Chapter 2: Regulations of Securities and Issuers - D. Exemptions Flashcards
Exempt securities – definition
A security that is classified as an exempt security is exempt from both state registration requirements and advertising filing requirements.
Even if a security is exempt from registration requirements, it is still subject to the antifraud provisions of the Uniform Securities Act. It is important to remember that no one or nothing is ever exempt from antifraud provisions of the USA.
Exempt securities – list
The Act specifies the following as exempt securities:
- 1) Any security issued by the U.S. government, any municipality, or agency of the government or any state;
- 2) Canadian (local and national) government securities and securities of other foreign governments with which the United States maintains diplomatic relations;
- 3) Issues of banks, savings and loans, trusts companies, and federal credit unions. This exemption does not apply to bank holding companies;
- 4) Building and loan association issues;
- 5) Insurance company issues, with the exception of variable contracts;
- 6) Railroad and common carrier issues regulated by the Interstate Commerce Commission;
- 7) Public utility issues regulated by the Public Utility Holding Company Act of 1935;
- 8) Any security listed on the New York Stock Exchange or any other exchange that has registered with the SEC or is included in the Nasdaq system, including the rights or warrants to purchase these issues, and any other exchange approved by the administrator (aka federal covered securities);
- 9) Issues of nonprofit or charitable organizations and professional trade associations and cooperatives;
- 10) Promissory notes that mature in 9 months (270 days) or less that are issued in denominations of at least $50,000, and carry a rating in one of the 3 highest categories of a nationally recognized rating organization. This essentially exempts corporate commercial paper;
- 11) Securities issued for employee savings plans, pension plans, profit sharing, and stock purchase plans; and
- 12) Municipal notes and bonds sold outside the state in which they were originally issued.
Federal covered securities – definition
The National Securities Markets Improvement Act of 1996 (NSMIA) established the term “federal covered security.” These are nationally traded securities, and are covered under federal rules that preempt states from regulating their public offerings, proxy solicitations, and periodic disclosures.
Regarding federal covered securities, states cannot require registration, subject the offering to a state review, or regulate any of the offering documents.
States can require issuers to file a notice, consent to service of process, and require the payment of a registration fee, even though the state cannot require full registration. These rules, however, do not apply to NYSE or Nasdaq securities. A state can also initiate investigation and enforcement actions for fraud, deceit, or unlawful conduct against a broker/dealer or its agents in conjunction with the offer or sale of federal covered securities.
Federal covered securities – list
The list of federal covered securities includes the following:
- 1) Securities listed on the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotation (Nasdaq), or any other national exchange determined by the SEC as having similar listing standards;
- 2) An issuer’s securities that have equal or greater seniority than a listed security;
- 3) Securities that are offered or sold to qualified purchasers. The SEC definition of a qualified purchaser encompasses sophisticated investors;
- 4) Securities issued by investment companies registered under the Investment Company Act of 1940, including face amount certificates, unit investment trusts, closed-end management companies, and open-end management companies (mutual funds);
- 5) Any security issued by the federal government or federal government agency;
- 6) Any security issued by a financial institution regulated by the Federal Reserve Board;
- 7) Certain private placements, such as Regulation D offerings; and
- 8) Municipal securities, except that municipal securities are not federal covered securities within the issuer’s state.
Exempt transactions under state law – definition
Exempt transactions are generally trades that do not involve the public.
A security offered in an exempt transaction does not have to be registered in the state. Individuals who represent issuers in exempt transactions are excluded from the definition of an agent as discussed earlier. These individuals also do not have to be registered. Note that individuals who represent broker/dealers in exempt transactions are not exempt from registration unless the broker/dealer itself is exempt. Note also that exempt transactions are subject to the antifraud provisions of the Uniform Securities Act.
Exempt transactions under state law – list
- 1) Isolated nonissuer transactions.These are secondary market trades for the benefit of a person other than the issuer. Typically, these transactions are limited to between 3 and 5 trades within a 12-month period, and, in order to take advantage of the exemption, the broker/dealer cannot be a resident of the state;
- 2) Certain nonissuer transactions in outstanding securities that are subject to the registration and reporting requirements of the Securities Exchange Act of 1934, trading of issues registered under the Investment Company Act of 1940, or transactions by companies that have been reporting to the SEC for a period of at least 180 days (6 months) prior to the transaction;
- 3) An unsolicited nonissuer transaction effected through a registered broker/dealer. The administrator typically requires that the broker/dealer retain on file a documented nonsolicited statement from the client;
- 4) Fiduciary transactions made by others - executors, administrators, sheriffs, marshals, trustees in bankruptcies, guardians, or conservators;
- 5) Transactions between issuers and underwriters;
- 6) Real estate mortgages or deeds of trusts where the entire mortgage or deed, together with the bonds, is sold as an entire unit;
- 7) A transaction by a bona fide pledge if the sale is not for the intent of evading the Act;
- 8) Any transaction with a bank, insurance company, trust, investment company, pension or profit-sharing trust, other broker/dealer, or other institutional buyer (because the general public is not involved);
- 9) Private placement offers to no more than 10 persons in a 12-month period, provided that the seller believes that all purchasers are buying for investment. No commissions can be paid for soliciting buyers other than financial or institutional investors. This state private placement exemption is different than the federal Regulation D exemption, which allows a sale to a maximum of 35 non-accredited investors and an unlimited number of institutional investors;
- 10) A sale of a pre-organization subscription, if no commissions are paid for soliciting any buyer, in which the number of subscribers is limited to 10 persons and no payment is made;
- 11) Offers to existing shareholders where no commissions are paid for soliciting buyers. This applies mainly to rights offerings and warrants whereby an existing shareholder subscribes to a new issue of the security by exercising their subscription rights; and
- 12) An offer (but not a sale) of a security for which a registration statement has been filed but has not yet become effective as long as no stop order is in effect. The sale can occur only after the effective date of the registration.
Securities exempt from registration under federal law
Some securities are exempt under the 1933 Act from registration and prospectus requirements. However, even securities that are exempt from the registration and prospectus requirements are subject to the antifraud provisions of the 1933 Act. Exempt securities include
- U.S. government and U.S. government agency securities;
- Municipal securities;
- Issues of nonprofit organizations, such as church bonds;
- Commercial paper;
- Issues of domestic banks and trust companies (but not bank holding companies); and
- Issues of small business investment companies.
Exempt transactions under federal law
Remember that the focus of this exam is state law. However, it is important to be familiar with federal law and exempt transactions under the Securities Act of 1933, in particular, Regulation D private placements. Other federally-exempt transactions include Regulation A (small issue exemption), Rule 147 (intrastate offerings), and Regulation Crowdfunding.
Regulation D
Rules governing the limited offer and sale of securities without registration under the Securities Act of 1933:
The Act requires any company that offers or sells its securities to register the securities with the Securities and Exchange Commission (SEC) or find an exemption from the registration requirements. Regulation D allows a company to sell its securities without limitations to accredited investors and with limitations to non-accredited investors.
Regulation D – not applicable
Regulation D does not apply to offers and sales of securities if their issuer is one of the following:
- Subject to the Exchange Act reporting requirements;
- An investment company; or
- A company in the development stage that either has no specific business plan or has indicated that its business plan is to merge with or acquire an unidentified company or other entity.
Conditions for exemption under Regulation D
Offers and sales must satisfy the general terms and conditions of Regulation D to qualify for exemption.
Specific conditions include the following:
- Number of purchasers: Under Rule 506(b), the company may sell its securities to an unlimited number of accredited investors, and up to 35 non-accredited investors, while Rule 506(c) allows only accredited investors;
- Nature of purchasers: Non-accredited investors must be sophisticated, meaning they must possess sufficient knowledge and experience in financial and business matters in order to make informed evaluations of the merits and risks of the prospective investments. To ensure that a non-accredited investor is sophisticated, the investor usually signs an Investment Letter stating their understanding that the issue is not registered.
Note that if a purchaser is not fully able to evaluate the issue, a purchaser representative may be used, such as a lawyer or accountant who evaluates the issue for a fee. In addition, the registered representative or agent selling the issue cannot act as a purchaser representative.
Regulation D – bad actors provision
Under the Regulation D 506(d), there is a bad actor provision. The bad actor disqualification would disqualify an offering from the Reg D exemptions in Rule 506(b) and Rule 506(c) if the issuer or any person associated with the offering, also known as “covered persons,” has a disqualifying event that occurred. Disqualifying events include relative criminal conviction, regulatory or court action. Anyone associated with the offering is considered a covered person.
Covered persons include the following:
- The issuer;
- Directors;
- General partners;
- Managing members;
- Executive officers;
- 20% owners;
- Promoters;
- Pooled investment fund;
- Investment managers;
- Principals; and
- Solicitors.
Rule 501 - Accredited Investor
Regulation D Rule 501 provides the definition of accredited investors. Although the accredited investors are important at a federal level, you need to remember that according to the USA, no individuals are considered exempt and treated as accredited investors. The rules under the USA are designed to protect the individual investor; therefore, being accredited or not accredited does not have any bearing.
At the federal level, however, the definition of accredited investor is important because it is a fundamental determinant of who is eligible to participate in the private capital markets. It is a key component of registration exemptions, including private placements under Regulation D. An accredited investor is an investor who can buy unregistered securities, by virtue of an exception in the rules. Although most investments must be registered with the SEC before they can be offered for sale to investors, unregistered securities may be offered if they are only being sold to accredited investors or a limited number of non-accredited investors.
Original definition - Accredited investors
Under the original definition, the following entities or individuals were considered accredited investors:
- A bank, insurance company, registered investment company, business development company, or small business investment company;
- An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- A charitable organization, corporation, trust, or partnership with assets exceeding $5 million;
- A director, executive officer, or general partner of the company selling the securities;
- A business in which all the equity owners are accredited investors;
- A natural person (alone or with a spouse) who has individual net worth that exceeds $1 million at the time of the purchase exclusive of their primary residence;
- A natural person with income exceeding $200,000 in each of the 2 most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
Note, however, that under the USA, there are no accredited investors; all individuals are treated equally.
2020 expanded definition of accredited investor
In 2020, the Securities and Exchange Commission amended and expanded the definition of accredited investor. The SEC amendment added several new categories of accredited investor, including individuals and business entities/institutional investors.
Individuals — The following individuals were added to the definition of accredited investor:
- An individual who holds a Series 7 (General Securities Representative), Series 65 (Investment Adviser Representative), or Series 82 (Private Securities Offerings Representative) license and other educational or professional certifications that the SEC may choose to designate in the future; and
- An individual who qualifies as a “knowledgeable employee” of a private fund, solely with respect to an investment in the fund. Knowledgeable employees include directors and certain executive officers of the private fund, an affiliated investment manager, and employees who participate in the investment activities of the private fund or other private funds or investment companies managed by the affiliated manager.
Individuals holding any of the three designations above in good standing can qualify as accredited investors. In addition, an individual who meets the requirements of either of these two new rules does not have to additionally meet the earned income and net worth requirements. In other words, they are independent of each other.
