Understanding Regulation D: A Quick Guide for Issuers

Whether large or small, public or private, all companies have one thing in common: they all need capital to fund, run, and grow their business. 

But raising capital — whether as a start-up or established company — is fraught with complexities and challenges.

As we will discuss in more detail below, Regulation D (or “Reg. D”) of the Securities Act of 1933 (“Securities Act”) allows issuers to raise capital without having to go through the burdensome and expensive process of registering their securities with the Securities and Exchange Commission (SEC).

But complying with Reg. D isn’t always that easy or straightforward.

Issuers can unwittingly misstep when trying to take “reasonable steps” to verify every single investor.

Failing to comply with all applicable laws, both state and federal, can have serious consequences.

Reg. D violations can result in severe penalties or even civil or criminal liability. Failing to verify accreditation status of even one investor could result in the issuer having to return all investments. Worse, the consequences of non-compliance may affect current and future offerings.

Not good.

So if you are an issuer, understanding Reg. D is absolutely critical.

Below, we present a basic guide to Regulation D for issuers. This overview should give you a good starting point for understanding Reg. D as an issuer, but keep in mind that this is a highly complex and complicated area of law. Therefore, always consult with the proper business and legal professionals for guidance, and use top-notch services to verify accredited investor status for your Reg. D offerings.

Understanding Regulation D: A Quick Guide for Issuers

Most businesses typically raise money through the sale of securities — stocks, bonds, convertible notes, and more. The term “securities” covers a broad range of investments.

Both state and federal laws govern how companies can raise capital from investors. These laws are often complex and difficult to understand. Moreover, especially for smaller companies, complying with them is both time-consuming and expensive.

At the federal level, the Securities Act of 1933 (“Securities Act”) governs the sale and exchange of securities. The Securities Act requires all public offerings of securities to be registered with the federal regulatory body, the Securities and Exchange Commission (SEC).

Unfortunately, raising money through public offerings and going through the SEC’s registration and reporting process can be prohibitively expensive for smaller companies. Plus, public offerings don’t always meet a company’s internal goals.

On the other hand, not complying with the registration laws can have drastic consequences for an issuer. Failing to register securities with the SEC grants a purchaser the right to sue to rescind the purchase and/or to seek damages against the issuer.

So, if you are an issuer, what can you do?

Is there a way for companies that can’t afford to register or conduct an initial public offering (IPO) to raise money from investors without having to register their securities with the SEC?

Yes.

…Enter Regulation D

The answer lies in the exemptions carved out by the SEC’s Regulation D (“Reg. D”) and its accompanying rules (Rules 504, 505, and 506.)

Aware of the difficulties registering securities with the SEC posed for smaller companies, over the years, the SEC and Congress created exemptions to the securities registration mandate. These exemptions allow companies to raise funds without having to register their securities or go through the public offering process.

As an issuer, (i.e., a legal entity that develops and sells securities to finance its operations), understanding Regulation D (or “Reg. D”) is vital. The law provides important exemptions from the SEC’s registration requirements for securities sales or offerings and makes it easier, faster, and less expensive for smaller companies and start-ups to raise capital.

But there’s a catch…

The requirements of Reg. D must be followed explicitly. Failing to comply with Reg. D’s requirements could cost an issuer its entire offering.

Regulation D Offerings Are a Type of Private Placement.

Similar to a private placement, Reg. D offerings allow companies to raise capital from accredited investors through the sale of equity or debt securities without having to register those securities with the SEC.

Private placements, also called “unregistered offerings” by the SEC, consist of the sale of securities to individual, pre-selected investors rather than conducting an initial public offering (IPO). These offerings are used to raise capital from private investors. They are exempt from the comprehensive disclosure requirements mandated for registered offerings.

Unregistered offerings cannot be publicly advertised, and, although disclosure requirements are limited, in practice, most companies do provide some level of disclosure through the use of a private placement memorandum (PPM) rather than the more detailed prospectus commonly used for registered offerings.

Regulation D is composed of several separate SEC rules. This allows issuers to choose which exemption best fits how they want to sell their unregistered securities to accredited investors. 

Rules 504, 505, and 506.

The three separate rules that makeup Reg. D are Rules 504*, 505* and 506. Each one of these rules has its own specific requirements that an issuer must meet to qualify for that particular exemption.

(*Note: The Rule 505 exemption was repealed in 2017, but it was not completely deleted. Instead, many of its provisions were integrated into Rule 504. Since Rule 504 applies to very specific companies and is used infrequently, we will focus our discussion on Rule 506.)

Before an issuer can sell or issue unregistered securities, it must choose the correct exemption that fits its business model best.

As each Reg. D rule has distinct advantages and disadvantages, it is essential for issuers to consult with experienced securities counsel and other business professionals before acting under Reg. D. 

Before we get too deep into Reg. D’s requirements, keep in mind that the federal securities laws are not the only laws that apply to issuers. Each state has its own securities laws (referred to as “blue sky” laws) which issuers need to know and must comply with. As always, it is best to consult with your securities counsel for advice and information.

Exemptions Under Rule 506.

The most common Reg. D exemption used by most issuers is found in Rule 506.

Rule 506 allows companies to raise an unlimited amount of money — as long as all the rule’s specific requirements are met.

Rule 506 has two subsections that provide registration exemptions — 506 (b) and 506(c).

We will look at each subsection in turn.

Rule 506(b) and the Interface with Section 4(a)(2).

Rule 506 (b) provides a “safe harbor” (discussed below) for Section 4(a)(2) of the Securities Act.

Before we discuss the “safe harbor” aspects of Reg. D, it may be best to briefly explain the requirements of Section 4(a)(2) of the Securities Act.

Section 4(a)(2) exempts “private placement” transactions — i.e., sales or offerings to sophisticated private investors that do not involve public offerings — from the registration requirements.

However, the exemption applies only to those specific offerings made under Section 4(a)(2) and extends to the issuer only. Thus, anyone who acquires securities from the issuer under Section 4(a)(2) cannot resell those securities without registering them.

In addition, Section 4 (a)(2) mandates that the sale or offering be directed to a “sophisticated investor.”

Exactly who qualifies as a “sophisticated investor” for purposes of Section 4(a)(2) is not defined by the SEC. Generally speaking, however, a “sophisticated investor” tends to be:

•                 an individual or entity with considerable knowledge and experience in investing,

•                 an individual or entity with considerable financial means,

•                 an individual or entity with access to professional advice,

•                 an individual or entity that can do their own research and make an informed decision regarding investments and investment risks.

The SEC considers sophisticated investors (and “accredited investors” under Reg. D is capable of making informed investment decisions and understanding the risks of investment, thus not in need of being protected the way a non-accredited investor might be.

Under Section 4(a)(2), the number of investors is generally limited — although there is no exact number. In addition, general solicitation or advertising of the offering is not allowed because that would constitute a “public offering.”

In sum, then, Section 4(a)(2) exempts securities from registration for issuers only, so long as the offerings are “private placement” transactions, are made to sophisticated investors, the number of investors is limited, and the offerings are made privately and not by general solicitation or advertising. Finally, the resale of Section 4(a)(2) securities is restricted.

This is all well and good, but, as noted above, the law does not specifically define who is a “sophisticated investor.” Plus, Section 4(a)(2) does not allow companies to advertise their offerings.

So how could issuers keep from running afoul of Section 4(a)(2) when making private placements?

The upshot was that an issuer had to have a preexisting relationship with their sophisticated investors.

This in turn meant that companies either needed to know their investors directly before the offering, or they had to be directly introduced to them. Not surprisingly, this made raising capital slow and difficult.

For more than 80 years, this was the only legal avenue available to issuers to conduct private placement offerings.

Then, in 2012, all that changed.

Rule 506 and the JOBS Act.

In 2012, President Obama signed the Jumpstart Our Business Startups (“JOBS”) Act into law. The JOBS Act required the SEC to amend the Securities Act to provide exemptions — particularly for smaller companies — that would allow issuers to raise capital without having to register their securities.

For our purposes here, suffice it to say that the SEC amended Rule 506 of Regulation D in order to implement the JOBS Act.

The amendments created subparts to Rule 506 and lifted the historical ban on advertising unregistered securities. They also allowed issuers to solicit investors for private offerings — so long as the specific conditions of Rule 506 (b) or 506 (c) were met.

Rule 506(b)

As noted above, Rule 506(b) provides a “safe harbor” for companies by establishing objective standards a company can rely on to qualify for Section 4(a)(2) exemption status.

Under Rule 506(b), a company may:

•        raise an unlimited amount of capital, and

•        sell securities to an unlimited number of accredited investors.

But a company may NOT:

•        engage in advertising or general solicitation to market its offerings, or

•        sell securities to more than 35 non-accredited investors.

Securities purchased under Rule 506(b) are restricted securities.

In addition, if non-accredited investors are participating in the offering, the company has additional disclosure requirements it must fulfill. Plus, any information the company provides to accredited investors, must be provided to non-accredited investors.

Rule 506(c)

Under Rule 506(c), a company is allowed to:

•        raise an unlimited amount of capital, and

•        advertise and generally solicit securities offerings, so long as

•        all purchasers are accredited investors, and the issuer takes “reasonable steps to verify” the accredited investor status of each investor.

As an issuer, then, what you need to understand about Reg. D 506(c), is that all investors must be accredited investors and you must act — i.e., take “reasonable steps” — to verify their accredited investor status.

Rule 506(c) provides issuers with two ways to do this.

1. The principles-based method, or

2. The non-exclusive “safe harbor” verification method.

The principles-based method requires an issuer to use his best judgment to verify an investor’s accredited status. To do this, the issuer must consider factors such as:

•        the nature of the purchaser and the type of accredited investor that the purchaser claims to be,

•        the amount and type of information that the issuer has about the purchaser, and

•        the nature of the offering, including the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

Relying on one’s own judgment to verify investor status is allowed, but it has its risks. If for any reason it is determined that any single investor was not properly verified, the issuer could lose the entire Rule 506(c) exemption for their offering.

The non-exclusive “safe harbor” verification method of Rule 506 (c) for verifying the accredited status of individual investors avoids the pitfalls of using one’s judgment to verify an investor. Under this approach, “reasonable steps to verify” include doing any or all of the following:

•        obtaining and reviewing recent tax documents to verify an investor’s income,

•        obtaining and reviewing credit reports, bank statements, brokerage statements, real estate appraisals, and other such documents to verify a person’s net worth,

•        verification of accredited investor status through third-party licensed or registered professionals.

Verifying accredited investor status is critical if an issuer wants to use the 506(c) exemption. Every single investor must be accredited, and the issuer must take “reasonable steps to verify” that status in order to meet the Rule’s requirements.

The Importance of Accredited Investor Status.

As can be seen from the foregoing, the SEC allows only accredited investors to participate in certain offerings and severely limits the number of non-accredited investors participating in unregistered offerings.

Why is that?

Well, the thinking behind this is that less experienced or unsophisticated investors need to be protected from fraud or unexpected losses that can arise from the lack of disclosures required for unregistered offerings. 

On the other hand, accredited investors are considered by the SEC to be (or are verified to be) sophisticated and experienced enough to judge the risks for themselves and are considered to be financially capable of withstanding any loss of investment.

Rule 501(a) of Reg. D defines “accredited investor.” In short, the definition includes:

•        individuals that have a high-income net worth, or

•        companies or financial institutions that have more than $5 million in assets, or

•        companies or financial institutions whose equity owners are all accredited investors.

In 2020, the SEC expanded its definition of accredited investor to allow more individuals and entities to take part in private offerings under Reg. D. The definition of “accredited investor” now includes:

•        knowledgeable employees,

•        registered investment advisors, exempt reporting advisers, and rural business investment companies,

•        a catch-all provision for entities that own more than $50 million, and

•        family offices and family clients.

The SEC’s tradeoff for allowing public advertisement of nonregistered offerings and expanding who may participate in those offerings was the requirement that issuers verify accredited investor status. 

How to Verify Investor Status.

Issuers wanting to verify investor status generally have four (4) different approaches they can take to verify an investor as accredited. Each one requires getting sufficient documentation from the investor to allow the issuer to verify the investor as accredited on that particular ground.

The 4 different methods are:

1. Proving that the investor is an insider. Investors who are “insiders,” such as those who hold the position of director, executive officer or general partner of the issuer, are considered to be accredited investors.

2. Professional letter(s) as proof of accredited status. This requires getting a letter from a licensed attorney, registered broker-dealer, investment adviser registered with the SEC, or certified public accountant, attesting that reasonable steps were taken to verify the investor’s accredited investor status.

3. Prove the investor’s income meets the law’s requirements. Accredited investor status can be based on an individual’s income. Getting proof that the investor meets the law’s income requirements can be done with tax documents, pay stubs, or other official documents showing the individual’s income exceeded $200,000 in each of the two most recent years, or that his or her joint income with a spouse was $300,000 over the same 2 years, and that his/her income is expected to continue at that level.

4. Prove the investor’s net worth meets the law’s requirements. Another way an investor can prove he is accredited by disclosing his assets and liabilities to show that, as a natural person, his or her individual net worth exceeds $1,0000, or that his or her joint net worth with a spouse exceeds $1,000,000 — excluding the value of the primary residence. This can be done through obtaining documents such as credit reports, IRS forms, deeds or third-party valuations of property the investor may own.

Each means of verifying investor status has its own advantages and disadvantages, of course, but overall, the process requires collecting, reviewing, and analyzing a significant number of documents.

And you need to do this for…

Every. Single. Investor.

There is no denying that the process is cumbersome, time-consuming, and expensive for an issuer to do.

But it is essential for any issuer trying to qualify for an exemption under Reg. D.

Fortunately, the law allows issuers to use third-party verification providers to verify the accredited investor status of their investors.

Taking “reasonable steps” to verify the accredited investor status of all your potential investors by using a third-party verification from the leading resource for verifying accredited investors as required by federal laws is the fastest and most reliable way of verifying the status of your investors. 

VerifyInvestor.com provides a fast, easy, cost-effective, and highly confidential way for issuers to verify their investors. Using VerifyInvestor.com to verify all your investors can shield you from the potential risks of noncompliance — including enforcement action or having to return funds to disgruntled investors. It’s good for you and it’s good for your investors.