May 19, 2011
Three Misconceptions About the Coverage of the Securities Act
I spend a lot of time on the Securities Act, and particularly on its application to small businesses. The Securities Act, as most of our readers know, makes it illegal to offer or sell securities without filing a disclosure document known as a registration statement with the Securities and Exchange Commission. But the Securities Act and SEC regulations adopted pursuant to the Securities Act include a number of exemptions, and many small businesses successfully use those exemptions to avoid the expense and burden of registration.
However, some start-ups and micro-entrepreneurs wrongly assume that they don’t have to worry about the Securities Act—that it doesn’t apply to them. Here are the three most common misconceptions I have encountered.
1. It’s only debt.
Some people believe that, unless they are selling stock or some other equity interest in a business, they don’t have to worry about federal securities law. It’s easy to see where this idea originated. We generally only think of stockholders or other equity participants as “owners” of a business, so I'm not really selling an interest in my business if I’m just borrowing money. But, whatever the origins of this idea, it’s simply wrong. As far as the Securities Act (and other federal securities laws) are concerned, there is no hard and fast line between equity and debt.
The definition of security includes various categories of debt: notes, bonds, debentures, “evidence of indebtedness.” And the Supreme Court has made it clear that investors who are promised only an interest payment and not any participation in the business’s earnings can be purchasing securities. SEC v. Edwards, 540 U.S. 389 (2004). That doesn’t mean that all debt is securities. If you go to a single bank and sign a note to borrow money, that’s pretty clearly not a security. But, if you borrow money from a number of people to finance the start-up or operation of your business, it’s quite likely that a security is involved. See Reves v. Ernst & Young, 494 U.S. 56 (1990).
You’re not free of the Securities Act registration requirement just because you’re borrowing money.
2. I’m only raising money from family and friends.
Some people think they don't need to worry about federal securities law if they are soliciting funds only from family members and friends. That’s simply wrong. There is no general exemption from the Securities Act for offerings to family and friends.
The closest possibility is probably the private offering exemption in section 4(2) of the Act and its safe harbor, Rule 506. The exact scope of the section 4(2) statutory exemption is uncertain, but it is generally limited to people who can fend for themselves and don’t need the protection of securities law. SEC v. Ralston Purina Co., 346 U.S. 119 (1953). It’s doubtful that most friends or family fit into that. And the Rule 506 safe harbor is only available if purchasers are either accredited investors or sophisticated. People are not accredited investors just because they’re friends and family, and many family members and friends are not going to meet the sophistication requirement. (Family/friend status may matter for purposes of the rule’s general solicitation restriction, but that’s just one of the rule's requirements.)
Even though you’re limiting your fundraising to family and friends, you still have to worry about the registration requirement of the Securities Act.
3. The SEC won’t go after me.
The argument here is not that the offering complies with the Securities Act, but that there are not likely to be any consequences. The SEC has limited resources, so it is possible the SEC will not discover the violation or may not prosecute if it does discover the violation. But notice the “mays” in that sentence. Over the years, the SEC has spotted and prosecuted many "small fry" who wrongly assumed they wouldn't be caught.
Even if the matter escapes government attention, private liability is a major concern. Section 12(a)(1) of the Securities Act gives a virtually unlimited right of rescission to anyone who is offered or sold a security in violation of the Act’s registration requirement. If the purchaser still owns the security, he can recover the purchase price with interest. If he has sold the security for less than he paid for it, he can recover the difference. The purchaser doesn’t have to show the failure to register harmed him in any way. And when are purchasers most likely to sue to get their money back? When the business takes a downturn and their investment loses value—in other words, just when the business needs the money the most.
But, going back to the second point, the entrepreneur doesn't need to worry if all those purchasers are friends and family, does he? Friends and family members won't sue. Don’t be so sure. When things go badly, family and friendship ties tend to go out the window. If you don’t believe me, scan a corporate law casebook and count the number of small business cases where family members and former friends are suing each other.
The SEC may find and pursue you if you don’t register an unexempted offering and, even if it doesn’t, you have to worry about having to give back the money at an inopportune time.
The interpretation of the legal provisions relevant to the small investors and the beneficiaries of the investments (including,of course, the investors themselves or those stepping into their shoes)so far as the Securities Act and the SEC are concerned,is very pertinent and serves as an eye-opener. Thanks!
Posted by: G S Prasad | May 20, 2011 5:51:49 AM
Thank you so much for posting this. Don't forget that state securities laws may also apply, and we are much more likely to go after the smaller violators. We hear these excuses on a daily basis. While we have many exemptions for registration, the anti-fraud rules apply even if registration is not required.
Posted by: Leslie | May 20, 2011 7:18:06 AM