Speaker 1: The securities laws are made up of five major federal statutes, two of which are the ones we spend most of the time talking about, the Securities Exchange Act of 1934 and the Securities Act of 1933. In this Part 1 discussion, we're going to focus on the most significant lessons we should learn regarding the Securities Act of 1933. In Part 2, we'll talk about the lessons from the Securities Exchange Act. So let's take a look at the Securities Act of 1933, and in particular, let's look here at Section 5. And let's just read the first part. Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise. Now what does that actually mean? It means that unless a registration statement is in effect as to the security, you can't sell it. That's basically what Section 5 is telling you. And when you think about that, that's pretty remarkable. This section basically tells you it is illegal to sell anything that is a security unless you first registered that sale with the SEC. You may ask, so what's the big deal? So what? You have to register with the SEC in order to sell a security. Well think about it. You read about the definition of security, and you've come to realize that it's a very broad and all-encompassing kind of concept. Basically if you see someone providing money to someone else in the hope of making a profit on that investment based on the efforts of that other person, so someone providing money to someone to start a business or to pursue a new venture idea with the expectation that if that venture or business succeeds, they'll make money on their investment, that's probably a transaction that involves a security. Certainly if you start selling member interests in limited liability companies or shares in a corporation, you are selling a security. So even if someone is starting a small business, but they're doing so in the corporate or limited liability company form, they are implicating Section 5 of the Securities Act of 1933. And so how would the world work if every time you start a small business as an LLC for example, or a corporation, you were required to register every sale of securities by that entity? Would that work? The simplest answer to that question is to look at how much registration typically costs. The latest estimate from 2016 is that the average accounting fees for going public, creating an IPO, was just under a million dollars, and that the average legal fees were 1.7 million. So clearly that's not an expense that small companies can undertake. Therefore something else has to be going on here. It can't be that every sale of a security has to be registered. But isn't that what Section 5 says? So if you look earlier in the statute, you'll find the answer to this question. And there are a few provisions, and in particular the one we're going to focus on here is Section 4A.2 of the Securities Act of 1933, that provide exceptions to the rule that every sale of a security has to be registered. But it's very important to notice the structure of the statute. The basic rule, the standard rule, the default rule, is that if you're selling a security and you've not registered it, you've violated the federal securities laws. And the only way around that is if you can identify within the statute an exception to the requirement to register. And so it becomes very important that you understand how these exceptions work, because Generally speaking, you do have the requirement to register. The most important exception to the Section 5 registration requirements is provided by Section 4A.2. And it reads, the provisions of Section 5 shall not apply to transactions by an issuer not involving any public offering. Now unfortunately, nowhere in the statute does it define what it means for a transaction to not involve a public offering. So how are we supposed to figure out what this exception actually includes? Well there are two answers. One is, of course, there have been a series of court cases where judges have told us how to interpret those words. And there's a line of judicial decisions that interpret what it means to not involve a public offering. But that's a very challenging way to do business. How do you want to rely on whether or not you fit within this exception if you're in the planning perspective, if you're trying to make sure that what you're about to do, as opposed to what you've already done, is not going to require registration under Section 5? Where's the guidance? Well fortunately, we have the Securities and Exchange Commission. The SEC is the administrative agency that has been delegated broad administrative authority under the federal securities laws to administer those statutes. And both expressly in many parts of the statute, but also where it's not expressed through judicial reasoning, we've given the SEC the power to provide definitive interpretations of sections of the statute, including things like what does it mean for a transaction not to involve a public offering. And fortunately for us, the SEC has adopted a series of rules. So these are not statute or provisions, these are not pronouncements enacted by Congress but these are pronouncements that have the force of law because they are enacted by the regulatory agency under the delegated authority provided by the statute here at the SEC. And what the SEC is doing in what we call Regulation D, or sometimes also called the Private Placement Rules, are defining what it is that you have to do in order to fit within the certain of the exceptions provided by the statute, the 33 Act, to the requirement of Section 5. Put simply, this is a set of rules that provide what they call a safe harbor, meaning if you comply with these rules, you can rest assured as a planner that you have successfully completed a transaction that's exempt from the registration requirements of Section 5. And you can imagine why that's so important. How is it that a startup company knows that it's not violating the federal securities laws by issuing shares to a venture capitalist? Well one way it can know that is by making sure it complies with Reg D. And the most important section of Reg D that we should focus on, I mean you should understand that generally Reg D exists, but there is one section that is probably the most commonly relied on by companies when they want to raise money and not go through the expense and burden of a full bore public offering, a registration, and that is Section 506. And we'll talk very quickly so you're aware of it, what the requirements of Section 506 are. But again, the idea is here the SEC has told us if you do these things, which we're going to review what those are quickly, you can be confident that you did not need to register the offering that complies with 506 under Section 5. Why? Because the SEC has told us that if you do the offering in compliance with 506, it is a transaction that is not involving a public offering and therefore benefits from the exception under the statute. So if you went to Rule 506 under Reg D and tried to come up with a list of the requirements for fitting within the safe harbor, you'd end up with something that looks like this. And quickly you'd understand why it is that 506 is such a significant and predominant source of an exception to the registration requirements under the 33 Act. For example, there is no maximum amount. Other exceptions have limits on the amount of an offering you can perform under the exception 506 does not. There's no restriction on the manner of offering, provided that you limit your offering to a certain kind of investor. In other exceptions, you can't offer securities to people you don't already know, for example. Or you cannot engage in a general solicitation which you make known to the world at large that you're going through this offering process. Clearly a significant restriction. There are no information requirements in 506, again, provided you limit the offering to a certain type of investor. Whereas in the other exceptions, you're often required to prepare a disclosure document that's really not that different from the prospectus that you have to do in a registered offering, which is very expensive. Indeed, the only requirement provided that your offering is qualified for 506 is that you file a Form D, which is a very easy, simple form to fill out, and you file online with the SEC. The most significant restriction, however, is this. And that is, you must limit your offering to qualify for 506 to accredited investors. There is some flexibility to add 35 non-accredited investors, but if you do that, now suddenly the restriction on manner of offering and the requirement that you provide information come back, and that makes it not as attractive as it otherwise would be. But the beauty of 506 is, if you limit yourself to so-called accredited investors, you can offer as many of them as much of what it is you're selling, with the security you're selling, as you want to, and you can do it in a fairly simple way, without any requirement that you give them any particular form of disclosure. So therefore, the most significant question is, well, what's an accredited investor? And the definition of accredited investor, under the rules, is someone who has a certain net worth or a certain level of income. Those are the two most significant qualifications. And so if we're talking about individuals, the requirement are that that person have at least a million dollars, excluding their primary residence in assets or net worth, or $200,000 a year of income, or slightly higher if you're going to combine with the spouse. So basically it's saying, if you're dealing only with wealthy people, relatively speaking, you can qualify for 506 and sell them securities with relatively little difficulty and without the need to register. That leaves us with a question. If every sale of a security requires registration, unless there's an exemption or exception, and the primary exception is that you only sell securities to wealthy people, how is it that a startup company, like let's say a small business or a pizza parlor, is able to sell securities to its founders in order to start the business? I mean, let's say two pizza parlor founders want to each buy 50% of the common stock of their new corporation for a few thousand dollars each, and they're not rich. How do you do that without violating the federal securities laws? Well, the answer lies in going back and remembering that the accredited investor 506 exception is a safe harbor created by the SEC to the statutory exception, right? It's a safe harbor that is implemented under and gives effect to the statutory exception under section 4A2. It does not replace the statutory exception. It does not completely fulfill the statutory exception. It is simply an example of a transaction that would fit within that exception. And there still remains the exception itself, the provision in the statute. And as we read in the Ralston Purina case, that still leaves room for judges to tell us, well, what wasn't included based on the purpose of the 33 Act? And one of the most common judicially accepted exceptions under the general exception of the statute, 4A2, is transactions involving the founders of a business, even if they're not rich, because clearly that's a limited offering to a small number of people who are deeply involved in the creation of the business itself, and therefore are not people who need the protection of the federal securities laws.