Unregistered securities

What Is Unregistered Securities?

Unregistered securities are financial assets that have not been registered with the appropriate regulatory authority, such as the Securities and Exchange Commission (SEC) in the United States. Within the realm of securities regulation, the general principle is that any offer or sale of securities to the public must be registered, unless a specific exemption applies. The primary purpose of registration is to ensure disclosure of material information to potential investors, thereby fostering investor protection and market integrity.

History and Origin

The concept of regulating securities offerings in the United States gained prominence after the stock market crash of 1929 and the ensuing Great Depression. Prior to this, securities oversight was primarily governed by state-level statutes, commonly known as Blue Sky Laws. The federal response to widespread investment fraud led to the enactment of the Securities Act of 1933. This landmark legislation established the fundamental requirement that all securities offered for public sale in interstate commerce must be registered with the SEC, unless an exemption from registration is available. The Act aimed to provide full and fair disclosure of information concerning securities, enabling investors to make informed judgments.⁴ The Supreme Court case of SEC v. W.J. Howey Co. in 1946 further defined what constitutes an "investment contract" and, by extension, a security, solidifying the scope of federal oversight.³

Key Takeaways

Unregistered securities are those that have not undergone the formal registration process with a regulatory body like the SEC.
The sale of unregistered securities to the general public without an applicable exemption is generally illegal under federal securities laws, notably the Securities Act of 1933.
These securities often carry higher risks for investors due to a lack of mandated public disclosure and regulatory oversight.
Common instances of unregistered securities arise from private placement offerings made to specific types of investors, or when a security does not meet the legal definition requiring registration.
Violations can lead to significant penalties for issuers, broker-dealers, and other parties involved.

Interpreting the Unregistered Securities

The term "unregistered securities" indicates a status of non-compliance with the general registration requirements of securities law. For investors, encountering unregistered securities means a significant absence of the regulatory safeguards typically afforded to registered offerings. This implies that the issuer has not submitted comprehensive financial statements, business descriptions, and risk factors to a regulatory body, which are standard in a public offering. Consequently, the burden of due diligence falls more heavily on the potential investor, who must rely on information provided directly by the issuer, which may not be as thoroughly vetted or standardized. The lack of public information can also affect the liquidity of an investment, making it harder to sell later.

Hypothetical Example

Consider a nascent technology startup, "InnovateTech," seeking to raise capital for its initial product development. Instead of pursuing a traditional initial public offering (IPO), which would require extensive SEC registration, InnovateTech decides to raise funds by selling equity shares directly to a small group of sophisticated investors, including venture capital firms and wealthy individuals. This offering is structured as a private placement under Regulation D of the Securities Act of 1933, which provides exemptions from registration for certain offerings not involving a public solicitation.

In this scenario, the shares issued by InnovateTech are unregistered securities. The company is not required to file a detailed registration statement with the SEC. Instead, it provides a private placement memorandum (PPM) to the potential investors, outlining its business plan, financial projections, and risks. The investors, being accredited investors, are presumed to be capable of evaluating the risks associated with an investment that lacks the extensive public disclosures mandated for registered securities.

Practical Applications

Unregistered securities are prevalent in various segments of the capital markets, especially where companies seek to raise capital without the expense and time involved in a full public registration.

Venture Capital and Private Equity: Many private companies, from startups to mature enterprises, raise capital through private offerings of their shares or debt to a limited number of investors. These typically involve unregistered securities, leveraging exemptions such as those under Regulation D.²
Crowdfunding: Certain forms of investment crowdfunding, particularly those conducted under specific SEC regulations like Regulation Crowdfunding, allow companies to raise limited amounts of capital from a large number of non-accredited investors without full registration, though they still have specific filing requirements.
Intrastate Offerings: Companies can offer and sell securities exclusively to residents within a single state without federal registration, provided they meet specific criteria under the Securities Act of 1933.
Employee Stock Option Plans: Shares issued to employees under certain benefit plans can sometimes be unregistered if they meet specific conditions for exemption.

The SEC actively enforces rules against unlawful sales of unregistered securities. Recent enforcement actions have targeted individuals and entities acting as unregistered broker-dealers, highlighting the ongoing regulatory scrutiny of such activities.¹

Limitations and Criticisms

While exemptions from registration are designed to facilitate capital formation, particularly for smaller businesses, unregistered securities come with significant limitations and criticisms:

Lack of Disclosure: The most significant drawback is the absence of comprehensive and standardized public information. Investors in unregistered securities do not benefit from the same level of mandated financial and operational data that is required for registered offerings. This information gap can make it challenging for investors to conduct thorough due diligence and assess the true risks and potential rewards.
Higher Risk of Fraud: The reduced regulatory oversight and lack of public scrutiny can make unregistered offerings more susceptible to fraudulent schemes and misrepresentations.
Illiquidity: Unregistered securities are often illiquid, meaning they cannot be easily bought or sold on public exchanges. There are typically restrictions on their resale, and finding a buyer can be difficult, limiting an investor's ability to exit the investment quickly or at a fair market price.
Limited Investor Protection: While anti-fraud provisions of securities laws still apply to unregistered offerings, investors have fewer remedies compared to those who invest in registered securities if problems arise. The lack of a registration statement means there is no strict liability for material misstatements or omissions that would apply in registered offerings.

Unregistered Securities vs. Exempt Securities

The terms "unregistered securities" and "exempt securities" are often used interchangeably or cause confusion, but they represent distinct concepts within securities law.

Unregistered securities simply refer to any security that has not undergone the registration process with a regulatory body. This could be because the issuer failed to register it when required (an illegal act), or because the security qualifies for a specific exemption from registration. Therefore, "unregistered" describes the state of not being registered.

On the other hand, exempt securities are a specific category of unregistered securities. These are securities that, by law, are not required to be registered with the SEC or other authorities because they meet certain criteria defined in the Securities Act of 1933 or subsequent regulations. Exemptions can be based on the nature of the security itself (e.g., government bonds, certain bank securities) or the nature of the transaction (e.g., [private placement]s, intrastate offerings, small offerings). Thus, all exempt securities are unregistered, but not all unregistered securities are exempt. An unregistered security sold without a valid exemption is an illegal offering.

FAQs

What are the main risks of investing in unregistered securities?

The main risks include a lack of mandated public disclosure, which makes it harder to assess the investment's true value and risks, potential illiquidity due to resale restrictions, and a higher vulnerability to fraud because of reduced regulatory oversight.

Are all unregistered securities illegal?

No. While the general rule under securities regulation is that securities must be registered, there are various exemptions that allow for the legal sale of unregistered securities. These are known as "exempt securities" and are often used for private placement offerings or offerings of limited size.

Who regulates unregistered securities?

Even when securities are unregistered due to an exemption, they are still subject to anti-fraud provisions of federal and state securities laws. The SEC and state securities regulators enforce these provisions. Additionally, broker-dealers involved in selling unregistered securities, such as private placements, are subject to rules and oversight by FINRA (Financial Industry Regulatory Authority).

Can I sell unregistered securities I own?

Resale of unregistered securities is often restricted. They typically come with limitations on who can buy them and when they can be resold. These restrictions are designed to prevent the securities from being distributed to the broader public without registration. Investors often need to hold them for a specified period or sell them only to other accredited investors or through limited transactions.