securities issues in closely held companies first run ... · intrastate offerings — rule 147...

SECURITIES ISSUES IN CLOSELY HELD COMPANIES

First Run Broadcast: November 27, 2017

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)

Closely held companies are subject to securities regulation as much as large, publicly traded

companies. Though the areas of emphasis may vary between smaller and larger companies,

federal securities regulations establish a range of eligibility and impose disclosure requirements

when closely held companies raise capital and substantial liability for any compliance failure.

Also, rapidly growing private companies issuing incentive stock to employees and new investors

also risk triggering “reporting company” status under federal securities law, which would impose

ongoing reporting obligations on the private company. This program will provide you with a

guide to how securities law applies when closely held companies issue new equity or debt, with

an emphasis drafting subscription agreements, and planning to avoid “reporting company” status.

• Securities law issues for closely held companies

• Framework of securities law requirements when issuing equity, debt or incentive

securities

• Subscription agreements – essential components to ensure adequate disclosure and avoid

financial liability

• Exemption planning – Regulation D, accredited investors v. qualified purchasers, non-

solicitation, and disclosures

• Understanding exempt securities v. exempt offerings

• How closely held companies trigger “reporting company” status and techniques to avoid

it

Speakers:

Eric R. Smith is a partner in the Baltimore, Maryland office of Venable, LLP, where he

represents closely held and publicly traded companies in capital raising transactions, mergers and

acquisitions, and joint ventures. He has extensive experience advising companies on securities

compliance issues in capital raising, periodic reporting, the fiduciary duties of directors and

communications with stockholders. He is a member of the ABA Committee on Federal

Regulation of Securities and the Committee on Corporate Governance. Mr. Smith earned his

B.S. from Cornell University, his J.D. from the University of Baltimore School of Law, and his

LL.M. in securities and financial regulations from Georgetown University Law Center.

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Securities Issues in Closely Held Companies Teleseminar

November 27, 2017 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: November 27, 2017 Seminar Title: Securities Issues in Closely Held Companies Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

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© 2011 Venable LLP

Securities Law Framework for Exempt Issuances and Essential Components of Subscription Agreements

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Issuing Securities Under the

Securities Act of 1933

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Three types of offers under the '33 Act

Registered

Exempt

Illegal

Securities Act Exemptions

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Exemptive provisions of the '33 Act:

§3 (Exempt Securities) — generally exempt due to the

nature of the issuer or the nature of the security itself

§4 (Exempt Transactions)

§19(a) — gives SEC general powers to prescribe rules

§28 — grants SEC broad exemptive authority if in the

public interest and consistent with protection of investors

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Note that exemptions are from

registration and not from the antifraud

provisions of the '33 Act

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Although styled “exempt securities,” some of the

Section 3 exemptions actually are transactional

exemptions (e.g., 3(a)(10) (Court Approved exchange)

and 3(a)(11) (Intrastate Offering))

Additionally, section 3(b) is not self-effecting - it

requires SEC rulemaking and is limited to $5

Million (or $50,000,000 once rules enacted by the SEC)

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Securities Act Exemptions Section 3

• 3(a)(1) Reserved

• 3(a)(2) Government securities; bank securities;

certain insurance contracts

• 3(a)(3) Commercial paper

• 3(a)(4) Certain non-profits

• 3(a)(5) S&Ls (and others)

• 3(a)(6) Railroad equipment trusts

• 3(a)(7) Certain bankruptcy securities with court

approval

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Securities Act Exemptions Section 3

3(a)(8) Certain insurance policies

3(a)(9) Exchanges with Issuer without other

remuneration

3(a)(10) Court-approved exchanges

3(a)(11) Intrastate offerings

3(a)(12) Acquisition of bank by holding company

3(a)(13) Certain church plans

3(a)(14) Certain securities futures products

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In this portion of the webcast, we will focus on the

following:

Integration Intrastate Offerings

Private Placements Regulation A (and A+)

Rule 701 Subscription

Agreements

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Integration

Prevents circumvention of registration

requirements by separating single non-

exempt offering into several exempt

offerings

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Integration (cont’d)

Five-factor test:

single plan of financing

same class of security

made at or about the same time

same consideration

same general purpose

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Integration (cont’d) - “safe harbors”

• Rule 147(b)(2) - “intrastate” offerings

• Rule 152 - public offering following private

offering

• Rule 155 - public offering following abandoned

private offering (and vice versa)

• Rule 251(c) - Regulation A offerings

• Rule 502(a) - Regulation D offerings

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Intrastate Offerings

§3(a)(11) exempts securities offered and

sold only to persons resident in a single state

by an issuer incorporated in, and doing

business in, that state

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Intrastate Offerings - Early Challenges

• Is the issuer doing business in that State?

• Is the issuer incorporated in that State?

• Are the proceeds used in that State?

• Is the offering part of another issue?

• Are the offerees and purchasers all residents of

that State?

• Have the securities come to rest in that State?

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Intrastate Offerings — Rule 147

•Residency

- Issuer must be incorporated and doing

business - financial objective tests provided in Rule

147 - so-called “80%” calculation

•Use of Proceeds - financial tests provided in Rule

•Integration - six month safe harbor rule

•Coming to Rest - 9 month resale test to residents of

same state

•Rule 147 only available to issuer

•Non-exclusive; may rely upon Section 3(a)(11)

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Intrastate Offerings — Benefits

‒ No limitation on dollar amount

‒ Investor suitability not required although each

must be a “resident” of a particular state

‒ Unlimited number of investors in that state

‒ No required disclosure of information

‒ Securities sold were eligible for immediate resale

to residents of that state

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Securities Act Exemptions - Section 4

• 4(a)(1) “other than issuer, underwriter or dealer”

• 4(a)(2) by an issuer not involving a public

offering

• 4(a)(3) dealer

• 4(a)(4) broker’s transactions

• 4(a)(5) offers/sales to accredited investors subject

to 3(b) limit

• 4(a)(6) crowdfunding exemption

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Private Placements

Section 4(2) creates an exemption for:

...transactions by an issuer not involving

any public offering...

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Private Placements

The Ralston Purina Case - 346 U.S. 119 (1953)

The Court’s decision confirmed the SEC’s position

that the sales by Ralston Purina under its stock plan

were not exempt under Section 4(a)(2).

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Private Placements - Ralston Purina “guidance”

• Focus is on “offerees” rather than actual purchasers.

• Court rejected SEC’s argument that extensive number of

offerees alone resulted in loss of the exemption.

• Availability of the exemption “should turn on whether the

particular class of persons ... need the protection of the

1933] Act” and whether the offerees “are shown to be able

to fend for themselves.”

• If offerees do not have “access to the kind of information”

which a registration statement would disclose, the issuer

must provide the same kind of information that otherwise

generally would be available in a registration statement.

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Aftermath of Ralston Purina

After a series of questionable judicial decisions rejecting

the availability of Section 4(a)(2), ABA Sub-committee

on Federal Regulation of Securities published the factors

it deemed most relevant in determining whether Section

4(a)(2) should be available:

‒ offeree qualification

‒ availability of information

‒ manner of offering

‒ absence of redistribution

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Rule 701 Offering

• Size?

• Manner of offering?

• Qualification/ suitability of offerees/purchasers?

• How many purchasers?

• What information required?

• Status of securities?

• Who can/can’t use Rule 701?

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Rule 701 Offerings

• Permits non-’34 Act companies to offer securities

pursuant to a written compensatory benefit plans to:

employees, directors, general partners, trustees,

officers, consultants and advisors pursuant to written

contracts.

• No limitation on number of offerees or purchasers

(note, however, that you do not want to exceed the

threshold requirements for becoming a ‘34 Act

reporting company).

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Rule 701 Offerings (cont’d)

•Amount available during any 12 month period is

limited to the greater of:

‒$1 million,

‒15% of the issuer’s total assets measured at the end

of the year, or

‒15% of the outstanding securities of that class.

•No integration requirement.

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Rule 701 Offerings (cont’d)

• Disclosure - purchasers must be furnished a copy of

the written plan; in addition, if amount of securities

sold in a single year exceeds $5 million, issuer

required to provide additional disclosures specified by

the Rule.

• Although issued as restricted securities, securities sold

in a Rule 701 offering become non-restricted and

otherwise freely tradable 90 days after the issuer

becomes subject to the reporting Requirements of the

‘34 Act.

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Regulation A (Rules 251-263)

Up to $5M of securities of an issuer plus up to

$1.5M of securities offered by affiliated selling

security holders in any 12-month period

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Regulation A - the Process

• Requires filing of a Form 1-A and delivery of offering

circular to investors

• Solicitation of Interest or “Testing the Waters” - Rule 254

‒ No pre-clearance with SEC of documents or advertising

or soliciting materials

‒ Consideration cannot be accepted

‒ No binding commitments permitted

• Offering Circulars

‒ Preliminary Offering Circulars permitted and

encouraged by SEC

‒ Content dictated by Form I-A

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Regulation A - Advantages

‒ Permits interstate offerings to an unlimited

number of offerees

‒ Suitability of purchasers not required

‒ Immediate resales without restrictions

‒ Permits issuers or underwriters to obtain

“indications of interests” from the market

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Regulation A — Disadvantages

‒ Limited dollar amount still may make the cost per

funds raised expensive - also limited number of

underwriters willing to participate in Regulation A

offerings

‒ Not available for ‘34 Act reporting companies nor

certain other companies

‒ State qualification still required

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Proposed Regulation A+

– Two tiered system

– Tier 1 would preserve the current $5 million

threshold and offerings would be subject to

state securities review.

– Tier 2 would provide an exemption for

offerings of up to $50 million in any 12-

month period, including no more than $15

million in securities sold on behalf of

selling stockholders.

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Securities Act Exemptions Regulation A+ (continued)

– Offerings in both tiers would be subject to the same basic

requirements relating to issuer eligibility, disclosure and other

matters.

– The proposed rules would incorporate a new investment limit.

The proposed rule would limit the permissible amount to be

invested by any individual to the greater of 10% of the

individual’s net worth or annual income.

– In addition, the proposed rules contain certain ongoing reporting

requirements. An issuer that has conducted a Regulation A

offering will be required to make certain limited ongoing SEC

filings.

– In order to address the most significant impediment associated

with current Regulation A, the proposed rule preempts state

securities law review for Tier 2 Regulation A offerings (those up

to $50 million). The proposed rule does so by defining a

“qualified purchaser” as any offeree or purchaser in a Tier 2

offering.

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Potential Exchange Act Issues

The “Inadvertent” Public Company

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The Securities Exchange Act of 1934

Becoming a ‘34 Act Company

Section 12(g)

More than 500 shareholders (non-accredited) or up to

2,000 if less than 500 are non-accredited

More than $10 million in assets

If test is met at the end of a fiscal year, must register

under the ‘34 Act

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The Securities Exchange Act of 1934

Consequences of Becoming a ‘34 Act Company

• Periodic reporting (section 13 - basic obligation)

• Proxy and tender offer rules (section 14)

• Section 16

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Subscription Agreements

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Subscription Agreement Overview

Describes the type of securities purchased by the

investor and the purchase price.

Sets out representations and warranties of the

issuer relating to the issuance of the securities.

Includes representations and warranties and

other acknowledgements by the investor to help

ensure the issuer's compliance with applicable

US securities laws in connection with the

issuance of the securities.

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Documents Needed in Private Placement

Subscription Agreement

Private Placement Memorandum

Registration Rights Agreement

Investor Questionnaire

Additional Materials (e.g. general solicitation

under 506(c) may involve additional materials

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Securities Legend

A subscription agreement typically has securities

law legends on its cover page. The legends are

placed on the agreement and on the securities

issued to investors to assist the issuer in

complying with applicable US securities laws.

Legends alert potential investors to the fact that

Securities issued under Reg D and 4(a)(2)

exemptions are restricted securities that cannot

be freely resold by an investor without registration

or exemption from registration with the SEC

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Securities Legend

Specifically, for an issuer to qualify for a Regulation D exemption,

Rule 502(d) requires the issuer to take reasonable steps to ensure

that the securities are not bought by underwriters and that the

purchasers are aware that they are buying restricted securities. The

issuer can demonstrate reasonable care by, among other things,

– giving adequate written disclosure to each purchaser prior to

sale that the securities have not been registered and cannot be

resold unless they are registered or an exemption from

registration is available. This disclosure usually takes the form

of a restrictive legend.

– Placing a restricted security legend on the securities stating that

the securities have not been registered under the Securities Act

and cannot be resold by the purchaser in the US without

registration or an applicable registration exemption.

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Confirming Accredited Investor Status

In a traditional Rule 506 offering under Rule 506(b), the

issuer must reasonably believe that the prospective investor

is an accredited investor or that it has enough knowledge

and sophistication to properly evaluate the investment

opportunity. This standard is often met by prospective

investors' self-certifications and by a further review of

prospective investors by the issuer.

More extensive disclosure requirements apply to non-

accredited investors under Regulation D. Rule 502(b)(2) of

Regulation D requires disclosure to non-accredited investors

similar to the type provided in a Securities Act registration

statement (often impractical).

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Subscriber Representations

Concerning the Company:

– Received a copy of the Offering Documents.

– The purchase involves risks.

– Not relying on any communication of the

Company as investment advice.

– Familiar with the business and financial

condition and operations of the Company

– Representations reaffirmed at Closing

– No federal or state agency has passed upon

the merits or risks of the investment or made

any finding concerning the advisability of the

investment.

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Reasons for Representations in Prior Slide

– Address the need for the investor to have

access to the information of the company to

evaluate the investment that it is undertaking.

– Limit the liability of the company to the

information that has been provided to the

investor.

– To preclude any claims by the purchaser for

implied representations and warranties of the

issuer.

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Status of Purchaser:

– Purchaser has such knowledge, skill and

experience in business, financial and investment

matters that the undersigned is capable of

evaluating the merits and risks of an investment in

the Securities.

– Purchaser is an "accredited investor“ (and has

completed questionnaire).

The burden of determining the status of potential

investors is placed on the company. This

representation causes the purchasers to represent to

the company that they are investors that are both

sophisticated and accredited.

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Restrictions on Transfers of Securities

– Acquiring the Securities solely for the undersigned’s own

account, for investment purposes, and not with a view

any distribution.

– Acknowledging the securities are "restricted securities"

under securities laws and that the Securities may only be

disposed of pursuant to an effective registration

statement or an exemption

This representation is included to confirm the purchasers

acknowledgement of the restricted nature of the securities

and restriction on resale. This goes hand-in-hand with the

legends included to provide notice to Purchasers of these

restrictions.

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No General Solicitation or Advertising:

– Purchaser acknowledges that the Company

did not offered to sell the Securities by means

of any form of general solicitation or

advertising.

This provision should be included if the issuer is

conducting the offering under Rule 506(b)

prohibiting the use of general solicitation. If the

issuer is conducting the offering under Rule

506(c) this representation should not be included.

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Statutory Liability:

– Section 17 of the Securities Act is the general antifraud

provision of the Securities Act. It applies to any purchase of

securities, whether part of a registered or an exempt offering. It

prohibits:

• any device, scheme or artifice to defraud.

• Obtain money or property by means of material

misstatements or omissions. (This only applies to the

disclosure documents provided to the investor before or at

the time of the contract of sale.)

• Engaging in any course of business that would operate as a

fraud.

– Section 17 does not give a private right of action to a purchaser.

Claims based on Section 17 may be enforced by the SEC.

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– Section 10(b) of the Exchange Act

• Section 10(b) makes it unlawful for any

person: "to use or employ … in connection

with the purchase or sale of any security …

any manipulative or deceptive device or

contrivance in contravention of such rules

and regulations as the [SEC] may

prescribe….."

• This section applies to all offerings of

securities. However, the statute requires

the SEC to prescribe rules to implement it.

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– The most important of the SEC's rules

enacted under Section 10(b) is Rule 10b-5.

Rule 10b-5 prohibits any of the following:

• Fraudulent devices and schemes, material

misstatements and omissions of any

material facts.

• Acts and practices that operate as a fraud

or deceit on any person.

– Neither Section 10(b) nor Rule 10b-5 provide

an express private right of action to securities

purchasers, however, an implied right of

action has developed over time.

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Questions???