Avoid Securities Law Loopholes, “this is not a security” arguments, loopholes or other shortcuts
Many entrepreneurs find themselves in hot water with investors and securities regulators because they believed that the investment they sold was not a security and not subject to securities laws. Many do not know that even a promissory note is a security. They tend to believe websites that claim to have found loopholes in securities laws.
When an inexperienced entrepreneur attempts to finance a business, she is surprised to learn how expensive legal fees can be to prepare the necessary disclosure. As any good business person would, the entrepreneur looks for alternatives. Sadly, those who market alternatives put the entrepreneur’s business at great risk. Few small businesses can recover from a mistaken violation of securities laws. The cost of a mistake include legal fees, regulatory fines, loss of ability to use exemptions, disruption of fund raising, and flight of potential investors.
United States’ securities laws exist at the federal level and in each state. In most cases, the issuer of a security must comply both with the federal law and the state law in every state an “offer” is made. The basic policy of all securities laws is to make the issuer, its control person (e.g. officers and directors), and any seller of the security liable for misstatements of material facts or failure to disclose all material facts. Any liability to investors is not dischargeable in bankruptcy under a Sarbanes Oxley amendment that makes securities violations nondischargeable. Proof of fraud is not necessary.
The “full disclosure” requirement is a reversal of the law’s general policy of caveat emptor (“buyer beware”) which ignores minor sales exaggerations or defects when the buyer had the opportunity to discover the defects with careful examination. If a seller claims an automobile gets “great gas mileage” when it actually gets very low gas mileage compared to other cars, the statement is generally not actionable.
Securities laws reverse this general law and adopt a form of caveat venditor (vendor beware”). Under caveat venditor It is probably necessary to disclose that the car does not get the gas mileage from competitors. This full disclosure requirement is not easy for many entrepreneurs who tend to be skilled salespeople who (in their exuberance) can occasionally exaggerate.
In addition to full disclosure, securities laws have a broad reach. Almost any payment of money when the motivation is gain from the efforts of others is a security. Promissory notes are securities. Sales of memberships in health clubs have been held to be securities. Even the sale of orange trees which are part of an orchard managed by others is a sale of securities.
The Washington and California statutory definitions of “security” provide good examples:
RCW 21.20.005 (17)(a): “Security” means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture; voting-trust certificate; certificate of deposit for a security; fractional undivided interest in an oil, gas, or mineral lease or in payments out of production under a lease, right, or royalty; charitable gift annuity; any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof; or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any security under this subsection. This subsection applies whether or not the security is evidenced by a written document.
Corporate Securities Law of 1968, Section 25019: “Security” means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees’ pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. “Security” does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section 31100 or 31101.
We had a client who believed what he read on a website and paid $15,000 for a private placement and related securities work. The company that did the work was not a law firm. The client was investigated by securities regulators. After paying $125,000 to the law firm defending him (not Tollefsen Law) he was fined $50,000 and barred from future private placements. The bad publicity caused investors to lose interest in his project. In the end, he lost everything and declared bankruptcy. Fortunately none of the investors pursued him to make non-dischargeable claims against him.
Moral: If you are going to raise money from the public, hire competent lawyers.