As we noted in our previous post on raising capital, under federal law, any offer of securities must either be registered under the Securities Act of 1933 (the “1933 Act”) or qualify for an exemption from registration. A registered offering under the 1933 Act is extremely time consuming and expensive, and generally occurs only once a company is thoroughly established. Prior to a public offering, a company will often raise money through smaller, private offerings. In our previous post, we discussed the exemption from registration provided by Rule 504 of Regulation D under the 1933 Act, which allows a company to raise up to $1 million per offering.
In this post, we discuss Rule 505 of Regulation D, the second of the three main private offering exemptions from 1933 Act registration. Rule 505 allows a company to raise up to $5 million dollars per offering, but is subject to more requirements and conditions than an offering under Rule 504.
Who may use Rule 505?
Rule 505 is available to any company except one subject to a “bad boy” disqualification. A “bad boy” disqualification prohibits certain companies from using Rule 505 that are sponsored, managed or otherwise related to a person or persons that, among other potential things, have been convicted or found guilty of, or have been enjoined from, violating certain laws in connection with raising money or selling securities. This disqualification seeks to prevent abuse of the relatively unregulated (when compared to a registered offering) private offering exemption under Rule 505.
What conditions must be met in relying on Rule 505?
An offering under Rule 505 is subject to a greater number of federally imposed requirements, and may still be subject to state law requirements. A company seeking to offer securities under Rule 505 should consult an attorney familiar with federal law and the law of the state in which the offers will be made to ensure compliance with applicable law. Because state laws can vary to a great extent, we will mainly deal with the federal requirements. Compliance with the federal requirements may satisfy state law in certain cases, provided that the company issuing securities makes the notice and other filings required in many states.
The federal restrictions on a Rule 505 offering include (i) a limitation on the total amount that can be raised, (ii) a limit on the number of purchasers who do not constitute “accredited investors”, and (iii) a limitation on the manner in which the offer and sale may be made.
Limitation on total amount raised. As noted above, a company can raise up to $5 million dollars in a single Rule 505 offering. A company may conduct more than one Rule 505 offering, but must ensure that sufficient time has passed (usually 6 months to a year) between offerings. If offerings are too closely related or held too close in time, a state agency or the Securities and Exchange Commission (the “SEC”) might “integrate” the two offerings, treating them as a single offering. Such integration could cause the company to exceed the $5 million limitation or fail to satisfy other requirements.
Number of purchasers. A company selling securities under Rule 505 is limited to 35 purchasers that are not “accredited investors” in a single offering. An accredited investor, generally, is defined to mean:
(1) a person (a) whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000 (excluding the value of his or her primary residence), or (b) who 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; or
(2) a company or other entity with assets exceeding $5 million.
The recently passed financial reform bill requires that the SEC review the definition of accredited investor in the coming year and every four years thereafter. As a result, this definition may change, and likely will be revised to require a higher net worth or income for individuals seeking to qualify as accredited investors.
If a company sells securities to non-accredited investors, it must provide those investors with a voluminous amount of financial and non-financial information about the company and the offering. As a result, many companies limit their offerings to accredited investors, for which the Rule does not specify any specific information delivery requirements.
Manner of offer. An offering under Rule 505, like certain offerings under Rule 504, cannot be made through any means of “general solicitation” or “general advertising.” A Rule 505 offer is exempt from registration under the 1933 Act because it is a private offering, and general publication of the offer and mass public advertising is incompatible with the private offering exemption. The SEC does not generally discuss what specific conduct constitutes general solicitation or general advertising, but it would include any mass mailing, cold calling, public seminars, newspaper, television or radio advertisements, among other things. Usually, Rule 505 offerings are made to sophisticated investors with whom the company or its officers have a prior business or other relationship, or to persons located by the company by a broker or referral agent, which normally must be a registered broker-dealer.
Can investors sell the securities purchased pursuant to a Rule 505 offering?
Generally, securities purchased in a private placement are subject to restrictions or limitations on resale. Resale provisions are available for investors to sell their shares, but such resales are subject to conditions. A company should restrict the ability of investors to resell its securities without the consent of the company in the documents governing the securities’ terms, given that improper resales can cause the company to lose the ability to rely on Rule 505 (or any private offering exemption) and create significant liability for the company. A company offering securities under Rule 505 should also inform purchasers about the restrictions on resale and the possibility that the investment may be illiquid for a long period of time.
As we noted in our previous post on raising capital, this post is intended only as a basic summary of the rules governing the sale of securities, and is not legal advice. A company considering raising capital through the sale of securities must contact an attorney to seek guidance. The federal and state securities laws can create enormous liability for improperly conducted offerings, even in the absence of any fraudulent intent on the part of the offeror. The applicable laws and regulations are complicated and often seem arbitrary, so the guidance and assistance of a professional is extremely important.