Exempt transactions

We discussed exempt securities in the previous chapter, which avoid registration requirements regardless of circumstance. We’ll now discuss exempt transactions, which allow non-exempt securities to be offered without registration in a specific type of transaction. A non-exempt security is one that does not have an exemption based solely upon what it is. Most securities, including the vast majority of stocks, are non-exempt.

These are the exempt transactions covered in the Uniform Securities Act (USA):

• Private placements
• Isolated non-issuer transactions
• Unsolicited non-issuer transactions
• Certain fiduciary transactions
• Debt-related transactions
• Transactions between issuers and underwriters
• Institutional transactions
• Offer of pre-organization certificates

Private placements

We discussed Regulation D in a previous chapter, which is the federal version of a private placement. As a reminder, a private placement is a non-public sale of a security to a small group of investors. The USA (state) has its own version of private placement that applies if the transaction will take place intrastate (in one state only).

A security offered to no more than 10 non-institutional (retail) investors in the previous 12 months is eligible for the private placement exemption. Additionally, these investors must buy the security for investment purposes (not just to immediately resell it). Last, no commissions from retail investors* can be collected by the financial representatives facilitating the transactions.

*Commissions can be collected from private placement sales to institutional investors.

Let’s assume a local business in your state wants to raise capital by selling stock while also avoiding state registration of the security. The company offers the security to you, plus 9 other retail investors while taking no commission. You purchase the stock for investment purposes and now hold an unregistered, non-exempt security. The issuer was able to sell their stock without registering it because of the way it was sold (an exempt transaction).

You now hold a restricted security that cannot be sold in the public markets until it’s registered. This doesn’t mean you can’t sell the security, though. If you can claim an exempt transaction yourself (most likely one of the many transactions below), you can sell the security.

Isolated non-issuer transactions

As per the USA:

Any isolated non-issuer transaction, whether effected through a broker-dealer or not [is considered an exempt transaction]

The USA is fairly vague with this type of transaction, but let’s break down the terminology. Isolated means infrequent and non-recurring. You already know what an issuer is; an issuer transaction is one where the issuer receives the proceeds from a securities sale. The private placement example we discussed above was an issuer transaction. So, a non-issuer transaction is one where the issuer does not collect the proceeds from a sale.

In most scenarios, an isolated non-issuer transaction occurs between family members, friends, or colleagues. Let’s revisit the example discussed above where you purchased stock from a local business in a private placement. You could sell the non-exempt unregistered stock to a friend of yours and claim this exemption as long as it doesn’t become a frequent transaction. By doing so, you were able to legally sell the security without it being registered.

Unsolicited non-issuer transactions

What if you wanted to sell your non-exempt unregistered stock, but couldn’t find a friend or family member that was interested? You could contact your broker-dealer and ask for help selling the security as long as it was on an unsolicited basis. The broker-dealer cannot recommend the transaction in any way, plus they may also ask you to sign a non-solicitation letter (some state administrators require them for these transactions). This document would declare you were attempting to sell the security without the coercion of the broker-dealer.

Certain fiduciary transactions

A fiduciary is a person placed in charge of managing another person’s assets or belongings. There are numerous types of fiduciaries in the world, but the USA specifically identifies these that qualify for exempt transactions:

• Estate executors and administrators
• Sheriffs and marshals
• Receiver
• Trustee in bankruptcy
• Guardians and conservators

An estate executor or administrator is appointed to oversee the estate of a deceased person. If the deceased person owned a non-exempt unregistered security, the executor or administrator could sell it through this exemption.

Sheriffs and marshals are law enforcement officers that may take possession of the assets of those subject to criminal prosecution. If a judge mandates a convicted criminal to pay a fine to the state, a liquidation of a non-exempt unregistered security may occur through this exemption.

A receiver is a person appointed by a judge to take temporary possession of assets while a lawsuit is taking place. If a sale of a non-exempt unregistered security is required by the court, the receiver can perform the transaction legally through this exemption.

A trustee may be appointed to oversee a person’s bankruptcy. If the bankruptcy court orders the liquidation of the bankrupt person’s assets, a non-exempt unregistered security may be part of the order. This exemption would allow the trustee to sell the security legally without registering it.

Guardians and conservators are court appointed fiduciaries tasked with overseeing the assets of a person incapable of doing so themselves, typically due to mental illness or incapacitation. If the person owns a non-exempt unregistered security and the conservator or guardian wants to sell it, they can do so through this exemption.

Debt-related transactions

Some loans are secured, or collateralized loans. For example, a mortgage is a secured loan; if the homeowner cannot make their required mortgage payments, the lender can repossess the property (collateral). It’s possible a person takes out a loan and pledges a non-exempt unregistered security as collateral. If the loan goes unpaid, the lender can sell the security through this exemption to recoup the borrowed money.

The USA sometimes makes reference to these loans being ‘bona fide,’ meaning they are legitimate loans. This would not be the case if a non-exempt unregistered security was pledged as collateral for a loan with an immediate intention of defaulting on it. It’s most likely a person doing this would only be taking the loan as a creative way to sell the security while falsely claiming this exemption.

Transactions between issuers and underwriters

Most public offerings of securities begin with a sale from the issuer to underwriters. As a reminder, an underwriter is a financial firm that sells securities on behalf of issuers. In a previous chapter, we discussed how Morgan Stanley and Goldman Sachs acted as co-lead underwriters on the AirBnB initial public offering (IPO). Prior to Morgan Stanley and Goldman Sachs selling AirBnB stock to the public, they first purchased the stock from AirBnB.

The sale of a security from an issuer to its underwriter(s) does not require a security to be registered. However, the subsequent sale from the underwriter to the general public does require registration (unless some other exemption exists).

Institutional transactions

As we’ve learned throughout this material, institutional investors don’t require many of the same protections offered to retail investors. This is why the USA allows a sale to virtually any institutional investor to occur without registration of that security. The following institutions are specifically mentioned:

• Banks
• Savings institutions
• Trust companies
• Insurance companies
• Investment companies
• Pensions
• Profit sharing plans
• Financial institutions
• Broker-dealers

Offer of pre-organization certificates

A pre-organization certificate is a pledge by an investor to purchase a security in the future from an organization that has not yet been formed. Companies tend to use them as a way to ensure they have access to capital (money) once officially formed. As long as they’re offered to no more than 10 potential subscribers and no payment or commission is received, pre-organization certificates avoid registration requirements through this exemption.

Let’s summarize a few things regarding the exemptions discussed in this and the previous chapter. Exempt securities avoid registration based solely on what they are, while exempt transactions allow the sale of non-exempt unregistered securities if a transaction occurs a specific way. It’s possible an exam question tests you on the difference. For example:

All of the following are exempt transactions according to the Uniform Securities Act, EXCEPT:

A) An offer of securities to 8 retail investors in a 12 month period
B) An offer of a Treasury bond to hundreds of retail investors
C) An offer of a pre-organization certificate to 9 potential subscribers
D) An offer of common stock to an institutional investor

Can you figure out the answer?

Many test takers remember exempt securities as nouns, while exempt transactions are verbs. An exempt security is exempt based on what it is (a noun), while an exempt transaction provides an exemption based on an action (a verb).

In the previous chapter, we learned how non-profit and employee benefit security exemptions can be removed by the state administrator if fraud or another “sketchy” situation is suspected. This same concept applies to all the exempt transactions discussed above.