Exemptions
Now that you know the registration process, we’ll need to discuss when issuers can avoid it. Registering securities with the SEC is a lengthy and costly endeavor.
To provide all the necessary documentation requested by the Securities and Exchange Commission (SEC), the issuer hires lawyers, accountants, and other professionals, all of which are costly. Through the registration process, these parties work with the issuer to provide detailed information relating to their background, financials, and goals for the future. Additionally, the SEC requires the payment of substantial filing fees.
Registration is important, as it ensures the investing public will obtain enough information to make an informed investment decision. However, the Securities Act of 1933 provides exemptions to certain types of issuers, issues, and transactions. When an exemption is provided, it’s usually because there’s limited risk to the investing public. There are two general types of exemptions:
- Exempt securities
- 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 securities (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. The regulators assume our government can be trusted to avoid fraud when offering securities to investors.
As a reminder, here 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 securities
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.
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. We also learned about banker’s acceptances, which are securities that facilitate international trade.
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 and banker’s acceptances are virtually always issued with maximum maturities of 270 days.
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 three ways a non-exempt security could be offered by an issuer and still gain an exemption:
- Regulation A+
- Regulation D
- Rule 147
Regulation A+
Regulation A+ offerings are known as “small dollar” offerings. When a company issues up to $75 million dollars of securities in 12 months, it can avoid registering the security with the SEC. $75 million might sound like a lot of money, but it’s not much in the grand scheme of finance. For context, Saudi Aramco raised $25 billion during its IPO in 2019. Smaller companies take advantage of this rule to avoid SEC registration.
When an issuer can bypass registration with the SEC, they avoid filing a traditional registration form and do not need to create a prospectus. However, investors taking part in a Regulation A+ offering still receive some disclosure (typically relating to the finances and background of the issuer) through a form called the offering circular. This document is less detailed than the prospectus but provides some information on the security and issuer. Issuers are required to file a copy of the offering circular with the SEC.
There are two tiers related to Regulation A+ offerings:
Tier 1 offering
- Up to $20 million can be offered
- Subject to SEC & state review
- Audited financial statements are not required*
- No purchase limits for investors**
Tier 2 offering
- Up to $75 million can be offered
- Subject to SEC review only*
- Audited financial statements
- Purchase limits for investors**
*Although Regulation A+ offerings avoid many of the rules and regulations typically imposed on public offerings, some regulator oversight still exists. This is why the SEC and the state administrator review some of these offerings. You don’t need to know the specifics, other than what type of review each offering is subject to.
**Purchase limits for investors only apply to Tier 2 offerings. If an investor does not qualify as accredited (see below), they cannot purchase more than 10% of their net worth or net income, whichever is greater.
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 initial public offerings (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:
- Raise capital from private placements
- Grow the business
- Repeat as much as possible
- 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
*This is a recent update to the accredited investor definition. Congratulations - if you pass this exam, you’ll be considered an accredited investor!
**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 are 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, the states have their own regulatory departments that regulate the financial markets. Known as “blue sky” laws, state laws have their own registration process defined and explained under the Uniform Securities Act. The term ‘blue sky’ refers to an old saying that fraudsters would sell you the blue sky if they could.
The equivalent to the SEC at the state level is known as the state administrator. Each state has its own securities administrator, which is an office of people dedicated to protecting investors in their state and enforcing the Uniform Securities Act. They have the same goal as the SEC, which is to prevent fraud and manipulation in the securities markets. Even if a security is sold in multiple states, it must be registered unless the security is exempt. Most of the exemptions we learned about earlier apply to the states as well.
There are three types of registration at the state level:
- Registration by filing (notice filing)
- Registration by coordination
- Registration by qualification.
Registration by filing (notice filing)
Larger, well-established issuers tend to register by filing, which results in federal registration only. Known as federal-covered securities, exchange-listed securities and investment company issues (like mutual funds) qualify to be registered only with the SEC. Although it’s referred to as ‘registration by filing,’ there is no registration happening with the state. The issuer does a notice filing, which is a notification that their security will be trading in the administrator’s state (but will be regulated only by the SEC).
Registration by coordination
This process involves securities being registered with the SEC and the state administrator. Registration by coordination is reserved for companies that trade in multiple states, but don’t meet the requirements to qualify as a federally covered security. These tend to be securities from smaller and lesser-known entities.
Registration by qualification
This form of registration is available to issuers selling their securities in one state only. Securities claiming a Rule 147 federal exemption will likely register their securities by qualification. Registration by qualification involves registration with the state administrator only and does not include SEC registration.
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