Newland's Business Notes

Stumbling Into Securities Status

Volume 5 Issue 4 -- July/August 2001

Many entrepreneurs get investors and start new businesses with little concern or knowledge of the fact that they may be committing securities law violations. 

Ned knows gnus and is sure he can successfully introduce gnus into the United States as a new (gnu) source of beef.  He decides to raise funds for his enterprise by getting 15 of his friends to contribute money for the creation of Ned=s Gnus, LLC.

After spending $600,000 in contributions to import and promote gnus, without making a profit or even the prospect of making a profit, several investors want to know how their investment cash was utilized.  Does Ned have a problem?  Yes, Ned could have legal problems worse than bad gnus.

If all goes well, there usually aren=t complaints.  But if money is lost, investors may well raise any argument to retrieve their lost funds — one of these arguments is that Ned may have violated the securities laws.

If the investors can prove Ned failed to comply with federal or state securities laws, they may be able to recover the amount invested without proving that Ned committed fraud. They may, in some cases, even qualify for treble damages, which is three times the amount invested! 

Ned quickly advises his disgruntled investors that they should have known that an investment like this was not a security, and that people lose money in the stock market all the time.  Furthermore, he counters, he did not issue stock. 

These rather naive arguments will not carry the day for Ned because a security is broadly defined to include any "investment contract" where the expectation of making a profit is dependent on the efforts of others, like Ned.

The securities laws (both federal and state) not only prohibit fraud.  They also require that any securities be “registered” before they can lawfully be sold.  Even if there is no fraud or misrepresentation, failure to comply with registration requirements can allow investors to recover their money.

There are permissible ways of raising investment funds without getting into Ned=s predicament.  In some instances, sales to a very small number of investors located all in the same state may be exempt from the federal and state registration requirements. 

Unless one of the exemptions from registration applies, a full public offering of the stock (a so-called S-1 registration) is required.  S-1 registrations typically  will cost in excess of $100,000. 

So what=s a small fry like Ned to do?  There are a number of so-called “limited offering” exceptions which permit sales of securities to limited numbers of investors with less complex requirements.

One popular type of limited offering is often referred to as a Regulation D (or Reg. D) offering, which allows promoters like Ned to raise funds without doing a full S-1 registration.  If there are fewer than a certain number of qualified investors and the maximum amount of capital does not exceed certain levels, then Ned could have lawfully raised funds using Reg. D, but even complying with Reg. D does not automatically satisfy the laws of the states in which the offers are to be made.

Whether it is Ned=s Gnus or IBM, there is no exemption from the anti-fraud provisions of securities law.  Investors need to be fully informed of the relevant risks, regardless of whether registration is required.  Even if registration was not required, Ned’s Gnus should have prepared a private placement memorandum to satisfy Ned’s duty of full disclosure.  Ned should have identified and explained the relevant risks to the investors, before they agreed to advance the money.

Far too often, I receive calls from entrepreneurs who have already received investment funds and then want to form an entity.  When I ask if the funds already received are loans (to be repaid) or a continuing investment (a security), the caller doesn’t know.  Critical planning for the manner in which investors will participate in profits and decision making, has been ignored. 

I have attempted to simplify an area of the law that is extremely complex.  Do not rely on this newsletter without seeking professional assistance.

Copyright 2001

Published by the law firm of Newland & Associates, PLC
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