Federal and state securities laws both require that the issuance, sale or transfer of securities be registered unless there is an applicable exemption. The federal requirement appears in Section 5 of the Securities Act of 1933, as amended1 (the "Securities Act") and the New Jersey provision is found in Section 13 of the Uniform Securities Law (1997)2 (the "Uniform Law"). The Securities and Exchange Commission administers the federal law and the New Jersey Bureau of Securities is responsible for enforcing New Jersey’s securities law. For many small and medium sized companies, and for virtually all start-ups, the time and expense involved in registering and going public is prohibitive. Thus, it is vital to many companies that they be able to raise capital and issue securities without registration. This article discusses the principal exemptions from registration under the Securities Act and the Uniform Law for companies raising capital in private placements or offerings.

The definition of a security is fairly expansive under both statutes,3 but for purposes of this article it suffices to say that a security includes common and preferred stock, options and warrants to acquire such stock, and debt instruments such as bonds and debentures. There is a substantial body of case law addressing those definitions, and two relatively recent United States Supreme Court decisions on the subject are Landreth Timber Co. v Landreth and Reves v. Ernst & Young.4

The registration process at the federal level consists of preparing and filing with the SEC a registration statement, which must be approved or declared "effective" by the SEC prior to the sale of any securities. The principal portion of the registration statement is the prospectus used to sell the securities, and the balance consists of certain required additional information and copies of documents and agreements that are material to the offering company. The prospectus includes a description of the offering and the anticipated use of its proceeds, the business, properties and management of the company and audited financial statements along with a narrative discussion of the company’s financial condition.5 The SEC’s requirements for registration statements are very detailed and involved, thus causing the time and expense of complying and going public.

Like most states, New Jersey has a registration requirement for the sale of securities. In the case of federally registered public offerings where the securities are listed for trading on the New York or American Stock Exchanges or Nasdaq, the Securities Act since 1995 has essentially preempted state regulation.6 Nevertheless, in the case of an offering in New Jersey that is exempt from registration under the Securities Act, a corresponding exemption must be found under the Uniform Act or else registration in New Jersey will be required. Fortunately, New Jersey has changed its securities laws over the past several years to become fairly consistent with federal securities law.

Each state’s securities laws govern offerings made within that state. This article discusses only New Jersey law, but in the case of private offerings made to potential investors in other states, the securities laws of those states must be considered and complied with as well.

Before turning to the exemptions, we need to emphasize what is not exempted. The two principal aspects of the Securities Act and the Uniform Act are the registration requirement and the anti-fraud provisions. The exemptions outlined below apply only to registration. All securities offerings, public and private, are subject to statutory anti-fraud rules. In addition to specific prohibitions against fraud itself, both the Securities Act and the Uniform Act prohibit the offeror or seller from making any untrue statement of a material fact or omiting any material fact necessary in order to make the statements that are made not misleading in light of the circumstances under which they are made.7 Non-compliance can result in civil and criminal liability, as well as rescission of a completed offering. Counsel to private issuers need to advise their clients thoroughly on this subject, and we will discuss below compliance with the anti-fraud rules in the absence of registration.

Federal Exemptions From Registration

The primary federal exemptions to be addressed in the context of private placements by non-governmental issuers are found in Sections 3(b) and 4(2) of the Securities Act.8 Section 3(b) gives the SEC the authority to create various small issue exemptions, while Section 4(2) exempts transactions not involving a public offering. The Section 4(2) provision somewhat begs the question of what constitutes a public offering; thus, most private placements are done pursuant to the safe harbor known as Regulation D which the SEC adopted pursuant to the authority of Sections 3(b) and 4(2). Regulation D consists of Rules 501 through 508, and the actual exemptions are set forth in Rules 504, 505 and 506.9

Rule 501 defines various terms used in Regulation D. The most significant one for our purposes is that for an accredited investor, discussed below. Rule 502 lists provisions that are generally applicable to private placements under Regulation D, including a prohibition on general solicitation and advertising except in certain Rule 504 offerings. Rule 503 mandates the filing of a Form D with the SEC within 15 days after the first securities sale under Regulation D.

Rule 504 exempts offerings by non-public companies of up to $1,000,000 in securities. In computing the $1,000,000 threshold, the Company must include all exempt securities sales within the prior 12 months. The rule does not limit the number of investors and no specific information is required to be delivered to investors. Nevertheless, because of the anti-fraud provisions, companies are well advised to deliver some type of disclosure document to prospective investors, including clear statements as to the risks inherent in the investments and the limitations applicable to the resale of the securities.

Rule 505 exempts offers up to $5,000,000, again including exempt sales made in the prior 12 months. To use this exemption, however, there may be no more than 35 non-accredited investors. The full definition of accredited investors is too long to include here, but as to investors who are individuals, an accredited investor is someone with a net worth, or joint net worth with his or her spouse, of at least $1,000,000, or income of $200,000 in each of the past two years ($300,000 jointly with his or her spouse) and the reasonable expectation of continuing that level in the current year. In addition, directors, executive officers and general partners of the issuer are accredited investors. Rule 505 mandates the delivery to investors of information concerning the company and the offering. The scope of the information is similar to, but not as expansive as, that required in a registration statement for a public offering. Some audited financial information is required in Rule 505 offerings, including at a minimum an audited balance sheet as of a date within 120 days of the offering.

Rule 506 is a safe harbor exemption under Section 4(2) of the Securities Act rather than Section 3(b). Rule 506 offerings are limited to 35 non-accredited investors, but there is no limit on the dollar amount of the offering. The information delivery requirements for 506 offering are the same as for Rule 505. However, the purchasers in a Rule 506 offering who are not accredited investors must satisfy the company that they have such knowledge and experience in financial and business matters to be able to evaluate the merits and risks of the investment. Any investor who does not satisfy this criteria must use a purchase representative who does have the requisite knowledge and experience. Companies satisfy this requirement by having the prospective investors or their purchaser representatives complete detailed questionnaires.

New Jersey Exemptions From Registration

The principal exemptions from registration applicable to offerings made in New Jersey are found in Section 3(b)(9) and 3(b)(12) of the Uniform Act.10 They substantially complement, but are not identical to, the federal exemptions. The Section 3(b)(9) exemption covers sales to 10 or fewer persons within 12 consecutive months. The company must reasonably believe that the buyers are purchasing for investment. Furthermore, no commissions or other compensation can be paid to solicit purchasers and no general solicitations or advertisements are permitted. The Chief of the Bureau of Securities has the power to increase the exemption from 10 investors to 20.

The exemption under Section 3(b)(12) more closely mirrors Regulation D. There can be no more than 35 non-accredited investors, using the same definition as under Regulation D, in 12 consecutive months. A written disclosure document, or private placement memorandum, must be given to offerees. General solicitations and advertisements are prohibited. A report on a form prescribed by the Bureau must be filed within 15 days of the first sale. It is important to note that the filing requirement is statutory, not regulatory, and the Bureau takes the position that it does not have the power to waive the 15-day requirement. Thus, an untimely filing could lead to a non-exempt transaction.

A final New Jersey exemption relevant to this discussion applies to Rule 506 offerings. Federal law bars the states from regulating such transactions except that notice filings can be required.11 New Jersey requires such a filing on SEC Form D within 15 days after the first security sale.12

Anti-Fraud Provisions

As noted, some of the above referenced exemptions require the delivery of information, which generally takes the form of a private placement memorandum, to qualify for the exemption. While certain exemptions have no such requirement, one should not simply assume therefore that such a document is unnecessary. This article previously pointed out that the anti-fraud provisions of the securities laws are applicable to offerings under any of these exemptions. Thus, the classic dilemma for counsel to companies offering securities privately is how to satisfy the anti-fraud requirements without an extensive document that begins to look like a public offering prospectus, with the time and expense such a document entails. There is no one answer to this question, and there are varying degrees of disclosure used in private offerings. From the attorney's pont of view, it is generally best to recommend the broadest disclosure reasonably possible, taking into account factors including the maturity of the Company’s business, the industry in which it operates, the company’s financial condition, the type of offering, the complexity of the securities being offered, and the experience and sophistication of the prospective investors. At the barest minimum, the risks of the investment must be described in a manner tailored to the particular company, industry and offering. This frequently creates an issue for the attorney with the client, who asks how can it attract investors if the attorney insists on being so negative. The key to successfully resolving that issue is to educate the client as to his or her own personal risks if the offering does not comply with the securities laws. This includes the concern that if the company eventually goes public, the SEC will require information relating to any private offerings previously made by the company, and may require verification that such offerings complied with applicable securities laws.

Exemptions For Stock Options

While stock options have long been used by companies as a component of their compensation programs, the past several years has seen an increase in their use by start-up and other privately held companies. Both options and the underlying common (or other) stock purchased upon exercise of the options are securities; hence, we must look for an exemption from registration.13 Prior to 1988, practitioners tried to fit these transactions into Regulation D or some other exemption. Fortunately, in 1988 the SEC adopted Rule 70114 which addresses this specific problem.

Rule 701 provides an exemption for offers and sales of securities under a written compensatory benefit plan (or written contract) established by the issuer or an affiliate. The plan or contract must cover employees, directors, officers, consultants and/or a few similar positions to have the benefit of the Rule. To be covered, consultants must be natural persons who perform bona fide services for the issuer or an affiliate, but those services cannot be involved in the offer and sale of securities for capital raising purposes or for making or maintaining a market in the issuer’s securities. The compensatory plan definition includes stock purchase and stock option plans, among others.

Rule 701 imposes no limits on the amount of securities that can be offered under its exemption, but the aggregate sales during any twelve-month period are limited. The measuring period for such sales is the date an option is granted, which the issuer controls, rather than the date of exercise, which the issuer cannot control as easily. The twelve-month limit is the greatest of (i) $1,000,000, or (ii) 15% of the issuer’s total assets, or (iii) 15% of the outstanding amount of the class of securities being offered and sold pursuant to the Rule, typically common stock. Offers and sales pursuant to Rule 701 are not integrated with those under other exemptions, so the 35 non-accredited investors allowed under Regulation D will not be diminished by issuing options covered by Rule 701.

To qualify for the Rule 701 exemption, the issuer must provide the optionee with a copy of the compensatory benefit plan or contract. Furthermore, additional disclosure must be given if the aggregate sales prices in any 12-month period (measured for this purpose as the sale dates rather than the grant dates) exceeds $5,000,000. Again, note that exemption from registration does not exempt the issuer from the anti-fraud provisions of the securities laws, and care should be taken that options are not being exercised by optionees who lack material information concerning the company.

The exemption provided by Rule 701 is available only to companies that are not publicly reporting under the Securities Exchange Act of 1934, as amended. The Rule does permit, however, options granted under the Rule while the company was not public to be exercised without registration after the company becomes public. Although no exemption similar to Rule 701 is available for public companies, registration of stock options and similar securities-based employee benefit plans is relatively easy and inexpensive by using Form S-8.

As noted above, an exemption under the Uniform Law will also be needed. That statute provides an exemption for "any investment contract issued in connection with an employees’ or professional stock purchase, savings, pension, profit-sharing, retirement or similar benefit plan if the bureau chief is notified in writing 30 days before inception of the plan."15 In 1995, the Bureau adopted a regulation under this provision explicitly exempting employee benefit plans covered by Rule 701 from registration under the Uniform Act.16

Resale Exemptions - Rule 144

Securities purchased from issuers pursuant to Regulation D or Section 4(2) of the Securities Act and a corresponding state exemption are, by definition, "restricted securities". They customarily bear a legend indicating they cannot be resold absent registration or some other exemption. The most common exemption is found in SEC Rule 144,17 which establishes a set of criteria that, if met, enable the holder of restricted securities to resell them freely in the public market. Thus, the first condition to the availability of Rule 144 is that the issuer of the securities be a publicly reporting company under the Exchange Act. Rule 144 does not apply to private companies.

The details and nuances of Rule 144 are far beyond the scope of this Article, so we can provide no more than a brief summary here of the conditions for resale. The issuing company must be up to date in all its public reporting obligations. The securities being sold must have been held by the seller for at least one year.18 The holding period does not begin to run until the seller has paid for the shares in full. If the shares were purchased with a promissory note from the issuer, the note will not constitute payment unless fully secured with collateral other than the shares being sold. The securities must be sold in a brokers’ transaction, i.e., through the public markets.

Rule 144 limits the number of shares that may be sold by a seller within any 90-day period to the greater of (i) 1% of the issuer’s outstanding shares of the class being sold or (ii) the issuer’s average weekly trading volume in such shares, measured over the four-week period immediately preceding the sale. Finally, a provision in the Rule, known as 144(k) eliminates most of the foregoing provisions for sellers who are not affiliates of the issuer and who have held the shares at least two years since having paid for them in full.19

Footnotes

1. 15 U.S.C.A. §77e(a).

2. N.J.S.A. 49:3-60.

3. 15 U.S.C.A. §77b(a)(1); N.J.S.A. 49:3-49(m).

4. 471 U.S. 681 (1985); 494 U.S. 5b(1990) (addressing equity and debt, respectively).

5. 15 U.S.C.A. §77g and 77h; See the SEC's Instructions to Form S-1.

6. 15 U.S.C.A. §77r(a) and (b).

7. 15 U.S.C.A. §77l; N.J.S.A. 49:3-52.

8. 15 U.S.C.A. §§77c(b) and 77d(2).

9. 17 CFR §230.501-508.

10. N.J.S.A. 49:3-50(b)(9) and (12).

11. 15 U.S.C.A. §§77r(b)(4)(D).

12. N.J.S.A. 49:3-60.1.

13. Arguably, the grant of the option does not involve the offer or sale of a security since the grantee of the option is not making an investment decision. The following discussion of Rule 701 makes that issue academic in the case of employee stock options and will not be pursued here.

14. 17CFR §230.701.

15. N.J.S.A. 49:3-50(a)(11).

16. N.J.A.C. 13:47A-12.2(b).

17 17CFR §230.144.

18. Rule 144 sets forth a number of instances where the holding period of a prior owner of the securities can be "tacked" to the seller’s holding period to satisfy the holding period requirement.

19. 17CFR 230.144(k).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances