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You Might Get Caught: Reasons to Abide by Private Placement Rules

Wed, 10/25/2017 - 10:00 -- admin25

by Valerie P. Thomas

Most passive investments are securities; a sale to even one person must be registered or exempt; registration violations can result in massive financial penalties or incarceration; and a term sheet is usually insufficient.

Unless an exemption is available, every issuance of a “security” must be registered under both federal and state securities laws. Persons issuing “securities” must abide by registration rules. Securities laws make it a crime to offer or sell securities without having first filed a registration statement. It is a strict liability offense.

Both federal and state laws define the term “security” so as to intentionally encompass virtually any instrument that might be sold as an investment. The statutory definitions include, among others: stocks, any evidence of indebtedness, “investment contracts”, any limited partnership interest, and various instruments representing interests in oil, gas, or other mineral rights. The interpretations of the phrase “investment contract” essentially state that if the arrangement allows a passive investor to profit from the efforts of someone else, it is probably a security. Partnerships are sometimes shielded from the application of securities law because of the presumed active participation of all the partners, but recent cases have eroded the “strong presumption” that a general partnership or joint venture interest is not a security, especially in cases where one partner exclusively manages the partnership.

Even the sale of an interest to a few friends could be labeled as a public offering of a security. Neither Regulation D nor Section 4(a)(2) to which Regulation D relates (or the case law thereunder), mentions a minimum number of purchasers or offerees. Even a sale to one person can be (and has been) considered a public offering. Additionally, the dollar value of the securities sold without registration is not a factor. However, the size of the offering is one relevant factor in determining whether or not a person has qualified for a Section 4(a)(2) private placement exemption from registration. However, the size of the offering is only one factor, which accounts for the prosecution of smaller deals.

Of course, not everyone registers securities designed to raise money from investors. Issuers may instead qualify for an exemption to registration, the most common of which is the Regulation D private placement exemption. However, there are very few, if any, instances in which the sale of an unregistered equity/debt interest to a passive investor can be legally accomplished without some paperwork aimed at establishing an exemption from registration.

The sanctions for a violation of the registration provisions include incarceration under federal law (up to five years) and under state law (two to five years).

Common civil remedies include full disgorgement or rescission, plus interest. Defendants may not offset disgorgement with actual expenses. Moreover, cases are often brought after the investment failed and the sentencing is often several years after the money is lost. The SEC has a broad range of other remedies available to it, including monetary penalties, injunctions, asset freezes, and the appointment of a receiver. The Texas Securities Commission may seek injunctions, appoint receivers (if fraud is present), and order administrative fines.

Often, clients may ask for a term sheet consisting of a few pages, highlighting the business aspects of the transaction instead of a full private placement memorandum. The Section 4(a)(2) exemption requires registration-level disclosure be provided to all offerees and Regulation D offerings under Rule 506 thereunder generally require nearly the same amount of disclosure for non-accredited investors. It is unlikely that all this information can be fully conveyed in a term sheet alone. Although Rule 502(b) does not explicitly call for detailed disclosure documents to be provided to accredited investors in a Rule 506 Regulation D offering, a prudent issuer will still issue detailed disclosure documents to all offerees to combat allegations of omission and/or misstatement and to establish a fallback position of reliance on Section 4(a)(2) if the Regulation D exemption is lost.

Valerie P. Thomas is a partner with Krage & Janvey, L.L.P. and can be reached at

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