Under the Securities and Exchange Commission’s (SEC) Regulation D, small companies can raise capital through securities without making a public offering. Providing quicker and lower-cost access to investor funding, Regulation D is ideal for those who wish to syndicate a business and entrepreneurs who need fast access to cash.
However, there are several rules that somebody offering securities under Regulation D must follow. One of those is Regulation D Rule 504, which we will examine in this article. (See https://www.law.cornell.edu/cfr/text/17/230.504 for the full text of Rule 504.)
Regulation D Rule 504 – An Introduction
Under Regulation D Rule 504, companies offering securities can do so without having to meet the SEC’s normal registration requirements. There are limitations in play here. The rule only applies to some companies. Plus, it ensures they can only sell a maximum of $10 million in securities during any 12-month period.
There are also issues to consider with the securities themselves. In most cases, securities sold under Regulation D Rule 504 are restricted securities. Bearing a symbol to mark them as restricted, you can only sell these types of securities in a legitimate unregistered transaction. For example, imagine that you’re an investor purchasing unregistered equity securities in a company. If those securities are restricted, you can’t then sell those securities to somebody else in a registered transaction. Instead, you can only sell them in an unregistered transaction completed under the rules of Regulation D.
Beyond these restrictions, there are also rules that the company offering the securities must follow:
- Any offers and sales can include an unlimited number of both accredited and non-accredited investors. Under Regulation D Rule 504, you can offer your securities to as many individuals or entities as you want without worrying about breaking any thresholds.
- You can only sell securities under Regulation D Rule 504 if your company is not subject to the SEC’s various reporting requirements. This means the rule does not apply to investment companies are any company that must report its transactions under SEC rules. Furthermore, any organization that does not have a specific business plan and intends to either merge with another unidentified company or get bought by one cannot offer securities under this rule.
- Any offering made under Regulation D Rule 504 is disqualified if a “covered person” involved in the transaction does not meet the requirements for such a transaction. A covered person is anybody who is in a position to influence the outcome of the transaction.
- There are no set disclosure requirements to follow when conducting a sale of securities under Rule 504. However, the sale must still comply with the anti-fraud conditions outlined in both federal and state law. On the basic level, these provisions compel you to share accurate and timely information without misleading the person who intends to buy the securities. Failure to comply with these laws can lead to the cancellation of the transaction and legal action being taken against the offending party.
- Though Regulation D Rule 504 transactions are unregistered, the issuer must still complete and submit Form D no more than 15 days after the first securities sale of their offering. Form D is simply a notice of the transaction and its exempt status.
- Generally speaking, the securities issuer cannot use general advertising or solicitation when making their offering. There are exemptions to this rule, such as if the transaction takes place in a state that requires a considerable amount of document disclosure, which makes avoiding advertising the securities impossible.
These technical requirements may vary depending on the state the securities are offered in. For example, the state’s regulators may require some form of qualification or registration for a Regulation D Rule 504 offering, even though the SEC does not. Furthermore, some states require such a comprehensive level of document disclosure that the restricted nature of the securities gets lifted.
The Benefits of a Regulation D Rule 504 Offering
There are several reasons why you may want to make a Regulation D Rule 504 offering, most of which relate to getting quick capital into your business.
Benefit No. 1 – Streamlining the Process
As the transaction does not require submission to the SEC for approval, the entire process is streamlined. There are no lengthy waiting periods to endure while the SEC examines the transaction. Instead, you can simply make the sale, have it go through quickly, and then begin benefitting from the capital the sale brings in. Of course, this assumes that the state you’re operating in doesn’t require some form of registration.
Benefit No. 2 – No On-Going Reporting
The lack of SEC registration also means you’re not required to conduct ongoing reporting of the offering once the sale is complete. This saves time and resources that you can divert towards building your business.
Benefit No. 3 – Much Lower Costs
The lack of registration requirements also leads to an overall lower cost for the offering. You won’t have to hire as many attorneys to ensure your transaction is above board, though this does not mean you won’t work with any attorneys at all. You also save money in terms of the time saved on the transaction. That time can go towards more business-focused activities, allowing you to generate revenue using time that you’d otherwise dedicate to paperwork.
Benefit No. 4 – Sales to Both Types of Investors
Under Regulation D Rule 504, you can sell securities to both accredited and non-accredited investors. What’s more, there are no limits on the number of investors you can bring into a single offering. This differs from sales made under some other Regulation D rules, which place limits on the number of non-accredited investors you can involve in an offering.
The Drawbacks of a Regulation D Rule 504 Offering
Though the speed and relative ease of selling securities under Regulation D Rule 504 are major plus points, there are some drawbacks to consider before you start creating your offering.
Drawback No. 1 – The Restrictions on Securities
As mentioned, any securities sold under Regulation D Rule 504 typically carry restrictions that prevent investors from selling them to whoever they want. These restrictions usually mean the security can’t be involved in a registered transaction until a certain period has passed. Some exemptions apply to this rule. However, the rule means that investors have fewer options available if they want to sell their securities.
Drawback No. 2 – The Blue Sky Laws Issue
Increased complexity comes in the form of having to follow Blue Sky Laws when conducting a Regulation D Rule 504 transaction. These laws can force you into registering an offering with the state, adding time to the process. The Blue Sky Laws issue is covered in more detail below.
The Blue Sky Laws Issue Explained
So, we can see that a Regulation D Rule 504 offering has several advantages. However, the issue of Blue Sky Laws is a serious one that can make the process more complicated than making an offering under a different Regulation D rule. For example, offerings made under Regulation D Rule 506(b) and Regulation D Rule 506(c) are typically simpler than those made under Rule 504 simply because these rules don’t involve Blue Sky Laws.
But what are Blue Sky Laws?
To answer that question, we need to understand the differences between federal and state securities laws. On the federal level, securities laws apply to all transactions unless they’re granted an exemption. We see some of these exemptions in play with Regulation D Rule 504. However, each state in the U.S. can apply its own laws to a securities offering in addition to any federal laws that apply.
These state-based laws are Blue Sky Laws.
Similar to the federal laws relating to securities, Blue Sky Laws exist to protect investors against fraudulent practices. The key difference is that Blue Sky Laws still apply to Regulation D Rule 504 transactions, even in cases where a similar federal law does not apply.
The most obvious example of this comes if the state you’re operating in requires you to register your offering. In these cases, you lose many of the benefits of a Regulation D Rule 504 offering because you still have to go through similar paperwork and checks that you’d deal with when offering registered securities. As such, a Regulation D Rule 504 may not be the right choice for you if you’re operating in a state where Blue Sky Laws require extensive documentation and registration.
The good news is that Blue Sky Laws vary from state to state. Some are stricter than others when it comes to registering securities transactions. However, most Blue Sky Laws are based on a single act – The Uniform Securities Act of 1956.
The Origins of Blue Sky Laws
There is some conjecture about where the term “Blue Sky Law” was first used. However, most agree that the term started gaining widespread use in the 1900s as a result of a ruling by a judge based in Kansas. This judge stated his wish to protect investors from speculative offerings that offered “no more basis than so many feet of ‘blue sky.’”
To understand what he meant, we need to consider what the stock market looked like in the early 20th century. Before the great crash of 1929, many of the stocks and investment opportunities offered to investors were either speculative or outright fraudulent. While every investment comes with an element of risk, many of those offered during this time were almost completely unsupported by facts or any evidence that they’d pay off. What’s more, the SEC did not exist during this period, meaning there was no regulatory body in place to protect investors’ interests.
The result of this is that many investors purchased securities without any substantial evidence that their investment might pay off or even exist at all. Unscrupulous companies of the time would even hide details about the offering from investors to attract more capital towards their businesses.
This lack of oversight and regulation came to a head in the 1920s. With speculative investments running rampant, the stock market got inflated to unsustainable levels. The crash that occurred in 1929 was an inevitability of these circumstances. It was also a signal that something needed to change regarding investment regulation.
The founding of the SEC occurred five years after the 1929 crash, which was the first major step to providing the required regulatory oversight. Today, the SEC oversees registered transactions to ensure they follow federal laws related to securities. However, unregistered transactions, such as those conducted under Regulation D Rule 504, do not have this oversight.
Blue Sky Laws exist to provide states with the ability to oversee transactions that aren’t regulated by federal authorities.
Interestingly, several states had Blue Sky Laws before the great crash. Again, Kansas is an excellent example because the state enacted some of these laws as early as 1911. The issue was that many of these early laws were so poorly worded that companies could either find ways around them or avoid them entirely by operating in a different state.
This situation changed in 1956 with the introduction of the previously mentioned Uniform Securities Act.
Think of this act as a template for states that wish to form their own frameworks for governing financial transactions. It is a model law that gives any state that uses it a starting point, including relevant legal language, that it can use to create its Blue Sky Laws. The act is also widely used, with 40 of America’s 50 states using it to create their Blue Sky Laws. With this template, states can govern financial practices, such as pyramid schemes, that occur on the local level and are not regulated by federal law. However, many states also use the act to create laws that require the registration of securities offerings even when the SEC does not.
How Can Blue Sky Laws Affect a Regulation D Rule 504 Offering?
The effect that Blue Sky Laws have on your offering depends on the state you’re operating in and the strictness of their application of the Uniform Securities Act. For example, those operating in Texas, Ohio, Arizona, and Arkansas may find they face stricter requirements than people operating in New York or Nevada.
On a general level, Blue Sky Laws may affect your offering if any of the following applies to you:
- Your business has a negative worth
- You have low capital
- You or the business have too many outstanding options and warrants
- You’re asking for an unreasonable offering price
- The business demonstrates a lack of verifiable earnings
- You’re offering cheap stock options
- Your business offers loans to employees and other company officials
- The expenses related to your offering are higher than expected
- Unequal voting rights exist in the business
Many of these are issues that your potential investors will uncover as part of their due diligence. Still, if the state discovers them, you may find that Blue Sky Laws prevent your offering from occurring.
These laws can also affect your offering during the state’s disclosure and merit review.
Again, the exact nature of the review you face varies depending on the state in question. Disclosure reviews tend to follow federal law fairly closely. In other words, the state compels you to fully disclose all materials relevant to your offering. Any inaccuracies or omissions, purposeful or otherwise, may be punished on both the state and federal levels.
Merit reviews are a little more complicated.
These laws regulate the information you disclose. They judge the information, and the offering as a whole, based on its fairness and the merits of the securities a company offers. In some states, merits reviews are conducted by independent organizations to ensure they’re completely fair. It’s in these types of reviews that many of the frameworks provided in the Uniform Securities Act come into play.
Failure to pass a merit review usually means that your company can’t offer securities in the state in question. Thankfully, merit reviews don’t typically prevent you from making institutional sales to banks and investment companies operating in the state.
Simply put, falling foul of Blue Sky Laws can cause a state to prevent the sale of your securities even if you meet all of the other requirements for a Regulation D Rule 504 offering. As such, you must work with a local attorney who specializes in applying these state-wide laws to your securities.
Regulation D Rule 504 Capital Raise Limits
Unfortunately, you can’t raise an unlimited amount of money using a Regulation D Rule 504 offering. The SEC puts limits in place, mostly to ensure that larger companies cannot conduct enormous transactions using the exemptions the rules grant.
The capital raise limit under Rule 504 has changed markedly since 2016. Up until that year, the SEC set the limit at $1 million within a 12-month period. Though this is a fairly substantial sum, it was low enough to prevent many companies from operating under the rule as they would not be able to raise enough capital. In 2016, the SEC increased this limit to $5 million, which went some way towards drawing more people towards operating under Regulation D Rule 504. However, it was still not a high enough figure in the modern business environment.
As a result, the SEC chose to raise the limit again in 2020.
It now stands at $10 million, which makes Regulation D Rule 504 a more attractive proposition for businesses that are trying to raise capital.
Of course, this capital limit is still a restriction. If you believe that your business needs to raise more than $10 million from its securities offering, this rule is not the right one for you. In many cases, companies that need to raise more than $10 million are better served with the registration of their securities to help investors feel more secure.
However, if you’re happy to parcel out your capital raises over several years, Regulation D Rule 504 may be a good choice. The $10 million limit applies per 12-month period. As such, you can make a securities offering up to this limit once per year. For some businesses, this limit can actually help them to control their growth and keep tabs on the debt and equity securities they’re selling.
Advertising and Resale Under Regulation D Rule 504
Generally speaking, Regulation D Rule 504 prevents you from advertising, marketing, or using general solicitation to try and sell your securities. For example, distributing flyers or running a television advert about your offering is not allowed under the rule. This lack of advertising can make it difficult to attract investors to your offering. In most cases, investment is restricted because only those who know of the opportunity via other means can take part.
Furthermore, the restricted nature of the securities offered under Regulation D Rule 504 comes into play here. When informing an investor of the offering, you must tell them that restrictions apply to the securities you’re selling. An investor cannot sell their securities for at least 12 months after the purchase date unless the issuer registers that sale with the SEC. Failure to disclose this information means you breach federal and Blue Sky Laws related to information disclosure.
Happily, there are some exemptions to the blanket ban on solicitation and advertising. You can market your offering if your Regulation D Rule 504 securities meet one of the following conditions:
Condition No. 1 – You Have to Register the Sale With the State
Some states have Blue Sky Laws in place that require you to register your offering with a public filing. Those that require this registration usually ask you to create a substantial disclosure document, which is delivered to any investor that shows an interest in the securities.
As mentioned, these requirements take away the key speed benefit of offering securities under Regulation D Rule 504.
To make up for this, the SEC allows you to market your offering using solicitation and general advertising in these circumstances. As a result, these Blue Sky Laws can help you to reach more investors even though they slow the overall process.
Condition No. 2 – The State Allows Advertising and Solicitation
In some cases, Blue Sky Laws can benefit you because they allow you to market your offering within the state.
Some limitations apply here.
Any advertising or solicitation you conduct can only occur in the state that allows it. In other words, you can’t assume that a television advert that is legal in one state will also be legal in another.
Furthermore, any sales achieved through advertising in this situation can only be made to accredited investors. These are individuals or entities that the SEC determines to have the knowledge and income required to make investments without the need for the protections provided to normal investors. The result of this condition is that you cannot bring non-accredited investors on board for a Regulation D Rule 504 offering if the state allows you to advertise the offering.
Condition No. 3 – The State Allows Conditional Advertising and Solicitation
Some states allow you to advertise your offering based on several conditions. In many cases, these conditions relate to an offering you’ve made in a state that allows advertising. Better yet, these states don’t require you to register the sale of your securities if you meet certain criteria. These typically include the following:
- You’ve registered the offering in another state, with your registration satisfying the conditions of the state you’re trying to sell in.
- You sell securities in another state following the same provisions as those in place in the state where you wish to sell securities.
- You deliver all relevant disclosure documents to investors in the state, in addition to providing them in the state you’re already registered in.
Essentially, these conditions ensure you don’t have to repeat the registration process multiple times to sell in different states. However, they’re not hard and fast criteria. Again, each state applies these rules differently, meaning you need to work with a local attorney or financial advisor who can help you when making offerings across multiple states.
The Non-Accredited Investor Issue
Under Regulation D Rule 504 you can generally accept purchases from both accredited and non-accredited investors. Better yet, you can bring as many of each type of investor on board as you like, with no limitations.
However, Blue Sky Laws can come into effect again here.
While Rule 504 allows non-accredited investors, this permission is overridden if the state does not allow them. For example, let’s say that you’re making a securities offering in five states. Of those five, four allow non-accredited investors under their Blue Sky Laws. However, the fifth state does not allow them. In this situation, you can’t accept non-accredited investors unless you choose not to sell your securities in a state that doesn’t allow them.
Alternatively, a state may have rules in place that limit the number of non-accredited investors included in an offering. Again, you must choose to either follow these limits or not make the offering in the state in question.
As with many of the elements of Regulation D Rule 504, this creates complexity that you’ll require a local legal expert to help you with.
What is a Non-Accredited Investor?
A non-accredited investor is any investor who does not meet the SEC’s requirements for accreditation. Generally speaking, this means the investor does not have a high net worth, large income, or substantial investing knowledge.
The SEC’s requirements for accreditation of an individual investor are:
- A net worth of at least $1 million, which excludes the value of their primary home.
- Income of at least $200,000 per year, though this rises to $300,000 if the investor has a spouse.
- Substantial knowledge of the area they’re investing in, which means they don’t require the same protections as other investors.
As such, a non-accredited investor is anybody who does not meet these criteria.
Non-accredited investors form the bulk of America’s investing population, as the term represents approximately 95% of people. The limitations on these types of investors exist to protect them. By ensuring that non-accredited investors can only get involved with certain types of transactions, the SEC prevents them from investing beyond their means. Furthermore, the SEC often requires these types of investors to work with a suitable professional when making their decisions.
Whether you need non-accredited investors or not depends on the nature of your offering. For some businesses, having a large pool of non-accredited investors can work. We see this most often in crowdfunding situations, where a large volume of non-accredited investors each offer small amounts of money to bring a project to life.
Still, many small businesses prefer to attract accredited investors for several reasons. Accredited investors have more money, meaning they can make a more substantial difference to a company’s available capital. Furthermore, accredited investors usually have more investment and business knowledge, which can prove useful to the securities offeror as they grow their business.
Bad Actor Rules Apply to Regulation D Rule 504
Any offerings made under Regulation D Rule 504 after January 20, 2017, have Bad Actor rules applied to them.
Bad Actor rules are disqualifying provisions that can prevent the completion of an offering. On the basic level, if somebody involved in the transaction is found to breach these rules, they’re disqualified from participating in the offering. In some cases, this disqualification can lead to the cancellation of the offering, especially if the Bad Actor played an important role in the deal.
Bad Actor rules apply to “covered persons” and include several “disqualifying events.”
What is a Covered Person?
Several of the people involved in your offering may be considered covered persons. These include:
- The securities issuer, along with any of their affiliates or predecessors in the company related to the offering.
- Any promoters or advertisers that have a direct connection to the issuer.
- Any directors, general partners, officers, and managing members involved with the issuer or their company.
- Anybody who receives compensation for soliciting investors for the offering.
- Any beneficial owner who has at least 20% of the issuer’s voting securities.
All of these covered persons are individuals who have a direct interest in the securities offering. They typically stand to enjoy financial gain as a result of the sale of securities, meaning you must declare who they are and the roles they play.
What is a Disqualifying Event?
A disqualifying event is anything that a covered person is served or imposed with that can affect the fairness of your offering. There are several disqualifying events, all of which make the covered person a Bad Actor that you must remove from the offering.
These events include:
- A false representation order issued by the U.S. Postal Service
- Any SEC disciplinary orders
- Restraining orders or court injunctions related to issuing or purchasing securities
- A cease-and-desist order from the SEC
- Some SEC stop orders
- Come final orders issued by federal or state regulators
- The suspension or expulsion of the covered person from select organizations
Furthermore, a disqualifying event can occur if the covered person has a criminal conviction related to any of the following:
- Creating a false filing for the SEC
- Purchasing or selling securities illegally
- Anything related to their professional conduct
The last of these disqualifying events directly applies to any investment advisers, paid solicitors, brokers, underwriters, dealers, and securities purchasers who are part of your offering.
Simply put, anybody who has broken the law or skirted around regulations related to offering securities could be a Bad Actor.
What Do Bad Actor Laws Require You to Do?
As the securities issuer, it’s your responsibility to conduct factual inquiries into anybody involved in your offering. You’re specifically looking for the presence of any disqualifying events related to the covered persons involved. If you find such an event, you must conduct further investigation to see if the event had a “look-back period”.
Many disqualifying events have set look-back periods during which the SEC, and potentially the IRS, closely examine the person in question. These periods differ depending on the disqualifying event, with the five-year period for a court injunction being a good example. In some cases, the end of a look-back period allows you to involve a covered person who previously took part in a disqualifying event. However, this participation depends on state rules.
Generally speaking, the presence of a Bad Actor in your offering means you can no longer make the offering under Regulation D Rule 504. This does not mean that you can’t make an offering at all. It simply means that you can’t benefit from the exemptions that Regulation D Rule 504 provides. You may still be able to create a public and registered offering under SEC guidelines with a Bad Actor in place, though you must disclose all details about the Bad Actors and their disqualifying events.
Any offering made before January 20, 2017, under Regulation D Rule 504 isn’t subject to these Bad Actor rules.
Investment Companies and Regulation D Rule 504
Investment companies cannot participate in securities transactions under Regulation D Rule 504. However, what constitutes an investment company can be a murky topic that requires further explanation.
The definition for an investment company comes from the Investment Company Act of 1940. Established in the wake of the 1929 stock market crash, this act details the regulatory framework under which all retail investment products must operate. The act also provides definitions for the various entities involved in the investment sector.
This act defines an investment company as follows:
“An investment company as an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire ‘investment securities’ having a value exceeding 40 percent of the value of its total assets.”
In other words, any company for which 40% of its assets come from investment activity is an investment company. To offer securities to the public market, an investment company must register itself with the SEC. Failure to do so prevents the company from offering securities.
There are three types of investment companies in the United States:
- Unit Investment Trusts
- Closed-End Funds and Closed-End Management Investment Companies
- Mutual Funds and Open-End Management Investment Companies
If your company falls under this definition, you cannot offer securities under Regulation D Rule 504. However, there are some possible exemptions. For example, hedge funds are usually classified as investment companies. However, a fund may apply for an exemption under either section 3(c)(1) or 3(c)7 of the Investment Company Act.
In short, those operating investment companies must find another way to raise capital. Typically, this means raising funds via a public offering, with full SEC registration and reporting.
Is Regulation D Rule 504 Right for You?
Regulation D Rule 504 exists to provide small businesses with the opportunity to quickly gain funding from a wide range of investors. The rule allows you to make securities offerings to both accredited and non-accredited investors. Additionally, the rule places no limits on the number of investors you can offer securities to. As such, the rule works best for smaller companies that want to syndicate or crowdfund their offering to attract as much support as possible.
However, Regulation D Rule 504 has some drawbacks.
Blue Sky Laws apply to the rule, which means you must follow your chosen state’s regulations when making an offering. In some cases, these laws require you to register your offering and complete extensive documentation. Couple this with the $10 million limit on Regulation D Rule 504 offerings and you may find that a more public offering suits your needs better.
Beyond considering each state’s Blue Sky Laws, you must ensure no Bad Actors can affect your offering. The presence of a Bad Actor may sink any transactions you attempt to make. Worse yet, failing to report a Bad Actor makes you liable for legal action as a result of misinforming your investors.
Ultimately, the choice to use Regulation D Rule 504 when offering securities comes down to your business’s circumstances. The rule is ideal for qualifying companies that wish to raise a small amount of capital with few limitations on the types of investors they bring on board. However, it’s not suitable for larger companies or those that operate in states where Blue Sky Laws create so many restrictions that the issuer loses the benefits of Regulation D Rule 504.
Are You Ready to Move Forward?
This article should answer many of the questions you have about Regulation D Rule 504. However, any capital raising activity you engage in carries legal issues specific to your company. That’s why it’s so critical that you have suitable legal representation in place to protect you from regulatory issues.
Do you think a syndication or securities offering under Regulation D Rule 504 is right for your business? If you do, the professionals at Moschetti Law are ready to help you. We offer an in-depth understanding of Regulation D, its rules, and what you need to do to ensure your offering achieves your goals. If you’re ready to move forward, give us a call on (888) 606-0990 and we’ll arrange a free consultation.