Private Placement

A private placement is an offer and sale of securities that is exempt from registration with the Securities and Exchange Commission because it is not a public offering. The exemption comes from section 4(a)(2) of the Securities Act of 1933, which covers "transactions by an issuer not involving any public offering." Because that phrase is a judgment rather than a checklist, issuers rely on a rule that converts it into conditions they can satisfy: 17 CFR 230.506, better known as Rule 506 of Regulation D, states that an offering meeting its conditions "shall be deemed to be transactions not involving any public offering within the meaning of section 4(a)(2) of the Act."

Two names describe one thing here, which is worth saying plainly because readers meet both. The market calls the transaction a private placement; the regulation calls it a Rule 506 offering, or loosely a Regulation D offering. The SEC uses the two together, titling its own small-business page "Private Placements - Rule 506(b)." The one place the names come apart is Rule 504, covered below: it is a Regulation D exemption that is not a section 4(a)(2) safe harbor at all.

Rule 506 has two branches, and the difference is advertising.

Under Rule 506(b), the issuer may sell to an unlimited number of accredited investors and to no more than 35 other purchasers in any 90-calendar-day period. That number is the single most misquoted figure in this subject, because the limit and its exclusion sit in different sections. Rule 506(b)(2)(i) caps "35 purchasers," and section 230.501(e)(1)(iv) then provides that, for counting purchasers under Rule 506(b) only, "any accredited investor" is excluded. Read alone the rule says an offering may have 35 investors; read with the section next door it says 35 non-accredited purchasers plus as many accredited investors as the issuer can find. Section 230.501(e) also excludes relatives sharing the purchaser's primary residence, and counts an entity as one purchaser unless it was organized specifically to buy the securities and is not itself accredited, in which case each beneficial owner counts separately.

Each non-accredited purchaser in a 506(b) offering must be sophisticated: section 230.506(b)(2)(ii) requires "such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment," alone or with a purchaser representative. A 506(b) offering also may not be marketed publicly, because section 230.502(c) bars any "general solicitation or general advertising," and names newspaper, magazine, television and radio communications and any seminar whose attendees were invited by general advertising.

Rule 506(c), added in 2013, inverts that trade. General solicitation is permitted, so the offering can be advertised openly, but all purchasers must be accredited investors and the issuer must "take reasonable steps to verify" it rather than accept a checked box. The rule lists five non-exclusive, non-mandatory ways to do that, including reviewing IRS income forms for the two most recent years, reviewing asset documentation dated within the prior three months plus a consumer report covering liabilities, or obtaining written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant.

What the purchaser gives up is disclosure, review and liquidity. There is no SEC review of a Regulation D offering at any point. The only filing is Form D, a notice due no later than 15 calendar days after the first sale, which the SEC describes as "a brief notice that includes the names and addresses of the company's promoters, executive officers and directors, and some details about the offering," but which "contains little other information about the company." Nor is there a required information package for an accredited buyer: section 230.502(b)(1) requires the specified financial and non-financial information only when a 506(b) issuer sells to someone who is not accredited, and states that the issuer "is not required to furnish the specified information to purchasers when it sells securities under section 230.504, or to any accredited investor." The securities themselves are restricted securities under section 230.502(d), which provides that they "cannot be resold without registration under the Act or an exemption therefrom" and directs the issuer to place a legend on the certificate saying so.

Two protections do survive. The antifraud provisions apply regardless of the exemption, so any information the issuer does provide must be free of false or misleading statements, and an omission that makes the rest misleading is barred as well. And Rule 506(d) disqualifies an offering entirely if the issuer or a long list of related people, including any 20 percent beneficial owner and anyone paid to solicit purchasers, has one of eight kinds of disqualifying event, such as a securities-related criminal conviction within the previous ten years (five, in the case of the issuer itself, its predecessors and affiliated issuers) or a Commission order barring them from the business.

State law is preempted for Rule 506, but not erased. Under 15 U.S.C. 77r(b)(4)(F) a security sold under a rule adopted pursuant to section 4(a)(2) is a covered security, so states cannot require registration, "except that this subparagraph does not prohibit a State from imposing notice filing requirements" substantially similar to those in effect on September 1, 1996. Section 77r(c)(1) separately preserves each state's authority to investigate and bring enforcement actions for fraud or deceit. The practical result is that a state regulator may hold a notice filing and a fee for the offering, and may prosecute a fraud in it, but does not pass on its merits.

Regulation D is broader than "private placement," because of Rule 504. Section 230.504 exempts offerings of up to $10,000,000 in a 12-month period, and both of the conditions that make a Reg D offering look private are written with a Rule 504 carve-out. Section 230.502(c)'s advertising ban applies "Except as provided in section 230.504(b)(1) or section 230.506(c)," and section 230.502(d)'s resale restriction applies "Except as provided in section 230.504(b)(1)." Section 230.504(b)(1) turns those exceptions on when the offering is registered in a state that requires a substantive disclosure document delivered before sale, or is made exclusively under state exemptions that permit general advertising to accredited investors. A Rule 504 offering taking one of those routes can be publicly solicited and sold free of resale restrictions, which is the opposite of a private placement in the section 4(a)(2) sense. This is also why the SEC tells investors to ask a state regulator whether it received notice of the offering "or, in the case of a Rule 504 offering, cleared the offering for sale in your state."

One consumer-facing consequence of the structure deserves stating as a fact about how these deals are sold rather than as a warning. Because there is no registration statement, no SEC review and, for an all-accredited offering, no mandated information package, the quality of what a buyer learns depends almost entirely on what the seller chooses to hand over, and the people distributing the offering are paid for placing it. The SEC notes in its own investor materials that while many unregistered offerings are legitimate, fraudsters also use them, precisely because so little has to be filed.

The mechanics of a Rule 506 offering run in a fixed order. The issuer decides which branch it wants, because that choice governs how it may find investors. It prepares whatever offering materials it intends to use, most often a private placement memorandum, a subscription agreement and the entity's governing documents. It then either approaches investors privately, under 506(b), or advertises and verifies accredited status, under 506(c). It sells the securities, files Form D within 15 calendar days of the first sale, makes any state notice filings, and issues certificates or book entries carrying the restrictive legend. The investor's money is committed from that point until the issuer creates a liquidity event, because the securities are restricted and there is no market to sell them into.

A hypothetical example of the counting rule, which is where issuers get into trouble. A start-up raises $5,000,000 under Rule 506(b) from 60 investors. Of those, 55 are accredited and 5 are not. Because section 230.501(e)(1)(iv) excludes accredited investors from the count, the issuer has 5 purchasers for the 35-purchaser test, not 60, and is well inside the limit. It must, however, furnish each of those 5 the information specified in section 230.502(b)(2), and must conclude that each of them is sophisticated enough to evaluate the deal. If the same issuer had instead advertised the round on social media, it would have been relying on Rule 506(c), where all 60 purchasers would have had to be accredited and individually verified, and those 5 sales would have broken the exemption for the entire offering.

Pros

• Lets an issuer raise capital without the cost, delay and continuing reporting obligations of a registered offering, and with no dollar ceiling under Rule 506.
• Gives investors access to companies and funds that never come to the public market, which is how most hedge funds, private equity funds, venture funds and real estate syndications are sold.
• Federal preemption under 15 U.S.C. 77r(b)(4)(F) means a Rule 506 issuer faces state notice filings rather than fifty separate registrations.
• The antifraud rules still apply, and Rule 506(d) locks out issuers and promoters with a disqualifying enforcement or criminal history.

Cons

• No SEC review of the offering, and Form D is a notice filed after the first sale rather than a disclosure document reviewed before it.
• An accredited purchaser is owed no specified information at all under section 230.502(b)(1), so the amount of diligence material is the seller's choice.
• The securities are restricted and cannot be resold without registration or an exemption, so the holding period is open-ended and set by the issuer.
• Valuations are not marked by a market, so a reported value between the purchase and an exit is an estimate rather than a price.
• The structure's thin filing requirements are also what makes it attractive to fraudulent offerings, which is why the SEC's investor alerts on unregistered offerings exist.