Chapter 5

• Jurisdiction: United States

Chapter 5 Exemptions From Securities Act Registration

Because the benefits of a securities offering may sometimes outweigh the costs of registration with the SEC, the Securities Act exempts certain securities offerings from full-blown registration, and, indeed, from the applicability of the 1933 Act in its entirety. Lawyers and a full-blown due diligence process are expensive and so is putting together a group of underwriters. The protections afforded by this process may not be necessary in all cases, especially where the investors are sophisticated and/or the security is less risky because it is secured or of a short duration. Aside from the expense, some companies do not want to go public in order to keep their financial affairs private; sunlight may be the best disinfectant, but as the experience of certain executives who have recently experienced criminal charges demonstrates, some companies do not believe in disinfectants.

In 2012, Congress recognized that the cost of "going public" was often prohibitive, and it passed the Jump Start Our Business Startups Act (the JOBS Act) that provided that companies need not register with the SEC unless their equity securities are held by either 2,000 persons or "500 persons who are not accredited investors," not including equity securities held of record by persons who acquired such securities by means of an exempt "crowd-funding" offering or pursuant to an exempt transaction under an employee compensation plan.¹

Section 3 of the 1933 Act begins "Except as herein expressly provided, the provisions of this title shall not apply to any of the following classes of securities . . ." Similarly, Section 4, titled "Exempt Transactions" begins "The provisions of Section 5 shall not apply to . . ." What are those securities and those transactions that have led the SEC to conclude that investors in such securities do not require the full-blown protections of a traditional public offering? This chapter will explore some of those offerings, including private placements, small offerings, "crowdfunding" offerings, and issuer exchanges. We will also briefly revisit state level blue sky registrations and exemptions (or the lack thereof) from those requirements. It should be recalled that even though certain offerings are exempt from registration requirements, in most cases, they remain bound by the antifraud provisions of Section 10b of the 1934 Act and other similar statutes and regulations.

What Securities Are Exempt From Registration?

There are two types of exemption, exempted securities and exempted transactions. The majority of securities offerings are made pursuant to a transactional exemption rather than through a registered offering.

Exempted securities are securities or categories of securities that are not required to be registered under Section 5 of the 1933 Act largely due to the intrinsic character or nature of the issuer itself. As the title suggests, transactional exemptions are based on the nature of the transaction and for each separate transaction (i.e., an offer and sale of securities), an exemption from registration must be "perfected."

The principal statutes relating to registration exemptions are Sections 3 and 4 of the 1933 Securities Act. Section 3 exempts certain securities and transactions, and Section 4 exempts certain transactions.

Section 3 Exemptions (Securities Exempt From Registration)

As noted, certain types of securities are exempted from the Section 5 registration requirements. In general, the rationale for such exemptions seems to be because such securities are either rare or have other safeguards, investors are otherwise protected.

• Government securities. Securities issued or guaranteed by federal governmental organizations are exempt from the Section 5 registration requirements (Section 3 (a)(2)). Firms that deal in municipal securities must provide investors with an "official statement" for offerings above $1 million (Exchange Act Rule 15c2-12). This now applies also to industrial development bonds. Why might the 1933 Act exempt all securities issued or guaranteed by the U.S. government? (Hint: they are considered safe.)
• Commercial paper. The 1933 Act exempts "any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." In other words, "commercial paper." This exemption is not applicable to a commercial paper program that takes advantage of the Section 4(a)(2) exemption. Recall that notes are typically purchased by banks and other institutional investors, not the general public. It should be noted that because the 1934 Act completely excludes short-term commercial paper from its definition of "security," it is one of the few instruments that is completely free from any liability under Rule 10b-5 of the 1934 Act. See generally Reves v. Ernst & Young, 494 U.S. 56 (1990).
• Railroad Trust Certificates (Section 3(a)(6)).
• Securities of an issuer exchanged with its own securities holders where no compensation or commission is paid. For example, an exchange of common stock upon a conversion of outstanding convertible debt (but not upon an exercise of a warrant by payment of a cash exercise price) (Section 3(a)(9)). Section 3(a)(9) is a transactional exemption; accordingly the securities received by the holder retain the character of the underlying security (i.e., if the old security is restricted, so is the newly issued security. Also, note, the issuer of the old and new security must be the same entity. Generally, a parent company and its wholly owned subsidiary are considered two different issuers. Why might investment banks not like offerings done in reliance of Section 3(a)(9)? (Hint: no compensation for them?)
• Securities issued in exchange for one or more securities, claims, or property interests (and partly for cash) where the exchanges have been approved by a court or agency (Section 3(a)(10)).
• Securities that are part of an issue offered and sold only to persons in the state where the issuer is resident, does its business and, in the case of a corporation, is incorporated (Section3 (a)(11)). Because this exemption seems to apply very narrowly, the SEC has created a safe harbor in Rule 147 and its amendment, Rule 147A. Unfortunately, those rules are hard to interpret. For starters, Rule 147 begins with a sentence that contains a triple negative.² It goes downhill from there.
• Securities of not-for-profit issuers (Section 3(a)(4)). This exemption applies so long as none of the issuer's net earnings benefits "any person, private stockholder or individual . . . or any security of a fund that is exempted from the definition of an investment company."

There are also a number of other securities that are exempted from the application of the 1933 Act, largely because they are otherwise regulated, such as by laws under the Employee Retirement Income Securities Act, state insurance laws, and bankruptcy law (i.e., certificates issued by bankruptcy trustees). These are all listed in Section 3 of the 1933 Act.

The takeaway is that exempt securities are not very significant, but as we will see, the same cannot be said for exempted transactions.

Section 4 Exemptions (Transactions Exempt From Registration)³

The relevant parties for transactional exemptions for equity offerings are primary issuers of securities. For example, a corporation issuing authorized but unissued securities would be a primary issuer, but a shareholder seeking to transfer shares to another person would not be. In fact, individuals reselling their stock must register any offer or sale unless they perfect an exemption, usually pursuant to Section 4(a)(1) or Section 4(a)(7).

The party seeking an exemption has the burden of proving that it has perfected the exemption. A failure to carry that burden can lead to liability for failure to register the security. In many cases, the offering participants will seek a legal opinion from counsel to the issuer and counsel to the initial purchasers that "no registration" is required for the offering. These opinions are highly caveated and based on the specific facts and circumstances. And even if the exemption was perfected, there can still be liability under the antifraud statutes such as Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Act. State blue sky laws may still be applicable as well.

Section 4 exempts seven types of transactions from the registration requirement, among which the most important are the following:

• All transactions by a person other than an "issuer," an "underwriter," or a "dealer" (Section 4(a)(1)).
• All transactions by an issuer not involving any public offering (Section 4(a)(2)). These are the so-called private placements that are subject to resale restrictions and that cannot be accompanied by a general solicitation (although a public company can make a public announcement subject to strict limits on the information included in the announcement), and securities that are subject to the Regulation D safe harbor for certain eligible private placements and that can be accompanied by a general solicitation. Simply put, these are offers as to which there is no dollar limit, and with respect to which the so-called Ralston Purina test applies: "Does the group of offerees need the special protection of the Securities Act?" In that case, the Supreme Court held that the company had made private offerings to non-managerial employees who, the court observed, were not "financially sophisticated" and the company did not carry its burden

...