Tight credit markets might make it tempting to raise cash by offering equity in your company to friends and family. But, if you make an unregistered offering outside of the protections of Regulation D of the Securities Act of 1933, you could be subject to civil and criminal penalties.
“Many are unaware of the federal and state laws that govern the sale of unregistered securities through private placements,” says David Kall, member of the business department and chair of the Capital Markets Practice Group at McDonald Hopkins LLC.
“But being unaware will not protect you against financial penalties or even incarceration for not following the laws. The laws are geared toward protecting investors, so even if you think you’re following the proper procedures, you have to be very careful.”
Smart Business spoke to Kall about how to sell equity without triggering civil or criminal liability and how to remedy unintentional violations of federal or state securities laws.
What is a private placement?
A private placement is an offering of securities to private investors that is not registered with the Securities and Exchange Commission and is being offered pursuant to an exemption from the federal securities laws. Regulation D is a safe harbor that clarifies how companies can be sure they are exempt from registration. Regulation D does not provide an exemption from registration under state securities law, also known as ‘Blue Sky’ laws. An issuer of securities must check the state’s requirements for exemption from state registration for each state in which it plans to sell securities.
What are the requirements of Regulation D?
To fall under Regulation D’s safe harbor, the company must do the following: It must not generally solicit or advertise the sale of its securities; it may sell its securities to an unlimited number of accredited investors but to no more than 35 unaccredited investors; it must provide certain disclosures about the company in a document called a ‘Private Placement Memorandum’ (PPM); and it may be subject to a limit on the amount of money it may raise in the offering.
What disclosures are made in a PPM?
A PPM discusses the terms of the offering, provides a description of the business, discusses the qualifications of the management, provides the company financials, describes conflicts of interest or affiliated transactions, summarizes key deals, discloses major competitors, discusses the risk factors of the business and provides any other material information about the company and securities.
What actions are considered violations of the anti-fraud provisions of securities laws?
Generally, the anti-fraud provisions of the federal and state securities laws make it illegal to make a misstatement or omission of a material fact in connection with the offering of securities. It is also illegal to commit fraudulent or deceitful practices in connection with the offering and sale of securities.
How do the officers and directors determine what information is ‘material’?
Information about a company is considered to be ‘material’ if there is a substantial likelihood that a reasonable investor would consider the information important in deciding whether to invest in the company. In deciding what information to include in the PPM, the officers and directors must decide if they would want to know this information before making an investment in a company.
What are the penalties for a violation of the federal or state securities laws?
Civil and criminal penalties vary by state. Willful violations can be subject to criminal penalties up to $5 million for individuals or up to $25 million for entities. Federal criminal penalties also may include incarceration of officers and directors up to 20 years. Civil penalties may include disgorgement of profits, payment of damages to investors and rescission of the investors’ investments.
How can a company and its officers and directors protect themselves?
When issuing securities, a company should follow the requirements of Regulation D and any applicable Blue Sky laws. The company should always distribute a current and complete PPM that contains all the material information about the company. The PPM provides a written record of what information was provided to the investors and can be used as a defense in any securities litigation. Companies should also have investors complete subscription agreements, which require that the investors make certain representations, including that they read the PPM, had the opportunity to ask questions, and are sophisticated enough to analyze the investment or were advised by a person that is.
What can a company do if it issued unregistered securities?
A company can give the investors an opportunity to rescind their investments via a ‘rescission offering,’ which provides an investor with all of the information found in a PPM and states how the rescission offering will be funded. A rescission offering also can be held in conjunction with an additional offering of equity in the company.
DAVID KALL is a member of the business department and chair of the Capital Markets Practice Group at McDonald Hopkins LLC. Reach him at (216) 348-5812 or firstname.lastname@example.org.