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Structured Private Placements Under Rule 506

Presentation to the Connecticut Department of Banking's Securities Forum

October 25, 1999

October 25, 1999

Preliminary Observations

  • Compliance with federal and state securities regulations is key, especially the anti-fraud rules. 
  • Practitioners approach capital formation to raise the most money with the least regulatory oversight while minimizing the transaction costs of the process, meaning that we are looking for exemptions from registration both on the federal and state levels. 

Note: Beginning premise is that registration is required on both the federal and state levels unless an exemption is available. 

    • Regulation D offers some of the better alternatives for capital raising given the practitioners’ approach. 
    • One such alternative is a structured private placement to accredited investors either with or without the assistance of a placement agent under Rule 506.

Why Rule 506?

    • NSMIA "preempted" state regulation of "covered securities."  

    • Under Section 18 of the Securities Act of 1933 (where the relevant part of NSMIA is codified), "a security is a covered security with respect to a transaction that is exempt from registration under this title pursuant to . . . Commission rules or regulations issued under Section 4(2), except that this paragraph does not prohibit a state from imposing notice filing requirements that are substantially similar to those required by rule or regulation under Section 4(2) that are in effect on September 1, 1996.  

Translation: Rule 506

    • Rule 506 has no dollar limitation.  

    • Rule 506 permits an unlimited number of accredited investors [formal definition noted at end of outline] and no more than 35 non-accredited investors who either alone or with their purchaser representative have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchasers come within this description.  

    • Rule 506 does not permit advertising or general solicitation. 

    • Filings – Form D with SEC and Connecticut Banking Department within 15 days of first sale. (Other states may require filings of a Form D or other notice filing as well.) 

What is a Structured Private Placement? 

    • The issuer makes an assessment of  

    • what type of security it wants to sell, 

    • the number of securities it wants to sell 

    • and the price it desires to receive. 

    • The issuer or its placement agent then tries to sell the securities to purchasers without further negotiation of the terms. 

What are the elements of a Structured Private Placement?

    • Placement Agent Agreement 

    • Who, what, when, where and how much? 

    • Investor Questionnaire – The questionnaire generally tracks the language of the definition of accredited investor to make sure that investors are in fact "accredited." 

    • Private Placement Memorandum or Offering Memorandum 

    • No specific disclosure is required for accredited investors; issuers should be guided by the anti-fraud rules. 

    • Typical elements 

    • Business description 

    • Risk factors 

    • Management 

    • Financial information 

    • Description of offering and how to participate 

    • Use of proceeds 

    • Transfer restrictions (by law and contract) 

    • Sometimes disclosure is achieved by delivery of a business plan accompanied by risk factors. 

    • Subscription Agreement – The document used by the purchaser to "sign on." 

Role of Internet

    • Very limited since the SEC views the use of the internet as advertising and general solicitation. 

Pre-IPO Issues

    • Underwriters will want to know that private placements were done in compliance with law so as to eliminate a concern of buyers’ exercise of rescission rights. 

    • Restrictive terms of a class of stock generally are expected to disappear in an IPO (e.g., preferred stock converts to common stock, director designation rights are terminated). 

    • Lock-ups – Underwriters will expect current (major) shareholders to agree not to sell their stock for some period of time after the IPO so as not to flood the market with shares. 

Rule 501(a) Accredited Investor

(a) Accredited Investor. "Accredited investor" shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of securities to that person:

(1) Any bank as defined in Section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934; any insurance company as defined in Section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in Section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in Section 3(21) of such Act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;

(2) Any private business development company as defined in Section 202(a)(22) of the Investment Advisers Act of 1940;

(3) Any organization described in Section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase, exceeds $1,000,000;

(6) Any natural person who had an individual gross income in excess of $200,000 in each of the two most recent years or had 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;

(7) Any trust with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); or

(8) An entity in which all of the equity owners are accredited investors.

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