Federal exemptions

Now that you’re aware of the federal registration process for securities, we’ll need to discuss when issuers can avoid it. As we’ve learned throughout this unit, registration is a time and cost-intensive process that many persons attempt to avoid if possible. The Securities Act of 1933 provides exemptions to certain types of issuers, issues, and transactions. When an exemption exists, it’s typically because there’s limited risk to the investing public. There are two general types of exemptions:

• Exempt securities
• Exempt transactions

Additionally we’ll discuss Rule 144, which regulates circumstances involving investors purchasing non-exempt securities through exempt transactions.

Exempt securities

Exempt securities are always exempt from registration, regardless of the situation or type of transaction. There’s a big advantage to raising capital (money) with these investments as it allows issuers to avoid the drawn-out process and costs associated with registration. These are the exempt securities we’ll cover in this section:

• Government securities
• Insurance company products (unless a variable contract)
• Bank securities (not bank holding company securities)
• Non-profit securities
• Commercial paper and banker’s acceptances
• Railroad ETCs

Government securities
US Government and all municipal (state and local government) securities are exempt from registration. These are the most commonly cited government securities:

• Treasury bills
• Treasury notes
• Treasury bonds
• STRIPS
• TIPS
• Mortgage agency securities (GNMA, FNMA, FHLMC)
• General obligation bonds
• Revenue bonds

Insurance company products
Insurance companies are regulated by their own laws, none of which you need to be concerned with. While it’s safe to assume the majority of insurance products are generally exempt, there’s one exception. Insurance products with a variable component are not exempt. We’ll learn about variable annuities in the annuities chapter, which is the primary non-exempt insurance product to be aware of.

Technically, most insurance products do not meet the definition of a security, therefore making them excluded from registration.

Bank securities
Banks are also subject to their own laws, resulting in their investment products generally avoiding registration. While it’s safe to assume bank securities are exempt, bank holding company securities are not. Bank holding companies are organizations that own banks, plus other types of companies. Bank of America is an example of a bank holding company; in addition to their banking services, they own other companies like Merrill Lynch. And therefore, Bank of America securities (including their common stock) are not exempt from registration. However, a security issued by a bank only focused on banking activities is exempt.

Non-profit securities
Securities issued by non-profits, including charities, religious organizations, and social advocacy groups, are exempt. If the Red Cross wanted to issue a bond, they could do so without registering it with the SEC.

Commercial paper and banker’s acceptances
As you learned in the corporate debt chapter, commercial paper is a short-term, zero coupon debt instrument. Sold originally at a slight discount, commercial paper matures at par. The Securities Act of 1933 specifies any security with a maturity of 270 days or less is exempt from registration. Because of this rule, commercial paper is virtually always issued with a maximum maturity of 270 days. The same applies to banker’s acceptances, which are short-term financing vehicles utilized by importers and exporters.

Railroad ETCs
Equipment trust certificates (ETCs) specifically from railroad companies are exempt. Common carriers like railroads already have other laws regulating how they do their financial business, so the Securities Act of 1933 doesn’t cover them.

Exempt transactions

Even if an issuer and the security itself are not exempt, an exemption could be granted based on the way the security is sold to the public. In this section, we’ll cover two ways a non-exempt security could be offered by an issuer and still gain an exemption:

• Regulation D
• Rule 147

Regulation D
Regulation D offerings are also known as “private placements,” which involve a sale of securities to a private audience, not the general public. As a reminder, the Securities Act of 1933 was written to protect the general investing public. When only a small non-public audience is involved, the rules are relaxed. If an issuer wants to sell a security utilizing this rule, they can avoid registration.

Most growing companies that eventually offer their securities through IPOs take advantage of private placements in the initial stages of their growth. Think about it - the process allows the issuer to raise capital by offering securities without going through the time and cost-intensive process of registration. In an issuer’s “perfect world,” securities would only be offered through private placements. However, these offerings may only involve accredited (wealthy and/or sophisticated) investors (defined below) and a small number of non-accredited investors. Obviously, there are only so many accredited investors out there. Issuers tend to take advantage of private placements until they must raise an amount of capital that exceeds what accredited investors can afford.

For example, Airbnb took part in multiple private placements from their inception in 2008 and onward. Eventually, the company took part in an IPO in late 2020 when they were seeking a significant amount of capital ($3.5 billion) they likely couldn’t attain only through accredited investors. Many companies follow this cycle:

1. Raise capital from private placements
2. Grow the business
3. Repeat as much as possible
4. Eventually take part in an IPO when necessary

There are limitations to who can take part in a private placement. Regulation D allows for unregistered, non-exempt securities to be sold to an unlimited amount of accredited investors. Because of this, millionaires, billionaires, and institutions make up the majority of investors in private placements. If an investor meets any of the following characteristics, they’re accredited:

Accredited investors

• Income-based
  • Single: $200k annual income for 2+ years
  • Joint: $300k annual income for 2+ years
• $1 million of net worth, excluding residence
• Holding the Series 7, 65, or 82 licenses
• Officer or director of the issuer
• Institution with $5 million+ in assets*
• Any entity where all owners are accredited investors

*For an institution to qualify as an accredited investor, it cannot be formed solely for the purpose of purchasing securities in a private placement.

Even if an investor doesn’t qualify as an accredited investor, they still may be able to participate. Regulation D allows for up to 35 non-accredited investors to take part in a private placement. Non-accredited investors must sign certain documents stating they understand the risks they’re taking on given the lack of information available. Remember, a private placement avoids registration, so they’re not going to obtain a prospectus. However, they will receive some disclosures in a document named the offering memorandum, which is like a prospectus with less detail.

Rule 147
Rule 147 allows issuers offering securities intrastate (within one state only) to avoid (federal) registration. Federal agencies like the SEC tend to regulate products offered interstate (across state lines). If an issuer decided to sell all of their securities in Colorado only (or any other single state), they could avoid SEC registration.

A few stipulations come with Rule 147. First, the issuer must be considered operating “primarily” in one state, plus their headquarters must be within the state where the offering will occur. Known as the “80% rule”, a company is considered primarily operating in one state if:

• 80% of the issuer’s business revenues collected in that state
• 80% of the issuer’s assets in that state
• 80% of offering proceeds will be spent in that state

Investors must be state residents and wait 6 months prior to selling any Rule 147 securities to a non-state resident. However, they can sell the securities immediately to another resident of the state.

Although there’s no SEC oversight for Rule 147 offerings, state registration typically applies. In particular, intrastate securities are usually subject to state registration by qualification (we’ll discuss more later in this unit).

Rule 144

When investors purchase non-exempt securities through exempt transactions, they are subject to the requirements of Rule 144. In particular, this rule regulates restricted stock, which is stock that is not registered with the SEC. As we’ve already learned, common stock is non-exempt and must be properly registered to be eligible for trading in public markets. Unregistered stock lacks disclosure on the security and issuer, which is why the SEC prevents free trading of restricted stock.

Restricted stock can be obtained in multiple ways, but they are most commonly obtained through Regulation D private placements. Rule 144 requires restricted stock to be held by their investors for 6 months before resale. After this time period, the investor can sell their shares.

Rule 144 also regulates control stock, which is stock held by an affiliate. An affiliate is any officer, director, or 10% shareholder. Basically, if you are an executive for the issuer or own a bunch of their stock, you’re considered an insider (affiliate). Rule 144 prevents insiders from selling significant amounts of their shares quickly.

This part of Rule 144 is referred to as the “dribble” rule. Insiders are the largest shareholders of their companies. Some CEOs own 51% or more of their companies to ensure their vote always controls the direction of their organization. If insiders were to liquidate all of their shares at once, it could significantly affect the price. A 51% shareholder selling all of their shares in one trade is similar to a manufacturer dropping off 10,000 lawnmowers at a local Home Depot and asking for them to be sold immediately. Dropping the price close to zero might be the only way to get this accomplished!

Affiliates (insiders) are subject to sales limitations to prevent this from happening. They are allowed to sell the greater of 1% of the outstanding shares or the four-week trading average, four times a year. Referred to as volume limitations, this rule prevents affiliates from selling significant amounts of shares in short periods of time.

You now know the definitions and rules of restricted and control stock. However, what happens if an affiliate owns unregistered stock? This is a common occurrence, as many executives of privately held companies own stock in their company. Restricted stock rules apply because the stock is not registered with the SEC. Control stock rules apply because they’re affiliate-owned shares. When this is the case, both sets of rules apply simultaneously.

To summarize, let’s take a look at a visual representation of Rule 144:

One last item to cover is Rule 144A, which relates to Rule 144 (obviously). If a sale of restricted or control stock occurs with a Qualified Institutional Buyer (QIB), the requirements of Rule 144 do not apply. A QIB is defined as an institution with $100 million or more of investable assets. When a QIB is involved in the sale of control or restricted stock, the 6 month holding period and volume limitations do not apply.