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very venturesome and do not offer finance in the “chasm” or “gap” area of
$250,000 to $5 million.

1.2 Federal Rules and Regulations”Exemptions from
The SEC has promulgated certain key rules and regulations that define those
offerings that are exempt from the SEC™s registration process. The most
widely known areas follows.

1.2.1 Regulation D
Reg. D contains Rules 501 through 508. Rules 504 and 505 are based on
Section 3(b) of the ™33 Act; Rule 506 is based on Section 4(2) of that act.

1.2.2 Regulation A: Public, Limit $5 Million
Regulation A allows for a public offering as an “exemption from registra-
tion” in the form of an Application for Exemption for offers and sales of se-
curities up to $5 million [under Section 3(b) of the ™33 Act]. There is an
anomaly involved: Even though not registered, the securities are not “re-
stricted” and can be traded (with the same possible limitations as in a SCOR
offering, see below). Using a Reg. A does not cause the issuer to be a report-
ing company, an important distinction from the use of an SB-2, especially
since the enactment of the Sarbanes-Oxley Act. Reg. A should grow in pop-
ularity because of this exemption from Sarbanes-Oxley.

1.2.3 Rule 504, SCOR: Public or Private, Limit $1 million
This is a safe harbor for public (or private) offerings not exceeding $1 mil-
lion. The federal government asserts no jurisdiction in a 504 offering. It is
under Section 3(b) of the ™33 Act (small offerings). This means that if a com-
pany follows the requirements of Rule 504, its public or private offering

(Rule 504 and SCOR) will be exempt from the registration requirements of
the SEC.
Rule 504 provides the basis for SCOR offerings (see below). All Rule
504 small public offerings, including SCOR, must be cleared with the state
regulators. Stock issued pursuant to Rule 504 is not “restricted”; however,
in California it frequently is not freely tradable through brokers.
Rule 504 is not usually used for a private offering because one frequently
can offer in only one state or use Rule 506. In California, one would proba-
bly use Section 25102(f) of the California Corporations Code, which pro-
vides for any number of accredited investors and allows up to 35
nonaccredited investors. If the offering is in more than one state, Rule 504
could be utilized with blue skying in each state. Remember that Rule 504 is
nothing more than the SEC not asserting any regulatory jurisdiction. At the
present time, stock issued pursuant to a 504 offering (public or private) that
has registered in at least one state is not, under federal rules, “restricted” ex-
cept as to “affiliates” (officer, director, and control persons). However, a
state may impose restrictions. In California, under Section 25102(f), the
stock is technically not restricted, though the investor must vouch that the
stock is not being purchased with a view toward further distribution and the
stock is usually not tradable through a broker, unless on an unsolicited basis.
Rule 506 requires that a more relatively complex offering document
(same as in a Reg. A offering) be given if stock is going to be sold to nonac-
credited investors, whereas Rule 504 does not require that any specific form
of offering document be used; however, each state may require a disclosure
document, especially in the case of a public 504 (SCOR) offering. Regardless
of whether a rule requires use of an offering document, proper disclosure of
material information is absolutely necessary to be able to avoid and/or de-
fend securities fraud claims from investors.

1.2.4 Rule 505: Private Limit $5 Million
This rule comes under Section 3(b) of the ™33 Act (small offerings) and pro-
vides a “safe harbor” for private offerings up to $5 million. It is contrasted to
Regulation A [also under Section 3(b)] which provides for a public offering
up to $5 million. Up to 35 nonaccredited investors are allowed. No general
solicitation or advertising is allowed. Strictly prescribed information is re-
quired to be given to the nonaccredited investors, including audited finan-
cials (offerings of $5 million). Stock issued pursuant to Rule 505 is
This rule is seldom used as the requirements for nonaccredited investors
are stiff, and, if going for a private placement, one would use Rule 506 (un-
limited amount) with its preemption of state review (see below).
Legal Primer on Securities Law Issues for Nonlawyers

1.2.5 Rule 506: Unlimited Private, Preemption
A new opening was created by the National Securities Markets Improvement
Act of 1996 in which Congress preempted from the states the authority to
review securities exempted from registration by Rule 506, a rule adopted
under Section 4(2) of the ™33 Act (not involving a public offering). The states
cannot review a Rule 506 offering; if to accredited investors only, no pre-
scribed disclosure document is required. However, one would use a private
placement memorandum (PPM) to avoid fraud charges. If nonaccredited in-
vestors (up to 35) are involved, a prescribed disclosure document is required.
The “joker” is that Congress allowed the states to require a notice filing and
to assess filing fees just as if no preemption exists. Nonetheless, this is an at-
tractive alternative for those who can find accredited investors. No advertis-
ing is permitted. The rule also allows a public offering to follow immediately
after the termination of the Rule 506 offering. Stock issued pursuant to Rule
506 is “restricted.”

1.2.6 Regulation S
Regulation S provides an exemption from registration of securities that are
sold outside the United States by companies meeting certain criteria. Reg. S
can be used for overseas sales, either public or private, and either in con-
junction with or separate from a U.S. offering. The securities, generally, must
not be sold to U.S. persons for one year (equity securities) or 40 days (debt
securities). Note, also, that resale into the United States, if done quickly, must
be done pursuant to an exemption from registration.
There was considerable abuse of Regulation S as a means of avoiding the
SEC™s registration requirements. As a result, the SEC has increased the period
during which the equity securities may not be sold to U.S. persons from 40
days to one year.

1.3 The States
The states all regulate the offer and sale of securities. Clearing with the states
is known as blue skying. As noted above, some states use full disclosure (sim-
ilar to the SEC) and some use merit review (such as California); however, in
administration of the laws, the shades of difference tend to blend. Merit re-
view requires a finding by the state that the offering is “fair, just, and equi-
table” to the purchaser. This test is frequently met by the administrators
declaring the offering is fair, just, and equitable only if offered to persons of
a certain level of wealth and/or sophistication. This is known as “suitability”
and is used extensively in California under a “limited” (as compared to an
“open”) public offering permit.

The states belong to the North American Securities Administrators
Association (NASAA), an organization that attempts to coordinate state reg-
ulation so as to lessen the burden on small issuers. The irony is that most
listed (on stock exchanges) companies only need notify the state to be
cleared. It is the small issuer that faces the task of clearing in each jurisdic-
tion in which offers (see “The Internet” below) and sales are to be made.
Certain states are cooperating on a regional basis for review. The New
England and certain western states are examples. Generally, California is not
participating. However, most states, including California, are now (as of
June 2004) participating in “coordinated equity review” wherein a state is
chosen (by the other participating states) to assign one full disclosure state
and one merit review state to review for the states in which offerings are to
be made. This process is limited to SB-1 and SB-2 offerings (and S-1™s).
Unfortunately, this route has lost its appeal due to the fact that each state in-
volved in the applied for clearance tends to put in its favorite restriction, and
the result is an unwieldy and restrictive permit. It is usually better to qualify
individually in the most promising states.
New York state is unique in that it has an antifraud statute (the Martin
Act) administered by the New York Attorney General.
Washington, DC, is even more unique in that it has no securities regula-
tion scheme.

1.4 California Laws
1.4.1 General: Merit Review, Suitability
As noted above, California is a merit review state using “suitability” in pub-
lic offerings. In a private offering (no advertising, no general solicitation),
one is allowed to sell to any number of accredited (California uses the term
excluded, which includes accredited) investors and up to 35 nonaccredited
ones. Only a one-page filing is required in the private offering [see
“25102(f)” below].

1.4.2 Section 25113(b)(i)*: Qualification. Public
This is the general qualification section for a public offering; usable if one
cannot use SCOR, for example, a foreign (Nevada or other state) corpora-
tion not qualifying under Section 25115.

*All sections refer to the Corporations Code of California.
Legal Primer on Securities Law Issues for Nonlawyers

1.4.3 Section 25113(b)(ii): Qualification, Public
Provides for California corporations and foreign (out-of-state) corporations
that meet certain tests to use the special rule of SCOR offerings.

1.4.4 Section 25102(f): Private, No Review
This is the great escape valve allowing one to raise any amount from ex-
cluded investors and not more than 35 nonexcluded on a private basis (no
ads, no general solicitation). There is no state review of the offering mate-
rials. There are limitations on who can buy securities in an offering under
Section 25102(f). Purchasers must have a preexisting business relationship
with the company or have demonstrated investor sophistication. The stock
is not “restricted”; however, finding buyers without the intervention of
brokers (who usually are not able to handle) is most difficult.

1.4.5 Section 25102(n): Private with Announcement
This section allows one to advertise in a private placement with sale to
“qualified investors” only. The ad, a “general announcement,” is strictly
prescribed. It is in the form of a “tombstone ad.” Many states are now
adopting similar laws. The California act is very complex and, because of
this, is the subject of a separate paper. So far, Section 25102(n) has not
proven to be very useful, despite early high hopes.

1.5 Accredited and Excluded Investors
“Accredited investor” is defined in Rule 501(a) of Reg. D. There are several
categories, the most important of which is a “natural person” with a single
income of $200,000 (or joint income with that person™s spouse of $300,000)
in the past two years and reasonable expectation of that rate of income con-
tinuing for the current year, or having $1 million of net worth, including
home equity.
California uses the term excluded to indicate exclusion from the count
of 35 nonexcluded that are allowed under Section 25102(f). Thus, in a pri-
vate offering, one can have any number of “excluded” investors because they
are excluded from the count. There are many categories of “excluded.” The
primary ones are:

1. Partner, officer, director of the issuer together with their relatives shar-
ing a residence.
2. Owners of more than 50 percent of the shares of the issuer.
3. Promoter.

4. A purchaser who purchases $150,000 of the offering, has enough so-
phistication (or has an investment adviser with enough sophistication)
to protect his or her interests, and whose investment does not exceed
10 percent of his or her net worth.
5. An individual who alone has an income exceeding $200,000 or, with
spouse, has income exceeding $300,000 in the two most recent years
and expects continuation of this income, or has a net worth exceeding
$1 million. Home equity is included, so the definition is the same as
the federal for “accredited.”


2.1 Introduction
Normally, one raises the first funds on a private basis, especially if the need
is modest, say, under $1.5 million. The cost is considerably less and the time
involved is frequently less, depending on one™s ability to raise funds from
wealthy sources. These are two basic criteria: amount and contacts. This sec-
tion reviews various approaches.

2.2 Multistate: Section 4(2) and Rule 506
If one knows wealthy sources in more than one state, there are two primary
routes to follow: the safe harbor of Rule 506 or simply Section 4(2) of the
™33 Act (not involving a public offering).
If Section 4(2) is used, each state must be “blue skied.” There are dif-
ferent requirements as to nonaccredited investors (California 35, Nevada 25,
etc.). If only accredited investors are approached, some states require only a
simple form and a fee.
Rule 506 has an obvious advantage; it preempts the states except as to
fees and a simple filing. One is sure that all one has to do for each state is pay
the filing fee and file a Form D report (a few pages showing sales in that
state). The disadvantage is that, if nonaccredited investors are involved, the
disclosure document is rather elaborate (like an offering circular in a Reg. A
The legal costs of a Rule 506 offering only to accredited investors can be
as low as $6,000 (excluding filing fees) if the business plan has good dis-
closure in which case a “wrap-around” can be used: wrapping the legal re-
quirements around the business plan to provide disclosure sufficient to
protect against successful fraud claims in the future.
If nonaccredited investors are approached, the cost rises substantially to
Legal Primer on Securities Law Issues for Nonlawyers

around $20,000 to $50,000 because the work is similar to a Reg. A offering,
with the exception of not having federal review of the document.

2.3 California: Section 25102(f)
In the event one offers securities only in California, Section 25102(f) stands
alone. It permits a private placement of any amount of money to be raised
from “excluded” or “accredited” investors and up to 35 nonexcluded in-
vestors. The stock would not be “restricted” in the federal sense (no Rule
144) but would be limited in trading (see Section 6 below). If more than one
state is involved, either Rule 504 of Reg. D or Section 4(2) must be utilized
and each state “blue skied.” Section 25102(f) would still be used in
Note that if Rule 506 is used, one wouldn™t use Section 25102(f) because
the state is preempted. When using Section 25102(f), there is no required dis-
closure document other than that necessary to avoid fraud charges: the clas-
sic use of a PPM and a one page reporting form must be filed with the
commissioner with a modest (maximum $300) fee.


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