According to the Attorney General’s press release, “More than 150 individuals from across the country made “movie production loans” to Alliance Group Entertainment, which has produced four B-movie flops since 2005, including “Confessions of a Pit Fighter” (2005) starring rapper Flavor Flav . . . .”

By soliciting loans without filing with the California Department of Corporations, he violated California securities laws.  His seeming intent to defraud investors made him subject to criminal prosecution.

Two months later you decide to do another securities offering under Rule 504 and your raise another $950,000.

Chances are, you will have violated the requirements of Rule 504.  Why?  Because the SEC will integrate the two offerings into one and you will have raised $1.9 million total which exceeds the $1 million maximum of Rule 504.

How can you prevent two separate securities offerings from being integrated?

The SEC looks at the following factors when determining whether two offerings should be integrated:

1. Whether the two offerings are part of a single plan of financing
2. Whether the two offerings are for the same class of securities
3. How close together the two offerings are in time
4. Whether the same type of payment for the securities is being received in both offerings
5. Whether the two offerings are for the same general purpose

It may be difficult to tell whether two offerings are likely to be integrated by the SEC.  Luckily, there is a “safe harbor” rule you can use to make sure that two offerings will not be integrated.  As long as the end of one offering is separated by at least six months from the beginning of another offering, they will not be integrated.

We have discussed the definition of an accredited investor elsewhere.

A recent change in the law has narrowed the definition.  The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act adjusted the “accredited investor” definition to exclude the value of an investor’s primary residence from the current $1 million net worth threshold.  This change went into effect immediately upon passage of the Act.

What is and is not general solicitation can get tricky!  Especially if you decide to make your private offering of securities using a third party web-based platform.  Beware!  Don’t assume that these services know what they are doing and are in compliance with the law.  If they screw up, you could be on the hook to return the money you raised using their platform.

What questions should you ask before deciding whether to use one of these platforms?

1. Is the operator of the platform a licensed broker-dealer?  If not, it can be risky to post your private placement on their site.

Section 15 of the 1934 Exchange Act requires persons that effect securities transactions on behalf of others to register as broker-dealers.  However, if the web-based platform is merely serving as a passive intermediary that facilitates the introduction of buyers and sellers, it may be able to operate legally without a broker-dealer license.  The types of activities to watch out for if the platform does not have a license include offering advice and information, handling funds, assisting with negotiations, and receiving fees based on a percentage of the purchase price.

2. How is the operator of the platform finding investors for the site?  Is it being done in a way that could look like general solicitation?  For example if the public web site invites potential investors to view specific offerings, this could be a general solicitation and all un-registered offerings on the site would be illegal.

3. Is access limited to accredited investors?  If not, it is necessary to provide an extensive private placement memorandum to potential investors and there is more risk of runnning afoul of the law.

4. How are investors screened?  How does the platform ensure that investors are really accredited and are making other required representations such as a statement that they are not purchasing for re-sale?  Generally speaking a lengthy questionnaire is required to determine whether the potential investor is suitable – having them check a box stating that they are accredited is not enough.

5. Once investors are given access to the site, are they allowed to view offerings that were already listed?  If so, this could be deemed general solicitation.

6. Are detailed records kept to ensure that the requisite pre-existing relationships can be documented if necessary?

7. Has the platform secured a “no action letter” from state and/or federal regulators assuring that the regulators will not bring an action against them?

Under the intrastate exemption (Section 3(a)(11) of the Securities Act of 1933), an issuer is exempt from the federal securities registration requirements.  To be eligible for the exemption, all investors must reside in a single state and the issuer must be incorporated in and doing most of its business in that state.

If the securities are offered, sold, or re-sold within nine months of the initial offering to even one out-of-state investor, the exemption may be lost.  Losing the exemption means the issuer could be required to return all the investors’ money.

The best way to ensure compliance with Section 3(a)(11) is to take advantage of the safe harbor provision in SEC Rule 147.  A safe harbor is a set of conditions that, if you comply with them, you can be assured that you will meet the requirements of an exemption.  However, it is not necessary to comply with the safe harbor conditions to comply with the exemption.  The conditions required to meet the safe harbor are as follows:

1. 80% of the company’s assets are located in the state in which the offering is made;
2. 80% of the company’s revenue comes from the state in which the offering is made; and
3. 80% of the proceeds from the offering will be used within the state in which the offering is made.

The intrastate exemption is self-executing.  The issuer is not required to file any paperwork with the SEC.

To prevent the inadvertent loss of the exemption, the issuer should do the following:

1. Place a legend on the certificate evidencing the security stating that the securities have not been registered under the Act and setting forth the limitations on resale;
2. Issue stop transfer instructions to the issuer’s transfer agent or make a notation in the appropriate records of the issuer; and
3. Obtain a written representation from each purchaser as to his residence.

Even if an offering qualifies for the intrastate exemption to federal registration, it is still necessary to comply with the securities regulations of the state in which the offering is made.

Example of the Use of the Intrastate Offering Exemption

Saranac Lake Community Store

After the town’s general store closed, members of the Saranac Lake community decided to open their own store.  They are offering shares to the public using the federal intrastate exemption and a special New York state registration process designed for issuers using the federal intrastate exemption.

Investors can purchase as little as one share for $100, with a maximum purchase of 100 shares. As of June 24, 2010, the Community Store has raised $442,900 from over 400 investors all over the state of New York.  The offering will close when $500,000 has been raised.  The Community Store organization has engaged the local community by holding “share parties” – small gatherings in homes and other intimate venues where potential investors can discuss the business plan with the interim Board of Directors and invest in shares if they choose.

The following are characteristics that will make it more likely that a court will consider an instrument to be a security, and therefore subject to securities regulations:

1. the right to receive dividends contingent upon an apportionment of profits;
2. negotiability (i.e., transferability);
3. the ability to be pledged or hypothecated (i.e. used as collateral);
4. the conferring of voting rights in proportion to the number of shares owned;
5. the capacity to appreciate in value;
6. the motivations of the seller and buyer – the seller’s purpose is to raise capital and the buyer’s purpose is to earn a profit;
7. the plan of distribution - there is “common trading for speculation of investment” and the instrument is offered and sold to a broad segment of the public;
8. public perception – the public reasonably perceives the instrument as an investment;
9. the instrument poses a risk to the investing public.

After I say that, the inevitable response is always “then how does REI do it?”  REI is a cooperative and sells memberships all over the country.

Great question!  I called REI’s corporate lawyer to ask why REI does not consider its memberships to be securities.

He said REI’s memberships are very far from the definition of a security because people don’t join REI to get financial returns.  While REI members do get patronage refunds each year, these are more like a discount on what they buy than a financial return – kind of like the discounts that people pay to get when they join Costco.

REI is so confident in this opinion that it has never requested a no action letter from the SEC.

It also helps that REI memberships are non-transferable and cannot appreciate in value.  It doesn’t hurt that the price of a membership is so low.

One benefit of allowing cooperatives to participate is that there is a state securities registration exemption for Washington cooperatives.  So promoters of community energy projects can use the co-op structure to bring in a diverse group of investors without having to register a public offering.

Click here for the bill.

Great job Stanley!

A security is defined under federal law as

“any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 15 U.S.C. 77b(a)(1).

The leading case on the definition of a security is federal Supreme Court case SEC v. W.J. Howey Co. (1946).  Under the Howey test, a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

In Howey, the “scheme” in question was the sale of land containing fruit trees as well as “service contracts” to cultivate and market the crops, with an allocation of the net profits going to the purchaser.

The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

The ninth circuit court of appeals distilled Howey’s definition into a three-part test: “(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” SEC v. Rubera (2003).

The courts have rejected attempts to narrow the definition of a security.  As one opinion put it, “[I]n searching for the meaning and scope of the word ‘security’ . . . form should be disregarded for substance and the emphasis should be on economic reality.”

The “investment of money” prong of the Howey test “requires that the investor ‘commit his assets to the enterprise in such a manner as to subject himself to financial loss.’”

The focus of the inquiry is on what the purchasers were offered or promised.  “The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”

What does it mean to create an expectation of profits?  The Supreme Court defined profits as “either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds.”

The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”

Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security.  If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.

There are some exemptions to this requirement.  One of the most commonly used is the 25102(f) exemption (named, creatively enough, after the section of the code where it is found).

The following are the requirements for the offer and sale of a security to be eligible for the 25102(f) exemption:

• The offering can be made to an unlimited number of Excluded Purchasers
  • Excluded Purchasers include banks, officers and directors of the company, a person that works for the company that has executive level duties and authority, and accredited investors

• The offering can be made to a maximum of 35 purchasers who do not meet the definition of an Excluded Purchaser, if they meet one of the following requirements
  • Have a preexisting personal or business relationship with the company and/or its principals; or
  • Have the ability to protect their interests due to their financial experience or the fact that they have experienced professional advisors

• All purchasers must state that they are purchasing for their own account and not for re-sale
• The offering of the security may not be advertised to the public

The term “preexisting personal or business relationship” includes any relationship consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen and general business and financial circumstances of the person with whom such relationship exists.

In addition, the company must make a simple filing with the Department of Corporations.

This is a very basic summary — please do further research or work with a lawyer before attempting to use this exemption!

Note also that the company still must qualify for a federal exemption from securities registration – see our earlier blog post on federal exemptions.