Exemptions to Registering Federal Securities with the SEC

When forming a California limited liability company (LLC) or corporation, it is important that the owners determine whether any of the ownership interests in the company will be treated as a security.  Under federal and state law, if one or more co-owners of a corporation (shareholders) or an LLC (members) seek to invest in the company for profit only, and do not wish to actually work for the company or take an active role in its management, the ownership interest will be treated as a security.  Essentially, a security interest is an ownership interest that is passive in nature (like investing in the stock market).  An ownership interest is not a security if all shareholders or LLC members actively participate in the company’s operations.  In such cases, there is no need for the owners to worry about qualifying for an exemption.  

courtroom-1-1207444-m.jpgRegistering with the SEC vs. Qualifying for an Exemption

LLCs and corporations with security interests are subject to securities laws governed by the Securities Act of 1923 and regulated by the Securities Exchange Commission (SEC). Registering securities can be a complex process requiring that the company provide investors various documents such as financial statements, documentation and other information designed to ensure that potential investors are able to make informed decisions prior to investing.  However, the SEC and state regulators have promulgated a number of exemptions allowing LLCs and corporations to avoid the complex process of registering securities. Once the owners of a company determine that the interest being sold is indeed a security, it must next determine whether the sale qualifies for an exemption.  State and federal exemptions are not identical but typically sales of securities that qualify for a federal exemption also qualify for state exemptions.  If the sale qualifies for an exemption, the next step is to apply for the exemption with the appropriate federal and state securities agencies.  This process is far less complicated than registering securities with the SEC.  

Summary of Commonly Used Federal Exemptions

The following is a brief summary of the most common exemptions to the federal registration requirement found in the Securities Act:

  • Government Securities: Any government treasuries or municipal bonds.
  • Non-Public Offering Exemption: Where the sale of the security is to “sophisticated investors” who have the financial means and have sufficient knowledge in business and investments.  The investor must have full access to information and agree not to redistribute the securities to the public.
  • Single State Offerings: Intrastate companies qualify for a federal exemption to the registration requirement.   An intrastate company is a company that does all of its business in a single state.  To qualify as an intrastate company, an LLC or corporation must:
    • Be incorporated or organized in the state the security is being offered or sold in; 
    • Have its principal place of business in such state; 
    • Be owned entirely by investors who are bona fide residents of such state; 
    • Maintain at least 80 percent of the company’s assets in such state;
    • Derive at least 80 percent of its gross revenues from such state; and
    • Use at least 80 percent of its net proceeds within such state.

    • Accredited Investors Exemption:  Accredited Investors include: banks, insurance companies and registered investment companies: employee benefit plans under certain circumstances; charitable organizations, corporations and partnerships with assets exceeding $5,000,000; directors, officers or general partners of companies selling securities; businesses whose owners are themselves accredited investors; persons who have a net worth exceeding $1,000,000 (excluding the value of any primary residence); persons with income in excess of $200,000 per year for the last two years (or $300,000 for a married couple); an trusts with assets in excess of $5,000,000.    
    • Regulation A: An exemption for public offerings that do not exceed $5 million in a 12-month period, as long as the company files an offering statement with the SEC including an offering circular, exhibits and notification.
    • Rule 504: Sales up to one million dollars in securities within a 12-month period are exempt from registration with some restrictions.  Generally, companies are not allowed to solicit or advertise the securities to the public.  Purchasers, with some exceptions, receive “restricted” securities limiting their ability to sell. 
    • Rule 505: Sales of up to five million dollars in securities within a 12-month period are exempt from registration. The company can sell securities to an unlimited amount of accredited investors and up to 35 non-accredited investors. The company must also inform investors that the the securities are “restricted” meaning that they cannot be sold for six months or longer without being registered.  If securities are sold to non-accredited investors, they must be given disclosure documents similar to the disclosure documents required when registration securities.  Finally, the company cannot solicit or advertise the securities to the public.  If a company qualifies for the Rule 505 exemption, it must file Form D (a simple notice that includes the names and addresses of the company’s owners and promoters). 

    The above information is only a summary of the various exemptions and the associated requirements.  Qualifying for each exemption requires a more detailed analysis.  Each of the exemption provisions are also subject to federal anti-fraud laws, and every company is responsible for being honest and accurate regarding the securities offered. Additionally, although a company may be exempt from registering securities with the SEC, there may still be state requirements.  If you have questions regarding which exemptions your security offering may qualify for, contact an experienced San Diego corporate attorney today.

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