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Table of Contents    Cover    MCLE Test

MCLE Article and Self-Assessment Test

Designed to Scale

The ability of small companies to raise capital has been dramatically eased by new federal and state securities rules. 

By Lee R. Petillon

Lee R. Petillon, a partner in Petillon & Hansen in Torrance, practices corporate and securities law, principally for emerging growth companies. He drafted the California SCOR legislation (AB 3763), Regulation A legislation (SB 667), and SB 261. He was assisted in this article by Mark T. Hiraide, a Petillon & Hansen associate and former attorney-advisor with the Securities and Exchange Commission. 

 

Lawyers who represent fast-growing businesses, particularly high-tech companies, will probably be asked at some time or another to help these companies find equity capital, either through the private or public offering markets. Increasingly, in California and across the nation, small but fast-growing companies generate most of the new jobs and new technologies, and these emerging companies need equity capital to fuel their expansion. 

A lack of equity capital is particularly noticeable in Southern California. Even though the Los Angeles area has more than 15,000 technology firms, as compared to about 9,000 in Silicon Valley, venture capital investment in Silicon Valley outpaced that of Los Angeles and Orange counties by a nearly five-to-one margin in the first nine months of 1996 ($1.7 billion versus $360 million, according to a Price Waterhouse survey). Similarly, in 1995 the number of initial public offerings in Silicon Valley exceeded those in Southern California by eight-to-one (sixty-five in Silicon Valley versus eight in Southern California, according to Venture One Corporation). And, even though Southern California has seen a recent pickup in employment, it still has 300,000 less jobs than it did before the latest recession. Many business observers believe that Southern California's path out of the recession will be led by these emerging small businesses and fledgling high-tech companies. 

Federal and state regulators, Congress, and the California Legislature, in recognition of these trends, have been working in recent years to remove regulatory impediments to public and private capital formation for relatively small companies. In adopting these reforms, policy makers are acknowledging a basic economic syllogism: small businesses create most of the new jobs by developing new technologies and products; small companies need equity capital in order to do this; therefore, easier access to equity capital encourages job growth. 

Since 1980, under a mandate from Congress, the Securities and Exchange Commission (SEC) has attempted to facilitate small company capital formation by adopting regulatory reforms that make it easier to comply with the federal securities laws for private placements and public offerings. In 1992 and 1993, pursuant to this mandate, the SEC adopted important changes called the small business initiatives. In 1992, California adopted similarly motivated legislation called the small corporate offering registration (SCOR). SCOR simplifies procedures for public offerings of up to $1 million annually that are exempt from registration under the federal Securities Act of 1933 (Securities Act).[1] 

In the past year, federal and state regulators have undertaken another round of reforms designed to further facilitate the raising of capital by small companies. In addition to these regulatory actions, Congress and the California Legislature have enacted statutes enhancing capital formation. In total, these regulatory changes can be divided into five general categories:

  • HR 3005, Capital Markets Efficiency Act of 1996, which amends federal securities laws.   
  • New SEC rules.   
  • New California private offering exemption under Corporations Code Section 25102(n).   
  • California rule changes affecting small company offerings and employee stock option plans.   
  • California Senate Bill 261.

The Capital Markets Efficiency Act of 1996 (the 1996 Federal Reform Act) was passed by Congress on October 2, 1996, and signed into law by President Clinton on October 11.[2] The statute includes several provisions that affect small companies.

First, the bill exempts from state regulations the offer and sale of "covered securities," i.e., securities listed on the New York Stock Exchange, the American Stock Exchange, the NASDAQ National Market System, and other stock exchanges specified by the SEC as having substantially similar listing standards. ÒCovered securities" include securities that are senior or equal to the listed securities. This provision parallels the exemption under California Corporations Code Section 25100(o), which exempts the same listed securities from the permit requirements, provided that such exchanges meet certain listing standards such as minimum income, net assets, float, share price, number of shareholders, and operating history. Since the federal preemptive provision has no conditions other than stock exchange listing, it provides a simpler and unconditional exemption not only from California regulation, but from that of the other 49 states. This should make multistate offerings easier, faster, and less costly.

The 1996 Federal Reform Act also preempts state regulation of securities offered publicly or privately to "qualified purchasers." In the statute, Congress gave the SEC broad authority to define the term: "[I]n prescribing such rule, the Commission may define the term Ôqualified purchaser' differently with respect to different categories of securities, consistent with the public interest and the protection of investors."[3]

The 1996 Federal Reform Act further preempts state regulation of offers and sales of securities exempt from federal registration under Section 4(1) of the Securities Act (transactions by any person other than an issuer, underwriter, or dealer); or Section 4(3) (transactions by a dealer, with certain exceptions) provided the issuer files periodic reports with the SEC under the Securities Exchange Act of 1934 (Exchange Act); or Section 4(4) (brokersí transactions).

The new legislation also preempts state regulation of private offerings that are exempt from federal registration under the rules and regulations adopted by the SEC under Section 4(2) of the Securities Act (transactions by an issuer not involving any public offering). Rule 506 was adopted pursuant to Section 4(2) and accordingly exempts from state regulation all private offerings that comply with its provisions, subject only to the right of the state to impose notice filing requirements and to charge filing fees in effect on the day before the date of enactment of the legislation. The exemption from state regulation does not restrict states from investigating and bringing enforcement actions due to fraud, deceit, or unlawful acts by broker/dealers.[4]

The 1996 Federal Reform Act also amends Section 3(c)(7) of the Investment Company Act of 1940, to exempt private investment pools, such as venture capital funds, from registration under the act when the offering is made privately to an unlimited number of Òqualified purchasers" plus no more than 100 investors who are not qualified purchasers. Qualified purchasers are defined as individuals with investments of $5 million or more and institutions with investments of $25 million or more. Also exempted from the Investment Company Act are state-chartered economic, business, and industrial development companies that provide financial or managerial assistance to business enterprises in that state and whose activities are limited to the promotion of economic, business, or industrial development in the state, if they 1) are regulated under a specific state statute[5] and organized under the laws of that state; 2) do not issue redeemable securities; 3) sell at least 80 percent of their securities to persons residing in the state where the company is organized; and 4) sell securities only to Òaccredited investors."[6]

The 1996 Federal Reform Act further authorizes the SEC to exempt, pursuant to application, closed-end funds from some or all of the provisions of Section 6(d)(1) of the Investment Company Act, if the offering amount is $10 million or less and is offered only to residents of a single state. Previous laws limited this exemption to offerings of less than $100,000.

The new legislation also effects certain reforms of the rules governing business development companies, which are closed-end funds that invest in small and developing businesses and are registered under the Investment Company Act. The rule changes are designed to make it easier and less costly for business development companies to offer securities and to invest in small businesses.

The 1996 Federal Reform Act also amends both the Securites Act and the Exchange Act, granting the SEC broad authority to exempt certain transactions from the requirements of the two acts.[7] This will presumably give the SEC the power it needs to implement its Òtest-the-waters" proposals and to increase the current $1 million dollar ceiling on offerings exempted under Section 3(b), such as SCOR offerings under Rule 504.

Finally, the reform legislation amends the Securities Act by adding a provision to Section 2 to require the SEC to consider, in addition to the protection of investors, whether its rule-making activities Òwill promote efficiency, competition, and capital formation."[8] This new subsection, together with Section 19(c), indicates a greater balance between protection of investors and facilitating capital formation and should benefit small business issuers.

Beyond the changes mandated by the Federal Reform Act, the SEC used its existing authority to implement additional rules and procedural changes in 1996.[9] Some of these steps are designed to further reduce the regulatory burden for small companies seeking to raise capital in the private and public markets. Others update SEC practices in recognition of technological and other changes that have affected the capital markets.

Among the rule changes was the adoption of new Rule 1001.[10] It exempts from federal registration offerings of up to $5 million (calculated on an offering-by-offering basis) that already qualify for exemption from many state regulations under California Securities Law (CSL) Section 25102(n). In a second rule change, the SEC amended Exchange Act Rules 12g-1, 12g-4, and 12h-3,[11] raising from $5 million to $10 million the minimum amount of total assets required to trigger the registration and reporting requirements of the Exchange Act. As a result, a public issuer need not register under Section 12(g) until it has 500 or more record holders of a class of equity securities and total assets of $10 million.

A third rule change, which became effective on November 9, 1996, simplifies for small business issuers the registration disclosure of financial statements of Òsignificant acquisitions."[12] The amended rules provide that financial statements of probable and recently consummated business acquisitions need be included in registration statements of a small business issuer only if the acquisition is significant.[13] This will provide relief to a small business issuer that, prior to ordering a registered offering, wants to acquire a smaller company that does not have audited financial statements. If under the test, the acquisition is not deemed significant, the reporting company will have 75 days after the consummation of the acquisition to disclose financial statements of the acquisition.

In addition to the rules it adopted in 1996, the SEC is still considering three other changes that it may adopt by the end of 1997:

New Rule 135d would extend the exemption for test-the-waters solicitations to all public offerings, not just Regulation A offerings.

Amendments to Rule 144 would reduce the holding periods for the resale of restricted securities from two years to one year, and for Rule 144(k), from three years to two years.

  • Exchange Act rule amendments would simplify the disclosure of officersí and directorsí compensation in proxy statements and periodic reports.   

    In other SEC actions of interest to small businesses, the commission, on October 6, 1995, adopted an interpretive release and rule changes to facilitate the dissemination of prospectuses and other offering materials on the Internet.14 By their very nature, such offers are automatically disseminated into every state electronically. As of December 31, 1996, 25 states, including California,[15] had adopted an exemption from state registration requirements for Internet offers. All of these exemptive rules are based on the following three conditions: 1) the Internet offer must originate from outside the state and must indicate that the securities are not being offered or sold to residents of the state; 2) the Internet offer is not directed to any person in the state, by or on behalf of the issuers; and 3) no sales of the securities will be made in the state unless they are qualified or are exempt from qualification. 

    The SEC made clear that it favors electronic media as a means of delivering information required by the Securities Act. However, to ensure adequate dissemination of electronically transmitted information, the commission requires that the intended recipients receive information substantially equivalent to that delivered in paper form. 

    This requirement involves two basic variables: notice and access. The SEC believes that issuers should consider the extent to which electronic communication provides timely and adequate notice to investors that information is available to them. The SEC also requires that recipients who are provided information through electronic delivery should have access comparable to those who receive the information via traditional media. Consequently, the use of a particular medium should not be so burdensome that intended recipients cannot gain effective and efficient access to the information.[16] Issuers must also be able to make available paper versions of documents delivered in an electronic medium. 

    Procedures that would provide evidence that these requirements have been met include: 

    1) Obtaining an informed consent from an investor to receive information through a particular electronic medium (e.g., e-mail or Internet Web site); 

    2) Obtaining evidence that the investor actually received the information (e.g., by electronic mail return receipt or confirmation of accessing, downloading, or printing); 

    3) Disseminating information through facsimile methods; 

    4) Providing Internet hyperlinks that enable investors to access required documents; and 

    5) Using forms or other material that are available only by accessing the information.[17] 

    The SEC also amended its rules governing the physical appearance of paper disclosure documents, such as type size and font requirements.[18] The new rules provide that if the document is being delivered in an electronic version, the issuer may comply with the requirements by presenting the information in a format readily communicated to investors. Where the former rules required legends to be printed in red ink or boldface type or by using a different font size, issuers may present the legends in any manner reasonably calculated to draw attention to them. In addition, the amendments provide that all versions of a disseminated document, whether paper or electronic, should convey substantially equivalent information to investors. 

    The SEC also will now permit voluntary electronic filing on the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system of securities ownership and transaction reports filed under Exchange Act Section 16(a).[19] This includes Form 3, Initial Statement of Beneficial Ownership; Form 4, Statement of Changes in Beneficial Ownership; and Form 5, Annual Statement of Beneficial Ownership of Securities. The amended rules provide filers of these forms with the option of filing them electronically or by the traditional paper method.

    T he state of California has also been active in reforming its securities laws affecting small company issuers. On September 26, 1994, California adopted a significant new statute, Corporation Code Section 25102(n) and regulations thereunder.[20] It exempts from state registration certain private offerings. This exemption combines the benefits of a private placement with those of a general solicitation, and applies to the sale of securities by California or quasi-California corporations[21] or any other business entity organized under California law. 

    The new law places no limits on the number of offerees or purchasers to whom an issuer can approach or sell securities, and allows the issuer to use a general solicitation to disseminate a general announcement of the offering. These general announcement provisions are comparable to the federal test-the-waters solicitations permitted for Regulation A offerings. 

    Offers may be made to any person who responds to the general announcement, but sales may be made only to Òqualified purchasers." The new section defines a Òqualified purchaser" in more flexible terms than the SEC definition of an Òaccredited investor" under Regulation D.22 The new law defines a qualified purchaser to include specified institutions, as well as natural persons who have 1) a minimum net worth of $250,000 and gross income of $100,000 during the immediately preceding tax year and who expect such income in the current tax year, or 2) a minimum net worth of $500,000. The calculation of net worth excludes home, home furnishings, and automobiles. 

    A qualifying natural person must, by reason of his or her business or financial experience (or that of his or her professional adviser who is unaffiliated and not compensated by the issuer), be reasonably assumed to have the capacity to protect his or her interests in connection with the transaction. In addition, the amount of the investment cannot exceed 10 percent of his or her net worth.[23] The exemption is not available for offerings related to roll-up transactions, "blind-pool" issuers, or investment companies registered under the Investment Company Act.[24] 

    Issuers must provide purchasers who are natural persons a disclosure document at least five days prior to any sale or post-amendment purchase.[25] Under CSL Rules,[26] if an issuer relies on the federal exemption provided by Rule 504,[27] a disclosure statement on Form U-7[28] will satisfy the requirements of Section 25102(n). The issuer must file a copy of the disclosure document with the California Department of Corporations upon 10 days written request by the department. 

    The CSL Rules under Section 25102(n) do not include separate rules for furnishing financial statements. Thus, it can be argued that when a small business issuer (see "Speaking of Securities: A Glossary," page 33) pursues a Section 25102(n) offering under amended CSL Rules Section 260.613, only an unaudited balance sheet and unaudited two-year statements of income and cash flows would be required. Hopefully, the commissioner of corporations will adopt a rule clarifying this requirement.[29] 

    The most innovative provision of Section 25102(n) allows an issuer to broadly disseminate a written announcement of the offering[30] that is tantamount in form and content to a general solicitation.[31] The issuer must disclose the following information in the general announcement: 

    • The name of the issuer.   
    • The title of the securities being offered.   
    • Suitability standards for "qualified purchasers."   
    • A statement that no money is being solicited or will be accepted on the basis of the general announcement, and that if delivery of a disclosure document is required, no sales will be made final until five days after delivery of the disclosure document.   
    • A legend disclosing the name, address, and telephone number where information concerning the offering may be obtained.[32]

    The issuer may also provide a brief description of the issuerís business and geographic location, as well as the issuerís proposed offering price.[33] The issuer may contact prospects by telephone only after determining that the prospect is a qualified purchaser.[34] 

    Section 25102(n) requires the issuer to file a first notice of transaction, together with a $600 filing fee, with the Department of Corporations upon commencement of the offering or upon publication of the general announcement, whichever occurs first. In addition, the issuer must file copies of the general announcement, if one is published.[35] The issuer must also file a second notice within 10 days of closing or abandoning the offering, but in no event later than 210 days after filing the first notice.[36] 

    Section 25102(n) also requires purchasers to represent that they are purchasing the issuerís securities for investment purposes and not for further distribution.[37] However, no holding period has been established. It can be argued that the duration of any holding period should be established by reference to the particular federal exemption selected by the issuer. For example, if an issuer conducts a Section 25102(n) offering under federal Rule 1001, then it would be reasonable that federal Rule 144(d), which imposes a two-year holding period subject to volume limitations[38] and three years without any volume limitations for nonaffiliates,[39] applies. 

    If the issuer pursued a Section 25102(n) offering under the Rule 504 exemption from federal registration, it can be argued that the purchaser should not be limited by any holding period since there is none under Rule 504. However, since Section 25102(n)(3) requires all purchasers to represent that they are purchasing the issuerís securities for investment, not resale, purposes, it is not clear how long such securities must be held before they may be resold under California law. This is a question that the Department of Corporations will need to clarify by interpretive rule. 

    The legislation did not establish any maximum amount for offerings under new Section 25102(n). Of course, if the issuer seeks an exemption from federal registration under Rule 1001, no single offer can exceed $5 million. If the issuer seeks exemption under Securities Act Section 3(a)(11)[40] and Rule 147,[41] no maximum should apply since there is none under this federal exemption. If the issuer relies on Rule 504, the offering cannot exceed $1 million, minus the aggregate amount of certain securities offerings.[42] 

    On January 27, 1995, the California commissioner of corporations published proposed amendments to California Securities Law rules relating to "small business issuers,"[43] which became effective on January 18, 1996. These new rules modify the commissioner's merit review standards for small business issuers, and are designed to make public offerings more viable for these companies. 

    New CSL Rules Section 260.140.01(e) provides for a waiver of the merit review standards in a private or public offering of $5 million or less by a small business issuer if the offering is limited to investors who 1) have a net worth of $75,000 and a gross income of $50,000 or who have a net worth of $150,000, and in either case, the investment does not exceed 10 percent of the investorís net worth; 2) have not purchased more than $2,500 of the issuerís securities in the previous 12 months; or 3) for individual retirement account investments, the buyer has not purchased more than $2,500 of the issuer's securities in the previous 12 months, unless the issuer is registered as a reporting company under Section 12 of the Exchange Act, in which case the net worth and gross income suitability tests of the first condition apply. If the offering by a 
    small business issuer of $5 million or less is limited to investors who meet these suitability requirements, the following merit review rules will be waived: 

    • The unseasoned company rule,[44] which enables the commissioner to disapprove permit applications when the issuer does not have a record of profits or does not expect to produce profits within a reasonable period of time. This rule is waived except for Subsection (c), which requires the delivery of the Consumer's Guide to Small Business Investments (prepared by the North American Securities Administrators Association) to each prospective purchaser. 
    • The promotional share rule,[45] which provides that the percentage of promotional shares may not exceed 50 percent of the companyís issued and proposed capitalization. 

    The offering price rule,[46] which allows the commissioner to determine the fairness of the offering price. This rule is waived except for Subsection (c), which requires a minimum public offering price of $2 per share. 

    The Department of Corporations also amended rules pertaining to CSL Rules Section 260.140.05 to allow any issuer that is not currently profitable to nevertheless obtain a permit for an open qualification if the issuer can demonstrate that it reasonably anticipates producing profits within a Òreasonable period of time." This period is defined as up to 24 months after the date of the approval of the application, or even longer if justified by the nature and circumstances of the applicant's business, including the operational norms for the industry in which the applicant operates.[47] The amended rule requires an issuer to submit prospective financial information regarding future profitability based upon "appropriate and reasonable assumptions." In addition, the Department of Corporations may require that the issuer's independent public accountants perform some due diligence in accordance with standards established by the American Institute of Certified Public Accountants.[48]

    CSL Rules Section 260.140.20 was modified to establish higher maximum selling expenses in public offerings by small business issuers. Under the amended rule, small business issuers may incur selling expenses of up to 18 percent of the aggregate offering price (increased from 15 percent) for offerings of up to $5 million, provided the underwriting discounts and commissions do not exceed 13 percent. For offerings of $3 million or less, selling expenses may reach as high as 20 percent of the aggregate offering price (increased from 15 percent), provided that underwriting discounts and commissions do not exceed 15 percent. These rules are designed to make small offerings more attractive to small broker/dealers who often avoid underwriting small offerings because of the 15 percent limitation that includes not only underwriting discounts and commissions, but a variety of other offering expenses.[49] 

    Further rule changes amended the promotional stock provisions in CSL Rules Section 260.140.31 to provide that a small business issuer that qualifies for a SCOR offering permit[50] may issue promotional shares up to 50 percent of the total common shares issued and proposed to be issued, rather than 25 percent as provided for all other issuers. The financial statement requirements in amended CSL Rules Section 260.613 reduced from three to two the number of fiscal years for which a small business issuer engaged in a private offering must provide statements of income and cash flows. Subsection 260.613(f) also provides that a small business issuer seeking a permit for a public offering of not more than $500,000 may provide reviewed, rather than audited, financial statements. 

    These amended rules should materially facilitate the process of raising capital through both private and public offerings for small companies because small business issuers will have an easier time qualifying their securities or obtaining appropriate exemptions under the CSL.

    Californiaís most recent effort to assist small businesses gain access to capital markets is embodied in California Senate Bill 261, which became effective on May 6, 1996. The legislation made several changes to the California Securities Law. New Section 25102(o) exempts stock option plans from the qualification requirements of the Department of Corporations. This amendment will save small companies the expense and delay of preparing and filing a permit application to qualify an employee stock option plan. This process often involves several thousand dollars in legal fees and several weeks or months of processing by the department. 

    The exemption from qualification under Section 25102(o) is limited to securities that are already exempt from federal registration under Rule 701 of the Securities Act,[51] the provisions of which are incorporated by reference into Section 25102(o). Rule 701 is available to issuers that are not subject to the reporting requirements of the Exchange Act and applies to compensatory stock plans that are limited to employees, directors, and consultants not related to a capital-raising transaction, where the amount of outstanding securities subject to offers under Rule 701, together with the securities sold in the prior 12 months under the rule, do not exceed the greater of 1) $500,000, 2) 15 percent of the issuerís total assets, 3) 15 percent of the outstanding securities of the same class, or 4) $5 million of securities in aggregate. Exempt plans are also required to comply with the commissioner's rules relating to stock-option and stock-purchase plans.[52] These rules establish several conditions, including the maximum amount of outstanding options, minimum price, restrictions on transfer, antidilution adjustments, minimum vesting requirements, minimum post-termination exercise periods, shareholder approval, restrictions on repurchase rights, and financial statement disclosure.[53] In addition, the issuer must pay the filing fee for qualification of such plans together with a notice of transaction. 

    SB 261 also amends CSL Section 25111 to permit qualification-by-coordination for Regulation A offerings. This provision will permit an issuer pursuing a multistate offering to coordinate the SEC's approval process with approval by California and other states that allow qualification-by-coordination. 

    SB 261 makes SCOR offerings more flexible by introducing three changes to Section 25113(b)(2): 

  • 1) The amended section no longer limits offerings to common voting stock. Now an issuer can effect a SCOR offering of preferred stock or a combination of preferred and common stock. 

    2) The amended section requires a majority, rather than unanimous, approval by the board of directors of the issuer's permit application and Form U-7. 

    3) The amended section reduces the minimum per share price from $5 to $2. This change will permit a SCOR issuer to issue and sell up to 500,000 shares at $2 a share, rather than a maximum of 200,000 shares at $5 a share. This gives the underwriter and market-maker greater flexibility in creating an orderly after-market for the offering. 

    CSL Section 25103(h) was also amended by SB 261 to exempt certain mergers and reorganizations (other than roll-ups) from qualification, if 1) the transaction would have been exempt from qualification under Section 25102(f); 2) not less than 75 percent of the outstanding equity securities of each constituent corporation (instead of 100 percent of the acquired corporation) votes in favor of the transaction; 3) not more than 10 percent of the securities of each constituent corporation votes against the transaction; and 4) dissentersí rights are addressed by the applicable state statutes. A notice with a $600 fee must be filed with the Department of Corporations. 

    Finally, SB 261 amends Section 25102(h) to remove the legend requirement and provide that companies that previously issued securities under this exemption may remove such legends, provided that each purchaser must now represent that he or she is purchasing for their own account (or for a trust account if the purchaser is a trustee) and not with the intent of reselling or redistributing the stock. 

    Taken together, these wide-ranging federal and state reforms provide California small businesses with new alternative methods for raising capital through the private and public equity markets, and significantly reduce the regulatory red tape that often inhibits small business capital formation. Significantly, regulators have finally recognized that small businesses generate most of the new jobs in Californiaís recovering economy. Indeed, the benefits of these reforms may help lay the foundation for a new and vigorous California economy based on emerging technologies and innovative products that will flourish in the highly competitive global marketplace of the twenty-first century. 


    SIDEBAR:
    Speaking of Securities: A Glossary 

  • Accredited Investors. Investors who, by reason of their financial position, do not need the protection of the disclosure requirements under Regulation D. These investors include 1) a natural person who has a net worth exceeding $1 million or income exceeding $200,000 (or $300,000 if married and filing a joint return) in each of the two most recent years and expects the same income level in the current year; 2) certain institutional investors such as banks, investment companies, and broker/dealers; 3) organizations with total assets exceeding $5 million; and 4) directors and executive officers of the issuer.[1] 

    Blind-Pool Issuer. An issuer with no specific business purpose.[2] 

    Excluded Purchasers. Investors who are excluded from the count of purchasers (35 maximum) under CSL §25102(f). Excluded purchasers include specified financial institutions, and natural persons whose net worth exceeds $1 million or whose income exceeds $200,000 for each of the two most recent years, provided that either 1) the investor has the capacity to protect his or her interests in the transaction; 2) the investor is able to bear the economic risk of the investment; or 3) the investment does not exceed 10 percent of his or her net worth (or joint net worth with the investorís spouse).[3] 

    General Solicitation. An offering of securities to the public at large without regard to the suitability of the investment, whether there has been a preexisting relationship between the issuer and the investors, or whether the investors have the requisite sophistication to evaluate the investment or financial position to accept the risk. 

    Integration. A concept applied by the SEC and the courts to determine whether two private offerings, each of which is exempt from registration, would still meet the exemption requirements of Regulation D or Section 4(2) of the Securities Act when considered together.[4] 

    Qualified Purchasers (California). Any person who meets one of the following conditions:[5] 

  • Executive officers of the issuer, or persons occupying a similar position.    
  • Designated institutional purchasers or their affiliates, including banks, savings and loan associations, insurance companies, investment companies registered under the Investment Company Act of 1940, pension and profit-sharing trusts, and self-employed individual retirement plans.    
  • Excluded purchasers as defined in CSL Section 260.102.13.    
  • Corporations or partnerships with total assets exceeding $5 million.    
  • Certain relatives residing with qualified purchasers.    
  • Promoters.    
  • Any person purchasing more than $150,000 of the offered securities.    
  • Entities specifically formed to acquire the securities offered under this exemption if all of its equity owners are qualified purchasers.    
  • Reporting companies under the Exchange Act if the transaction involves the acquisition of all of the issuerís capital stock for investment.    
  • A natural person whose net worth exceeds $500,000 or whose net worth exceeds $250,000 and whose annual income exceeds $100,000 provided that in either case:   

    1) The transaction involves only one class of common voting stock (or preferred stock with at least the same voting rights as the common stock);   

    2) The investment does not exceed 10 percent of the purchaserís net worth; and  

    3) The purchaser is able to protect his or her own interests in the transaction (alone or with the help of an unaffiliated professional advisor).

  • Pension and profit sharing trusts, 401(k) plans, and individual retirement accounts, if investment decisions are made solely by individual qualified purchasers.

    Quasi-California Corporation. A foreign corporation that is made subject to certain provisions of the California Corporations Code because more than 50 percent of its outstanding voting securities are held by California residents and more than 50 percent of the average of its property, payroll, and sales are derived from California.[6] 

    Reporting Company. A publicly held company that is required to file periodic reports with the SEC under Exchange Act Section 13(a) or 15(d). 

    Restricted Securities. Securities acquired directly or indirectly from the issuer or an affiliate in a transaction or chain of transactions not involving any public offering or that are subject to the resale limitations of Regulation D or Rule 701 under the Securities Act.[7] 

    Small Business Issuer (SEC). A company with annual sales of less than $25 million and public float of $25 million or less.[8] 

    Small Business Issuer (California). A California corporation, or a quasi-California corporation subject to Corporations Code Section 2115, that is not an investment company or blind pool, with annual revenues of less than $12.5 million.[9] 

    Test-the-Waters. Solicitations of interest from prospective investors conducted before the issuer incurs the expense of preparing the offering materials and financial statements. Adopted in 1992 for Regulation A offerings only, proposed Rule 135d would extend this procedure to all initial public offerings. The term is also used to describe the general announcement permitted broad dissemination under the offering exemption of CSL Section 25102(n).ÑL.R.P. 

    1 Securities Act Reg. D Rule 501(a), 17 CFR §230.501(a). 

    2 Cal. Code Regs. tit. 10 [hereinafter CSL Rules] §260.113.1. 

    3 CSL Rules §260.102.13. 

    4 Securities Act Reg. D. Rule 502(a) defines integration, using a five-factor test and provides a safe harbor for offerings separated by a six-month period. 

    5 As defined in CSL §25102(n). 

    6 Corp Code §2115. 

    7 Securities Act Rule 144(a)(3). 

    8 Securities Act Reg. S-B Item 10(a)(1), 17 C.F.R. 5228.10. 

    9 CSL Rules §260.001(i). 


  • 1 For a summary of these initiatives, see Lee R. Petillon, Raising Capital for Small Companies, Los Angeles Lawyer, Dec. 1992, at 24.  

    2 The 1996 Federal Reform Act amends the Securities Act of 1933 [hereinafter Securities Act], the Securities Exchange Act of 1934 [hereinafter Exchange Act], the Investment Advisory Act of 1940, and the Investment Company Act of 1940, and is the most comprehensive federal securities legislation since 1940. All of the provisions discussed in this article became effective on Oct. 11, 1996, except the provisions exempting investment pools from the Investment Company Act, which become effective upon the earlier of 180 days after the effective date of the act or upon adoption of rules defining "investments" by the SEC.  

    3 Securities Act §18(b)(3).  

    4 Securities Act §18(c)(1).  

    5 The Senate Committee on Banking, Housing and Urban Affairs, S. Rep. No. 104-293, 104th Cong. 2d Sess. (1996) states that 44 states, including California, have enacted such statutes. The applicable California regulatory authority is apparently found in three separate statutes which can be located at Corp. Code ¤¤14,000-14,101; Fin. Code ¤¤31,000-31,953; and Fin. Code ¤¤32,000-32,960.  

    6 Investment Company Act §6(a)(5). The term "accredited investor" is defined in the Securities Act ¤2(a)(15). See also ÒSpeaking of Securities: A Glossary," page 33.  

    7 Securities Act §28 as amended; Exchange Act §36 as amended.  

    8 Securities Act §2(b) as amended.  

    9 The changes were originally proposed for public comment on June 27, 1995. See SEC Rel. Nos. 33-7185, 33-7186, 33-7189 (June 27, 1995) for a detailed description of those changes. The first two rule changes became effective on May 2, 1996, and the third on Oct. 4, 1996.  

    10 Reg. CE, 17 CFR §230.1001. SEC Rule 504 previously exempted from federal registration requirements general solicitations for offerings of up to $1 million. In lieu of raising this ceiling, the SEC adopted Rule 1001.  

    11 17 C.F.R. §§240.12g-1, 240.12g-4, and 240.12h-3.  

    12 Reg. S-B Item 310, 17 C.F.R. §228.310. See also SEC Rel. No. 33-7355 (Oct. 10, 1996).  

    13 According to the new rules, an acquisition is considered significant if 1) the acquiring companyís investment in and advances to the acquired company exceeds 50 percent of the total consolidated assets of the acquiring company (or in a pooling of interests, the number of common shares issued or to be issued by the acquiring company exceeds 50 percent of its total issued and outstanding common shares); 2) the acquiring company's proportionate share of the total assets of the acquired company exceeds 50 percent of the total consolidated assets of the acquiring company; or 3) the acquiring companyís equity in the pretax net income from continuing operations of the acquired company exceeds 50 percent of the consolidated income of the acquiring company. Reg. S-B, Item 310 (c), 17 C.F.R. §228.310.  

    14 SEC Rel. No. 33-7233 (Oct. 6, 1995).  

    15 California Department of Corporations, Commissionerís Rel. No. 100-C (Nov. 5, 1996).  

    16 For example, if an investor must wade through a continuing series of menus to view a document, this procedure would likely be viewed as unduly burdensome.  

    17 See SEC Rel. No. 33-7233 for additional procedures that provide evidence of satisfaction of the delivery requirement. The SEC provides a number of examples in SEC Rel. No. 33-7233 that illustrate the basic principles described in the text.  

    18 SEC Rel. No. 33-7234 (Oct. 6, 1995). Release No. 33-7234 amends Rules 253, 420, 481 and 482, 605, 304, as well as Exchange Act rules for dissemination of mutual fund prospectuses and proxy statements under Sched. 14 and tender offer statements under Regs. 14D and 14E.  

    19 SEC Rel. No. 33-7231 (Oct. 5, 1995).  

    20 California Securities Law [hereinafter CSL] §25102(n) (codified at Corp. Code §25102(n)) and Cal. Code Regs. tit. 10 [hereinafter CSL Rules], ¤¤260.102.16 to 260.102.18.  

    21 I.e., a foreign corporation subject to Corp. Code §2115. See "Speaking of Securities: A Glossary," page 33.  

    22 See "Speaking of Securities: A Glossary," page 33, for the definition of an "accredited investor" as defined in Securities Act Rule 501(a).  

    23 See "Speaking of Securities: A Glossary," page 33, for a more detailed definition of "qualified purchaser."  

    24 CSL §25102(n)(1). See "Speaking of Securities: A Glossary," page 33, for the definition of Òblind-pool issuer."  

    25 CSL §25102(n)(4).  

    26 CSL Rules §260.102.17. All references in the text to CSL Rules refer to Cal. Code Regs. tit. 10. See supra note 20.  

    27 Reg. D Rule 504, 17 C.F.R. §230.504.  

    28 Form U-7 is a standardized question-and-answer form formulated by the North American Securities Administrators Association and authorized by many states, including California, for small corporate offering registrations (SCOR).  

    29 Since CSL Rules §260.113.1 item 7, which governs Form U-7 disclosure documents, provides that financial statements required by Form U-7 shall comply with CSL Rules ¤260.613, and the financial-statement requirements under CSL Rules ¤260.613 include provisions for both private placements and public offerings (the latter defined as an application for open qualification), the less exacting private-placement rules in CSL Rules §260.613 should be applicable to CSL §25102(n) offerings in view of the fact that such offerings must be limited to "qualified purchasers" who must represent that they are purchasing for investment.  

    30 Although CSL §25102(n)(5)(A) provides that a general announcement of the proposed offering may be published "by written document only," the California commissioner of corporations has ruled that dissemination of such information in readable form by electronic means such as the Internet satisfies the requirement for a written document. California Department of Corporations, Commissioner's Interpretive Op. No. 96/2C (Oct. 17, 1996).  

    31 CSL ¤25102(n)(5).  

    32 CSL §25102(n)(5)(A)(vi).  

    33 CSL §25102(n)(5)(B).  

    34 CSL §25102(n)(6).  

    35 CSL §25102(n)(7).  

    36 Id.  

    37 CSL §25102(n)(3).  

    38 Rule 144(d), 17 CFR §230.144(d).  

    39 Rule 144(k), 17 CFR §230.144(k).  

    40 Securities Act §3(a)(11), 15 U.S.C. §77c(a)(11).  

    41 Rule 147, 17 C.F.R. §230.147.  

    42 Rule 504 requires an issuer to deduct from the total offering the amount of all securities sold within 12 months prior to the offering of securities 1) in reliance on Rule 504 or any other exemption provided by ¤3(b); or 2) in violation of Securities Act ¤5.  

    43 CSL Rules §260.001(i). For the definition of "small business issuer," see "Speaking of Securities: A Glossary," page 33.  

    44 CSL Rules §260.140.05.  

    45 CSL Rules §260.140.31.  

    46 CSL Rules §260.140.50.  

    47 CSL Rules §§260.140.05(a) and (b).  

    48 CSL Rules §260.140.05(b). The modified rule provides that services required to be performed by a CPA may include 1) examining of prospective financial statements, either forecasted or projected; 2) compiling prospective financial statements, either forecasted or projected; 3) performing feasibility studies; 4) providing assistance in developing forecasting systems; and 5) identifying factors to be considered in developing prospective financial statements, forecasts, and projections. The modified rule (CSL Rules §260.140.05(c)) also requires small business issuers to deliver to prospective purchasers a copy of the investorís guide, A Consumerís Guide to Small Business Investments. Copies of the guide may be obtained from the Department of Corporations.  

    49 Selling expenses, as defined in CSL Rules §260.140.20, include expenses related to printing; engraving; mailing; salaries of employees while engaged in sales activity; charges of transfer agents, registrars, trustees, escrow-holdersí depositaries, and engineers and other experts; expenses of qualification of the sale under federal and state laws; and any other expenses directly related to the offering, but excluding accountants' fees and the issuer's attorneys' fees and options to underwriters.  

    50 Pursuant to CSL §25113(b)(2).  

    51 17 CFR §230.701.  

    52 Specifically, CSL Rules §§260.140.41, 260.140.42, 260.140.45, and 260.140.46.  

    53 The stock option rules generally provide for the following requirements and limitations:

    • The total number of shares issuable under options or rights to purchase shares cannot exceed 30 percent of the outstanding shares of the company (on a fully diluted basis with convertible securities deemed to be converted).

    • The exercise price must not be less than 85 percent of the fair value of the stock at the time the option or right to purchase is granted (or 100 percent for purchasers who hold more than 10 percent of the company's stock, or 110 percent for optionees who hold more than 10 percent of the companyís stock.

    • The term of options may not exceed 10 years.

    • Vesting rights must be at least 20 percent per year over five years from the date of grant.

    • The plan must terminate not more than 10 years from the date of its adoption or the date of shareholder approval.

    • Options must be nontransferable other than by will or the laws of descent and distribution.

    • The plan must be approved by shareholders within 12 months after it is adopted by the board of directors.

    • Shareholders must receive financial statements annually.

    • Where the company has the right to repurchase shares upon termination of employment, the repurchase price must be either 1) the higher of the original purchase price or fair value of the stock on date of termination of employment, or 2) the original purchase price provided that such right to repurchase lapses by at least 20 percent per year.

    • The companyís repurchase right must be exercised within 90 days of the termination date, and such right terminates when the companyís stock becomes publicly traded.

    • The filing fee is $200 plus 1/5 of 1 percent (.002) of the aggregate value of the securities issuable under the plan up to $2,500.


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