Regulation D Law and Legal Definition
Regulation D is a section of the U.S. federal securities law that provides the means for businesses to sell stock through direct public offerings (DPOs). A DPO is a financial tool that enables a company to issue stock directly to investors—without using a broker or underwriter as an intermediary—and avoid many of the costs associated with "going public" through an initial public offering (IPO). Regulation D exempts companies choosing this form of offering from many of the registration and reporting requirements of the Securities and Exchange Commission (SEC).
DPOs, private placements of stock, and other exempt offerings provide businesses with a quicker, less expensive way to raise capital than IPOs. The primary advantage of DPOs over IPOs is a dramatic reduction in cost. IPO underwriters typically charge a commission of 13 percent of the proceeds of the sale of securities, whereas the costs associated with a DPO are closer to 3 percent. DPOs also can be completed within a shorter time frame and without extensive disclosure of confidential information. Finally, since the stock sold through a DPO goes to a limited number of investors who tend to have a long-term orientation, there is often less pressure on the company's management to deliver short-term results.
DPOs and other exempt offerings also involve disadvantages, however. For example, the amount that a company can raise through a DPO within any 12-month period is limited. In addition, the stock is usually sold at a lower price than it might command through an IPO. Stock sold through exempt offerings is not usually freely traded, so no market price is established for the shares or for the overall company. This lack of a market price may make it difficult for the company to use equity as loan collateral. Finally, DPO investors are likely to demand a larger share of ownership in the company to offset the lack of liquidity in their position. Investors eventually may pressure the company to go public through an IPO so that they can realize their profits.
RULES 504, 505, AND 506
Regulation D—which was adopted in 1982 and has been revised several times since—consists of a set of rules numbered 501 through 508. Rules 504, 505, and 506 describe three different types of exempt offerings and set forth guidelines covering the amount of stock that can be sold and the number and type of investors that are allowed under each one. The most common type of DPO is the Small Corporate Offering Registration, or SCOR, which is included in Rule 504. SCOR gives an exemption to private companies that raise no more than $1 million in any 12-month period through the sale of stock. There are no restrictions on the number or types of investors, and the stock may be freely traded. The SCOR process is easy enough for a small business owner to complete with the assistance of a knowledgeable accountant and attorney. It is available in all states except Delaware, Florida, Hawaii, and Nebraska.
A related type of DPO is outlined in Rule 505. This option enables a small business to sell up to $5 million in stock during a 12-month period to an unlimited number of investors, provided that no more than 35 of them are non-accredited. To be accredited, an investor must have sufficient assets or income to make such an investment. According to the SEC rules, individual investors must have either $1 million in assets (other than their home and car) or $200,000 in net annual personal income, while institutions must hold $5 million in assets. Finally, a DPO conducted under Rule 506 allows a company to sell unlimited securities to an unlimited number of investors, provided that no more than 35 of them are non-accredited. Under Rule 506, investors must be sophisticated, or able to evaluate the merits and understand the risks of the transaction. In both of these options, the securities cannot be freely traded.
Hicks, J. William. Limited Offering Exemptions: Regulation D. Thomson West, 2005.
Jennings, Marianne M. Business: Its Legal, Ethical, and Global Environment. Thomson West, 2006.
Roberts, Barry S., and Richard A. Mann. Business Law and the Regulation of Business. Thomson South-Western West, 2006.
U.S. Securities and Exchange Commission. "Regulation D." Updated 6 March 2003. Available from http://www.sec.gov/divisions/corpfin/forms/regd.htm. Retrieved on 16 May 2006.
Hillstrom, Northern Lights
updated by Magee, ECDI