Mistakes in Private Placements: Navigating the Quagmire

By Daniel Roberts

PART ONE

Our client approached us with a problem: what to do when a company has sold securities through a Regulation D private placement, but violated the requirements of the exemption?

When seeking investment capital to scale a business, simple administrative errors can sometimes result in dire—or at least expensive—consequences for the company. As a basic rule of securities law, a company must register its investment offering with the federal government (the Securities and Exchange Commission, (“SEC”)) and register with the state(s) where investors are located, unless an exemption applies at each level.  These exemptions however, can be lost if the company issuing securities (the “issuer”) doesn’t follow the rules.

Under Regulation D (“Reg D”) Rule 506 of the Securities Act of 1933 (the “1933 Act”),[1] the federal government partially preempted state jurisdiction over the private sale of securities.  Reg D Rule 506 is a “safe harbor” for compliance with the private offering exemption in Section 4(2) of the 1933 Act and allows a company to avoid filing an extensive registration statement both with the SEC and with every state where it sells securities—but only if it follows a strict set of guidelines concerning the status of the prospective investors, the information provided to them, and the means by which information about the offering is communicated.  Under the “safe harbor” of Reg D, Rule 506, a company may offer its securities privately to an unlimited number of accredited investors, and to a maximum of 35 unaccredited investors,[2] all of whom must be “sophisticated.”[3] Since the safe harbor only applies to private offerings, the issuer must not publicly advertise or solicit investors.  In practice, issuers rarely solicit unaccredited investors when doing an offering under Rule 506 because this triggers very onerous additional requirements for the type of information that must be provided to potential investors.

In the event of a breach of the requirements under Rule 506, an issuer will be deprived of the safe harbor.  If the issuer can argue that although it has violated Rule 506, it has still kept the offering private, it may be able to rely on Section 4(2) of the 1933 Act to claim that it has not made a public offering.  Even so, this circumstance more than likely puts the issuer in the unfortunate predicament of offending most state securities laws in the absence of the federal safe harbor.  An issuer may then be forced to retroactively register the securities at the state level, be subject to civil or criminal penalties, and even (gasp!) be required to offer rescission to its investors (meaning to offer the investors the opportunity to rescind their investment and get their money back).

READ: PART TWO: Section 4(2), Unregistered Public Offerings, and Offering Rescission