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Roadmap to Securities Law Compliance for Private Companies

I suspect there is a sense of comfort for many attorneys who do not represent publicly-traded companies, investment advisers, broker-dealers and other participants in our securities markets that they will never be confronted with securities law issues in their practices.  However, while this message is not new, this is a friendly reminder that securities law issues arise in the most basic business transactions.  Consider the following examples:

·      Your client plans to purchase an office building using a limited partnership. She will be the general partner with sole authority to manage and operate the building.  The project will be financed with funds contributed to the partnership by your client and four doctors who will be silent partners.  Your client asks you to draft a limited partnership agreement setting forth the terms agreed upon by the parties.

·      Your client has decided to sell his residential construction business to seven employees.  The business is owned through a holding corporation which owns some related assets that will be included in the sale.  Your client asks you to prepare the necessary documents and structure the transaction as a transfer of the stock in the holding corporation.

·      Your client, a farmer, advises you that he intends to purchase 250 acres of prime farmland by borrowing the money from six local retired farmers.  Your client asks you to prepare notes that will mature in a year, bear interest at 8% and not be secured.  The notes will serve as bridge financing until your client can secure long-term financing through a bank.

In each of the above scenarios, your client is likely engaged in the sale of a security and will require legal advice to comply with the securities laws.  A failure to comply can result in serious consequences, including criminal liability, monetary fines, refund of amounts paid by investors and prohibitions or limitations on conducting future sales.

If you represent a client in forming a private business entity or any capital raising or business acquisition transaction, you should routinely consider two important issues at the outset.  First, you should determine if your client is involved in the offer or sale of a security.  If so, you should follow the guidelines set forth in this article to comply with the securities laws.

Is my client engaged in the offer or sale of a security?

The determination of what constitutes a security is very important and should be the first inquiry anytime there is an investment of money or property or formation or acquisition of a business entity or interest.  Typical financial instruments such as stocks and bonds can easily be characterized as securities; however, the classification of other non-typical financial instruments can be difficult and involve complex legal issues.

Section 2(1) of the Securities Act of 1933 and Section 8-1101(15) of the Securities Act of Nebraska provide basic definitions for the term “security”.  The definitions include the typical items you would expect to see covered (e.g., stocks and bonds) and also include non-typical items.  For example, the term “investment contract” is included in both definitions and serves to capture investments of money that do not fit neatly into the definition of a security.  The term investment contract is not defined by statute; however, a framework has developed in the case law to determine what constitutes an investment contract.

In S.E.C. v. W.J. Howey, 328 U.S. 293 (1946), the U.S. Supreme Court developed a test to determine what constitutes an investment contract.  Under the Howey test, an investment contract involves (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) to come solely from the efforts of others.

The fourth part of the Howey test (profits to come solely from the efforts of others) has not been strictly interpreted by the courts following the Howey decision.  Therefore, investment contracts may exist even though there is some investor participation.  Under existing case law, a security may be found if profits come primarily from the efforts of others.

Some of the more common scenarios in which a private company may be involved in the offer or sale of a security are discussed below.

Stock as a Security / Sale of Business Doctrine.  A common stock issuance by a corporation is the most basic example of a sale of a security.  Common stock exemplifies all the elements generally associated with securities.  However, prior to 1985, some courts held that the sale of stock in connection with the sale of an entire business did not involve the sale of a security.  This concept was labeled the “sale of business doctrine”.

In 1985, the U.S. Supreme Court rejected the “sale of business doctrine” in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).  In Landreth, the Supreme Court held that stock involved in the sale of an entire business possessed all of the characteristics traditionally associated with common stock and is a security.  As a result, if a business acquisition/disposition is structured as a transfer of the stock in the corporation (rather than as a purchase/sale of the assets), the sale of a security is involved.

Notes as Securities.  Both the Securities Act of 1933 and the Securities Act of Nebraska include the term “note” in their definition of a security.

The courts have generally determined that basic commercial transactions involving home mortgages, consumer installment purchases and similar commercial financings are not securities notwithstanding that the financial instruments involved are notes.  A number of approaches have been developed to analyze whether a particular note is commercial in nature and does not involve a security, or if the note is an investment warranting protection by the securities laws.

In Reeves v. Ernst & Young, 494 U.S. 56 (1990), the U.S. Supreme Court applied the “family resemblance test” to determine whether notes are securities.  Under this test, any note with a term of more than nine months is presumed to be a security until the defendant rebuts this presumption by showing that the note bears a strong family resemblance to one of the following six enumerated categories of truly commercial instruments:  (1) a note delivered in consumer financing; (2) a note secured by a mortgage on a home; (3) a short-term note secured by a lien on a small business or some of its assets; (4) a notice evidencing a “character” loan to a bank customer; (5) a short-term note secured by an assignment of accounts receivable; or (6) a note that simply formalizes an open-account debt incurred in the ordinary course of business, particularly if, as in the case of the customer of a broker, it is collateralized.

Partnership Interests as Securities.  The status of whether a partnership interest is a security is determined by analyzing the third and forth elements of the Howey  test – will profits come from the efforts of others?  Based on this approach, general partnership interests are typically not securities since general partners usually control and manage, or have the right to control and manage, the partnership.  However, limited partnership interests generally are deemed securities because limited partners are usually silent investors who do not participate (and are precluded by statute from participating) in controlling and managing the partnership.  Limited partners generally rely upon the managerial skills of the general partner.  Nevertheless, the determination of whether a general or limited partnership interest is a security must be made on a case-by-case basis.

Limited Liability Company Interests as Securities.  The treatment of interests in LLCs as securities is largely unsettled under federal law.  However, a good rule of thumb is that LLC interests should be classified in the same manner as partnership interests – by analyzing the third and fourth elements of the Howey test.  As with general partnerships, LLC interests that are member-managed are not likely to be deemed securities due to the control and management of the members in the company.  On the other hand, board-managed LLCs, like limited partnerships, are likely to have their LLC interests classified as securities due to the lack of control and management by their members.

Several states, including Nebraska, have enacted laws classifying LLC interests as securities in certain situations.  The definition of a security under Section 8-1101(15) of the Securities Act of Nebraska includes membership interests in any limited liability company, except when each of the following exist:  (1) the member enters into a written commitment to be engaged actively and directly in the management of the limited liability company; and (2) all members of the limited liability company are actively engaged in the management of the limited liability company.  The Nebraska Department of Banking and Finance has advised (through Interpretive Opinion No. 25) that it will consider the following factors in determining whether a membership interest in a limited liability company is a security:

1.      whether the members retain, under the limited liability company’s operating agreement, the right to exercise practical and actual control over the management decisions of the enterprise;

2.      whether the number of members of the limited liability company is so great as to render the managerial power afforded the members by the operating agreement insignificant and meaningless;

3.      whether the members are so geographically dispersed as to render the managerial power afforded the members by the operating agreement insignificant and meaningless;

4.      whether the promoter has some particular skill which is necessary for the successful operation of the limited liability company and, without which, the enterprise will likely be unsuccessful; and

5.      whether any other special circumstances exist which render meaningless the managerial powers given to the members by the operating agreement.

What guidelines should I follow for my client to comply with the securities laws?

Federal and state securities laws generally apply to a company’s offer or sale of any security and require that the company either (1) “register” the security with the Securities and Exchange Commission (“SEC”) and/or the applicable states or (2) rely on an exemption permitting the transaction to be conducted without registration.  Registration is a time consuming and expensive process that ultimately results in a company “going public”.  For any number of reasons, “going public” is not an available, desirable or practical option for most private companies.  As a result, private companies that engage in an offer or sale of securities will likely rely on an exemption from registration.

If your client is involved in the offer or sale of a security, precaution should be taken to comply with the securities laws to avoid the serious consequences that can result from non-compliance.  This task may appear daunting at the outset due to the volume and complexity of the securities laws.  However, by following three basic guidelines, counsel can isolate the issues that must be resolved for compliance purposes.

First – Determine Which Securities Laws Apply

Securities law compliance for most private companies involved in the offer or sale of a security will take the form of structuring the transaction to fit within an exception from registration.  The United States operates under a dual system of federal and state securities laws and regulations.  As a result, a single transaction can result in regulation by the federal government and multiple states.

Federal Regulation.  Section 5 of the Securities Act of 1933 regulates the use of “instruments of transportation or communication in interstate commerce” and the “mails” in the offer or sale of a security.  Federal law should, consequently, be presumed to always apply.  If a truly intrastate offer or sale of securities appears to be present, counsel should consider the availability of the intrastate offering exemption under Section 3(a)(10) of the Securities Act of 1933 and the Rule 147 safe harbor thereunder.

State Regulation.  The application of state jurisdiction in any securities transaction generally depends on whether or not the transaction takes place in that state.  Transactions are deemed to take place in the states where the offer was generated and directed and where the transaction closed.

However, state law does not apply with respect to certain transactions.  The National Securities Market Improvements Act of 1996 created a category of securities called “covered securities” and provided for federal preemption of certain aspects of state regulation of transactions involving covered securities.  Section 18(a) of the Securities Act of 1933 prohibits state law from (1) requiring registration or qualification with respect to covered securities, (2) regulating offering documents that relate to a covered security or (3) regulating the offer or sale of any covered security based on the merits of the offering or issuer.  State securities commissioners retain the ability to investigate fraud and take enforcement actions, require notice filings and assess fees in connection with certain transactions involving covered securities.  Securities offered and sold in certain exempt offerings are covered securities.

Second – Assess the Availability of Exemptions

There are a number of exemptions available on the federal and state levels; however, a review of the criteria and requirements of numerous exemptions is beyond the scope of this article.  Therefore, the following sections will only focus on what are usually the more useful exemptions.

Federal Exemptions.  When assessing the availability of various exemptions, consideration should be given to the use of a federal exemption that preempts state law.  By doing so, an offering directed to persons located in a number of different states will only need to meet the requirements of the federal exemption.  Note, however, that notice filings and fee payments may need to be made in the various states.

Section 4(2) of the Securities Act of 1933 is the private placement exemption.  This exemption applies to “any transaction by an issuer not involving any public offering”.  The U.S. Supreme Court, numerous federal courts, the SEC, the ABA and others have interpreted this exemption.  The general view of these interpretations is that offeree qualification, availability of information, manner of offering and absence of redistribution are the most relevant factors applicable to the exemption.

The SEC has enacted safe harbor regulations with respect to many exemptions, including the Section 4(2) exemption, to provide more certainty to the process of structuring an offering to be exempt from registration.
Rule 506 of Regulation D is a safe harbor under the Section 4(2) exemption.  The Rule 506 criteria include:

1.      Offering Size.  There is no limitation on the dollar amount of the offering.

2.      Number of Purchasers / Purchaser Qualifications.  There can be no more than 35 purchasers that are non-accredited investors.  There can be an unlimited number of purchasers that are accredited investors.

·      Purchasers that are non-accredited investors must have such knowledge and experience in financial and business matters to make them (alone or through a purchaser representative) capable of evaluating the merits and risks of the investment.

·      Accredited investors include:  certain financial institutions, certain entities with $5 million in total assets, directors, executive officers or partners of the issuer, natural persons with $1 million net worth and natural persons whose annual income is $200,000 individually or $300,000 jointly with a spouse.

3.      Disclosure.  Financial and non-financial information must be furnished to non-accredited investor purchasers a reasonable time before sale and is typically made through an offering document called a private placement memorandum.  The level of information required depends on the size of the offering.  Although disclosure is not required to be made by the rule to accredited investors, consideration should be given to disclosure in each instance because of the litigation risk involved with non-disclosure.  Federal and state anti-fraud and civil liability provisions remain applicable to exempt sales of securities.  As a result, any material misstatement or omission in connection with the offering may result in a fraud-based lawsuit.  A private placement memorandum serves as an insurance policy against claims that misstatements were made or material information was not disclosed.

4.      General Solicitation and Advertising.  General solicitation and advertising are not permitted.

5.      Resales and Transfers.  Following consummation of any sales, the securities in the hands of the purchasers will be restricted and resale limitations will apply.

6.      SEC Notice Filing.  A Form D notice filing must be made with the SEC within 15 days after the first sale.

A security offered in compliance with the Rule 506 safe harbor is a covered security and will result in the federal preemption of state law.  However, the applicable state regulations should be reviewed for notice filing and fee requirements.  For example, many states, including Nebraska, will require that the state receive the Form D filed with the SEC, a consent to service of process on Form U-2 and a fee.

Beyond the Section 4(2) exemption and Rule 506 safe harbor, the most useful exemptions available to private companies are the various safe harbors under the limited private placement exemption provided by Section 3(b) of the Securities Act of 1933.  Section 3(b) gives the SEC authority to prescribe exemptions by regulation due to the limited nature of an offering.  Section 3(b) exemptions have an aggregate offering price cap of $5 million and the securities offered in compliance with the Section 3(b) safe harbors are not covered securities (no federal preemption).  Listed below are certain of the Section 3(b) safe harbors:

·      Rule 504 of Regulation D.  The Rule 504 safe harbor has a $1 million aggregate offering price cap, but there are no purchaser limitations or qualifications and no disclosure requirements.  There are also limited exceptions to the rules regarding general solicitation and advertising and resale restrictions.

·      Rule 505 of Regulation D.  The Rule 505 safe harbor as a $5 million aggregate offering price cap and otherwise closely resembles the Rule 506 safe harbor.

·      Regulation A.  The Regulation A safe harbor has a $5 million aggregate offering price cap and is beneficial because there are no purchaser limitations or qualifications, immediate resales by purchasers are permitted and the issuer or an underwriter can obtain “indications of interest” from the market prior to commencing an offering.  However, the Regulation A safe harbor requires filing of a disclosure document with the SEC on Form 1-A, qualification of the offering with the SEC prior to making any sales and filing reports with the SEC regarding sales and use of proceeds.

·      Rule 701 under the Securities Act of 1933.  Rule 701 provides an exemption for securities issued in compensatory circumstances.  Rule 701 sales cannot exceed (in any 12 month period) the greater of $1 million, 15% of the issuer’s total assets or 15% of the outstanding securities of the class sold.  If sales exceed $5 million (in any 12 month period), the issuer is required to provide specific disclosure concerning the benefit plan, risks of the investment and its financial statements.

State Exemptions.  If a federal exemption is relied upon that does not provide for federal preemption, the state exemptions must be reviewed for availability.  Various versions of the Uniform Securities Act have been adopted by approximately 40 states.  As a result, the exemptions among many states closely resemble each other.  States generally have two types of exemptions – self-executing exemptions that do not require any affirmative actions by the issuer and exemptions that have disclosure, notice filing and/or fee payment requirements.

For example, Section 8-1111(8) of the Securities Act of Nebraska provides a self-executing exemption for offers or sales solely to accredited investors and Section 8-1111(9) of the Nebraska Securities Act provides a limited sales exemption that requires a notice filing.  Specifically, Section 8-1111(9)’s criteria include:

1.      Number of Purchasers.  Sales can be made to not more than 15 persons (other than accredited investors, existing security holders and employees as designated in subdivisions 8, 11 and 17 of Section 8-1111, respectively) in Nebraska during any 12 consecutive month period.

2.      Investment Purpose.  The seller must reasonably believe that all the buyers are purchasing for investment.

3.      Commissions.  No commission or remuneration can be paid or given directly or indirectly for soliciting any prospective buyer except to a registered agent of a registered broker dealer.

4.      General Solicitation and Advertising.  No general or public advertisements or solicitations can be made.

5.      State Notice Filing.  A notice generally describing the terms of the transaction and containing a representation that the conditions of the exemption are met must be filed by the seller with the Director of the Nebraska Department of Banking and Finance within 30 days after the first sale for which the exemption is claimed.  Specific line item requirements for the notice are set forth in Chapter 15 of the Rules of the Nebraska Department of Banking and Finance.

Third – Follow a Compliance Checklist and Take the Necessary Precautions

Prior to the commencement of an exempt offering, the attorney should use a compliance checklist.  These checklists are available through various sources, such as the Practicing Law Institute, law firm websites and other legal resources.  A well drafted compliance checklist will identify the criteria and requirements of a particular exemption, which will greatly assist reviewing laws and regulations for applicable provisions.  In addition, a well drafted compliance checklist will provide guidance and reminders on practical considerations and precautions.  A checklist for a Rule 506 exempt offering may include the following practical guidance:

1.      Number of Purchasers / Purchaser Qualifications

·      A questionnaire should be prepared and given to each potential investor at the earliest possible moment, setting forth various items of information relevant to whether the potential investor is a qualified offeree.

·     The subscription or stock purchase agreement should contain purchaser representations regarding education, background, and investment experience.

·      Records should be established dividing potential purchasers among three groups – (1) accredited investors, (2) non-accredited investors and (3) represented investors.  For each of these groups, the applicable rules of Regulation D should be used to create a checklist to assure that proper disclosure and qualification has been followed for each purchaser.

·      Offers and sales of securities within the past 6 months by the issuer, or any affiliate, in any subsidiary, parent or related company, along with future plans, should be reviewed to determine whether integration principles should be applied.

2.      Disclosure

·      Counsel should prepare a schedule of all disclosure items required by Rule 502(b) of Regulation D, based upon the size of the offering and the nature of the issuer, to be used in the preparation of the private placement memorandum.

·      A private placement memorandum should be prepared and procedures established to assure document delivery.

·      Procedures should be established to assure that opportunity is given to all offerees to ask questions and receive additional information regarding the offering.

·      The subscription or stock purchase agreement should contain a purchaser’s acknowledgement of receipt of (1) the private placement memorandum, (2) other enumerated disclosure materials, (3) a statement regarding resale limitations and (4) the offeree questionnaire.

3.     General Solicitation and Advertising

·      All advertising and other communications by the issuer should be reviewed in advance by counsel, regardless of whether mention is made of the securities offering.

·      All persons involved in the offering process should be advised against solicitation of persons that do not have a pre-existing relationship with the issuer or its representative.

4.     Resales and Transfers

·      Procedures should be developed to assure that each purchaser is advised of limitations on transferability.

·      An investment letter or similar statement of investment intent should be prepared by the issuer for execution by each purchaser.  The subscription or stock purchase agreement should also contain a statement of investment intent (which references the purchaser’s investment letter).

·       Inquiries should be made directly to each purchaser, prior to sale, as to past investment and trading practices and current plans.

·      An appropriate legend should be drafted regarding transferability and procedures established to place the legend on each securities certificate.

·      Instructions should be given to issuer’s transfer agent, or to issuer’s employees responsible for stock records, prohibiting any share transfer without prior written consent of the issuer or its counsel.

5.     SEC Notice Filing

·      Procedures should be established so that the party responsible for filing Form D is advised as soon as possible of the date of the first sale.

·      The Form D should be reviewed periodically to determine whether any reported information should be changed by an amended filing.

Final Word

As a reminder, securities law issues may arise in many business transactions.  While I have given you a brief roadmap to a private company’s compliance with the securities laws, please remember that securities regulation is a complicated area.  Every transaction has a unique set of securities issues.  A thorough analysis of the transaction and applicable securities laws will enable you to give your client the advice necessary to comply with the securities laws.