Securities Laws

Regulation D: Accredited Investors Only?

Registering with the Securities and Exchange Commission (SEC) often takes a lot of time and money that small businesses cannot afford to lose. Regulation D offers exemptions that let companies sell securities to accredited and non-accredited investors without going through the hassle of SEC registration. Before using Regulation D exemption rules, it is important to understand how they could affect your business.

The Basics of Regulation D

According to the Securities Act of 1933, individuals and businesses that sell securities have to either register with the SEC or meet an exemption. Regulation D outlines three rules that investors can use to avoid registration requirements. This lets qualifying companies sell securities without registering with the SEC. Companies that want to take advantage of Regulation D exemptions, however, must file the appropriate forms to ensure they are following rules and enter their information in the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database.

The Three Exemption Rules of Regulation D

Regulation D has three rules that can exempt companies from SEC registration.

Rule 504

Rule 504 is useful for companies that only plan to sell $1,000,000 of securities within a 12-month period. Companies that meet this requirement can have as many investors as they want. They can also pay commissions and resale securities.

Rule 505

Rule 505 is useful for companies that sell $5,000,000 or less within a 12-month period. Companies that choose this exemption may sell securities to no more than 35 non-accredited investors. They can, however, sell to an unlimited number of Reg D accredited investors.

Rule 506

Rule 506 does not enforce financial limitations. Companies can, therefore, sell any amount of securities to investors. Like those using Rule 505 for exemption, companies using Rule 506 can only have up to 35 non-accredited investors. They can have an unlimited number of Regulation D accredited investors.

Rule 506 gives companies a little more responsibility when choosing investors. While they can sell to non-accredited investors, they must make sure that each investor meets a sophistication standard. The individual investor may meet this standard on his or her own, or by working in conjunction with a Purchaser Representative who understands the industry well.

Important Differences Between Reg D Exemption Rules

Financial restrictions are the most obvious differences between these three rules. If a company wants to sell more than $1,000,000 in securities, then it cannot claim the 504 exemption. 504, however, does let the company sell to an unlimited number of accredited investor Regulation D and non-accredited investors. The looser regulation makes sense within the industry because the company is working with relatively small amounts of money.

Rule 505 restricts security sales to $5,000,000 or less. It also prevents companies from using general solicitation and advertising to attract investors.

Rule 506 differentiates itself from 504 and 505 in two important ways. First, it doesn’t restrict the amount of securities that companies can sell. Second, it lets companies use general solicitation and advertising to attract investors. Rule 506 prevented general solicitation until the JOBS Act of 2012. According to Forces writer Cheryl Conner, this change to the Reg D program could add a trillion dollars of new funding to the industry.

Finding and Approaching Investors Without Breaking Reg D Rules

The exemption rule that a company uses can significantly influence how they find and approach investors. Any company that gets an exemption from Rule 504 or 505 will need to find investors privately without using an advertisement or anything that could be construed as general solicitation. That means they cannot advertise in newspapers, billboards, the Internet, or any other public forum.  

Companies that claim an exemption under Rule 506, however, can attract investors via any of these methods.

They can purchase a list of investors; create websites to collect leads; make billboards advertising their investment options; air commercials on TV; or use any number of advertising strategies that might attract more investors.

Once a potential investor contacts the company about buying securities, though, the company must make sure that the investor has a sophisticated understanding of the industry. This creates a kind of self-regulation that makes it harder for unscrupulous companies to take advantage of investors who don’t understand the risks and options when buying securities.

Reg D exemptions are extremely helpful to companies that want to sell securities. The exemption that you take should depend on your business’s specific needs.

Money Manager Charged With False Advertising

New York, NY: The Securities and Exchange Commission (SEC) has charged a New York based money manager and his firm of false advertising.

The charges stem from claims made by the company on their Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund that the firm manages.

In an SEC order issued against Mark A. Grimaldi and Navigator Money Management (NMM), the SEC found that they selectively promoted and touted the performance of the Sector Rotation Fund (NAVFX) and specific securities recommendations they had made to client in the past. The order found that the firm cherry picked what it chose to highlight, while excluding less favorable data and relevant facts that would have painted a more complete picture.

“The securities laws require investment advisers to be honest and fully forthcoming in their advertising to give investors the full picture.

Grimaldi and his firm are being held accountable for using social media and widely disseminated newsletters to cherry-pick information and make misleading claims about their success in an effort to attract more business.” said Sanjay Wadhwa, senior associate director for enforcement in the SEC’s New York Regional Office.

According to the SEC’s order, The Money Navigator is a newsletter which was used extensively by Grimaldi and NMM to solicit clients. For the Sector Rotation Fund. Grimaldi, who is the majority owner, president and, Chief Compliance Officer of NMM, promoted their successes in a way that was misleading and did not give a full accounting. For example, according to the details provided in the SEC order they misleadingly claimed in a December 2011 newsletter that Sector Rotation Fund was “ranked number 1 out of 375 World Allocation funds tracked by Morningstar.”  However, a time period of Oct. 13, 2010 to Oct. 12, 2011 was cherry-picked to broadly acclaim that ranking, and Sector Rotation Fund had a poorer relative performance during other time periods.  From Jan. 1 to Nov. 30, 2011, the day before Grimaldi published the ad, at least 100 other mutual funds in that same Morningstar category outperformed Sector Rotation Fund.

The investigation and subsequent SEC order process began in 2008, when the SEC conducted an investigation of NMM and a fund it manages.

The SEC staff conducting the investigation then informed NMM that the newsletters could be considered a solicitation or advertisement under Rule 206(4)-1, which generally prohibits false or misleading advertisements by investment advisers.  SEC staff also noted that the newsletters could be considered advertisements under Rule 482, which governs advertisements for mutual funds and other investment companies and has specific requirements for ads containing performance data.

Other violations detailed in the order claim that NMM was advertised as a “five star (Morningstar) money manager” in the newsletters, on the website, and in emails sent out. This would be misleading because Morningstar rates mutual funds, not investment advisors. Grimaldi is also found to have made misleading statements on Twitter. He claimed responsibility for model portfolios in his newsletters that “doubled the S&P 500 the last 10 years.”  However, Grimaldi made the claim even though he had no involvement in the model portfolio performance for the first three years.

Grimaldi and NMM, without admitting to any of the specific finding have agreed to pay a $100,000 fine, to be censured, and to comply with certain undertakings including the retention of an independent compliance consulting company for three years. The company also agreed to cease and desist from future violations of these sections of Securities Laws.

Advertising, regardless of their source, can often be misleading with even small discrepancies painting an entirely different picture from reality. Vetting and conducting due diligence is highly recommended for any investor, regardless of whom you are dealing with or what the level of interaction.

Accredited Investors and Blue Sky Laws is a leading seller of accredited investor lead lists. Marketers who use our lists to offer private placements should always be aware of the state regulations governing offerings that have been exempted from registration by the Securities and Exchange Commission, since these offerings may also require exemption from state regulations. If an offering is exempt under the Federal securities laws, it does not necessarily imply exemption from state regulations. These state regulations are dubbed blue sky laws because they are aimed at defending potential investors from being duped into purchasing securities with “as much value as a patch of blue sky”.

Thus, state blue sky laws have been established to protect the public from fraud. Each state has its own unique set of laws, but they all lay out regulations for the registration and exemption of securities sold within the state. Also, each state has its own regulatory body to enforce its laws and specify the legal basis for civil law suits. Forty states have adopted model uniform securities statutes, arising from the Uniform Securities Act of 1956, upon which they base their blue sky laws.

In recent years, Federal laws were passed which circumscribed the power of the states to critique, confine or otherwise limit the sale of most securities. The law’s purpose was to remove redundancies occurring among Federal and state securities laws. Currently, the abilities of most states to prohibit registration or exemption from registration of securities offerings that are made on a national or regional basis have been substantially limited. Nonetheless, there are still notice and filing requirements in each state that must be observed. Additionally, Federal legislation did not remove the authority of the state regulators to lead investigations and to pursue legal actions for fraud.

Fortuitously, many kinds of securities, and many security transactions, are exempt from state registration rules. Exemptions under Rule 506  of Regulation D are not subject to state review, with the exception of New York State. Many states provide exemptions for Regulation D private placements, as long as there is complete observance of SEC Rules 501-503. However, though particular kinds of offerings or transactions may not necessitate registration, many states demand filings or place extra conditions on exemptions. An issuer, before offering an exempt security for sale in any state, should retain experienced blue sky counsel to assess the pertinent state regulations and take whatever steps are needed to allow the offering to be made in any given state.

Eric Bank