Securities Act Exemptions.

Rule 506(c) permits issuers to broadly solicit and generally advertise an offering, provided that:

• all purchasers in the offering are accredited investors

• the issuer takes reasonable steps to verify purchasers’ accredited investor status and

• certain other conditions in Regulation D are satisfied

Purchasers in a Rule 506(c) offering receive “restricted securities.” A company is required to file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering. Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(c), the states still have authority to require notice filings and collect state fees.

Rule 506(c) offerings are subject to “bad actor” disqualification provisions.

Summary of Rule 506 Bad Actor Disqualification and Disclosure Requirements

On July 10, 2013, the Securities and Exchange Commission (the “Commission”) adopted bad actor disqualification provisions for Rule 506 of Regulation D under the Securities Act of 1933, to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The disqualification and related disclosure provisions appear as paragraphs (d) and (e) of Rule 506 of Regulation D.

As a result of Rule 506(d) bad actor disqualification, an offering is disqualified from relying on Rule 506(b) and 506(c) of Regulation D if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013, the effective date of the rule amendments.  Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e) discussed in part 6 of this guide.

This guide is designed as an outline to help issuers understand and comply with the “bad actor” disqualification and disclosure provisions of Rule 506 of Regulation D.   

Covered Persons

Understanding the categories of persons that are covered by Rule 506(d) (which we refer to in this guide as “covered persons”) is important because issuers are required to conduct a factual inquiry to determine whether any covered person has had a disqualifying event, and the existence of such an event will either disqualify the offering from reliance on Rule 506 or will have to be disclosed to investors.

“Covered persons” include:

• the issuer, including its predecessors and affiliated issuers

• directors, general partners, and managing members of the issuer

• executive officers of the issuer, and other officers of the issuers that participate in the offering

• 20 percent beneficial owners of the issuer, calculated on the basis of total voting power

• promoters connected to the issuer

• for pooled investment fund issuers, the fund’s investment manager and its principals

• persons compensated for soliciting investors, including their directors, general partners and managing members

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What are restricted securities?

“Restricted securities” are previously-issued securities held by security holders that are not freely tradable. Securities Act Rule 144(a)(3) identifies what offerings produce restricted securities. After such a transaction, the security holders can only resell the securities into the market by using an effective registration statement under the Securities Act or a valid exemption from registration for the resale, such as Rule 144.

Rule 144 is a "safe harbor" under Section 4(a)(1) providing objective standards that a security holder can rely on to meet the requirements of that exemption. Rule 144 permits the resale of restricted securities if a number of conditions are met, including holding the securities for six months or one year, depending on whether the issuer has been filing reports under the Exchange Act. Rule 144 may limit the amount of securities that can be sold at one time and may restrict the manner of sale, depending on whether the security holder is an affiliate. An affiliate of a company is a person that, directly, or indirectly through one or more intermediaries controls, or is controlled by, or is under common control with, the company.

How can an investor resell non-restricted securities?

An investor that is not affiliated with the issuer and wishes to sell securities that are not restricted must either register the transaction or have an exemption for the transaction. An exemption commonly relied upon for the resale of the securities is Section 4(a)(1) of the Securities Act which is available to any person other than an issuer, underwriter or dealer.  Please be aware that several exemptions, including the exemptions under Regulation D, are only available for offers and sales by an issuer of securities to initial purchasers and are not available to any affiliate of the issuer or to any person for resales of the securities.

What Is Private Company Stock?

A private company is a privately-held commercial entity. While it may issue shares of stock, these shares are not offered to the general public and aren't listed on a public stock exchange. Private company stock includes shares issued by the company to employees or investors.

For example, startups often use equity to compensate employees during the early stages when cash flow is limited. Public companies also use equity compensation programs. These programs are designed to motivate employees by tying a portion of their pay to the company's earnings. 

Contrary to a public company, a private company doesn't have to provide financial information to investors or shareholders. In addition, due to the often smaller size of private companies, they typically issue fewer shares of stock. That can make the shares less liquid and difficult to sell.

KEY TAKEAWAYS

• Private company stock is a type of stock offered exclusively by a private company to its employees and investors. 

• Unlike public stocks, the purchase and sale of private stock must be approved of by the issuing company. 

• Buying private stock of a company that intends to go public can be a lucrative investment strategy. 

• Private companies are not required to provide inside information to the public, so investors are often hesitant to buy private equity.

• Although private stocks are not registered with the SEC, SEC regulations still apply to their purchase and sale.1

How Private Company Stock Works 

Selling stock in a private company is not as simple as selling stock in a public company. Public company employees and investors can sell company shares through a broker. To sell private company stock—because it represents a stake in a company that is not listed on any exchange—the shareholder must find a willing buyer.

In addition, a sale of private stock must be approved by the company that issued the shares. Some companies may not want their shares to be widely distributed.

What's more, some employees of startups may feel pressured to hold onto their company stock as proof of loyalty. If there is a good reason for the sale—such as a downpayment on a house—a company could be persuaded to approve a sale. 

Special Considerations 

Pre-IPO Private Stock

Shares of a startup company that plans to go public with an initial public offering (IPO) are often easier to cash out. A number of web-based companies, such as EquityZen and Forge, connect sellers of, and investors in, pre-IPO shares. 

Pre-IPO private company stock exchanges are essentially venture capital markets for the masses. An employee who holds stock in a pre-IPO private company can list shares for sale on such an exchange. Some of these secondary market sites offer loans to buy pre-IPO stock.

What Is the Secondary Market?

The secondary market is where investors buy and sell securities. Trades take place on the secondary market between other investors and traders rather than from the companies that issue the securities. People typically associate the secondary market with the stock market. National exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, are secondary markets. The secondary market is where securities are traded after they are put up for sale on the primary market.

KEY TAKEAWAYS

• The secondary market provides investors and traders with a place to trade securities after they are put up for sale on the primary market.

• Investors trade securities on the secondary market with one another rather than with the issuing entity.

• Through massive series of independent yet interconnected trades, the secondary market drives the price of securities toward their actual value.

• The secondary market provides liquidity to the financial system and allows smaller traders to participate.

• The stock market and over-the-counter markets are types of secondary markets.

• How the Secondary Market Works

• As noted above, securities are bought and sold by investors among one another on the secondary market after they are first sold on the primary market. As such, most people call the secondary market the stock market.

• Transactions that occur on the secondary market are termed secondary simply because they are one step removed from the transaction that originally created the securities in question. For example, a financial institution writes a mortgage for a consumer, creating the mortgage security. The bank can then sell it to Fannie Mae on the secondary market in a secondary transaction.

• Though stocks are one of the most commonly traded securities, there are also other types of secondary markets. For example, investment banks and corporate and individual investors buy and sell mutual funds and bonds on secondary markets. Entities such as Fannie Mae and Freddie Mac also purchase mortgages on a secondary market.

• Types of Secondary Markets

• Stock Market

• The stock market is made up of centralized exchanges that allow buyers and sellers to come together to trade stocks and other assets. There is no contact that takes place between each party—physical or otherwise. Most trading takes place electronically. Traders must abide by the rules and regulations set forth by the appropriate regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States.

• Examples of stock markets (or secondary markets) include the NYSE and Nasdaq in the U.S., as well as the London Stock Exchange (LSE), the Hong Kong Stock Exchange, the Bombay Stock Exchange, and the Frankfurt Stock Exchange.

• Over-the-Counter (OTC) Market

• The over-the-counter (OTC) market involves the trading of stocks, bonds, and other financial assets. But rather than take place over a centralized exchange, trades occur through broker-dealer networks. As such, these assets aren't traded on an exchange. Stocks on the OTC market are normally those of smaller companies that don't meet listing requirements.

• OTC markets include the:

• OTCQX: This is the top-tier marketplace. The stocks of companies on the OTCQX must trade over $5.

• OTCQB: This is the mid-tier market for OTC securities. It is called the Venture Market and has a high number of developing companies available for trade.

• Pink Sheets: The Pink Sheets allow investors to trade securities of companies that can't meet the listing requirements for major exchanges. Most of the stocks listed are penny stocks.2

• Secondary Market vs. Primary Market

• It is important to understand the distinction between the secondary market and the primary market. When a company issues stock or bonds for the first time and sells those securities directly to investors, that transaction occurs on the primary market.

• Some of the most common and well-publicized primary market transactions are initial public offerings (IPOs). During an IPO, a primary market transaction occurs between the purchasing investor and the investment bank underwriting the IPO. Any proceeds from the sale of shares of stock on the primary market go to the company that issued the stock, after accounting for the bank's administrative fees.

• If these initial investors later decide to sell their stake in the company, they can do so on the secondary market. Any transactions on the secondary market occur between investors, and the proceeds of each sale go to the selling investor, not to the company that issued the stock or to the underwriting bank.

• Primary market prices are often set beforehand, while prices in the secondary market are determined by the basic forces of supply and demand. If the majority of investors believe a stock will increase in value and rush to buy it, the stock's price will typically rise. If a company loses favor with investors or fails to post sufficient earnings, its stock price declines as demand for that security dwindles.

• Are the Secondary and Stock Market the Same?

• Most people consider the stock market to be the secondary market. This is where securities are traded after they are issued for the first time on the primary market. For instance, Company X would conduct its initial public offering on the primary market. Once complete, its shares are available to trade on the secondary market. Major stock exchanges like the NYSE and Nasdaq are secondary markets.

• Who Are the Major Players in the Secondary Market?

• The key participants in the secondary market are the broker-dealers who facilitate trades, investors who initiate buy and sell activity, as well as any intermediaries, such as banks, financial institutions, and advisory service companies.

• Why Is the Secondary Market Important?

• The secondary market is where securities are traded after they go through the primary market. It is a key part of the financial system, providing liquidity to the market. It also allows traders with a centralized location where they can make trades. Investors who deal with large and small volumes of trades have the ability to participate in the market.

• The Bottom Line

• When you buy and sell stocks, bonds, or other securities, you're participating in the secondary market, which most of us consider to be the stock market. This market is an important part of the financial system because it gives investors like you a place to conduct your financial transactions. It also provides much-needed liquidity to the market. But don't confuse it with the primary market. This is where companies and other entities go to offer the first-round of securities before they become available to the general public.