A:

The term "accredited investors" is defined by the U.S. Securities and Exchange Commission (SEC) as individuals with a net worth (not including a primary residence) in excess of $1 million, or individuals with a gross income of at least $200,000 ($300,000 for joint income with a spouse) for each of the two last years. The individual must have the expectation that the same level of income will continue in the current year. The definition for accredited investor is contained in Rule 501 of Regulation D of the Securities Act of 1933 (Reg D).

Rule 506 of Reg D contains an exception to the accredited investor requirement, and states up to 35 non-accredited investors may invest in a private placement offering. Rule 506 places standards on the type of non-accredited investors which can participate, stating that non-accredited investors must have knowledge and experience in financial and business matters such that they are capable of evaluating the merits and risks of the private placement. This is an ambiguous standard, and it can be difficult to prove if there is later litigation over a private placement investment. Rule 506 further contains additional information disclosures if the placement includes non-accredited investors. The required information is similar to that of public companies. There is another accredited-investor exemption in Rule 504, which allows for a company to raise less than $1 million in a 12-month period, and contains no restriction on selling securities to accredited investors. However, all solicitation done under Rule 504 must be in compliance with state securities regulations.

Reg D provides an exemption to the SEC to registration requirements for private placements. Private placements are companies offering securities in non-public offerings that are not required to comply with certain portions of federal securities laws. Companies rely on Reg D to claim exemption from SEC requirements. Reg D allows smaller companies to access capital without having to go through the expensive process of a public offering.

The SEC generally limits private placement investments to accredited investors due to risk. Private placements have greater risk for a couple of reasons. There is limited information available about the company issuing the securities. No regulatory background checks have been performed on the company’s management. The financial information has not been reviewed by any regulatory agency, and it has not been publicly disclosed. This makes it difficult to ascertain the accuracy of the financial information contained in the private placement offering memorandum. The limited information for a private placement makes it more difficult to adequately weigh the risk of an investment.

Another factor making private placements risky that private securities are illiquid. Since the securities are not publicly traded, investors may be forced to hold the securities for a long time if they are not able to find a suitable buyer for the securities. Private securities are also illiquid since they may only be sold to other accredited investors, which reduces the pool of possible purchasers.

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