Securities Regulation
Solar businesses seeking to raise capital in the United States for investment in their business activities must concern themselves with federal and state securities laws. In addition, solar businesses that intend to develop and operate community solar gardens may, by virtue of the contractual relationships involved in those projects, become subject to the securities laws. However, as discussed below, many solar industry arrangements feature parties or transaction structures that permit industry participants to avoid registration under applicable federal and state securities laws by relying upon one or more exemptions from such registration. In very general terms, solar projects that involve a limited number of sophisticated commercial and industrial participants will often be exempt from securities registration because the parties investing or subscribing qualify as “accredited investors” (as defined below). Conversely, depending on the number and nature of prospective subscribers, community solar gardens that seek subscriptions that are deemed to be securities from large numbers of residential consumers may not be able to claim the exemptions available for sales of securities solely to accredited investors.
Given the wide range of solar industry transaction structures and participants (and the importance of the facts and circumstances of each arrangement), a solar industry developer or other participant should seek advance legal advice regarding the possible application of federal and state securities laws. In most circumstances, that legal advice will focus on the availability of exemptions from securities registration for the proposed transaction, but may also focus on whether or not the proposed transaction actually involves the offer and sale of securities.
The following sections of this chapter are intended to provide a general overview of federal securities regulation, with an emphasis on disclosure obligations, securities registration requirements, those exemptions from registration likely to be of most interest to solar industry participants and, finally, the resale of securities by affiliates of the issuer and other investors.
Introduction. The United States and each state have laws regulating the purchase, sale, and trading of securities. While the laws are generally similar in most respects, there are some important differences, so it is necessary to check both the federal law and the law of each state in which the fundraising or trading activity will occur.1
Federal securities laws are subject to regulation and enforcement by the Securities and Exchange Commission (the “SEC”). The SEC also empowers and oversees the activities of various self-regulatory organizations, such as the Financial Industry Regulatory Authority, and the various exchanges and other systems on which securities are traded, such as the New York Stock Exchange and NASDAQ. These organizations enact their own regulations within the areas of their authority, but their regulations are subject to review and approval by the SEC. State securities laws are subject to regulation and enforcement by state securities authorities.
Neither federal nor state securities laws are explicitly restricted as to the geographical scope of their application. In practice, federal securities laws are applied principally to regulate transactions in the United States and its territories or transactions to which U.S. citizens or residents are a party. Even when no U.S. citizen or resident is a party, U.S. securities laws may be applied when substantial activity in connection with the transaction occurs in the United States, or in circumstances in which the nature of the transaction tends to undermine confidence in U.S. securities markets.
State securities laws apply to protect the citizens and residents of a state who are contacted within the state in connection with a transaction. Thus, for example, state laws regulating the sale of securities by the businesses that issued them (“issuers”) apply to sales made to purchasers resident in the applicable state.
I. What Is a Security? Both federal and state laws define a security very broadly to include a wide variety of instruments, including stock and other forms of equity and certain debt instruments. In addition to the specific list of instruments that constitute securities, an “investment contract” is a security. An investment contract has been defined by courts to be a contract or instrument involving the investment of money or other value in a common enterprise with the expectation of profit resulting from the efforts of others.2
As an initial matter, it is important to determine whether a contemplated transaction involves a security, because the securities laws apply only if it does. The answer depends on a number of fact-specific issues, but here are a few general guidelines:
Almost any instrument evidencing ownership of a business, including stock, limited partnership interests, limited liability company interests, or other instruments having equivalent function, is a security. However, joint venture agreements, general partnership interests, and similar instruments representing ownership of a business that the owners will collaborate in running may not be securities.
- Securitized debt instruments, including bonds, debentures, and other instruments evidencing debt held similarly by a group of investors, are securities. Conventional, commercial loan arrangements, whether with traditional lenders or pursuant to private arrangement, are not securities, including syndicated loans with a group of traditional lenders.3 The line between commercial and securitized debt has generated considerable judicial analysis and requires careful review in the case of novel or unusual interests.
- Derivative instruments, such as options, warrants, and other instruments evidencing the right to exchange the interest for a security or to purchase a security, are deemed to constitute the security into which they are convertible or for which they are exercisable, and may also be securities in their own right. Thus, for example, the sale of a warrant exercisable to buy stock is the sale of a security, as is the sale of the stock on exercise of the warrant. The existence of the warrant may also be a continuing offer to sell the stock.
Finally, an agreement or instrument may constitute or contain a security regardless of its form. Agreements or instruments of any kind may be securities if, as a matter of fact, they meet the definitional test of an investment contract described above. As a result, agreements such as those found in community solar garden subscriptions must be analyzed to see if they represent (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profit, and (iv) from the efforts of others. However, because this analysis is very much based on the facts and circumstances of a particular arrangement, securities lawyers will typically advise clients to structure the transaction at hand in such a way that either the transaction does not involve the offer or sale of securities or the issuer can claim the benefits of an exemption from registration. Many exemptions contain “safe harbor” provisions that provide a greater degree of certainty than the uncertain weighing of factors involved in determining whether or not an agreement or instrument constitutes a security. Only if an exemption is not available or is not desirable from a business standpoint will the analysis turn to considering whether the bundle of rights and obligations made available to the investor or subscriber comprises an “investment contract” and therefore a security subject to the application of the securities laws.
II. What Do the Securities Laws Regulate? The securities laws regulate transactions in securities but do not regulate all such transactions. In general, securities laws regulate (1) purchases or sales of securities, (2) offers to purchase or sell securities, and (3) the activity of markets that trade in securities and those who use them. Securities laws generally do not regulate bona fide gifts of securities, nor do they attempt to control the nature of the instrument that constitutes a security or the rights of holders of such securities under such instruments. Such rights are generally controlled under state corporate laws or are determined by private agreement.
Purchases and Sales of Securities. Numerous laws and regulations govern the activity of persons who purchase or sell securities. The general purpose of these laws is to ensure that a transaction is fair to both sides by requiring a buyer or seller with knowledge of material facts relevant to the value of the securities to make that information known to the counterparty in the transaction.4 As described in more detail below, both federal and state securities laws regulate both the sale of securities by issuers (generally upon original issuance to raise capital) and the resale of those securities by others, in a secondary transaction.
Offers to Sell or Purchase Securities. Not only are purchases and sales of securities regulated, but offers to purchase or sell securities are independently regulated. Thus, for example, it is possible to violate a securities law by offering to sell a security even though no sale ever occurs. In practice, offers are rarely the subject of either public or private enforcement proceedings. In the case of public proceedings, the absence of harm resulting from the offer generally limits enforcement efforts to obtaining cease-and-desist orders against persons regularly making unlawful offers. The same lack of harm effectively precludes private enforcement action.
The fact that offers are rarely the subject of independent enforcement proceedings does not mean, however, that offers can be made with impunity. As discussed in more detail below, some rules relating to whether and how a security may be sold apply differently depending on whether, how, and to whom offers have been made. Accordingly, ill-considered offers to purchase or sell securities can cause a related sale of securities to be unlawful, even if it would have been permitted had the offers not been made.
Regulation of Trading and Trading Markets. If securities are held by a relatively large number of people, or if they are traded on an exchange or other trading facility, numerous regulations apply to the issuers of the securities, the markets on which the securities are traded, and those persons trading on such markets. Most of the rules applicable to the latter two categories are of only minor significance to energy businesses, but the first category can impose substantial regulatory cost and impose other restrictions and burdens on companies whose securities are traded in the United States. In general, these rules do not apply to companies whose securities are illiquid and closely held, or to companies whose trading markets are in countries other than the United States.
III. Purchases and Sales of Securities: Regulatory Overview.
A. Disclosure Obligations. U.S. securities laws provide a general disclosure standard by making it unlawful for a person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, in connection with the purchase or sale of a security,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person[.]5
This requirement sets a standard for honesty and fair dealing in connection with securities transactions that is considerably more stringent than the standard applicable in other commercial contexts, in which actual fraud is unlawful, but in general the parties to an agreement are charged with protecting their own interests.6
Under this provision, a purchaser or seller of a security has a legal claim upon a showing that the counterparty made a false statement of a material fact (a material fact being a fact that a reasonable person would consider to be important in connection with the related investment decision). These claims are generally known as “Rule 10b 5 claims,” referring to the regulation under which they exist. Rule 10b 5 does not prohibit material omissions unless the information omitted was necessary to make a statement that was made not misleading. Accordingly, there is no general duty of complete disclosure in connection with securities transactions. As described below, however, there are numerous rules under which specific disclosure is required. Such rules can impact both the original issuance of a security and a subsequent resale of that security.
In addition to the general 10b 5 obligation described above, certain disclosure obligations may impact businesses seeking to obtain capital in a registered offering of their securities. Registration of securities with the SEC requires that detailed information be provided about the company issuing the securities, its business activities, the terms of the securities being offered, the terms of the offering, and the risks of the investment. Certain exemptions from registration also specify, as a condition of claiming the exemption, the information to be provided to prospective investors.7
In addition to the disclosure requirements associated with the original issuance of securities, case law has, since the 1970s, held that, if a party to a securities sale is in possession of material, nonpublic information with respect to the business whose securities are the subject of the transaction, that party must disclose the information to the other party (or determine that the other party also has that information) in such a way that the other party can take that information into account in making its decision with respect to the transaction. Nonpublic information is information that has not been made available to the general public by press release, regulatory filing, or other method. The requirement is obviously most applicable to businesses buying or selling their own securities or to members of management of the business engaged in such transactions. However, the scope of the requirement is not limited to those persons, and anyone engaged in a securities transaction can be liable for breach of the requirement if he or she goes through with the transaction without making the required disclosure. A breach of this requirement is actionable by the counterparty to the transaction, who may sue to recover the lost value of the investment, if any.
A person may have Rule 10b 5 liability if that person (known as a “tipper”) improperly provided information to a third party who then improperly traded based on that information. Thus, an officer, director, or employee of a business may have Rule 10b 5 liability, even if he or she did not actually trade based on the information or profit from any such trade, if he or she improperly provided material nonpublic information to someone who did trade. If the officer, director, or employee provided the information in his or her capacity as an agent of the business, the business itself may be liable, which is why it is important for businesses whose securities are traded on any regular basis to take appropriate steps to prevent such disclosures.
There are a number of limitations to the scope of Rule 10b 5 liability. For example, a tipper can be liable only if the provision of the information was in some way in violation of a duty of the tipper not to provide the information. Inadvertent or fortuitous disclosures or disclosures for a proper business purpose cannot be the basis for tipper liability. Similarly, a person who declined to participate in a securities transaction cannot sue under Rule 10b 5 based on a claim that material information in the possession of the potential counterparty would have resulted in a decision to go through with the transaction. In general, however, trading while in possession of material nonpublic information can be the basis for a claim by the counterparty if the investment decision turns out to have been a poor one.
It is critical to keep in mind that, unlike the rules relating to registration and exemption discussed below, Rule 10b 5 applies to all sales of securities and all persons engaged in such sales. It applies to both sellers and buyers, and both to securities that are required to be registered as a condition of sale and to those that are exempt from such requirements. In particular, businesses involved in raising money through securities sales may tend to focus on the registration and exemption requirements and the disclosure requirements necessary to complete registration or to claim an exemption. In so doing, they might forget that Rule 10b 5 applies as well. Such a failure can have serious consequences, even if all of the registration, exemption, and required disclosure rules are carefully observed.
B. Registration and Exemption Rules. Federal and state securities laws impose duties on persons who propose to offer or sell securities. Unlike the Rule 10b 5 obligations described above, these rules apply only to sellers of securities and do not impose any duty on buyers.
The core concept of these rules is that a security that is to be sold must be registered unless either the security or the contemplated transaction is exempt from registration. Registration consists of filing a registration statement with the SEC or relevant state authority that meets the requirements for such documents. In theory, absent objection from the relevant authority within a prescribed period of time, the securities can be sold as long as a disclosure document, usually known as a prospectus, is delivered to the buyer in time to permit the buyer to use the information contained therein to make an informed investment decision. In practice, the SEC has made clear that, except in situations generally involving large, established companies, it expects to review and comment on the registration statement, after which there will follow a dialogue with the SEC staff, resulting in one or more amendments being filed and reviewed. Once the SEC staff is satisfied with the registration statement, it “declares” the registration statement effective and sales can take place. While the issuer and the SEC are in discussions regarding the content of the final registration statement, offers, but not sales, can be made by a preliminary form of prospectus.
While billions of dollars’ worth of securities trade every day in the United States, the cumbersome process of registration with the SEC or relevant state authority does not apply to the overwhelming majority of such sales. Most of these sales occur under a registration exemption that exempts sales by persons who are not the issuer of the security, who are not affiliated with the issuer, and who are not underwriters of the securities or dealers in securities. Separate exemptions cover most sales by dealers in securities and by underwriters after a period of time has elapsed from the underwriting, thus allowing regular market transactions to proceed in the ordinary course without precondition.
Other exemptions apply to certain kinds of securities, regardless of the type of transaction involved. Of particular interest to energy companies, sales of securities that are issued or guaranteed by a government entity in the United States, such as municipal bonds and other forms of governmental instruments that are often issued to support a particular project, are exempt from registration without regard to the kind of transaction in which they are sold. As noted above, however, the exemption is from the registration requirements only. The requirements of Rule 10b 5 will apply to the sale, and other securities laws may either apply to the sale itself or be triggered by the fact that the sale took place.
Given the breadth of these exemptions, the registration rules are an issue mostly for four groups: (1) businesses seeking to raise capital by issuing their own securities (issuers); (2) directors, senior managers, general partners, and persons with equivalent management responsibility, and substantial equity holders in connection with reselling securities of the business that they own or manage (affiliates); (3) owners of “restricted securities” in connection with the resale of those securities; and (4) underwriters of securities. Sales by issuers, resales of restricted securities and resales of securities by affiliates are discussed below.
IV. Sales by Issuers.
A. Public Offerings. Issuers raising capital by selling their securities are generally faced with a choice of registering the securities to be offered and sold or complying with the requirements of an exemption. Any securities can be sold without meaningful restriction if the issuer files a registration statement and delivers a prospectus to each investor. Securities sold pursuant to registration are unrestricted, except those purchased by affiliates or underwriters, so they are freely tradable in the hands of the general public.
One of the results of a registered securities offering is that the issuer will become a “public company.” As such, it will be subject to the reporting requirements of the Securities Exchange Act of 1934 (the “Exchange Act”) and will have to file with the SEC annual and quarterly reports, and other reports upon the occurrence of specific events.8 This obligation will continue for at least a year and thereafter as long as there are more than a specified number of record holders of the securities (in most cases, 300). If the publicly owned securities are equity, numerous other provisions of the Exchange Act are also likely to apply, including provisions relating to the holding of stockholders meetings; trading of the securities by executive officers, directors, and holders of more than 10 percent of the securities; reports required to be filed by holders of more than 5 percent of the securities; and the conduct of tender offers for the securities. Finally, although it is not required by law, the likely result of a registered securities offering is that the securities will be listed on an exchange or other trading mechanism, causing the issuer to be subject to the rules of that facility.
For a company that is not already public, a decision to do a registered securities offering represents a choice of strategic direction in addition to the selection of a capital-raising method. An initial public offering generally takes from six months to a year to consummate. The expense is quite large, and a considerable amount of the expense is not avoidable if the offering does not work. The volatility of capital markets creates risk that an offering that seems sensible at the time of the decision to proceed may appear less attractive at the time it is consummated. Following the offering, there is significant additional recurring expense. There is also a need to publicly report information that would normally be considered proprietary in a private company. Finally, the need to establish and maintain constructive investor relationships is time-consuming and can lead to management decisions that may not optimize the potential of the business.
The advantages of being a public company include access to public capital markets, which, after an initial period of time, can be accessed quite quickly and efficiently; increased flexibility in structuring acquisitions; and increased liquidity for stockholders. Additionally, under the Jumpstart Our Business Startups Act adopted by Congress in 2012 (“JOBS Act”), the SEC offered some relief to issuers that qualify as emerging growth companies by reducing certain disclosure requirements.
In general, a decision to go public is one involving economies of scale. In a larger business, the advantages of public status, combined with the ability to amortize the cost over a larger capital base, can make the alternative attractive. Smaller businesses are generally well advised to remain private if they are able to do so.
B. Private Placements and Other Exemptions.
Private Placement Exemptions. Issuers that are and intend to remain private generally rely on one or more of several exemptions from registration. Most frequently claimed are exemptions for which the general requirement is that the securities are not sold, either directly or indirectly, to the general public.9 These exemptions, available only to issuers and generically known as “private offering exemptions,” allow issuers to offer and sell securities without registration as long as (1) they are offered and sold only to a limited group of investors, and (2) the issuer takes steps to prevent immediate resale of the securities by restricting their resale. The securities so issued and so restricted are referred to as “restricted securities,” subject to the rules on resale discussed in Section V below.
Offer Restrictions. The availability of the exemption for the offer and the sale depends on whether the issuer engages in “general solicitation or general advertising” in connection with the offering. The SEC rules define general solicitation or advertising to include any advertisement, article, notice, or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio, and any seminar or meeting whose attendees have been invited by any general solicitation or advertising. Until the adoption of amendments to the private placement exemptions in 2012, any offer made by a general solicitation or advertising, such as newspaper advertisements, mass emails, or other forms of general distribution in which the individual recipients were not known and identified as potential investors who were qualified to receive the offer, would violate the conditions for reliance on the exemption.10
Under the JOBS Act, regulations have been adopted that permit general solicitation and advertising for certain private placements if (1) the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors, and (2) all purchasers of the securities are accredited investors.11 In general, financial institutions, institutional investors of significant size, and individuals meeting certain net worth or income thresholds are accredited investors.12
Issuers that engage in general solicitation and advertising of an offering face significant consequences if they rely on the new exemption but fail to meet the “reasonable steps” accredited investor verification standard. This is because the use of general solicitation or advertising not only would invalidate the exemption for those investors who were publicly solicited but also for the offering as a whole, thus leaving the issuer without an available exemption for the offering.
Investor Identity Restrictions. Federal securities regulations permit private placements to be made to an unlimited number of accredited investors. If the total amount to be raised in the offering exceeds $5 million, each investor must also be financially sophisticated enough (or have retained an advisor with such sophistication) to understand the merits and risks of the investment.
The regulations also permit private placements to be made to up to 35 nonaccredited investors, provided that the investors, while nonaccredited, still meet certain suitability criteria and the issuer has not used any general solicitation or advertising. This provision has some utility in specific instances, although its use is limited. The most important reason is that the informational requirements are substantially greater if the offering is made to any nonaccredited investor. Additional reasons include the fact that the effort required to solicit nonaccredited investors is disproportionate to the amount that they can prudently invest and the likelihood that selling securities to nonaccredited investors increases the risk of legal action if things do not go well for the investment.
Most private placements are made to a small group of institutional investors and/or very wealthy individuals. In the case of newer and smaller businesses, the former are known as “venture capital investors” and the latter are known as “angels.”13 In either case, the investment is likely to be in the form of preferred, convertible stock. More mature companies are funded by a group of institutions generally referred to as “mezzanine” or “institutional” investors. These investments are more likely to involve debt securities, possibly with an equity piece as an inducement. Fully mature companies and projects have access to a wide variety of private funding alternatives, and it is not uncommon for a project to be funded at various levels by different institutional investors.
“Bad Actor” Disqualification. The SEC adopted bad actor disqualification rules on July 10, 2013 to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the “bad actor” disqualification rules, a private offering that otherwise would qualify for an exemption from registration is disqualified from claiming the exemption if the issuer or any affiliated parties, including directors, general partners, executive officers, and beneficial owners owning more than 20 percent or more of the issuer or placement agents have participated in or been subject to a disqualifying event. Disqualifying events include certain criminal convictions, SEC disciplinary or cease-and-desist orders or suspension or expulsion from membership in a self-regulatory organization. An issuer, therefore, must exercise diligence to confirm that none of the parties affiliated with the issuer, including any prospective investor that may acquire a significant ownership interest in the issuer, jeopardize the exemption from registration
Intrastate Offering Exemptions. In addition to the widely used private placement exemptions discussed above, another type of securities exemption may be of use in the solar industry. In particular, community solar garden projects focused on participation and subscription by consumers (rather than commercial or industrial parties) may have difficulty claiming the benefits of the private placement exemptions discussed above. The requirements of those exemptions regarding public solicitation and sales to nonaccredited investors would not be met if the subscriptions are determined to be securities and the solar developer wished to contact large numbers of potential subscribers, many of whom would not qualify as accredited investors. Although not regularly used, there is another type of exemption that may be of use in some limited circumstances. That is the “intrastate” exemption.
Under the Securities Act, an exemption from registration is available for securities that are offered and sold only to residents of the state in which the corporation offering the securities is both incorporated and doing business. A rule adopted by the SEC (Rule 147) provides additional clarity by specifying, among other factors, the portion of a company’s business and assets that must be within the state in which the intrastate offering is to be conducted. This exemption has historically been of limited use, with many securities professionals concerned about the difficulty of being sure that offers and sales are made only to residents of a single state. In addition, most states have not historically had a parallel securities exemption, meaning that companies relying on the intrastate exemption for an exemption from federal securities registration might not be able to claim an exemption from registration under state securities laws, but would need to register with the applicable state. (Some renewable energy businesses, particularly those involved in biofuel production, have pursued such an approach by claiming the federal intrastate exemption while registering in the state where the business is incorporated and operates.)
In connection with the securities law amendments described above, a new intrastate exemption was created by the adoption of Rule 147A. Intended as part of a series of changes to facilitate the formation of capital for start-up businesses, Rule 147A generally contains the same requirements as Rule 147 except that the issuer need not be incorporated in the state in which the issuer operates its business.
While the intrastate exemption has historically been of limited utility, it is an area in which the law is evolving. In particular, some changes in state securities laws in the past few years have focused on community-based capitalization efforts such as crowdfunding. Those changes may make a viable combination of an intrastate exemption at the federal level and a state exemption, depending on the particular facts involved and the particular state in which the offering is to be conducted. In any event, a solar enterprise should carefully consider the intrastate exemptions if the private placement exemptions are not available and the transaction in question involves the offer and sale of securities.
C. Brief Introduction to Integration. As noted above, offers and sales of securities may be exempt from registration if the nature and manner of the offering meet certain requirements. To determine whether the requirements have been met, it is necessary to define the “offering” that is required to meet the applicable requirement. Offers of securities deemed to constitute a single offering for this purpose are said to be “integrated.”
A single entity offering stock to a number of investors at a given time is engaged in a single offering. However, a question arises if an issuer is simultaneously offering stock to investors as a capital-raising project and to employees on exercise of options that are a part of the issuer’s compensation program. Similarly, if a company is doing a public equity offering at the same time that it is restructuring its securitized debt arrangements with institutional lenders, an integration question is raised. In a somewhat different way, if a number of related entities are simultaneously raising capital for a common project, an integration analysis is required.
The SEC recently adopted rule amendments to modernize the integration framework. A majority of the rule amendments captured in new Rule 152 to the Securities Act of 1933 (the “Securities Act”) became effective on March 15, 2021.14 Rule 152 provides certain safe harbors addressing, among other things, offerings made more than 30 calendar days before or after another offering. Additionally, if the safe harbors do not apply, offers and sales generally will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering.15 Notwithstanding the clarity offered by Rule 152, issuers still must exercise caution, as Rule 152 may not be used as part of a plan or scheme to avoid registration requirements. As a result, it is still important for an issuer to seek legal guidance if its activities could possibly constitute a series of offering transactions.
V. Sales by Holders of Restricted Securities and Affiliates. Affiliates of an issuer are defined as people or entities that control, are controlled by, or are under common control with, the issuer. In general, affiliates include senior management and large stockholders of the issuer as well as a corporate parent, subsidiary, or other related entities. As noted above, normal sales of publicly traded securities by persons other than the issuer of a security and holders of restricted securities are exempt from registration without any meaningful precondition. Sales by affiliates of the issuer are also subject to restriction and can be resold only upon satisfaction of certain conditions.16
Resales of Restricted Securities. Certificates representing restricted securities normally contain a legend indicating that the securities may not be resold except pursuant to registration or an applicable exemption. In a sense, the legend states the obvious, since all sales of securities are subject to that restriction. The legend reinforces this requirement and also usually indicates that the issuer will not recognize or assist with any sale that does not meet this requirement to its satisfaction.
Restricted securities can be resold pursuant to registration as soon as the registration statement is effective. If no effective registration statement exists for restricted securities, an exemption will be required. By far the most commonly used exemption for resales of restricted securities exists under Rule 144, which generally permits such resales (1) after a period of time in which the reseller has held the securities, if certain conditions are met, or (2) without condition after a longer period, as long as the reseller is not an affiliate. The conditions, if applicable, relate to the manner in which the securities are sold, the number of securities sold in relation to either the number of publicly traded securities or the trading volume, the need to file a report with respect to the sale with the SEC, and the need for publicly available information about the issuer. For most sellers, meeting the conditions is not onerous except that doing so takes time and also takes the sale out of the trading routine under which unrestricted securities are normally sold.
Once the restricted securities can be resold without condition, it is customary for the holder of the certificates to apply to the issuer to have new certificates issued without the legend, which no longer applies and the existence of which can delay and complicate a trade, even when an ordinary trade is permissible.
Resales by Affiliates. Affiliates reselling restricted securities are subject to all of the restrictions applicable to those securities in the same way that the restrictions apply to nonaffiliates. In addition, affiliates must continue to meet all of the conditions applicable to resales under Rule 144, without time limit.17 Affiliates selling unrestricted securities (for example, securities that they purchased in the open market or in a public offering) may do so at any time, subject to the applicable conditions.
Institutional Trading in Restricted Securities. The limitations on resales of restricted securities do not apply to transactions entirely among qualified institutional buyers (“QIBs”). QIBs are generally very large financial institutions, such as banks and insurance companies, that the SEC has determined not to be in need of the protection afforded to less sophisticated investors under the securities laws. QIBs may freely trade restricted securities among themselves, and there are markets set up that facilitate such trading. The markets are, of course, restricted to QIBs.
Private Resales of Restricted Securities. As written, the private placement exemptions apply to sales of securities by their issuers, and there exists no express rule under which an investor can resell restricted securities by limiting the offer and sale of the securities in the same manner that the issuer would limit such offers and sales if it were making the offer under a private placement exemption. Nevertheless, it is generally accepted that the resale of a restricted security is exempt if it is made under circumstances in which the sale would have been exempt as a private placement if made by the issuer. The analysis supporting this theory is excessively convoluted, but the principle is well established.
Insider Trading Considerations. As noted above, compliance with registration or exemption requirements does not relieve any participant in a securities sale from the obligation to make adequate and timely disclosure of material nonpublic information. This consideration is a particular issue for resales by affiliates, which may regularly be in possession of material inside information and, even if they are not, may be assumed to be in possession of such information. To avoid either the reality or the appearance of a problem in this area, affiliates are well advised to carefully consider the timing of any sales of securities. In general, it is best to make such sales in the period closely following the release by the issuer of a periodic report on its condition. A number of issuers address this issue by creating policies (either mandatory or advisory) that discourage or prohibit trading except during periods in which such trading is least likely to pose a problem. The fact that any particular trade occurs in compliance with these policies does not ensure that there is no insider trading problem, and any and all such trades should be evaluated with the issue in mind.
The burdens that these considerations impose on affiliates can be alleviated, at least for the purpose of permitting affiliates to engage in a regular program under which they dispose of securities, by adopting a plan under which the securities are automatically sold at certain times and under certain conditions. An affiliate that adopts such a plan is deemed to have material nonpublic information only if it had the information at the time the plan was adopted. The affiliate’s knowledge on the date of any particular sale is not relevant. Of course, the plan must provide (subject to some general ability to make amendments to the plan from time to time) for the automatic execution of the sales.
1Except where we specifically mention that we are describing other law, this chapter generally describes the applicable provisions of the federal securities laws and regulations. In very general terms, the equivalent state laws are likely to be similar, but there may be differences or separate filing and fee requirements that must be observed.
2There is some slight variation in the definition, but all variations are generally to the effect described above. 3Some lenders in connection with conventional loan arrangements require warrants or other derivative interests in addition to the normal interest provisions of the loan documents. In such cases, the loan documents themselves may not be securities but the warrants are securities.
4Federal securities laws are limited to regulating the process whereby information is disclosed in connection with securities transactions. State laws, as interpreted by state regulatory bodies, are not limited in this way, and most state laws have defined transactions that they deem to be “unfair” and that are prohibited without regard to the extent and accuracy of disclosure. In practice, the difference is largely theoretical because the SEC will usually attempt to use its regulatory authority to make it difficult to engage in transactions that the SEC believes to be substantially unfair, while state regulators will ordinarily grant exceptions to unfairness prohibitions in exchange for restrictions on sales to persons most likely to be victimized by any unfairness.
5Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. 6The application of different standards for securities transactions and normal commercial transactions has raised numerous issues concerning which standard is applicable to statements that are made in a commercial context but are seen and possibly relied on by parties in a securities transaction. As a very general proposition, a statement made in a regular commercial context that does not have the purpose or probable effect of conditioning the related securities market is not held to the securities standard. The matter is complex, however, and companies engaged in offering securities should discuss with counsel the appropriate policy with regard to general commercial disclosures.
7Please note that sales of securities solely to accredited investors do not require any specified body of information or form of disclosure; instead, the disclosure standard imposed by 10b-5 will drive the issuer’s obligations to prospective investors.
8Even without a registered offering, an issuer of securities can become subject to the requirements of the Exchange Act if it has total assets in excess of $10 million and a class of nonexempt equity security held of record by more than either (a) 2,000 persons or (b) 500 persons who are not accredited investors. Such a result could occur if a business engages in a series of exempt offerings over time.
9The use of private placement exemptions is not limited to private businesses. Public companies regularly engage in private placements as part of their capitalization program.
10Using open-access websites constitutes public solicitation if they contain an offer of securities, but websites that are restricted to a group of potential investors whose suitability has been determined in advance are permitted.
11The private placement exemption for offers and sales that do not involve public solicitation remains in effect; businesses can choose to pursue a placement involving public solicitation if the securities are offered and sold only to accredited investors. If sales are to be completed to nonaccredited investors, the placement must be conducted without public solicitation to qualify for the applicable exemption.
12An individual is an accredited investor if (1) his or her net worth exceeds $1 million (generally excluding both the person’s primary residence and debt associated with that residence), (2) his or her income exceeded $200,000 in each of the last two years, or (3) his or her joint income with spouse exceeded $300,000 in each of the last two years. Additionally, pursuant to amendments adopted by the SEC that became effective on December 8, 2020, individuals who hold certain professional certifications and individuals qualifying as “knowledgeable employees” of certain private funds qualify as accredited investors. A business or other entity, a trust, a family office or a family client of a family office, in each case that is not formed for the specific purpose of investing in the placement, is an accredited investor if it has total assets in excess of $5 million.
13It is also not uncommon for relatively small amounts of seed capital to be raised from friends and family at the very initial stages of a business. These investments also generally qualify under a private placement exemption, if properly conducted.
14 Certain regulation crowdfunding provisions became effective upon the publishing of the final rule on January 14, 2021.
15Securities Act Rule 152(a).
16These restrictions apply only to sales to which U.S. securities laws are generally applicable. Sales that take place entirely outside the United States may not be subject to limitation under U.S. securities laws.
17This restriction also applies to persons who, at the time of the resale, had recently been affiliates.