When a Connecticut company issues any equity interests (such as stock in a corporation or membership interests in an LLC) to an investor, those interests will be deemed “securities” under federal and state law. In general, a company must register securities for offer and sale under both federal and applicable state securities laws. Companies issuing securities to investors must either comply with all of the applicable registration requirements or properly qualify for an exemption from registration. Registering securities can be extremely time- consuming and expensive, so qualifying for an appropriate exemption to registration is crucial.

Under federal and state securities laws, there are a variety of exemptions from registration available to companies seeking to raise capital. Their availability depends on the type of the investor, the amount of capital to be raised and the manner in which the offering is made. Some exemptions require that detailed disclosures and information be given to investors. While some companies ignore securities law requirements when accepting money from investors, they risk civil and criminal fines and penalties for noncompliance. Additionally, investors may be able to recover the amount of any of their losses or interest from a non-complying company. The exemptions from registration which are most commonly used by companies issuing securities (“issuers”), because they are the most efficient in both time and expense, are briefly described below.

OFFERINGS TO ACCREDITED INVESTORS

Issuers most commonly rely on the “private placement” exemption under federal Rule 506 of Regulation D adopted under the Securities Act of 1933. In these offerings, securities will normally only be issued to persons and entities that qualify as “accredited investors” under Rule 506. An accredited investor is one who is assumed, by virtue of the investor’s financial position, sophistication and/or relationship with the company, to be capable of obtaining the information necessary to evaluate the benefits and risks of the potential investment. For this reason, mandatory disclosures to accredited investors are eliminated (though some disclosure is recommended to protect the issuer from liability under the federal and state anti-fraud rules which are discussed below). Another advantage of Rule 506 is that it preempts substantive state regulation of the offering. Connecticut’s Department of Banking, for example, only requires issuers to file a copy of the Securities and Exchange Commission’s (“SEC’s”) Form D exemption notice and to pay a small filing fee (currently $150). Due to these advantages, offerings under the Rule 506 exemption can be accomplished more quickly and less costly than offerings under other exemptions. While companies are also allowed to issue securities to non-accredited investors under Rule 506, provided that the non-accredited investors or their formal representatives are sophisticated from a financial standpoint, they generally avoid doing so because substantial mandatory disclosures and other information must be provided to non-accredited investors which can be cost-prohibitive.

CONNECTICUT’S DE MINIMIS EXEMPTION

If Rule 506 is unavailable to the issuer, another company-friendly federal exemption must be sought, as noted below. Since state law will generally not be preempted under other federal exemptions, the issuer will need to identify a state registration exemption as well. Connecticut has a very favorable de minimis exemption that may be available to companies with limited offerings. Under this exemption, the company will not be required to register the offering with the State if it limits the number of purchasers of its securities to 10 or less, does not publicly solicit investors and does not pay commissions in connection with the solicitation of investors. If there are any out-of-state investors, the issuer will also need to comply with the regulations of each state where the investors reside. Additionally, even though there are no mandatory disclosure requirements when using this exemption, it is a good idea for companies to make appropriate written disclosures to their investors anyway to minimize potential liability under federal and state anti-fraud rules. These anti-fraud rules, which apply to every offering of securities, subject companies to civil fraud lawsuits by their investors or the SEC if, among other things, they make any untrue statement of material fact or omit any material fact in connection with the purchase or sale of any security. Connecticut’s de minimis exemption is often used in combination with certain federal registration exemptions, most notably Rule 504 of Regulation D which exempts offerings of up to $1 million in any 12-month period.

CHANGES TO SECURITIES LAW UNDER THE JOBS ACT

The main drawback of the Rule 506 exemption is that, under current law, a company cannot make general solicitations of its offering to investors. However, the Jumpstart Our Business Startups Act (the “JOBS Act”), which was enacted in April 2012, will allow for general solicitations to accredited investors as soon as the SEC adopts implementing rules (which should hopefully be in the near future). Also, despite what you may have heard, companies may not issue securities via crowdfunding – which is a method of raising relatively smaller amounts of capital from a larger pool of investors, typically through the internet – until the implementing rules for the JOBS Act are adopted. Companies will thereafter be allowed to raise up to $1 million in any 12-month period through crowdfunding transactions. However, the issuer will need to offer its securities through a registered funding portal and comply with mandatory financial and other disclosures, annual reporting rules and other requirements. Companies will have to examine carefully the SEC’s final rules to determine whether crowdfunding will be a practical option for them to raise capital.

This article is intended to serve as a short introduction to selected federal and state securities law exemptions. It does not cover all of the potential requirements for compliance. Hence, it is important to consult with an attorney before your company issues any securities to investors. For more information, please contact Mark W. Klein (mklein@brodywilk.com).