On September 20, 2012, the California Department of Corporations filed a complaint in the Los Angeles Superior Court that alleged that a number of companies did not qualify the offer and sale of limited liability company interests, bridge loans, promissory notes and convertible debentures in at least 215 transactions worth more than $23 million. Further, the Department of Corporations claimed that the information that the investors were given contained numerous misstatements and omissions. The money raised was used for financing of entertainment projects, including motion pictures.
Although this law suit is taking place in California, the allegations lead to believe that there may be a number of federal securities law violations that are typically investigated by the Securities and Exchange Commission (SEC).
The federal Securities Act of 1933 (the “Securities Act”) requires all companies to register offerings of their securities with the SEC unless an offering complies with one of the exemptions. These exemptions from registration are typically found in Regulation D. Each state has its own securities laws (referred to as “blue sky” laws). So, when raising capital, companies need to comply with both the federal and the state securities laws.
First, let’s take a look at the definition of a “security” in the Securities Act. Apart from the obvious stocks, “security” includes many debt instruments and even certain contracts. Courts have determined, for example, that an investment contract can be a security, if a person invests his or her money in a common enterprise with an expectation of profit derived solely from the efforts of others. There is no requirement to issue formal certificates to such investors. According to this rule, membership interests in an LLC can be “securities” if the investors have passively invested their money in the LLC with an expectation of a financial return on their investment.
Similarly, a promissory note can also be a security. The question of whether a promissory note is a security turns on whether the note looks like a security and whether the selling of the note looks like a securities offering. Factors to consider include the number and sophistication of the investors/lenders, whether the note is collateralized, whether the investors/lenders are also owners of the business they are lending money to, etc. It is likely that if a company is raising money for its general operations, and the investors are investing with an expectation of return, the promissory note will be deemed to be a security. Same analysis applies to other forms of investments.
When a company is offering and selling its securities to the investors, it generally distributes a disclosure document in which it describes the offering terms, its own business, management, market, competition, financial condition, and other factors, including the risks, that can influence the investors’ decision-making. According to the federal Rule 10b-5 under the Securities Exchange Act, companies cannot intentionally include material misstatements and omissions in such disclosure documents, and they have to update all stale information to make the statements be true.
Although compliance with the federal and state securities laws may be onerous, but it is not optional. Timely compliance with the applicable securities laws and regulations is much cheaper than paying hefty fines imposed as a result of the securities law violations.
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.