If Regulation D Is Not Available?

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP


While Regulation D has proven in practice to be extremely useful in aiding venture-backed placements, not every issue can or will be sold in compliance with the exemption. Regulation D specifically provides that it is not exclusive; thus, §4(2) is (at least theoretically) available in time of need. Certainly, however, the occasion for sole reliance on §4(2) will be infrequent. If Regulation D is lost because there has been a "general solicitation," one can hardly imagine the circumstances that could encourage the issuer to turn to §4(2).

Reliance on §4(2) standing alone is most likely, first, in those gilt-edged placements (the classic instance of a limited placement to a small number of highly sophisticated institutional investors) when compliance with Regulation D is deemed to be a bother. The issuer does not feel it necessary to qualify the investors as accredited or to file Form D. The second major category is after-the-fact justification, a common problem in venture finance. When Start-up, Inc. was organized, the founder was unaware of either Regulation D or §4(2) and thus complied with none of the formalities. Some years later, when Start-up, Inc. is ready for an initial public offering, it will be necessary for counsel to recreate the exemption, as it were, in aid of its opinion that the initial issue was not in violation of the securities laws. Ex post facto compliance with Regulation D is not usually an option, leaving §4(2) as the only available alternative.

The gist of §4(2) is that it focuses on offerees. For the exemption to obtain, each person to whom the investment opportunity is exposed, each offeree, must fit within one or more of the special categories. Those categories have been developed in the case law revolving around the central notion developed in the Ralston Purina opinion, that the disclosure requirement entailed in a registered offering should only be relaxed if all the potential buyers were of the type that they could "fend for themselves" in the sense that each could develop "access" to the information a statutory prospectus would provide.

For many years, the courts, counsel, and the SEC staff have danced around the fend-for-themselves conception without reaching a test that was, or is, entirely satisfactory. As former SEC Chairman Ray Garret has noted, the principal element in the equation–the "saving recipe" as he called it–has remained a moving target, a "brew" made up of a number of elements but lacking an agreed-upon, objective list of ingredients. There is, however, a consensus on the identity of the elements going into the brew, what facts the courts have deemed important in the past, albeit no consensus on the weight to be accorded each one.

Thus, it is clear that the offerees as a class should have one or more special abilities which give them the power and/or ability to obtain access to information about the issuer and to process that information intelligently. At one extreme, a director of the issuer, particularly one sophisticated in financial matters, is almost certainly an eligible offeree. On the other hand, the mere fact that the offerees are employees of the issuer is not (without more) sufficient to invoke the exemption; this is the holding of the Ralston Purina case.

Over the years, the idea of the "sophisticated" investor has crept into the folklore of §4(2), a concept now enshrined in the requirement that non-accredited investors in Regulation D offerings of more than $1 million have "such knowledge and experience in financial and business matters as to be capable of evaluating … the merits and risks of the prospective investment." In the strictest sense of Ralston Purina, a "sophisticated" or "smart" investor might have no power to obtain access to information because the issuer either did not have it, or would not supply it. However, the "smart" investor presumably would know how to factor in the dearth of information in making an investment decision.

Moreover, the "smartness" of the offerees is one, and only one, factor in the "recipe." Thus, the number of offerees has always been deemed important, although not determinative, since an offering involving as few as one offer, at least conceptually, could be outside the scope of §4(2) if the other factors in the "brew" so militated. Counsel were led to follow the suggestion of the SEC's general counsel in an early opinion that twenty-five or fewer offerees constituted a safe harbor, but no authoritative court or Commission pronouncement ever adopted that number as a rule. As stated above, one factual thread runs through many (if not all) of the instances in which a non-fraudulent offering was deemed outside the scope of §4(2); that is, the defendant issuer was unable to show how many offers had been made because it had failed to keep records.

The number of offerees is ultimately related to an important, and obvious, factor: the manner of the offering. If an offering is made using the traditional media of public offerings–advertisements, open seminars, paid salespeople, extended mailings, cold calls–it stands to reason that a public offering is in progress. The desire of issuers, particularly in the tax-shelter area, to reach out to a wide number of potential purchasers has often stretched this criterion, prompting counsel to creative heights with such devices as "screening." Again, as stated above, screening involves the idea that there are allowable techniques for prequalifying potential investors (thereby reducing the number of offerees), which do not rise to the dignity of an offer and, therefore, can be conducted more or less with impunity. One notion is to send out a private placement memorandum from a deal already closed and inquire of the recipient whether he would be interested in an investment resembling the "dead" deal; another is to circulate an offering only to financial advisers–lawyers, accountants, investment advisers–to induce them to disgorge names, coupled with an admonition that the deals are not to be shown to the clients until authority is given by the issuer. Regulation D being viewed generally as an expansion of the ambit of §4(2) , counsel recommending that an issuer who cannot use Regulation D because of the ban on "general solicitation" may nonetheless resort to screening under §4(2) will be taking an aggressive position. That said, since Regulation D is getting a bit more hair on it, pending requirements that the issuer, its executives and major shareholders file "bad actor" statements, reversion to 4(2) is predicted by some.

Finally, the §4(2) exemption, like Regulation D, is conditioned on the nonexistence of a subsequent public distribution. The investment-letter device, coupled with a legend on the stock certificates themselves, should be employed in private placements generally.


Introduction to Venture Capital and Private Equity Finance