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Recent Amendments to SEC Rule 504 “Seed Capital” Exemption and Securities Act of Nebraska Exemption

on Thursday, 11 May 2017 in The Closer - M&A, Securities & Corporate Counsel: Kevin P. Tracy, Editor

Since its original adoption in 1982, Securities and Exchange Commission (“SEC”) Regulation D, Rule 504 has been limited in amount to the issuance of no more than $1 million in securities in a 12-month period. Effective January 20, 2017, the SEC increased the maximum offering amount to $5 million in a 12-month period. 

Rule 504 has been referred to by the SEC as the “seed capital” exemption, designed to aid small businesses raising their initial seed capital.  Rule 504 has been used, for example, by start-up companies in the company’s initial round of “friends and family” capital raising, since it permits nonaccredited investors to be included, and has no limits on the number of investors in the offering (see, however, limits imposed under state law below).  Its usefulness was limited, however, by the $1 million limit, and the increase to $5 million will provide new opportunities and flexibility to smaller companies raising capital in the $1 million to $5 million range.

In addition to complying with Rule 504 as a matter of federal securities law, companies must also comply with state securities laws, either through registering their securities in the state(s) in which the offering is being made, or finding an applicable exemption from registration.  The most commonly used exemptions under Nebraska and Iowa law are discussed below, including a recent amendment to the Securities Act of Nebraska, signed into law by the Nebraska Governor on April 27, 2017, and expected to be effective September 2, 2017, which expands the classes and number of investors permitted under Nebraska Securities Act exemptions.

I. Federal Securities Law: SEC Rule 504 Requirements. 

Limitation on Amount Issued.   Under Rule 504 as amended, the aggregate offering price for securities to be issued cannot exceed $5 million in a 12-month period.  This is a moving 12-month period, so that you should always look back at all sales or issuances of securities which occurred in the 12-months prior to the date of the proposed issuance.

Nature of Issuer.  To use Rule 504, the company cannot be a SEC-reporting company, an investment company or a development stage company that has no specific business plan or intends to merge with or be acquired by an unidentified company (commonly called “blank check” companies).  

Limitation on Manner of Offering.  Securities of the company cannot be offered or sold by any form of general solicitation or general advertising, such as any advertisement, article, notice or other communication published in any newspaper, magazine or similar media, or broadcast over television or radio, or at any seminar or meeting where the persons in attendance have been invited by any general solicitation or general advertising.

Information to be Furnished.  Although there are no specific informational or disclosure requirements under Rule 504, the company must comply with antifraud disclosure requirements in connection with the offering of its shares, i.e., not make any material misrepresentations or omissions of material facts with regard to the company and the offering.  Companies should make full disclosure of all material aspects of the company and the shares being offered.  Both the company and its controlling persons may have liability for breach of these disclosure obligations.  

Opportunity to Ask Questions.  The company should make available to each potential investor, at a reasonable time prior to his or her investment decision, the opportunity to ask questions and receive answers concerning the company, and terms and conditions of the offering and to obtain any additional information the company possesses or can acquire without unreasonable effort or expense that is necessary in making the investment decision.

Limitations on Resale.  The company must exercise reasonable care to assure that the purchasers/investors of securities are not acquiring such securities with a view toward distribution publicly, with certain limitations on resale.

Filing of Form D Notice.  The Company must file with the SEC a notice on Form D no later than 15 days after the first sale or issuance of securities in this offering.  This filing is done with the SEC online, using the SEC’s EDGAR system, requiring the company to have its own Central Index Key or “CIK” number.  

II. State Blue Sky Laws.  In addition to complying with federal securities laws through Rule 504, a company must comply with all applicable state securities laws and regulations for private offerings.  Generally, the state of residence of the investor, or the state where the offer and sale of the security is made, must be complied with in the issuance of company securities.  Commonly, because of the cost and time involved, start-up companies seeking seed capital do not go through the registration process with state securities regulators, but look for exemptions from registration to follow in their offering.  The following outlines the exemptions under Nebraska and Iowa law most commonly used in connection with a Rule 504 offering.  

A. Section 8-1111(9), Securities Act of Nebraska.

Under Section 8-1111(9), Securities Act of Nebraska, an offering of securities is exempt from registration if all of the following requirements are met.

Limitation on the Number of Investors:  A key issue in the proposed issuance of securities by a company is the number of persons who may become investors.  Although there is no limit under SEC Rule 504 in the number of investors purchasing securities, there is a limit under the Nebraska Securities Act.  Under the Section 8-1111(9) exemption, sales may be made to no more than 15 persons during any period of 12 consecutive months.  However, excluded from the 15 person limitation are the following persons:

  1. Any director, executive officer, general partner of the issuer;
  2. Any manager of a limited liability company that is the issuer of the securities being offered;
  3. Any natural person whose individual net worth, or joint net worth that person’s spouse, at the time of his or her purchase, exceeds $1 million, excluding the value of the primary residence of such person; or
  4. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

In 2017, the Nebraska Legislature passed LB No.148, with an expected effective date of September 2, 2017, which expanded the definition of accredited investors which are not included in the 15-person limit under Section 8-1111(9), making it consistent with the definitions of accredited investors under SEC Regulation D, by adding to the above categories, the following:

  1. A corporation, business trust or partnership with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered;
  2. A trust with total assets in excess of $5 million, not formed for the purpose of acquiring the securities offered, whose purchase is directed by a person who has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the prospective investment; and
  3. Any entity in which all the equity owners are individuals who are individual accredited investors.

No Commission Payments:  No commission or other remuneration may be paid or given directly or indirectly for soliciting any prospective investor except to a person who is a Nebraska-registered agent of a Nebraska-registered broker-dealer.

No General Solicitation:  No solicitations for sales of shares may be made by newspaper, radio or television.

Filing of Notice:  A notice filing must be made with the State of Nebraska by the issuer representing that all conditions of the exemption have been made within 30 days after the first sale in Nebraska. 

Investment Intent:  As is required under Rule 504, the company must have a reasonable belief that the securities purchased are taken for investment purposes.

Potential Requirement for Audited Financial Statements:  Although the maximum permitted under Rule 504 has increased to $5 million, it is important to note that in Nebraska, the additional requirement of audited financial statements kicks in if the sales amount exceeds $1 million.  Under Section 8-1111(9)(b), if the company (i) makes sales pursuant to this exemption for five (5) consecutive twelve-month periods, or (ii) makes sales of at least one million dollars ($1 million) from one or more offerings pursuant to this exemption, the company must, within 90 days after such occurrence, file with the Nebraska Department of Banking, audited financial statements and a sale report which lists the names and addresses of all purchasers and holders of the company securities and the amount of securities held by such persons.  If the start-up company believes it may exceed $1 million in capital raised under this exemption, it should obtain an audited balance sheet at its inception and require audited financial statements going forward, to save time and money involved in obtaining audited financial statements at a later date.

B. Section 502.202(14), Iowa Securities Act.  If there are investors who are residents of Iowa, the company must also find an exemption under the Iowa Securities Act.  In this regard, Section 502.202(14), Iowa Securities Act, exempts sales or offers to sell securities by or on behalf of an issuer, if the transaction is part of a single issue in which all of the following apply:

  • There are no more than 35 purchasers/investors in Iowa during any 12 consecutive months.
  • There is no general solicitation or general advertising in connection with the offer of the securities.
  • No commission or other remuneration is paid or given in connection with the securities offering, directly or indirectly, to any person other than a broker-dealer or agent registered in the State of Iowa.
  • The issuer reasonably believes that all investors in Iowa are taking the shares for investment purposes.
  • This is a “self-executing” exemption; and there is no filing requirement under this exemption required with the State of Iowa.

Even assuming total compliance with applicable federal and state exemptions described above, state and federal securities laws have antifraud provisions which impose liability on the company and its controlling persons, for misleading statements or material omissions in connection with the sale of its securities.  In this regard, it is important to work with knowledgeable securities counsel in structuring your company’s offering of securities to avoid legal problems under state and federal securities laws.

Dennis J. Fogland

1700 Farnam Street | Suite 1500 | Omaha, NE 68102 | 402.344.0500