Securities Straight Talk Vol. 2: Out With the Old (Rule 505), In With the New (Rule 504)
By Lindsey Altmeyer
There’s been a surprising shake-up within the federal government. And I’m not just talking about the recent presidential election. The SEC released its final ruling that amends Rule 504 and repeals Rule 505, altering Reg D as we know it. The announcement may not have quite the impact that the presidential election had on the country, but the ruling is important to many startups conducting small offerings up to $5,000,000.
The Current Regime
Any business that wants to raise money from investors must either register those securities with the SEC and state securities board(s) or qualify for an exemption. As a refresher, read Securities Straight Talk Vol. 1: Securities Laws Matter To Startups (Yes, Yours Too).
Three popular federal exemptions are Rule 504, 505, and 506 of Regulation D, or Reg D. Currently, Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. There is no limit to the number of investors; investors are not required to be accredited (simply put, wealthy) or sophisticated; nor must the company disclose any specific information to potential investors.
Additionally, the company may advertise the offering, but only if
(1) the securities are registered under state law or
(2) the securities are sold only to accredited investors and the offering qualifies for a state law exemption that permits general solicitation and advertising.
Essentially, if the offering is $1,000,000 or less, the SEC is content in leaving regulation to the states, with a minimal notice filing requirement.
In contrast, Rule 505 exempts an offer and sale of securities up to $5,000,000 in a 12-month period. The company may sell to an unlimited number of accredited investors, but only up to 35 non-accredited investors, and is prohibited from general solicitation and advertising. Although no specific information is required to be given to accredited investors, the company must provide any non-accredited investors with burdensome disclosure documents similar to those used in a registered offering, such as certified financial statements.
Please note, this is not an exhaustive description of these exemptions; check out Understanding Reg D Exemptions for Raising Capital for further restrictions and requirements.
Amended Rule 504
On October 26, 2016, the SEC announced it had adopted final rules to amend Rule 504 and repeal Rule 505. The rule also made changes to Rule 147, the intrastate offering exemption.
The final rules retain the existing Rule 504 framework but increase the offering limit allowed under the 504 exemption to $5,000,000 and impose “bad actor” disqualifications substantially similar to those already found in Rule 506. Essentially, the “bad actor” provision eliminates the exemption for any company, including certain related individuals, that has been engaged in fraudulent, deceitful, or criminal acts relating to securities, the SEC, or state securities boards.
Therefore, under the new Rule 504 exemption:
- a company can raise up to $5,000,000 in a 12-month period;
- there is no limit to the number of investors;
- investors need not be accredited or sophisticated;
- there is no disclosure requirement;
- the company can use general solicitation and advertising if:
- the securities are registered under state law; or
- sales are made only to accredited investors and general solicitation and advertising is allowed under a state law exemption;
- a notice on Form D must be filed with the SEC; and
- the exemption is not available to “bad actors.”
The amendments to Rule 504 will take effect on January 20, 2017.
In a nutshell, the SEC has combined the best of Rule 504 (unlimited investors, no accredited investor requirement, no burdensome disclosures) with the best of Rule 505 (a $5,000,000 offering limit). This all sounds great to businesses—and it is—but this is not the SEC letting companies run wild with small offerings, turning a blind eye to how companies conduct offerings less than $5,000,000. Instead, as mentioned above, the SEC is attempting to encourage capital growth by relaxing some of the federal requirements and allowing the states to regulate these smaller offerings. And note, businesses must comply with the state securities laws in every single state in which the securities are offered or sold.
The Repeal of Rule 505
With the increase of Rule 504 to $5,000,000, the SEC found no reason to retain Rule 505 and ruled to repeal it. The repeal of Rule 505 will be effective on May 22, 2017.
Currently, many states have adopted the Uniform Limited Offering Exemption that provides an exemption from registration for offerings made pursuant to Rule 505. However, many states, including Texas, do not have a coordinating Rule 504 exemption; therefore, a company conducting a Rule 504 offering in Texas must either register the securities or qualify for another exemption (which was the intent of the SEC). All eyes will now be on the states to see what they do, if anything, to revamp their small offering exemptions.
As discussed above, there are some big changes in store for Rules 504 and 505, however this is not an exhaustive list of all of the requirements and restrictions. So check in with your attorney before you begin your capital raise to ensure that you qualify for the exemption.