Exempt securities are not typically financial instruments sold by publicly-traded companies or the government to investors. The revenue from the sale of securities is used as a means of raising capital. Many of these instruments must be registered with the SEC and abide by the provisions of the Securities Act of 1933. In short, the Securities Act of 1933 does a couple of things. It requires that a publicly held company disclose full financial information and that the information is truthful. However, not every security issuance must register with the SEC. Certain types of securities can be granted an exemption from full filing requirements. Exempt securities, under Section 4 of the Securities Act of 1933, are financial instruments that carry government backing and typically have a government or tax-exempt status. Securities that do not need to be registered with the SEC under the Security Act of 1933 or the Securities Exchange Act of 1934. Examples of exempt securities include small issues, agency securities, most other debt instruments issued by the federal or a local government, and issues made only in a single state. Private placements are also usually exempt from registration.
Securities Exempt from Registration
There are many securities which are exempt from the Securities Act of 1933—requiring neither registration nor a prospectus. There are several reasons why securities may be exempt from registration requirements:
• the securities are considered safe because they are issued by a government authority, such as US Treasuries or municipal bonds;
• the sale of the securities is restricted to a given geographic area, usually within a state; or
• the securities are sold to accredited investors, either wealthy individuals or institutions who are considered to have the wherewithal and expertise to manage their money and to avoid fraudulent schemes.
A tax-exempt security is an investment in which the income produced is free from federal, state, and/or local taxes. Most tax-exempt securities come in the form of municipal bonds, which represent obligations of a state, territory or municipality. For some investors, U.S. Savings Bond interest may also be free from federal income taxes.
How a Tax-Exempt Security Works?
Income, such as dividends and interest, on tax-exempt securities does not have federal tax applied to it. Depending on where the investor lives, a tax-exempt security may be free from all taxes. An in-state resident will usually receive a state and federal tax exemption on general obligation bonds from his or her home state. While municipal bonds are the most common references of tax-exempt securities, mutual funds that invest in municipal bonds, U.S. Savings Bonds, or other tax-exempt securities can also receive tax-exempt status. Federal government bonds, namely the U.S. Savings Bond and Treasury Inflation Protected Securities (TIPS), are taxed at the federal level, but exempt from state and local taxes.
An exempt transaction is a type of securities transaction where a business does not need to file registrations with any regulatory bodies, provided the number of securities involved is relatively minor compared to the scope of the issuer’s operations and that no new securities are being issued. Exempt securities are the instruments used that the government backs, which have tax-exempt status. An exempt transaction is a securities exchange that would otherwise have to register with the Securities and Exchange Commission (SEC) but does not because of the nature of the transaction in question.
How an Exempt Transaction Works?
Exempt transactions cut down the amount of paperwork needed for relatively minor transactions. For example, it would be a big hassle to perform a filing with the SEC every time a non-executive employee wanted to sell back some of the company’s common shares he or she purchased as part of an employee stock purchase plan.
Types of Exempt Transactions
A private placement or Reg D offering is a type of exempt transaction in which the securities are not offered to the public, but are instead sold privately to an accredited investor. According to the SEC, an accredited investor can be:
• An insurance company, bank, business development company, small business investment company, or registered investment company
• An employee benefit plan administered by a bank registered investment company, or insurance company
• A tax-exempt charitable organization
• Someone with at least $1 million in net worth, excluding his or her primary residence
• A person with more than $200,000 in income, or joint income of more than $300,000 with a spouse in both of the previous two years
• An enterprise owned by accredited investors
• A general partner, executive officer, or director of the company selling the securities
• A trust with assets of at least $5 million, as long as it has not been formed just to buy the securities in question.
Other types of exempt transactions include Reg A offerings, also known as small business company offerings, which permit the issuing company to raise no more than $5 million in 12 months. This allows smaller companies to access securities markets to raise capital. Rule 147 offerings, or intrastate offerings, are also exempt. Transactions with financial institutions, fiduciaries, and insurance underwriters may be considered exempt. Unsolicited orders, which are those executed through a broker at the request of his or her client, are also considered exempt. Usually, an exempt transaction involves a small amount of money or an accredited or sophisticated investor, or does not, for some other reason, warrant a full registration. However, even exempt transactions are subject to some regulations, such as anti-fraud provisions. Investors and companies can still be held liable to misleading or false statements made on behalf of the company, the offering, or the securities, even if the transaction is exempt. And while exempt transactions may not need to be registered with state securities regulators, those state authorities retain the authority to investigate fraud, collect associated state fees, and enforce state filing requirements. Therefore, companies should take care to remain in compliance with state securities regulations, even if their offerings and transactions are exempt under federal filing regulations.
Types of Exempt securities
Certain securities are exempt from the registration requirements under the Securities Act of 1933. Either these securities come from issuers that have a high level of creditworthiness, or another government regulatory agency has some sort of jurisdiction over the issuer of the securities. These types of securities include:
• Securities issued by the U.S. government or federal agencies
• Municipal bonds (local government bonds)
• Securities issued by banks, savings institutions, and credit unions
• Public utility stocks or bonds
• Securities issued by religious, educational, or nonprofit organizations
• Notes, bills of exchange, bankers’ acceptances, and commercial paper with an initial maturity of 270 days or less
• Insurance policies and fixed annuities
Fixed annuities are exempt from SEC registration because the issuing insurance company guarantees the payout. However, variable annuities require registration because the payout varies depending on the performance of the securities held in the separate account.
U.S. government securities—Treasuries—and municipal bonds are all exempt from registration.
An intrastate offering is an offering made only to the residents of a state by a corporation in that state. The offering must be registered in the state, and it must comply with SEC Rule 147:
• the issuer is incorporated in the state;
• at least 80% of the issuer’s revenues must come from business within the state,
• at least 80% of the issuer’s assets must be located in the state,
• at least 80% of the proceeds of the offering must be used in the state;
• buyers of the offering must be state residents or an entity owned by state residents.
Resale is permitted only:
• to other state residents;
• or to other buyers only after 9 months after the termination of the Rule 147 offering;
• and the certificates and offering document must specify these resale restrictions.
Most life insurance contracts are exempt, except for those contracts that have investment risk, such as variable life policies and variable annuities.
Commercial Paper and Bankers Acceptances
Commercial paper is exempt from registration if its term is 270 days or less; and banker’s acceptances, if the term 180 days or less.
Regulation A of the Securities Act of 1933 (aka Reg A) exempts small offerings of securities from the regular SEC registration if these conditions are met:
• The public offering is not for more than $5,000,000 within a 12-month period.
• The offering statement, which is a simplified disclosure document, must be filed with a Regional Office of the SEC at least 10 days before the issue is offered for sale.
• The offering circular, which, like the prospectus, provides full disclosure, must be sent to each buyer of the issue at least 48 hours before the confirmation of the sale.
• The offering circular must be revised if the issue is still being offered 9 months after the initial issue, and the issuer must file a sales report of the issue with the Securities and Exchange Commission (SEC) every 6 months until the offer is terminated.
A private placement is the sale of securities to wealthy or sophisticated investors but not to the general public. Private placements are exempted from SEC registration under Regulation D of the Securities Act. Some broker-dealers — sometimes referred to as private placement agents — specialize in private placements. Nonetheless, private placement agents are required to be registered by the SEC even though the securities that they sell are usually exempt from registration requirements.
The details of Reg D are explained in Rules 501 to 506. No public advertisements or solicitations for a Reg D issue are allowed. A tombstone ad may provide notice of the completion of an offering, but not the offering itself.
Rule 501: Definition of an Accredited Investor
Securities are exempt if sold to accredited investors, who are basically individuals or institutions that have a lot of money and the financial wherewithal to invest in risky unregistered securities. Accredited investors include:
• corporations, partnerships, or other organizations:
o financial institutions;
o with more than $5,000,000 of assets:
o corporations and partnerships, not formed expressly for this investment;
o non-profit organizations;
o any entity owned entirely by accredited investors;
• individuals or married couples
o corporate or partnership insiders;
o with assets worth more than $1,000,000;
o or individuals who earned at least $200,000, or $300,000 for a married couple, in the last 2 years, and expect to make at least the same amount in the current year.
Although the SEC does not require that a disclosure document be offered to accredited investors, the issuer will usually provide a Private Offering Memorandum instead. After all, even accredited investors want to know some details about what they are investing in. A non-accredited investor, who the law presumes does not have sufficient knowledge of financial matters to evaluate the risks and merits of a private placement, must have a purchaser representative who does have the necessary expertise to evaluate any private placement that a non-accredited investor is considering. A purchaser representative may not be affiliated with the issuer unless he is related to the investor.
Rule 503 — Form D
The issuer must file a Form D within 15 days after the commencement of a Reg D offering.
A non-reporting company can raise up to $1,000,000 from any number of individuals, accredited or not, without a SEC registration.
Rule 505 — Purchaser Limitation Rule
A corporation can raise up to $5,000,000 within a 12-month period from any number of accredited investors, but no more than 35 non-accredited investors. A non-accredited investor is anyone or organization who is not an accredited investor. However, a married couple counts as 1 non-accredited investor, as well as any purchase of issues under the Uniform Gifts to Minors Act (UGMA) for their dependent children. A partnership that was not formed for a Reg D investment is considered 1 non-accredited investor; if the partnership was formed expressly for this investment, then the number of non-accredited investors depends on the status of each partner.
Rule 506 — Investment Sophistication
The dollar limitation of Rule 505 can be waived if the non-accredited investors are sophisticated investors who have had prior experience with a Reg D offering, or they are represented by a purchaser representative who has, such as an investment adviser, accountant, or attorney.
Rule 502 restricts general solicitation or advertising for a private offering, stating specifically that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising….” This rule may apply if the media finds out about the offering and publishes it widely, creating a demand for the private offering.
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