Don't Run Afoul of Securities Laws (2024)

Know SEC registration and exemption rules

Fortunately for the small business owner, most small, privately held corporations are exempt from the need to register with the SEC.

An issuance of securities to yourself, your immediate family members and a few other investors will usually be totally exempt form both federal and state securities laws. In this case, the exemption generally is “self-executing”—that is, the exemption is automatic. In fact, a self-executing exemption does not require the filing of any documentation with the federal or state governments.

Generally, an automatic or self-executing exemption will apply when the offering of securities has all of these attributes:

• limited to 10 or fewer individuals who are all organizers of the business or who, alternatively, invested through direct in-person solicitation
• did not involve any use of the mails, telephones or the Internet in solicitations
• limited to one state

If you are required to register with the SEC, there are two common ways to do this:

• Regulation D Rule 504 combined with a SCOR filing
• Regulation A combined with a SCOR filing

Methods for registering securities

A federal Regulation D, Rule 504 (Rule 504) exemption coupled with a uniform state small corporate offering registration (SCOR) filing is the most common route taken for small businesses that are interested in raising capital from the public by issuing securities.

Both the federal exemption and the state filing limit the amount raised to $1 million in a one-year period. To prevent abuse, a second offering cannot be made for six months after the first 12 months expire. Effectively, the small business owner could rely on this combination to raise $1 million every 18 months.

The Rule 504 exemption contains no onerous restrictions (other than the $1 million limitation). The issuer is free to advertise the securities and to solicit potential investors. In addition, there are no restrictions on the number or type of investors. Nor are there any resale restrictions on the securities.

The SEC requires that Form D be filed after the first sale, notifying the SEC that the issuer has used the exemption. However, it is wise to file this form prior to offering the securities for sale, in case the SEC has any questions related to registration and exemption, and refrain from any advertisem*nts, offers or sales until the SEC approves the form.

The intent of Rule 504 has always been that the issuer registers the securities in each state in which they are offered for sale and comply with the strict registration requirements imposed by the states. This is why under Rule 504, the issuer faces no real federal restrictions related to the sale—the states are supposed to be the watchdogs.

The current rules effectively limit the use of Rule 504 to those offerings made only in states where registration is required or is exempt only with severe restrictions, such as bans on general advertising of the securities, limits on the numbers and types of investors, etc. The result is that, today, an issuer who wants to raise capital from the public through a general solicitation, and rely on Rule 504, will have to register the securities in the states through a SCOR filing.

States vary in scrutiny of SCOR filings

The state SCOR filing is an actual registration, rather than an exemption. Unlike other aspects of state securities laws, the SCOR form is uniform, meaning that one form can be completed and submitted to each state that accepts the form.

States not accepting SCOR filings.

While nearly all states accept the SCOR filing, the following states do not accept it, at this time:

• Alabama
• Delaware
• Florida
• Hawaii
• Kentucky
• New York

Non-merit review states.

The following states do not conduct a merit review of a SCOR filing:

• Connecticut
• Georgia
• Illinois
• Maryland
• New Jersey
• New York
• Vermont
• Washington

In non-merit-review states, the offering will automatically be approved, provided all of the information on the forms is complete and accurate. Note that "non-merit review" is also the policy embodied in federal securities law.

Merit-review states.

Although the form used for a SCOR registration is uniform, the registration request is not treated identically when it reaches the individual states. Most states are "merit-review" states. They review the offering to determine whether it is "fair" to investors. In the merit-review states, if the regulators believe the offering is not fair to investors, they will not approve it. However, even within the merit-review states, there is a wide range of scrutiny accorded the SCOR form.

The following merit-review states have a reputation as being progressive toward SCOR filings:

• Arizona
• South Carolina
• Iowa
• Washington

The following merit-review states have a reputation as being hostile toward SCOR filings:

• California
• Massachusetts
• Texas

The small business owner making a public offering of securities may want to consider offering the securities only in the non-merit-review states and the merit-review states with a progressive stance toward SCOR offerings.

Using Regulation A and SCOR to register securities

Regulation A allows small business owners to use a simplified form to gain an SEC exemption when issuing securities. While Regulation A is technically an exemption, it is best thought of as a simplified registration because a filing must be made with the SEC before any offers to sell securities can be made (unlike Regulation D, Rule 504).

Regulation A permits an issuer to raise up to $5 million in a 12-month period. However, because the state SCOR registration has a $1 million limit, Registration A effectively is limited to this same amount when it is combined with a SCOR registration in each state.

The most significant advantage of using Regulation A (rather than Regulation D, Rule 504) is that it allows issuers to test the waters for investor interest before undertaking the arduous and expensive process of preparing the required SEC documents for registration.

Because of the expense of preparing federal and state documentation, testing the waters may be essential, if the small business owner intends to make a public offering of securities.

Testing the waters is only available under Regulation A, which may make it a better alternative than Regulation D, Rule 504. The fact that an Internet site—using a coupon that can be e-mailed, or printed and mailed, to the issuer—can qualify under the rules also makes this option very attractive.

The Regulation A form, designated Form 1-A by the SEC, can be prepared in several versions, including a simplified question-and-answer version that uses the SCOR Form U7. This simplified format, which is a recent option, overcomes what previously had been the biggest impediment to using Regulation A rather than Regulation D, Rule 504—the added complexity and expense of preparing the standard Form 1-A.

If the offering is limited to $1 million, Regulation A can be coupled with a state SCOR filing, further simplifying the process of registration.

Requirements imposed on “testing the water.” The SEC imposes strict requirements on an issuer who will be testing the waters under Regulation A. These rules dictate that:

• Solicitation of interest may take the form of written documents or scripted radio or television broadcasts (this would allow the use of a web site on the Internet as a means of determining whether there is sufficient interest to justify an offering).
• Solicitations of interest may not be made after the filing of the Regulation A Form 1-A offering statement.
• No offers, sales or exchange of consideration can take place during the testing process. Sales may not be made until 20 calendar days after the last publication or delivery of the document or radio/television broadcast.
• Any written document under this section may include a coupon, returnable to the issuer, indicating interest in a potential offering, revealing the name, address and telephone number of the prospective investor.
• On or before the date of its first use, the issuer must submit a copy of any written document or script of any broadcast to the SEC's main office in Washington D.C. (Attn: Office of Small Business Policy).
• Oral communications with prospective investors and other broadcasts are permitted, after this submission. Further, the rules require that the written document or broadcast must contain specific information, including:
  • the name and telephone number of a person able to answer questions about the document or broadcast
  • a statement that no money or other consideration is being solicited and, if sent in response, will not be accepted
  • a statement that no sales of securities will be made or commitment to purchase accepted until delivery of an offering circular that includes complete information about the issuer and the offering
  • a statement that an indication of interest made by a prospective investor involves no obligation or commitment of any kind
  • a disclosure of identity of the chief executive officer of the issuer, as well as a brief and general description of the business and its products

Testing the water and state law. Not all states have provisions that allow testing of the waters. However, the following states do allow issuers of Regulation A to gauge interest beforehand: