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This rule provides a clear exemption from registration of the offering under the federal Securities Act of 1933 (Securities Act). It also provides preemption of securities registration provisions of state securities laws, including the Alaska Securities Act.
An offer of a share in the ownership of your company is very likely an offer of a security under state and federal law, regardless of the form of ownership. There are some limited exceptions, such as ownership through a general partnership. However, the definition of a security is very broad under that law. It covers a wide range of business ownership forms.
Under state and federal securities law, an offer of a security, unless exempt, must be registered before it can be made to prospective purchasers. The exemptions are many and varied. Under the Securities Act, one of them is the private offering exemption. This exemption has been interpreted, in part, through federal Regulation D, Rule 506.
The provisions of Rule 506 are not meant to be the exclusive means of satisfying the private offering exemption. However, the rule provides a safe harbor for reliance upon the exemption. It further provides that failure to comply with its terms does not, under limited conditions (all of which must be satisfied), result in loss of the exemption. These conditions are detailed but, at least in part, include that the failure was insignificant with respect to the offering as a whole.
Up until 1996, many states - including Alaska - required registration of Rule 506 offerings. In that year, federal law was enacted to preempt state registration requirements for such offerings.
That law, entitled the National Securities Markets Improvement Act of 1996 (NSMIA), does allow states to require an issuer of such securities to make a notice filing and pay a notice filing fee. Securities in such offerings are referred to under NSMIA as "covered securities." They are referred to as "federal covered securities" in many state securities laws, including the Alaska Securities Act.
For Rule 506 offerings, most, but not all, states now require a notice filing and payment of a notice filing fee. The specific notice filing fee varies from state to state. However, the state notice filing for Rule 506 typically requires the issuer to file a federal Form D. It is the same form as is required under the Securities Act for such an offering.
Under Rule 506, the Form D must be filed with the Securities and Exchange Commission, the federal agency charged with administering the Securities Act. The filing must be made with the SEC within 15 days of the first sale. Similarly, states having notice filing requirements each typically mandate that the filing must be made within 15 days of the first sale of the security within its jurisdiction.
A notice filing is typically effective within a state jurisdiction for one year. Thereafter, should the issuer wish to continue the offering, some states, including Alaska, require another notice filing and notice filing fee.
The Form D is in essence a sales report. In addition to a specific breakout of the use of proceeds of the securities sale, the form requires disclosure of the names and addresses of the issuer's promoters, officers and principal security holders. It also requires identification of the states in which sales have been made, including the number of investors (separately as accredited and non-accredited investors) and the dollar amount sold to them in each state. The form must be signed by a principal of the issuer, e.g., the president or an executive officer of a corporate issuer.
While NSMIA preempts Rule 506 state registration requirements, it does not limit the ability of states to regulate the persons through whom securities offerings are made in reliance upon the rule. For example, several states, including Alaska, require registration of such persons as broker-dealers or agents for the issuer. The registration provisions can include passing a special examination, filing a special application and paying of a registration fee.
Alaska and many other states have an exemption from, or upon request, otherwise waive compliance with such registration so long as the person is an officer of the issuer and receives no commission on the sale of securities. Some other states further limit the exemption to such persons who have not been involved in the sale of securities for a stated time period prior to the offering. Still others also limit the exemption to one or more persons where the sale of the securities in the offering is for each only an incidental portion of that person's duties to the issuer.
The NSMIA Rule 506 state registration preemption does not limit a state from exercising its power to enforce anti-fraud provisions of its securities laws. For example, under the Alaska Securities Act, the state may, upon a special finding, issue an administrative stop order suspending the offer and sale of federal covered securities, with limited exception. The exception is in the context of securities traded on certain stock exchanges and stock markets for which exclusive jurisdiction is reserved to the SEC under NSMIA.
The scope of special findings is broad. It can be based upon the state's determination that the stop order is in the public interest or that there is a failure to comply with a condition established for a notice filing.
The Alaska Securities Act has been interpreted through regulations to set forth a number of attributes of an acceptable securities registration for a public offering. For example, a public offering cannot involve more than a limited amount of what is generally termed "cheap stock" to insiders in the transaction. Cheap stock is a security sold to an insider at a price less than that which is required of investors in the offering.
Under Alaska regulations, such cheap stock cannot exceed 25 percent of the shares outstanding, and the price paid by insiders must be at least 50 percent of the offering price. The Alaska cheap stock regulations are expressed in terms applying to a corporation. However, it is possible that they might be used by the state in the context of other organizational forms, e.g., a limited liability company or partnership.
A public offering cannot, under the Alaska regulations, involve commissions and expenses exceeding 17 percent of gross proceeds. In addition, options and warrants granted to insiders may, under those regulations, be subject to escrow before the issuer attains subscriptions totaling a stated amount of the offering. In addition, such offerings may only be made through a licensed broker-dealer or agent for the issuer.
These various attributes of a public offering are of importance to an issuer intending to make use of Rule 506 for one simple reason. Failure by the issuer to satisfy all provisions of the rule causes the loss of the exemption in Alaska.
An offering made without benefit of registration exemption may be considered an offering subject to all the regulations limiting an offering made under registration. In this context, in addition to failing to register the offering, the issuer is laid open to claims of violation of these other attributes.
The substantive disclosures required by Rule 506 are contained within the rule. They include the nature and scope of financial and non-financial disclosures. These items in turn depend upon the amount of proceeds to be raised through reliance upon the rule.
Rule 506 has a number of specific substantive disclosure requirements, the description of which go beyond the scope of this article. However, a few of its more significant limitations are as follows:
• Sale of securities must be limited to no more than 35 purchasers, not including accredited investors.
• Offer and sale of securities can only be made without general solicitation.
• Each purchaser who is not an accredited investor must have such knowledge and experience in financial and business matters that the investor is capable of evaluating the merits and risk of the prospective investment.
Regulation D defines the term "accredited investor" as including, in addition to several business organizations and financial institutions, an individual satisfying certain conditions. The definition includes an individual having income reaching at least a certain level ($200,000 alone, or $300,000 jointly with spouse) during each of the two years prior to the offering and expecting the same in the year of the offering. It also includes an individual who has at least a certain level of net worth ($1 million alone or jointly with spouse). The definition further includes any director, executive officer or general partner of the issuer.
Avoiding the snare of a prohibited general solicitation can be challenging. For example, the issuer, in reliance upon Rule 506, must not use any advertisement, notice or other communication published in a newspaper or similar media or broadcast it over radio or television. Furthermore, the issuer must not use any seminar or meeting whose attendees have been invited by general solicitation or general advertising.
The determination of adequacy of level of sophistication and financial status of a prospective purchaser is the responsibility of the issuer. This level usually is determined, at least in part, through a purchaser questionnaire prepared by the issuer for completion by the prospective purchaser.
An issuer questioning the prospective purchaser's sophistication to make an informed decision on an investment may require the prospective purchaser to seek the advice of a purchaser representative, the selection of whom is satisfactory to the issuer. In this instance, the issuer may prepare and require the purchaser representative to complete a purchaser representative questionnaire describing the representative's qualifications and experience.
There are many other provisions of Rule 506 with which the prudent issuer must become familiar. In particular, the issuer must understand the rule's substantive disclosure requirements. In this way, unpleasant compliance surprises may be avoided at the time of the offering and thereafter should the issuer be confronted by a disgruntled investor.
Rule 506 can provide an excellent means of access to private capital in the manner prescribed by the rule. Read and understand its provisions and the notice filing requirements of the states in which the offering is to be made. Seek out appropriate legal and accounting advice, especially if you are not familiar with the intricacies of the rule.
Good luck on your new venture in 2006!
Julius Brecht is managing shareholder of, and an attorney in private practice with the law firm of Wohlforth, Johnson, Brecht, Cartledge & Brooking, A Professional Corporation, with offices in Anchorage. Brecht's concentration of practice is in state and federal securities law and corporate and finance law. The content of this article was not prepared as, and must not be construed as, legal or investment advice to anyone. He may be reached at jbrecht@akatty.com.
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