Typically, when you sell a security you must register the sale with the Securities and Exchange Commission (SEC). However, Section 4(2) of the 1933 Act exempts “transactions by an issuer not involving any public offering.” In these transactions, better known as private placements, the 4(2) exemptions apply to accredited investors, who are deemed by the SEC to be sufficiently sophisticated and have sufficient bargaining power so as not to require the protection afforded by federal registration, as well as institutional investors who have obvious sophistication and bargaining power. You can learn more about the private placement exemption here.
In 1953, the SEC fought against Ralston Purina Co. over whether Ralston’s security offering to its employees was exempt under 4(2). Ralston argued that an offering of stock that was limited to its own employees was necessarily exempt since it did not involve a public offering. Ralston was relying on the literal interpretation of the statute, maintaining that its offering was to a limited group and it could, therefore, not be characterized as a “public offering.” The Court disagreed, ruling that since the stock being offered was made available to all employees, regardless of their connection with the issuer and knowledge of the business, the offerees and purchasers represented a sufficiently broad slice of the investing public so as to render the exemption unavailable to Ralston.
The Court announced “guidelines” that continue to form the basis for all private placement exemptions. First, all offerees must have access to the types of information that would be contained in a full 1933 Act registration statement. Second, all offerees must be capable of fending for themselves, i.e. the offerees must be sufficiently sophisticated to demand and understand the information made available to them. The two factors go hand in hand. In order to properly fend for oneself, you must have access to sufficient information. The SEC has made it clear that a brochure containing the desired information is not by itself sufficient since the sophistication of the offeree is an equally important factor. Last, the Court noted that while the number of purchasers involved is not necessarily a determinative factor, it is a significant one in considering the scope of the exemption. The size of the offering, both in terms of number of securities offered and the offering price, and the number of offerees, is important because the larger the numbers of each, the more difficult it is to control the downstream effects that would inevitably result from a larger offering. Sales would eventually filter the securities into the hands of the general investing public. As these sales become more likely to reach the general investing public, it becomes less likely that the transaction is in fact a “private” placement. Ultimately, Ralston’s offering to its 500 or so employees was considered a public offering and, thus, it was not exempt from the federal registration requirements.
If you’re considering raising money for you business you should be aware of some of the ways private placement exemptions can go awry so you can avoid unnecessary hassles down the road. Check out our prior blog post for information about the Regulation D safe harbors under Rule 504, 505, and 506.