PART TWO: Section 4(2), Unregistered Public Offerings, and Offering Rescission

By Daniel Roberts, Attorney at Katovich & Kassan Law Group

So, say you own a startup company that’s trying to raise seed funding to create the next great software platform for social change, such as Kiva or Echoing Green.

You’ve exhausted all your personal finances, maxed out your credit cards.  You’ve already taken on some investment capital from family and friends—now it’s time to really scale and hire a bunch of software designers, developers, and other employees to turn your brainchild into reality.  Where can you find $5 million to achieve this next phase of growth?  You search your networks, but you’re only 90% successful.  You realize that although you’ve secured $4.5 million from the accredited investors in your network, you’re not going to get that last $500,000 without taking on non-accredited investors.

Rule 506 and Non-Accredited Investors

It is completely legal to sell equity security interests in a private placement to non-accredited investors who meet the requirements under Regulation D.[1]  However, selling to non-accredited investors triggers an additional (and very onerous) disclosure requirement[2]—and there must be no more than 35 of them.

But what happens if you just happen to sell to too many non-accredited investors, or otherwise fail to meet the requirements of the Rule 506 Safe Harbor?

Under federal law, even if an offering exceeds the Rule 506 Safe Harbor, it may still conform to the broad exemption of Section 4(2) of the 1933 Act, which exempts from registration “transactions by an issuer not involving any public offering.”  The legal lines of what defines a “public offering” are not tightly drawn.[3]  If the offering really wasn’t a private offering, investors may have a federal rescission right under Section 12 of the 1933 Act.

At the state level, the result of failing to meet the requirements of Rule 506 is that the registration exemption provided by Rule 506 no longer applies.  Without the safe harbor exemption, an issuer must analyze the offering in the context of the laws of each of the states where the securities were sold.

Just like under federal law, a sale of securities must be registered with state regulators—unless an exemption from registration applies.  In some states, limited offering exemptions may apply if securities were only sold or offered to a small number of investors.[4]  In such cases, an issuer may never have to register the securities or face penalties from the regulators, and may only be required to file notice with the state.  If no state registration exemption is available, an issuer may be able to file a registration statement with the state securities regulator retroactively.  Even so, an issuer may still face administrative fines or other penalties at the state level for offering and selling securities in the absence of a valid registration.


If an issuer has sold securities illegally, and there is no way to make the sale legitimate after the fact, the issuer can be held liable to investors who bought the unregistered securities.  Under many state laws, the only way to “clean up” the problem of having sold unregistered securities is by offering investors the right to rescind their investment.

The legal term “rescission” simply means an undoing or cancelling of a transaction.  In the context of securities law, it means offering an investor back the money she paid to buy the securities, plus interest.  Offering an investor the option to rescind his or her investment will in most cases extinguish the investor’s right to sue the issuer for failing to properly register the securities.[5]  Although a rescission offer may extinguish civil liability as to the investor, it does not necessarily extinguish enforcement liability as to the regulators.  Even so, regulators whose job it is to protect their constituents, generally favor voluntary rescission offers bigolive pc and will tend not to prosecute the underlying misstep in the absence of outright fraud.

A rescission offer can be a useful tool to avoid liability to shareholders not only when a company may have violated the securities registration requirements, but also if it has provided investors with misinformation or omitted material information.  Practitioners should be forewarned however, that a rescission offer will often be considered an offer of securities.  In such instances, rescission offers must conform to the registration requirements of state and federal law, and may require the submission of a prospectus with updated financial statements to regulators prior to making the offer.  In some states, the securities regulators provide simple form-letters for offering rescission, which greatly simplify the process.[6]

Generally speaking, offering rescission can be an extensive process, often requiring the prior approval of regulators before offers can be made to a company’s investors.  The drain on resources can be immense and time consuming—whether or not investors choose to accept their money back.  If there is a lesson to be learned here, it is to follow the rules when selling securities privately—the first time through.

READ PART ONE: Mistakes in Private Placements: Navigating the Quagmire


[1]  17 CFR 230.506, N. 2. “Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.”

[2] Under Rule 506, companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. (See 17 C.F.R. § 230.502(B)(2)).  If a company provides information to accredited investors, it must make this information available to non-accredited investors as well.

[3]  In Securities and Exchange Commission v. Ralson Purina, 346 U.S. 119 (1953), the Supreme Court laid out the factors that more clearly define what constitutes a public offering.

[4] For example, Colorado exempts offerings to fewer than 20 investors. Colorado Securities Act, § 11-51-308.

[5] See Model Uniform Securities Act, Section 510.

[6] See, e.g. New Hampshire rescission offer letter, found at

Learnings from the California Coop Conference: Coop Incubators

Learnings from the California Coop Conference: Coop Incubators


A coop incubator is an organization set up to help coops form.  Most coop incubators are nonprofit 501(c)(3)s or they are coops themselves.

How can a 501(c)(3) justify setting up coop businesses as a charitable/educational activity?  Generally speaking, an organization that provides business services to disadvantaged populations qualifies for 501(c)(3) status.  So if a nonprofit helps low income people set up worker coops, for example, it should be eligible for 501(c)(3) tax exemption.

Also, an organization that offers education and training to people interested in learning more about coops and how to form them should qualify for 501(c)(3) status as an educational organization.

One example of a nonprofit that is a coop incubator is WAGES.  The Arizmendi Association of Cooperatives (AAC) is coop that incubates coops.  The members of the AAC are the coops that the AAC has incubated.

Is it a good idea for the incubator to retain ownership and/or control of the coops it incubates?

Some of the reasons to do this are

  • Protect community assets – allows the incubator to ensure that the coops it sets up continue to be coops and to serve the incubator’s mission
  • Generate resources for the incubator – if the coops that the incubator sets up are successful, they can channel some of their profits to the incubator, making it possible for the incubator to set up more coops
  • Ensure ongoing participation in a larger movement – for example, some unions are incubating coops and would like the coops they incubate to be unionized

The amount of control the incubator has over the coops it incubates does not need to be static.  Control can be transferred over time as the coop members gain skills for self-management.  It is important to be clear up front about the timeline for transition.

If the coop is taxed under Subchapter T of the Internal Revenue Code, it is necessary to ensure that patron member control is meaningful – if the incubator has too much control, this could jeopardize the coop’s eligibility to be taxed under Subchapter T.

What kinds of relationships can there be between the incubator and the coops it incubates?

  • The coops can have a special class of membership for the incubator – this special class can have the same voting rights as other member classes or can have limited voting rights, such as the right to vote only on major decisions like dissolution of the coop
  • The incubator can be named in the coop bylaws as an entity that has the right to designate some of the coop board members (under some state coop statutes)
  • There can be contractual relationships between the incubator and the coops – examples include licensing of intellectual property to the coop, lease of space to the coop, etc.

Note that the incubator will need to consider whether the relationship that it creates with its incubated coops could create an inadvertent franchise.

Also note that if the coop is a “pass through entity” (i.e. taxed under Subchapter C or Subchapter K of the Internal Revenue Code), its activities can be attributed to its owners.  If a 501(c)(3) owns an interest in a pass through entity that does not conduct charitable/educational activities, the nonprofit’s tax exempt status could be jeopardized.

When AAC starts a new worker coop bakery, AAC appoints the initial board.  The workers go through a 6-month candidacy process before they become members.  After the initial workers become members, the AAC-appointed board resigns and appoints the first worker-member board.

AAC coops must agree to certain principles if they want to continue to use the Arizmendi brand and trade secrets.  These include

  • requirement to do quarterly reports
  • minimum 3-month candidacy period for new workers
  • no permanent/indefinite non-member employees
  • one member-one vote

The AAC provides a lot of support to its member coops to get off the ground – they deposit funds in the coop’s bank to guarantee their loan, they enter into a lease with the landlord and sublease to the coop, and they provide extensive training on baking and coop governance.

There are currently six Arizmendi coops and more on the way!

How Long Does a DPO Take?

How Long Does a DPO Take?

This is common question and the answer is – it can vary quite a bit.

There are three stages of a DPO:

  1. preparation
  2. compliance filing
  3. selling the investment opportunity


The preparation to do a DPO can take as little as a few days or several months.  This process involves

  1. ensuring that the entity that is making the offering (the “issuer”) is in good shape – making sure any previous financings complied with applicable securities law; the entity has clean and up-to-date financials; the required legal formalities for the entity have been observed; etc.
  2. deciding what type of security to sell (sometimes the kind of security you want to sell will not be consistent with your entity type and you will need to convert to a different kind of entity)
  3. preparing an offering document that describes the issuer and the offering
  4. preparing legal documents for the offering – for example, promissory note, stock certificate, purchase agreement, etc.

Compliance Filing

This is the submission of a package of compliance materials to the state securities regulators in every state where you will be offering securities.  These materials include your offering document, specimen security, formation documents, financials (usually not required to be audited or reviewed), an attorney opinion (not always required), etc.

From the date of submission to the date you receive regulatory approval to conduct your public offering can be as little as three weeks and as much as six months.

The factors that affect this timeline include the following:

  • some states are simply faster and more friendly to direct public offerings
  • anything in your offering that is unusual will likely generate questions from the regulators – each round of questions can add a month or more to the process
  • regulators will sometimes send you many rounds of questions even if your offering is straightforward and your company has a good track record – some of them feel very compelled to look under every possible rock before approving your offering
  • if you request anything special like confidential treatment of your financials, this can add time to the process
  • there are times of year when the securities regulators are especially busy
  • some states do “merit review” and other states do “disclosure review” – merit review means the states look at whether the offering is likely to pose a risk to the investing public while disclosure review simply looks at whether there is sufficient disclosure – merit review usually takes longer

Selling the Offering

Once you receive approval from the regulators, you can sell to the public (subject to any limitations imposed by the regulators and the applicable law).

Generally, you have one year to raise funds.  You can renew the application every year and continue to raise funds indefinitely.