Private Placement of Securities in Pennsylvania: A TLO Primer

Introduction

Raising funds to capitalize a new venture is not for the faint of heart.  This applies whether you are a true startup business about to go to market, but can also apply if you are an experienced business person that creates special purpose entities (SPEs) to carry out discrete economic activities such as large scale commercial real estate development. 

In Pennsylvania (as in every other state), there is an overlay of state securities law that provides an additional set of considerations to the federal laws and rules promulgated by the US Securities and Exchange Commission. 

One thing, however, all potential securities issuers should know: compliance with the federal and state securities laws can require time, energy and resources prior to any actual sale or acceptance of investor funds.  If you intend to raise money from investors, strategic planning is necessary to ensure compliance with state and federal law. 

The Securities Act of 1933

As a general rule, we must start with the federal Securities Act of 1933 (the "1933 Act"), which provides, among many other things, that the sale of securities is prohibited unless a registration statement has been filed with the SEC.  1933 Act, at Section 5. 

Registration is expensive and slow: the twin enemies of any startup endeavor.  Fortunately, there is a safe harbor provision in the 1933 Act that businesses can rely upon.  Section 4(2) of the Act provides an exemption from registration for transactions not involving any public offering.  Thus, private placements of securities can be exempt from the registration requirements of federal law if the correct steps are followed.  Rule 506 of Regulation D was promulgated pursuant to this part of the 1933 Act.  More on this later.

In addition, Section 3(b) of the 1933 Act grants the SEC the authority to adopt other exemptions from registration for issuers of securities with an aggregate offering price to the public of no more than $5,000,000 USD.  This gives rise to Rules 504 and 505 of Regulation D.  

Types of Security Offerings

There are many, many restrictions on the way in which funds can be raised from investors.  There are also many restrictions on the types of investors that can participate in a private placement.  Each Rule listed below has a different set of requirements regarding investor sophistication and their eligibility to participate in the offering while still providing a Safe Harbor for the Issuers. 

Suffice it so say that detail about those restrictions is best explored on case by case basis with competent legal counsel.   In very general terms, there are three main types of safe harbor offerings that are exempt from the registration under the 1933 Act:

  1. Rule 504 Offerings.  An issuer may sell up to $1,000,000 USD of securities.  The issuer may only sell up to $1,000,000 USD in any twelve month period.  Thus, if the issuer sold $500,000 USD in securities 5 months ago, for the next 7 months looking forward, that same Issuer may only sell $500,00 USD in securities.  The general rule here?  No more than $1,000,000 USD in sale in any rolling 12 month period. 
  2. Rule 505 Offerings.  An issuer may sell up to $5,000,000 USD of securities, subject to certain restrictions. 
  3. Rule 506 Offerings.   An issuer may sell an unlimited amount of securities, subject to certain restrictions. 

As we will see below, Pennsylvania places some additional requirements on those listed above. 

The Pennsylvania Securities Commission

In addition to the SEC, each state has an agency tasked with enforcing the state securities laws and regulations.  In Pennsylvania, that agency is the Pennsylvania Securities Commission, which is now part of the Pennsylvania Department of Banking and Securities. 

The PA Securities Commission has a wide range of powers, including, but not limited to, the ability to compel issuers to make a rescission offer to all its investors if the PA Securities Commission determines that the Issuer has violated the PA Act.  A rescission offer is a written offer from the Issuer to its investors to purchase back the securities which were sold, plus interest. 

What is a Security Under the Pennsylvania Securities Act?

The Pennsylvania Securities Act of 1972 (the "PA Act") contains a sprawling definition of what constitutes a "security":

"any note; stock; treasury stock; bond; debenture; evidence of indebtedness; share of beneficial interest in a business trust; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; voting trust certificate; certificate of deposit for a security; limited partnership interest; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under such a title or lease; membership interest in a limited liability company of any class or series, including any fractional or other interest in such interest, unless excluded by clause (v); or, in general, any interest or instrument commonly known as or having the incidents of a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by written document." PA Securities Act, Section 102(t). 

In short, almost any document evidencing an equity interest in an asset is a security regulated by the PA Act.  This encompasses partial equity interests in special purpose entities created to hold real estate assets and/or developments. 

The PA Act Requirements

The point at which the state and federal laws intersect is where this process can become cumbersome.  

Under Section 203(t) of the PA Act, Rule 504 Offerings are exempt from registration if:

  1. All the securities are sold only to accredited investors (whether residents of PA or another state); 
  2. A PA Form E is filed with the PA Securities Commission together with the offering literature (i.e. the private placement offering memorandum and related documents);
  3. The PA Form E must be filed no later than the day on which the issuers receives an executed subscription agreement or any monies, whichever comes first. 
  4. No compensation is paid directly or indirectly to a person other than a registered broker-dealer; and
  5. Neither the issuer nor its affiliates are subject to certain disqualifications. 

** Special note must be made of two things listed above.  First, the private placement offering memorandum ("PPOM") and related documents must drafted and finalized prior to filing the Form E.  This means that a lot of work has to be done to prepare, edit, and revise the PPOM before the first sale of securities is ever made.  It is a highly advisable practice to provide a copy of the draft PPOM to the PA Securities Commissions for their review and approval prior to filing the Form E.  This avoids the messy circumstance of having to revise the PPOM after it has been circulated to potential investors.  Second, no investor dollars should be accepted until the Form E has been filed.**

Under Section 203(s) of the PA Act, Rule 505 offerings are exempt from registration if:

  1. A PA Form E is filed with the PA Securities Commission together with the offering literature (i.e. the private placement offering memorandum and related documents);
  2. The PA Form E must be filed no later than the day on which the issuers receives an executed subscription agreement or any monies, whichever comes first; and
  3. No compensation is paid directly or indirectly to a person other than a registered broker-dealer.

There are other state specific exemptions (called self-executing exemptions) contained in the PA Securities Act.  Consult competent legal counsel for more detail.

The Private Placement Offering Memorandum

The Private Placement Offering Memorandum (PPOM) is a lengthy disclosure document that is designed to accomplish at least two tasks.  First, to provide a complete picture to the potential investor of the proposed investment.  Second, the PPOM should be drafted with an eye to insulating the issuer from any claims of failure to disclose or fraud.  PPOMs will vary greatly from deal to deal and great care should be taken to draft the PPOM specifically to the proposed investment opportunity. 

Generally, the key sections of a PPOM include (but are not limited to):

  1. A Summary of the Offering, including detailed terms about the economics, price and potential rate of return, liquidation preferences, holding periods, corporate structure, etc.;
  2. A detailed listing of the Risk Factors present: risk factors may include competitive forces within the industry, market risk, continuity of founders/senior management team.  In particular, these should be completely and comprehensively disclosed;
  3. Detail about Investor Suitability Standards: this often will change depending on how many Accredited Investors are permitted depending on which safe Harbor rules the issuer is proceeeding under;
  4. A description about the Use of Proceeds;
  5. A description of the Issuer's product or service portfolio and business model;
  6. A listing of key contractual relationships the Issuer may have that affect the proposed investment opportunity; 
  7. Financial projections prepared by ab outside CPA firm; and 
  8. Management Team biographies. 

As stated above, the content of each PPOM will depend and may change greatly with each different project. 

What is an Accredited Investor?

Each of the federal Safe Harbor Rules detailed above (and the PA Act requirements also) have different requirements with respect to Accredited Investors.  In general terms, an Accredited Investor (in the case of a natural person, and NOT an LLC, corporation, or partnership) is one who:

  • earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
  • has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

Each Issuer must determine, prior to providing a draft subscription agreement or a copy of the PPOM, which potential investors fit the definition of Accredited Investor.  This is accomplished through the use of an Accredited Investor Questionnaire, which will require the potential investor to verify their status with respect to the net worth or income requirements listed above. 

Conclusion

Securities Laws, whether state or federal, can be very difficult to navigate without competent counsel to provide advice on the structure of the potential investment and the process by which the Issuer proceeds.  There are both civil and criminal penalties included in both the PA Act and the federal securities laws which demand that caution and planning be central to any business strategy to issue private securities.  

For more information, please contact Tuk Law Offices regarding your specific situation.