to conform to the law.
Although this is a far more complex issue than we can cover here, as an investor, it might be wise to be cautious of issuers with whom you do not have a relationship if they email you, or you see their advertisem*nt in the newspaper, or they blog or Tweet about their 506(b) securities offerings. Any or all of these things can constitute “general solicitation.”
Why is Accredited Investor Status So Important?
One aspect you may notice in both Rule 506(b) and 506(c) is the emphasis placed on whether an investor is “accredited” or “non-accredited.”
For example, although 506(b) allows issuers to sell to non-accredited investors, the number is severely limited. (No more than 35).
Meanwhile, under 506 (c), an issuer can sell to an unlimited number of investors but only if they are all accredited investors.
Why this difference? Why does the SEC place such emphasis on whether an investor is “accredited” or not?
Because accredited investor status is meaningful.
Since Reg. D creates exemptions from registering securities, being an accredited investor provides the SEC with some level of confidence that the investor does not need the protections available in registered offerings.
Accredited investor status is an indicator that the investor has the appropriate level of income, experience, and knowledge to understand the risks of investment, and withstand those risks.
Who Can Be an Accredited Investor?
Rule 501 of Reg. D of the Securities Act defines “accredited investor.” It allows for natural persons as well as companies, partnerships, financial institutions, trusts, and other entities to be accredited investors.
As long as an individual meets the law’s net worth and income requirements, he can qualify as an accredited investor.
The SEC recently amended Rule 501 to add additional categories for individuals to qualify as accredited investors. The definition now includes:
individuals with certain professional certifications, designations, or credentials,
individuals who are “knowledgeable employees” of a private fund,
SEC- and state-registered investment advisers.
The expansion of the definition of “accredited investor” allows many more people to participate in unregistered securities offerings.
How Do You Become an Accredited Investor?
So how do you become an accredited investor?
Well, there is no SEC process, governmental procedure, or specific test you need to pass to qualify as an accredited investor.
Instead, it is up to the issuer to prove your accredited status to the SEC. To do this, the issuer will look to you to establish your accredited investor status by answering questions and providing it with various documents when it conducts its due diligence prior to a sale.
Rule 506(c) requires an issuer to take “reasonable steps to verify” the accredited status of investors. What constitutes “reasonable steps” depends on the approach an issuer uses to verify the status of its investors.
There are two (2) different methods an issuer can use to verify accredited investor status:
The principles-based approach, or
The non-exclusive “safe harbor” approach.
The principles-based method set out in Rule 506(c) requires an issuer to use his best judgment to determine whether an investor meets the law’s requirements. To do this, an issuer will collect and review various financial documents and information (such as financial statements, credit reports, etc.) from the investor, and will consider factors regarding the offering as well as the purchaser, to determine whether the investor qualifies as an accredited investor.
The non-exclusive “safe harbor” verification method of 506 (c) allows an issuer to take “reasonable steps to verify” accredited status by doing any or all of the following:
obtaining and reviewing recent tax documents to verify an investor’s income,
obtaining and reviewing recent credit reports, bank statements, brokerage statements, real estate appraisals, and other such documents to verify a person’s net worth,
verification of accredited investor status through third-party licensed or registered professionals.
Regardless of which one of the methods above the issuer chooses, you, as the investor, will be required to provide sufficient information about your financial situation (income, liabilities, assets, etc.) to allow the issuer to determine whether you qualify as an accredited investor.
What is the Quickest and Most Secure Way to Get Accredited Investor Status?
Clearly, the information you will need to provide to an issuer is highly personal. Thus, you will want to ensure that your information is kept private, safe, and confidential.
At VerifyInvestor.com, we offer safe, secure, and affordable professional accredited investor verification services for investors looking to prove their accredited investor status and get accredited investor verification letters.
Our services allow issuers to verify their investors and allow investors to verify themselves.
Being an accredited investor gives you great advantages. It allows you to take advantage of more diverse offerings without being restricted by how much money you can invest.
As an accredited investor, you can take advantage of more investments and higher-risk investments as well.
The risk may be higher, but very often so are the returns.
