AVOIDING THE
SECURITIES MINEFIELD
I
n the 1970s and 1980s, the Fram oil-filter company used
a very popular marketing campaign; its TV ads showed a
who have chosen to avoid paying for a little advice from an
experienced securities lawyer in order to save some money only
to find out later that they have to pay a lot more to try to repair
the damage from violating the securities laws. When it comes
to complying with federal and state securities laws, “You can
pay us now, or you can pay us later!”
mechanic holding a Fram oil filter while in the background,
a second mechanic looked over an automobile engine that
required very expensive repairs because its owner hadn’t used a
Fram oil filter. Fram oil filters were considered top of the line at
that time, so they were a little more expensive. The tag line of
the ad campaign was, “You can pay me now [as the mechanic
pointed to the more expensive Fram oil filter], or you can pay
me later [as he looked over his shoulder and pointed to the
ruined engine block]!” What does that have to do with the
securities laws? Over the years, we have encountered many
Any financial instrument, ownership interest, or investment
contract that is defined as a “security” is subject to the federal
and state securities laws. The securities laws are complex,
confusing, and treacherous, especially for the uninitiated, with
many traps for the unwary. No one should enter the securities
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minefield without an expert guide who knows where the mines
are located and can help avoid and defuse them. As we have
seen over and over again, many business people end up in the
middle of this dangerous minefield before they even realize
they’re in one.
The term “investment contract” has been construed for securities
purposes as a contract, transaction, or scheme whereby a person
invests money in a common enterprise with the expectation of
making a profit solely from the efforts of third parties. The form
and title of the instrument are irrelevant. It is the substance
of the transaction—the relationship between the person selling
the instrument (called the issuer) and the purchaser of the
instrument and the economic realities of the relationship—
that determine whether or not a financial arrangement is an
investment contract and, therefore, a security. Hence, a sale of
a condominium can be a security under certain circumstances.
The primary federal securities law is the Securities Act of 1933
(the “1933 Act”), as amended, and the rules and regulations
promulgated thereunder. In addition, each state has its own
set of securities laws, rules, and regulations, which often,
but not always, are very similar to the federal law but are
separately enforced by that state. The two primary purposes of
the securities laws are (1) to require sellers of securities to give
investors all material information that a prudent investor would
need about the issuer and its business, financial history, and
management to make an informed investment decision and (2)
to prohibit fraud, misrepresentation, and deceit in the sale of
securities. To achieve both of these purposes, the 1933 Act and
most other securities laws are liberally construed.
The key element is “solely from the efforts of other persons.”
However, “solely” does not really mean only. The real test is
whether the efforts of third parties are undeniably the significant
efforts essential to the success or failure of the venture, which
is a legal conclusion based upon the particular facts and
circumstances involved.
The 1st Mine: Do I Have a Security?
An ownership interest in a partnership or a limited liability
company (LLC), for example, is a security if it constitutes
an investment contract. Whether or not such interest is an
investment contract is determined by whether the efforts of
third parties are undeniably the significant ones that are essential
to the success or failure of the venture. This determination is
made by analyzing the management, governance, and control
provisions of the applicable partnership or LLC company
agreement.
The starting point in understanding the securities laws is
the prohibition at both the federal and state levels against
selling a “security” unless it is legally registered. Thus, for the
securities laws to apply, there must be a security involved—
and the definition of a security is critical! The 1933 Act
contains a descriptive definition of a security and lists various
types of financial instruments that are securities. Some of
these, such as stocks, notes, bonds, and debentures, are well
defined in the law. However, the statutory definition also lists
as securities “investment contracts and certificates of interest
or participation in any profit sharing agreement,” neither of
which has a specific definition in law. To make it even less clear,
the definition includes the clause “in general, any interest or
instrument commonly known as a security.”
With a traditional stock, bond, note, or debenture, it is very
Where management, control, and governance are concentrated
in third parties, the partnership or LLC interest will almost
certainly be an investment contract and, therefore, a security
subject to the securities laws. Where the applicable governing
document allocates legal and practical management control and
governance among all purchasers of the ownership interests,
then the partnership or LLC interest might not be an investment
contract. However, an interest in a noncorporate entity can also
clear that a security is involved, but if it is a financial interest
be structured in such a way that it so resembles shares of stock
or other type of ownership interest, such as an investment
contract, other factors have to be analyzed to determine if it is
a security.
of a corporation and, on that basis alone, be deemed a security.
Some of these attributes include the following:
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• The right to receive profits based on the apportionment
of the interest of the purchaser in the issuing entity,
• The power to vote in proportion to the percentage of
ownership interest held,
• Whether or not the interest is assignable or negotiable, and
• The possibility of appreciation in value of the interest.
The 2nd Mine:
Have I Made an Offer to Sell a Security?
The 1933 Act permits offers and sales of securities to occur
without such SEC registration in some limited circumstances
if the security or the transaction qualifies for a specific
exemption from the registration process. The penalties for
selling securities without the requisite approvals can be severe.
The mere offer or sale of nonexempt securities without any
fraudulent or criminal intent is sufficient to incur civil liability.
Violations of federal and state securities laws are punishable
by fines, which can be significant, prohibitions against future
violations, and, in the case of willful violations, criminal
prosecution and imprisonment.
The 1933 Act regulates the offer and sale of securities. The
term “offer” has a different and far broader meaning in
securities law than in basic contract law. Under the 1933 Act,
an “offer to sell” or “offer for sale” includes every attempt or
offer to dispose of, or solicitation of an offer to buy, a security
or interest in a security, for value. The term “sale” or “sell”
includes every contract of sale or disposition of a security or
interest in a security, for value. Given these broad terms, almost
any attempt to dispose of a security for value will amount to an
offer or sale under the securities laws. Those who simply want
to “test the water” to see if their idea has merit and can be sold
often cross the line and constitute an “offer to sell” or an “offer
for sale” of a security. This mine is very easy to trip and once
tripped, it is very difficult to keep it from detonating.
The 4th Mine: Qualifying for an Exemption
Because of the number, size, and manner of many securities
transactions, Congress and state legislatures have exempted
certain types of securities and certain types of transactions
from the registration requirements of the securities laws. In
general, the types of securities that are exempt from registration
are securities issued by governmental subdivisions, industrial
revenue bonds, and securities issued by or for the benefit of
certain not-for-profit entities. Business entities generally do
not qualify for issuance of exempt securities.
The 3rd Mine: If I have a Security
That Will Be Offered for Sale, What Then?
Among the most common types of exemption from the
registration process relied upon by issuers are exempt
transactions, and the most common exempt transactions
relied upon are those that do not involve a public offering.
These are often referred to as private offerings and generally
involve an offering to a small group of investors who have
a pre-existing, substantive relationship with the issuer. If
the transaction qualifies under one or more of the specific
exempt transactions available, the issuer is not required to file a
registration statement and go through the very expensive and
time-consuming registration process.
One of the primary purposes of the securities law is to require
each seller of a security (referred to as the issuer) to disclose
all material facts that a prudent person would need to know
before making an investment decision. This is generally
accomplished by requiring all issuers to prepare a written
document, called a “registration statement,” pursuant to a
highly regulated registration process. This document is then
filed with and reviewed by the United States Securities and
Exchange Commission (SEC) and the securities regulatory
authorities of each state in which the issuer intends to make
or solicit offers to purchase its securities. The preparation
and filing of this registration statement can be very timeconsuming
and expensive
and will subject the issuer to further
regulation
and oversight
by
the SEC and other securities
regulatory
authorities.
To qualify for an exempt transaction, the issuer must satisfy all of
the statutory, regulatory, and judicial requirements for that
particular exempt transaction, of which there are several.
Fortunately, the SEC has promulgated certain safe harbor
exempt transactions under its Regulation D. Regulation D
provides three distinct safe harbors: Rules 504, 505, and 506. By
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far the most frequently used safe harbor under Regulation D
is Rule 506.
traditional Rule 506(b), which is why most private offerings
are still being conducted under Rule 506(b) despite the
prohibition on general solicitation.
The 5th Mine: Satisfying the Requirements of Rule 506
Rule 506 is the most frequently used exempt transaction safe
harbor for good reason: when it applies, this transaction is
exempt from the registration process under federal law, and all
state regulators are preempted from reviewing and approving
the transaction under their applicable state securities laws.
There are actually two distinct exemptions that fall under Rule
506: the older Rule 506(b) and the newer Rule 506(c).
Purchasers of securities offered pursuant to either Rule 506
exemption receive “restricted” securities, meaning that the
securities cannot be sold for at least a year without registering
them. Issuers relying on the Rule 506 exemption do not have to
register their offering of securities with the SEC, but they must
file what is known as a “Form D” electronically with the SEC within
a certain period of time after they first sell their securities.
Under either 506 exemption, an issuer can raise an unlimited
amount of money. However, under Rule 506(b), an issuer:
What qualifies someone as an "accredited investor"? Regulation
D describes specific requirements.
For
example, for an
individual,
it is a person who qualifies under one or more
of
three
tests:
• cannot use general solicitation or advertising to market
the securities,
• may sell its securities to an unlimited number of "accredited
investors" and up to thirty-five other purchasers (all
nonaccredited investors, either alone or with a purchaser
representative, must be sophisticated—that is, they must
have sufficient knowledge and experience in financial and
business matters to make them capable of evaluating the
merits and risks of the prospective investment), and
• the “net worth” test, by having a net worth of at least $1
million (excluding such individual’s personal residence),
• the “income” test, by having made at least $200,000
in each of the past two years and with the reasonable
expectation of making at least that amount in the current
year (or $300,000 when combined with a spouse’s income
in each such year), and
• must be available to answer questions by prospective
purchasers.
Under the more recently adopted Rule 506(c) exemption, an
issuer can broadly solicit and generally advertise the offering
but still be deemed to be undertaking a private offering not
requiring registration if:
• the investors in the offering are all accredited investors and
• the issuer has taken reasonable steps to verify that its
investors are accredited investors, which could include
reviewing documentation—such as W-2s, tax returns,
bank and brokerage statements, credit reports, and other
• the “insider” test, by being a director or executive
officer of the issuer or a general partner of the issuer or
a director, executive officer, or general partner of the
general partner of the issuer. The “insider” test applies
to persons holding those specific titles who, based upon
all of the applicable facts and circumstances, are deemed
not to need the protections provided by registration
because their positions should provide them with access
to information about the issuer and the securities offered.
However, a person’s title alone is not always sufficient to
qualify for this test. Thus it is not always possible to create
an accredited investor solely by naming the person as an
executive officer or director. Other definitions apply to
similar documents.
different types of entities.
What constitutes reasonable verification methods will depend
on the facts and circumstances of each case, but they generally
involve a more intrusive inquiry than an offering under
A nonaccredited investor is an investor who does not meet the
definition of an accredited investor.
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The 6th Mine: Integration
is “substantive” when the issuer (or a person acting on the
issuer's behalf ) has sufficient information to evaluate, and does
in fact evaluate, a prospective offeree’s financial circumstances
and sophistication, in determining the offeree’s status as an
accredited or sophisticated investor. Self-certification alone (by
checking a box) without any other knowledge of a person’s
financial circumstances or sophistication is not sufficient to
form a “substantive” relationship.
Sometimes issuers will try to avoid the thirty-five nonaccredited
investor limitations in Rule 506(b) by structuring multiple
transactions. If multiple transactions are part of the same plan
to raise money, they can be integrated and treated as the same
transaction by federal and/or state regulators. But if there are
more than thirty-five nonaccredited investors, the transaction
will not qualify for the Rule 506(b) exemption.
The 7th Mine:
Entities Formed to Invest in the Transaction
Frequently entities (usually LLCs) are formed for the purpose
of aggregating individuals to make an investment in a transaction.
These
entities
are
generally disregarded
for
purposes
of
determining
the status of the investor
as accredited
or nonaccredited,
and
the
owners
of
that
entity
will
each
be
treated
as
separate
investors
in the transaction.
The 8th Mine: General Solicitation
Whether general solicitation exists can be an important issue,
because (as mentioned above) the SEC takes a very broad view
of what constitutes an “offer” to sell securities. Information
designed to arouse or that can have the effect of arousing
investor interest in an issuer, even if no actual mention
of any securities being offered or sold is included, may in
some instances be considered to be “general solicitation or
advertising.” An example might be a press release that includes
rosy projections about future potential growth or future
earnings. The idea is that if an issuer is considering raising
capital in the near term, widely distributed communications
that have (or appear to have) the intent of stirring up interest
may be deemed to be “general solicitation,” which again would
preclude the issuer from relying on the registration exemption
under Rule 506(b). As the SEC puts it, information that serves
to “condition the public mind or arouse public interest” in a
securities offering (even where the offering is not mentioned
or alluded to) would result in a violation of the general
solicitation ban.
Regulation D does not define the term “general solicitation”
or “general advertising,” though it does offer a nonexhaustive
list of what would be considered to be so, including the use
of “any advertisement, article, notice or other communication
published in any newspaper, magazine, or similar media or
broadcast over television or radio.” Some SEC guidance has
been issued regarding what can be done without violating the
prohibition on “general solicitation,” but many questions still
remain. The greater the number of people with whom an issuer
does not already have a pre-existing, substantive relationship,
the more likely it will be that the SEC will find that there has
been general solicitation. There is, of course, no predetermined
number; as with everything else, the determination will depend
on the specific facts and circumstances of each case.
The 9th Mine: The Use of Finders
A relationship with an offeree is “pre-existing” (for purposes
of demonstrating the absence of general solicitation) when
the relationship was formed prior to the commencement of
the securities offering or, alternatively, when it was established
through either a registered broker-dealer or investment
adviser prior to the registered broker-dealer or investment
adviser participating in the offering. Similarly, a relationship
One of the most persistent “urban legends” in the private
placement arena is the notion that an individual who is not
a licensed broker can be paid to assist an issuer in locating
investors, so long as he or she is “just a finder” and is not
acting as a broker-dealer. The problem with this notion is that
it is truly just an urban legend. The SEC has never formally
recognized the concept of a “finder” and has repeatedly stated
that persons paid to find investors in a securities transaction
must be duly licensed. The SEC has issued a few isolated “noaction”
letters in which it chose to take no enforcement
action
against
an individual for involvement
in a securities transaction,
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despite the person being compensated for that involvement. But
the facts in each of these cases are very specific; they should
not be treated as precedent for the position that a finder can
be paid to assist an issuer in finding investors. State securities
administrators generally take the same position and are very
aggressive in pursuing violations. We have handled numerous
cases in which the Alabama Securities Commission has accused
an individual of violating the law by receiving compensation
in some form as an unlicensed broker-dealer in the State of
Alabama. Under no circumstances can any type of remuneration
or compensation be paid to anyone for helping find investors,
unless that person is a duly licensed broker-dealer salesman.
prudent investor would want to see before making a decision
to invest. It is generally advisable to provide such information
in written form, because the burden of proving delivery of such
information falls upon the issuer. It is also important to ensure
that all information that is provided is not misleading in any
material way. It is equally misleading to omit a material fact as
it is to misrepresent a material fact.
Final Thoughts
The 10th Mine: Exemption from Registration Does
Not Equal Exemption from Antifraud Provisions
Any issuer desiring to raise capital from investors must be
careful about how it goes about that task, what information
it provides or chooses not to provide, and to whom it provides
that information. As this article has hopefully made clear, there
are numerous land mines that must be avoided in the process
of raising capital, and it is always prudent before starting the
process to consult with experienced securities counsel who can
serve as “mine detectors” to safely guide issuers through the
securities-law minefield.
The exemption from registration enables the issuer to avoid
the registration process, but it does not exempt the issuer from
the other main purpose of the securities laws: the prohibition
of deceit, misrepresentations, and other fraud in the sale
of securities. These are known collectively as the antifraud
provisions of the federal and state securities laws. The antifraud
provisions work by requiring issuers to deliver adequate
disclosures to prospective investors. All information passed on
in the course of a private offering, either orally or in writing (in
an offering memorandum, circular, or other form of disclosure
document), is subject to these antifraud provisions. An issuer’s
officers and directors may be personally liable for an investor’s
damages in a fraud case, so providing the reasonably necessary
information is obviously crucial here.
If you have questions or comments about the article or are
interested in learning more about this topic, feel free to contact
its authors, John H. Cooper and Peter J. Hardin.
JOHN H. COOPER
[email protected] | 205.930.5108
Practice areas:
Corporate & Securities
Ta x
Regulation D requires that in transactions in which
nonaccredited investors are offered the opportunity to invest,
an issuer must provide prospective investors with disclosure
documents that generally are the same as those used in
registered offerings. In addition, an issuer must provide
certain audited financial statements, depending upon the
total amount sought to be raised. If securities are only being
offered to accredited investors, an issuer is not required to
furnish any specific information, but the antifraud provisions
still apply. Accordingly, it is very important for an issuer to
provide in some form all of the material information that a
PETER HARDIN
[email protected] | 205.930.5392
Practice areas:
Corporate & Securities
Health Care
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