Section 4(2) of the Securities Act of 1933 provides that the registration requirements of Section 5 do not apply to “transactions by an issuer not involving any public offering.” The definition of an “issuer” is pretty straightforward as found in Section 2(a)(4) and includes, “the person who issues or proposes to issue” a security and is understood to mean the entity that originally sells the securities. However, not so straightforward is what constitutes a “public offering,” which term is not defined in the Securities Act. In reliance on Section 4(2) the SEC enacted Rule 506 as part of Regulation D.

Rule 506 as a Safe Harbor Provision

Rule 506 is a Safe Harbor. In other words, if all the conditions of Rule 506 are met, you can rest assured that the conditions of Section 4(2) have been satisfied. However, Section 4(2) can be satisfied as a standalone exemption separate from Rule 506. The importance of the distinction between Section 4(2) and Rule 506 cannot be underestimated. Often, when the technical requirements of Rule 506 have not been met, usually inadvertently, the Section 4(2) exemption will still stand and save the day. Moreover, many Issuers satisfy the Section 4(2) exemption “by chance” when other exemptions fail. Section 4(2) does not have filing requirements and at times may be the only exemption available to save an Issuer from civil or even criminal liability.

SEC vs. Ralston Purina Company

The leading case defining a public vs. a private offering is SEC vs. Ralston Purina Co., wherein the U.S. Supreme Court laid down its guidelines. The U.S. Supreme Court focuses on the sophistication of the investor coupled with their access and receipt of disclosure information from the Issuer. Disclosure information should be the “kind of information which registration would disclose.” Importantly, the U.S. Supreme Court refused to establish a quantity standard based on the number of investors. Although, ultimately quantity may be considered, the important factors remain investor qualification and access to disclosure information.

SEC Release No. 4552

The leading SEC pronouncement on Section 4(2) is SEC Release No. 4552 in which it set forth what it considers to the requirements for a private placement. According to the release, all the surrounding circumstances must be considered, “including such factors as the relationship between the offerees and the issuer, the nature, scope, size, type and manner of the offering.” Unfortunately, the release does not offer much guidance on each of the factors. Release No. 4552 does however discuss two important concepts in analyzing an offering. The first is “coming to rest” and the second is “integration.”

Coming to Rest

“Coming to rest” is a concept that deals with the issue of when a particular offering is over. The SEC considers an offering to be continuing until the offered securities have “come to rest” in the hands of the persons who are not “merely conduits for a wider distribution.” Integration deals with the issuer of when purportedly singe offerings are integrated to form one larger offering and whether when viewed as a whole, this larger offering, qualifies for an exemption. The list of factors relevant in analyzing integration include, whether:

• The different offerings are part of a single plan of financing;
• The offerings involve the issuance of the same class of security;
• The offerings are made at or about the same time;
• The same type of consideration is to be received; and
• The offerings are made for the same general purpose.

Courts of Appeals have offered guidance on their interpretations of SEC vs. Ralston Purina Co. and Release No. 4552. In particular, in determining whether an offering is private or public (for purposes of the Section 4(2) exemption), courts consider such factors as:

• The number of offerees and their relationship to each other and to the Issuer;
• The number of units offered;
• The size of the offering;
• The manner of the offering;
• Whether the offerees are sophisticated and/or accredited;
• Access and availability of information that would otherwise be found in a registration; and
• Absence of redistribution.

Investor Qualifications

The American Bar Association offers excellent guidance in determining the qualification of the investor, which is a key point regardless of whose guidance is followed. In particular, the following factors should be considered:

• Risk-bearing ability (it is assumed an accredited investor can bear the risk of an investment);
• Degree of sophistication (whether the offeree can understand and evaluate the offering);
• The offerees representative (including investment advisors, accountants and attorneys);
• The manner of disclosure (the clearer and more thorough the disclosure, the less concentration on sophistication);
• Nonqualified offerees (and the impact they have on the entire offering); and
• Economic bargaining power.

In conclusion, the best way to analyze whether a particular offering meets the requirements of the Section 4(2) exemption is to examine the offering through the eyes of the state and federal securities regulators and/or plaintiff’s attorneys. If they could reasonably find problems with the offering, either changes those problem areas before embarking on the offering or come up with a new strategy.

Securities attorney Laura Anthony provides expert legal advice and ongoing corporate counsel to small public Companies as well as private Companies seeking to go public on the Over the Counter Bulletin Board Exchange (OTCBB). Ms. Anthony counsels private and small public Companies nationwide regarding reverse mergers, due diligence on public shells, corporate transactions and all aspects of securities law.

Ms. Anthony is the Founding Partner of Legal & Compliance, LLC, a national corporate, securities and civil litigation law firm based in West Palm Beach, Florida. The firm’s corporate and securities attorneys provide technical legal services to small and mid-size private and public (OTCBB) Companies, entrepreneurs, and business professionals nationwide. Contact us today for a FREE consultation!

The integration doctrine prevents issuers from circumventing the registration requirements of the Securities Act of 1934 by determining whether two or more securities offerings are really one offering that does not qualify as an exempt offering, or an exempt offering is really part of a registered public offering.

Securities Act Release No. 33-4552 (November 6, 1962) sets forth a five factor test that is used as a guideline in determining whether the separate offerings of an issuer that occur within a short time of one another will be integrated. These same factors are set forth in the Note to Rule 502(a) of Regulation D, which factors address whether the offerings:

1. are part of a single plan of financing;
2. involve the issuance of the same class of securities (convertible securities, warrants, and other
3. derivative instruments generally are deemed to be the same class as the underlying security unless the terms of the primary security prohibit exercises until at least the one year anniversary date);
4. are made at or about the same time;
5. involve the same type of consideration is to be received; and
6. are made for the same general purpose.

Rule 502(a) provides for a six-month (soon to be 90 days) safe harbor wherein multiple private offerings that are conducted at least six (6) months apart will not be integrated. In addition, a private offering that is conducted at least six (6) months before or after a registered or exempt public offering will not be integrated with the public offering. Fortunately, effective February 4, 2008, the SEC changed the length of integration safe harbor from six (6) months to ninety (90) days.

In addition, Rule 155 sets forth a safe harbor for abandoned private and public offerings (Release No. 33-7943, effective March 7, 2001). Generally, the rule creates safe harbors to allow: (i) a public offering immediately following an abandoned private offering and (ii) a private offering thirty (30) days after an abandoned public offering, without integrating the public and private offerings in either situation. These safe harbors provide issuers with more flexibility to react to volatile capital market conditions.

Rule 155 does not replace, but rather supplements, the five factor test that will be used whenever the safe harbor is inapplicable. For example, the five-factor test, rather than Rule 155, would apply when evaluating whether two or more private offerings should be integrated with each other. Moreover, Rule 155 recognizes only Sections 4(2) and 4(6) and Rule 506 offerings as exempt offerings. Finally, Rule 155 is not available for shelf registration statements.

Concurrent Private and Registered Offerings in PIPE Transactions

The primary legal consideration in any PIPE (private investment in public entity) investment is ensuring that the issuer takes all steps necessary to make the investment a valid private placement. The issuer must conduct the PIPE offering in a manner that does not involve any general solicitation or advertisement. In this context, an issuer that had considered a public offering and filed a registration statement with the SEC may be deemed to have engaged in a general solicitation for the offering, and the issuer would have to completely abandon that offering by withdrawing the registration statement for a period of time before engaging in the PIPE transaction.

SEC Rule 155

Rule 155 does not alter the position taken by the SEC staff in its no-action letters to Black Box Inc. and Squadron, Ellenoff, Pleasant & Lehrer. In these letters, the staff indicated that it would not integrate a registered offering and a concurrent unregistered offering made only to Qualified Institutional Buyers (as defined by Rule 144A under the 1933 Act) and no more than two or three large accredited institutional investors.

Given that a PIPE transaction inherently involves a private placement of securities and a subsequent public offering, the PIPE transaction has higher integration risks. To ensure that the PIPE transaction is respected as two separate transactions, the initial private placement must be “complete” prior to filing of any registration statement for the underlying securities. In the standard PIPE transaction, meeting this requirement normally does not pose a problem since the registration statement is filed following the closing of the PIPE transaction.

Private Placement Completion

The SEC will consider a private placement complete if: (a) all of the purchasers have fully paid the purchase price for the securities in the private offering, or (b ) each purchaser is irrevocably obligated to purchase a set number of securities, the purchase price is fixed and the transaction cannot be renegotiated.

The SEC has permitted concurrent registered and private offerings to be made under the conditions set forth in its Black Box and other related “no action” letters (described above). A “Black Box PIPE” would be undertaken, for example, during a period when the company has on file an effective resale or shelf registration statement. In such situations, the SEC requires that the private offering be made only to: (a) persons who are qualified institutional buyers (QIBs) as defined in Rule 144A(a) under the Securities Act, and/or (b) no more than two or three large institutional accredited investors.

Securities attorney Laura Anthony provides expert legal advice and ongoing corporate counsel to small public Companies as well as private Companies seeking to go public on the Over the Counter Bulletin Board Exchange (OTCBB). Ms. Anthony counsels private and small public Companies nationwide regarding reverse mergers, due diligence on public shells, corporate transactions and all aspects of securities law.

Ms. Anthony is the Founding Partner of Legal & Compliance, LLC, a national corporate, securities and civil litigation law firm based in West Palm Beach, Florida. The firm’s corporate and securities attorneys provide technical legal services to small and mid-size private and public (OTCBB) Companies, entrepreneurs, and business professionals nationwide. Contact us today for a FREE consultation!