Businesses looking to fundraise through selling securities, like equity or debt, in their company may be surprised to learn that this activity is highly regulated in the U.S. The Securities Act of 1933 requires that every security issued, even if it's just one share of stock, and even if it's sold to your mom, must be registered with the Securities & Exchange Commission (SEC) unless an exemption from registration is available. Registration is what publicly traded companies do and is extremely cost prohibitive, so most businesses utilize common exemptions available for private placements of securities with U.S. investors. Favored for its safe harbor provisions that preempt individual state laws for the sales of securities, Regulation D is the most commonly used exemption available for the sale of securities to U.S. investors.
Nevertheless, I often encounter business owners in the act of fundraising who feel frustrated by what they perceive as costly compliance regulations thrust upon them by the SEC. In a previous post you can find here, I've addressed the reasons for these regulations and how the right disclosures can attract investors. Nonetheless, some business owners believe that if they focus their efforts on selling securities abroad, they can avoid SEC regulations altogether. As I will explain, this route may not be the convenient escape plan you think it is. Keep in mind, though, that Reg. S has some rather detailed provisions, and this article is not intended to provide an exhaustive analysis, but rather a broad, generalized introduction.
Regulation S, comprised of eight preliminary notes and Rules 901 through 905 found in 17 CFR 230, governs how the offer and sale of securities outside the U.S. may be made without igniting the ire of the SEC. While Reg. S does speak to non-U.S. (or "foreign") issuers of securities, I will focus on how a U.S. (or "domestic") issuer may offer and sell securities to investors outside the U.S.
Generally speaking, the Preliminary Notes clarify that the five rules do not apply to the anti-fraud or other provisions of the federal securities laws, and Reg. S cannot be used as part of a plan or scheme to evade the SEC. Further, Reg. S is non-exclusive, and may be combined with under with other available exemptions like Regulation D or Rule 144A. Regardless, all Reg. S offerings are subject to the following two conditions:
The offer or sale must be made in an "offshore transaction", meaning the buyer cannot be physically located in the U.S.
No "directed selling efforts" may be made by the issuer, a distributor, or any of their affiliates, or anyone acting on their behalf. This means that the foreign offering cannot be generally advertised in the U.S., nor can it be directed at identifiable groups of U.S. citizens abroad like the U.S. military.
Discussion of the Five Rules of Regulation S
Rule 901 makes a general statement that that offers and sales of securities made outside the U.S. are exempt from registration.
Rule 902 contains definitions of the terms used in Rule 903.
Rule 903 provides safe harbor for direct offers of securities outside the U.S. by issuers, their distributors (underwriters, brokers, and dealers) and their affiliates. This Rule is further divided into three Categories based on the type of securities offered, whether the issuer is domestic or foreign, whether the issuer is a reporting company, and whether there is a "Substantial U.S. Market Interest" or "SUSMI".
Category 1 transactions are those least likely to flow back into the U.S. due to a lack of SUSMI, and thus are largely available only to foreign issuers.
Category 2 transactions have a medium risk of flow back and include equity securities of a foreign issuer, debt securities of a U.S. or foreign issuer, and debt securities of a non-reporting foreign issuer, even if there is a SUSMI. However, these securities are subject to a 40 day distribution compliance period, meaning these securities cannot be resold to a U.S. person during this time.
Category 3 is the most likely to be used by small and medium-sized domestic businesses raising money abroad. This category includes debt or equity offerings by non-reporting U.S. issuers, equity offerings by U.S. reporting issuers, and equity offerings by non-reporting foreign issuers for which there is a SUSMI. This has the highest risk of flow back into the U.S., and has the most restrictions, like a six-month distribution compliance period for reporting issuer and one-year for non-reporting issuers.
Rule 904 provides safe harbor for resales outside the U.S. of securities first issued either outside the U.S. in a Reg. S offering, or in an unregistered offering.
Rule 905 instructs that securities acquired from U.S. issuers (or their affiliates) in a Reg. S transaction will be treated as "restricted securities" as defined in Rule 144.
Additional Requirements for Regulation S Offerings
There are a few more important requirements to note.
Distributors selling securities on behalf of U.S. issuers do need to provide written statements that they will comply with all distribution compliance periods.
All offering materials and documents other than press releases must include statements that the securities have not been registered under the Securities Act of 1933, and may not be offered or sold in the U.S. unless they are registered, or an exemption from registration is available.
Where U.S. issuers are concerned, statements regarding restrictions on hedging transactions must be included in specifically within an offering prospectus or marketing materials.
Finally, and this is extremely important, the issuer must hire securities counsel in the country where the securities are being sold to ensure compliance with local law.
In conclusion, while Reg. S can be a great tool for domestic businesses interested in raising money overseas, there are still complicated compliance issues to consider, especially where flow back of the securities into the U.S. marketplace is more likely. Nevertheless, careful planning aforethought can mitigate most of the risk involved. If you would like to explore how to raise money for your business, please contact me for further information.