Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 1: Introduction

Written by Casey W. Riggs § May 28th, 2012 § 1 comment § permalink

In this series of posts, we’ll explore ways to attract and retain key employees, directors and other service providers (all of which I’ll refer to throughout this post simply as “service providers”) of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock.  Clients considering such plans often think of stock first, but there are several arrangements that can accomplish various goals and objectives of the organization and which should be considered.  To the typical client question:  “which is best”, comes the typical attorney response: “it depends”, so in this series of posts we’ll attempt to explain some of these arrangements and provide some suggestions for companies considering an equity or similar compensation plan.

First, here’s a list and generic description of plans or arrangements that are often used to retain and reward key service providers:

  • Stock Options – a stock option gives the service provider the right to purchase a share of the company’s stock at a set exercise price
  • Restricted Stock  - a grant of stock to the service provider which vests over some period of time or upon attainment of certain goals
  • Phantom Stock – a deferred compensation arrangement that provides a payout (usually in cash) based upon the value of the Company’s stock
  • Stock Appreciation Rights – the right to a payment (usually in cash) based on the appreciation in the value of the Company’s stock
  • Profits interests (for entities taxed as partnerships) – gives the employee or service provider a share of future profits in the Company but no ownership in the current capital of the company

One point of clarification that I’m often asked about involves the distinction between stock warrants and stock options.  Stock warrants differ from stock options in that they are typically granted in an investment transaction whereas stock options are granted in connection with the performance of services.  Therefore, if as a company you are granting a right to purchase stock to an employee or other service provider in exchange for services, then you are providing an option and not a warrant.  This distinction has important consequences for tax purposes, which we’ll discuss in a later post.

Where to Start

So where does one start when considering a plan to retain or reward key service providers?  It seems to us that a good decision is best made by starting by clearly defining and articulating the purpose of the plan in the context of the specific employer.  Questions to consider include:

  • What is the legal structure of the company (corporation (taxed under subchapter C or S?), partnership, limited liability company, etc.)?
  • What does the Company produce or what service does it provide?
  • Where is the company in its life cycle (start-up, growth company, established company, etc.)?
  • What critical goals must the company meet in the next  12, 24, 36 months, etc.?
  • How many service providers does the company have?
  • Who is the plan for?  It is for one key service provider?  Or all service providers?
  • What is the purpose of the plan specifically?  Is it to incentive the key service providers generally by aligning their interests with those of the employer?  Or is it to motivate one or more service providers to help the Company achieve a specific goal?

With some of these questions answered, it will be easier to narrow the choices.  However, there are many additional considerations that need to be explored.  In future posts, we’ll describe the basic features of the various alternatives in more detail, their tax treatment (from the employer and the service provider side), accounting treatment, fiduciary and corporate governance issues, and securities laws considerations.

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© 2012 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

When does a deal involve securities regulation? Part 4: Promissory Notes

Written by Alexander J. Davie § May 19th, 2012 § 0 comments § permalink

This post is the fourth in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws, and covered when various categories of instruments constitute a security, including partnership and limited liability company interests.  In this post, we’ll explore when a promissory note falls within the definition of a security under federal law.

Under the federal Securities Act, the definition of a security includes “any note.”  Taken literally, this could bring within securities regulation a vast number of transactions, including personal loans, commercial loans, and mortgage transactions, which would require the borrower to comply with securities laws. Fortunately, courts have not taken the words “any note” literally, and in the case Reves v. Ernst & Young, 110 S. Ct. 945 (1990), the Supreme Court adopted the “family resemblance” test to determine whether a particular loan transaction involves securities laws.

Under the family resemblance test, there is a rebuttable presumption that a note is a security, unless it resembles a type of note that commonly is not considered a security.  However, the court also recognized that most notes are, in fact, not securities.  The Court listed a number of categories of transactions that do not implicate U.S. securities laws:

  • A note delivered in consumer financing.
  • A note secured by a mortgage on a home.
  • A note secured by a lien on a small business or some of its assets.
  • A note relating to a “character” loan to a bank customer.
  • A note which formalizes an open-account indebtedness incurred in the ordinary course of business.
  • Short-term notes secured by an assignment of accounts receivables.
  • Notes given in connection with loans by a commercial bank to a business for current operations.

Just because a transaction does not fit within the list above does not mean that the note is a security.  For other transactions, the Court set out a four factor balancing test.  The four factors are:

  1. Whether the borrower’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest.  The second half of this factor is not particularly helpful, since almost all loans involve earning a profit.[1]  However, the first half can often come into play.  If purpose of the transaction is to raise money for general business use or to finance a substantial investment, the note is more likely to be security; conversely, if the purpose is to facilitate the purchase and sale of a minor asset or consumer good, or to correct for cash-flow difficulties, or to advance some other “commercial or consumer purpose,” the note is less likely to be a security
  2. Whether the borrower’s plan of distribution of the note resembles the plan of distribution of a security. In general, the more buyers and the less sophistication of the buyers, the more likely it is that the notes are securities.  In addition, the presence of any significant negotiation over the terms of a loan (or if the lender dictates the terms of the loan) usually makes it less likely that the note would be considered a security.
  3. Whether the investing public reasonably expects that the note is a security. If the purchasers view the notes as a type of investment, they are more likely to be securities.  In addition, if the notes are unsecured, they are more likely to be securities.
  4. Whether there is a regulatory scheme that protects the investor other than the securities laws. For example, if notes are regulated under Federal Deposit Insurance or ERISA, they are less likely to be a security.

Of course, with any kind of multi factor balancing test, there is a high degree of subjectivity.  As a result, it is fair to say that a note is often a security when a court thinks that it should be, which makes structuring loan transactions all the more tricky.  Here are some practical guidelines:

  • If you’re selling notes to multiple people, it is likely to be a security.  This is even more the case if the purchasing parties are not in the business of making loans.
  • If you’re getting a loan from one party that is in the business of making loans (like a bank), then the note associated with the loan is not likely to be a security.
  • If you’re borrowing the money personally, it is less likely to be a security than if your business is borrowing it.

Beyond that, if the circumstances are ambiguous, be sure to find qualified securities counsel.

Footnotes

[1] However, a loan among family members, where the prime motive is not profit, would be a good example of a note where profit was not the motive behind making the loan.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Missouri Commissioner of Securities Proposes New Private Fund Exemption Based on Model NASAA Rule

Written by Alexander J. Davie § May 9th, 2012 § 0 comments § permalink

On April 26, 2012, the Missouri Commissioner of Securities proposed revised regulations exempting certain private fund managers from investment adviser registration with the State of Missouri.

Background

Prior to the repeal of the federal 15-client exemption, Missouri had an exemption for fund managers who were exempt under the old federal 15-client exemption and who managed investments solely for private funds with at least $5 million under management.  After the repeal of the federal 15-client exemption, fund managers have relied on a No-Action Determination by the Missouri Commissioner of Securities dated July 20, 2011, which allowed private fund managers in Missouri to continue to rely on Missouri’s old exemption, until the earlier of June 28, 2012 or the promulgation of a new exemption, notwithstanding the repeal of the federal 15-client exemption.  Now, it appears that the Missouri Commissioner of Securities is ready to adopt that new exemption.

The New Proposed Regulations

The new proposed regulations are based upon the NASAA model rule exemption for investment advisers to private funds.    They provide for an exemption from registration for “private fund advisers.” A private fund adviser is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund).[1]   A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations.  The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would.

Any private fund adviser that advises one or more 3(c)(1) funds (other than venture capital funds, as defined under federal regulations) must also comply with additional restrictions.  All investors in these funds must be (i) an accredited investor, as defined in Regulation D  or (ii) a qualified client, as defined in federal regulations. [2]  However, the exemption does not allow private fund managers that advise a 3(c)(1) fund to accept accredited investors who are individuals that qualify solely by the income test.[3]    The inclusion of certain categories of accredited investors within 3(c)(1) funds is a significant departure from the model NASAA rule, which requires that all investors in a 3(c)(1) fund at least be a qualified client (at least for the fund manager to be exempt from registration).  The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners.  Finally, the fund manager must provide financial statements to each investor.  This is also a departure from the NASAA model rule, which requires that such financial statements be audited.

The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before the effective date of the new regulations but cease accepting, after the effective date, accredited investors that are individuals that meet the income test but don’t meet the net worth test, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption.

The Commissioner of Securities did not state in their announcement when they expect the new exemption to take effect, but we can expect that to occur on or prior to June 28, 2012.

Footnotes

[1] A 3(c)(1) fund is a fund which has not more than 100 investors.  A 3(c)(7) fund is a fund which is limited to qualified purchasers, which are defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.

[2] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse, but not including the value of the individual’s primary residence) of more than $2 Million.

[3] Rule 501 of Regulation D allows an investor to qualify as an accredited investor if such investor has income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Looking to Invest? How to Determine Whether an Investment Is Worth It

Written by Alexander J. Davie § May 4th, 2012 § 3 comments § permalink

This article was originally posted on business.com on May 1, 2012.

Investing in a new venture can be exciting. In addition to the potential to make a profit, many people invest in start-ups for the thrill of being involved with helping a fledgling company make its mark. The possibility of funding a breakthrough company is enough to get many investors enticed, committed, and involved.

However, it’s also a fact of life that many, if not most, start-up companies fail. Alongside that, some investment opportunities are fraudulent, being promoted by people only looking to swindle you out of your money and then move on to pursue other ventures (and victims).

This can be the case even if it appears on paper that the company has a fantastic business model, an intricate plan, or even an extensive list of key assets. While not all promoters of start-up investment opportunities are out to do such a thing, the smart investor needs to gather important information before considering investing in a business – good or bad.

  • Determine if the Promoters are Legitimate: Conduct a Google search on the person promoting the opportunity. If the person is in the financial industry or works as a securities broker, check out his profile on brokercheck.finra.org. If you find any history of securities law violations, fraud, lawsuits, or criminal conduct, it should function as a huge red flag.  A history of bad conduct means the company is likely to continue with such actions in future endeavors.
  • Ask for the Company’s Offering Memorandum or Financial Statements: If the company doesn’t have some kind of offering memorandum or due diligence packet, that’s a red flag, as it alerts you that the company either is unwilling to provide information to potential investors or simply lacks the patience to put in the work the goes into compiling such information.  That being said, a small company may not have the money to produce a formal offering memorandum; in this case, you should ask for its financial statements. These should be prepared by an outside accountant in order to provide some degree of independent verification. The reliability of such documents is further enhanced if they’re audited.  Finally, it’s also a good idea to require copies of past tax returns in order to verify their claims.
  • Obtain a Copy of the Company Business Plan: A company’s business plan is the ultimate road map that will guide a company to success. Not only does it provide the main objectives of the company, it also tells you the demographic they’re marketing their goods or services toward, along with the resources it will take to accomplish the company’s plans.  Companies that take the time to prepare a business plan have demonstrated that they have put some thought into how they are going to use your investment to produce a profit.

As an investor, you should have an informal team consisting of a lawyer, an accountant, and an investment adviser (one who’s paid a fee to advise you, not a broker who receives a commission on the sale). Your lawyer(s) should specialize in business law – don’t use the family lawyer who wrote up your will.  Having a team can be very important to you, as an investor, in several ways:

  • Negotiations between You and Company: If the deal is negotiated between you and the company, rather than a prepackaged securities offering made to a number of investors, a lawyer experienced in start-up finance can help you negotiate protections and better terms.
  • Understanding the Contents of Legal Documents and Disclosure: Your team also will be able to help you understand both the economics and the legal terms of the transaction.  Having an investment team is important when it comes time to review the documents binding you to the start-up. If you don’t understand something, your team of advisers is there to help. You pay them to help you sort through confusing and complicated issues.
  • Establishing Credibility: Having a team is not only smart for legal reasons, but it also lends you a level of immediate respect.  Parties without lawyers show they don’t take themselves seriously, or don’t have the means to prepare their documents in a professional manner.  In addition, if the other party drafted the documents without a lawyer, the documents will likely contain serious problems and key issues will be overlooked.

If you’re an individual with a high net worth, it’s beneficial to join an angel investing group. These are local organizations comprised of individuals looking to invest in promising companies.  Joining such a group is beneficial, as it allows you to compare your notes about the companies with other potential investors. It also allows you to invest more money as a group.

While investing in a start-up company can be a gamble, proper investigation and preparation, from researching the promoters to working with your investment team, will allow you to make smarter and more profitable investments. The better investments you make, the more likely you are to invest in that breakthrough company.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Implications of the Recent Mayo Case on Patentable Subject Matter

Written by Shane Cortesi § April 27th, 2012 § 0 comments § permalink

Last December, I wrote a series of posts about what was – and remains – a hot topic in patent law:  patentable subject matter under 35 U.S.C. § 101.   The law on patentable subject matter often boils down to whether the invention is so abstract or such a product of nature that the invention is not patent eligible even if it meets the other statutory requirements of being new, not obvious and useful.  Since those posts, the Supreme Court has issued another decision further limiting patentable subject matter in Mayo Collaborative Servs. v. Prometheus Labs., Inc.  I believe that patent eligible subject matter is going to continue to be a thorny issue for many software, medical diagnostic and biotechnology inventions.  However, I believe that in the majority of cases involving mechanical devices, medical devices, and new chemical compositions, patent eligibility under § 101 is going to be a non-issue, that is most inventions in these fields will readily qualify under § 101.

In Mayo, the invention related to the discovery that a particular concentration of drug metabolites in the blood should be targeted by doctors when they prescribe a particular class of autoimmune drugs.  (A drug metabolite is a chemical formed when the body digests – i.e., metabolizes – a drug.  In the pharmaceutical industry, it is extremely common to identify metabolites and their concentrations during clinical testing).    In particular, each claim of the plaintiff’s patent included (1) an administering step that instructed a doctor to administer the drug to his patient (2) a determining step that told the doctor to measure the resulting metabolite levels in the patient’s blood and (3) a wherein step that described the target metabolite concentration and informed the doctor to adjust the patient’s dosage if the patient’s metabolite levels were outside of the target concentration.

Addressing the patent eligibility issue, the Court repeated the commonly recited proposition that laws of nature, natural phenomena and abstract ideas are not patent eligible.  The court then found that the heart of the invention — namely, the discovery of the relationship between the concentrations of certain metabolites in the blood and the likelihood that the prescribed drug dosage would prove ineffective or cause harm — was simply a law of nature.  Further, in the Court’s view, the three recited steps failed to “add enough” to render the claimed method a patent-eligible process.  The Court found that the first step referred to a pre-existing audience, namely, doctors that already administer the drugs, the second step merely told doctors to measure metabolites in the blood, and the wherein step merely informed doctors about the law of nature.  Accordingly, the Court held that the claimed process was not patent eligible.

In my view, the Mayo decision is problematic for a few reasons.  For example, while it’s easy to say that laws of nature, natural phenomena and abstract ideas are not patent eligible, it’s often difficult to apply this rule in practice and conclude when an invention “adds enough” to render a claimed method patent eligible.  Indeed, perhaps for this reason, the Federal Circuit had crafted a machine-or-transformation patent eligibility test in which a claimed process was generally patent-eligible if it was implemented with a machine or transformed matter, and patent ineligible if it was not implemented with a machine or transformed matter.  Additionally, in my view, the proper way to strike down the patent in Mayo was on obviousness grounds.  It has been known for decades that it’s important to measure drug metabolite levels and at the time of the invention at issue in Mayo, scientists knew that the metabolites at issue were correlated with drug safety and effectiveness.  Though the particular target levels were not known, the methods to test metabolite levels were old and there was clearly a motivation to use these known methods to find the target levels.

It goes without saying that how the lower courts will apply Mayo will be important for companies in the software, diagnostic and biotechnology industries.

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© 2012 Shane V. Cortesi — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Massachusetts Securities Division Adopts Final Private Fund Adviser Exemption Based Upon NASAA Model Rule

Written by Alexander J. Davie § April 19th, 2012 § 0 comments § permalink

Previously, I reported that the Massachusetts Securities Division had proposed an exemption from investment adviser registration for advisers to private funds.  In late winter, the division adopted these regulations as final (with small changes).  They are, more or less, identical to the NASAA model rule and include the model rule’s grandfathering provisions.

As part of the rule, advisers to 3(c)(1) private funds (that are not venture capital funds) must, among other requirements, accept only qualified clients (as defined in SEC regulations) as investors.  However, under the grandfathering provision, an adviser to a 3(c)(1) private fund may have non-qualified clients as investors only if the fund ceased to accept non-qualified clients as of February 3, 2012.  (In the previous proposed rule, this date was March 30, 2012).

The new exemption takes effect August 3, 2012.  Prior to that, private fund managers can continue to make use of “institutional buyer” exemption, which exempts any adviser that only advises entities (i) whose investors are solely accredited investors each of which has invested a minimum of $50,000, (ii) existed prior to February 3, 2012, and (iii) ceased accepting new investors or new capital from existing investors after February 3, 2012.  If a fund manager does keep accepting new investments, then it must comply with the requirements of the new exemption.

Massachusetts joins several other states in adopting (or proposing to adopt) some form of the NASAA model rule, including California, Virginia, and Rhode Island.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

When does a deal involve securities regulation? Part 3: Partnerships and Limited Liability Companies

Written by Alexander J. Davie § April 13th, 2012 § 0 comments § permalink

This post is the third in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws.  One of the categories of investments that constitutes a “security” under federal law is an “investment contract.”  The term is a rather open-ended one, but under the so-called Howey Test, the term includes any arrangement or transaction that is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  As a result, any transaction which constitutes an investment contract is a security under federal securities law.  In this post, we’ll explore when an interest in a limited liability company (“LLC”) or a partnership constitutes an investment contract, and consequently, a security.

When the Securities Act of 1933 was written, there was no such thing as an LLC or a limited partnership.  The only type of partnership-like entity available was a general partnership, which featured unlimited joint and several liability for the partners.  As a result, it was very rare that someone would invest in a partnership in a passive role.  Therefore, partnership interests were left out of the definition of a “security” under the Securities Act.

Now, with the advent of limited partnerships, limited liability partnerships, limited liability limited partnerships, and limited liability companies, there are a myriad of choices available that allow an investor to invest in a partnership and enjoy limited liability.  Therefore, passive investing in partnerships and partnership-like entities is now common.  But because interests in these kinds of entities are not listed within the definition of a “security” under the Securities Act, a partnership or LLC interest will only be considered a security if it constitutes an investment contract.

That said, interests in many LLCs and partnerships fall under the definition of an investment contract.  For instance, in manager-managed LLCs, the non-managing members are essentially passive owners.  The same also applies to limited partners in a limited partnership.  An investment contract is, quintessentially, an arrangement where a passive owner invests money with another person who promises to use that money to make a profit for the passive owner.  Therefore, in each of these instances, the non-managing member interests and the limited partnership interests would be considered investment contracts and consequently securities.[1]

Conversely, a general partnership interest in a partnership or a managing member interest in an LLC are generally not securities, because the control that the general partner or managing member has over the company causes the general partner or managing member’s interest to fail to meet the final prong of the investment contract definition (that is, profit arising primarily from the efforts of people other than the investor).  Likewise, members in a member-managed LLC are usually not deemed to be holders of securities if they have the ability to participate in management.

However, even if a member of an LLC or a partner in a partnership has management rights on paper, the LLC or partnership interest could still be considered an investment contract, if in practice, there is no expectation that the investor will be active in generating profits.  In securities law, substance often trumps form.  Thus under Williamson v. Tucker, 645 F.2d 404 (5th Cir 1981), the Court of Appeals for the Fifth Circuit held that a general partnership interest could be a security if the investor was dependent on the promoter and could not exercise meaningful control.  Examples of such a situation are (i) where the managing partner cannot be replaced or is very difficult to replace, (ii) where the investors are inexperienced in business affairs and cannot exercise their abilities to participate in management, or (iii) where the promoter has unique managerial abilities which cause de facto reliance on the promoter.  Generally, if one of these situations exist at the time of initial investment, then the investment is likely to be an investment contract.

Whether a partnership interest or an LLC interest is a security often depends highly on context.  The less involved the holder of the interest is in the activities of the company, the more likely that the interest will be considered a security.  In addition, the relative sophistication of the purchaser of the interest as compared with company management also has a role to play.  Interests sold to less sophisticated investors are more likely to be considered a security than those sold to more sophisticated ones.  Unfortunately there is no bright line test that determines whether an LLC or partnership interest is a security, and consequently, the context of the transaction pays a significant role.

Footnotes

[1] It is possible that a limited partnership interest or a non-managing member interest in an LLC could be outside the definition of an investment contract if the economic realities indicate that the limited partner has significant and legal control of partnership management.  See Steinhardt Group v. Citicorp, 126 F.3d 144 (3rd Cir. 1997).

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

When does a deal involve securities regulation? Part 2: The “Howey” Test

Written by Alexander J. Davie § April 5th, 2012 § 0 comments § permalink

This post is the second in a series exploring when securities laws impact business transactions.

In my previous post, I provided a general overview of the definition of a “security” under federal securities laws.  The Securities Act of 1933 provides for a very far reaching definition of a security, including “any note, stock… investment contract…, or, in general, any interest or instrument commonly known as a ‘security’…”  As explained in my prior post, this definition, taken literally, can result in both overinclusiveness and underinclusiveness.  I’ll discuss the issue of overinclusiveness and how it is addressed in future posts; this post will discuss how the inclusion of an “investment contract” within the definition of a security allows the definition to include classes of investments that are not specifically listed, like limited liability company interests and limited partnership interests, which are both concepts that had not even been invented when the Securities Act was passed.

The principal case which defined the term “investment contract” under federal law is SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  In the case, the defendant, Howey was sued by the SEC to enjoin it from selling plots of land that had citrus trees planted on them.  Along with the plots of land, Howey offered management contracts where the purchaser would lease the plots back to Howey and Howey would harvest them.  However, the purchaser was not required to enter into such a management contract and could purchase the land without doing so.  Nonetheless, the Supreme Court held that the land sale together with the management contract collectively constituted an investment contract, and thus a security.

In this decision, the Supreme Court set forth a test, now known as the Howey test, for determining whether a transaction constitutes an investment contract.  Under the Howey test, a contract or transaction is an investment contract if “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.”  Please note however that while the Supreme Court in Howey stated that the profit must arise “solely” from the efforts of others, later decisions by lower courts and the Supreme Court[1] have expanded this, so even if the investor has the power to be involved, the transaction may still be an investment contract if the efforts of others predominate.  Therefore, there are three essential components for this test: (1) investing money in a common enterprise, (2) the expectation of profit, and (3) the profit arising primarily from the efforts of people other than the investor.

In future posts, I’ll explore how the Howey test operates in specific situations.  In addition, I’ll also explore situations where some classes of investments are excluded from the definition of a “security” even if they are listed within the federal definition.

Footnotes

[1] More recently in United Housing Foundation v. Forman, 421 U.S. 837 (1975), the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The word “solely” was conspicuously left out.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

When does a deal involve securities regulation? Part 1: Introduction

Written by Alexander J. Davie § March 29th, 2012 § 3 comments § permalink

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

“[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, 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.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types to transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.

Footnotes

[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

In spite of what you may have heard, the Senate just effectively killed crowdfunding.

Written by Alexander J. Davie § March 25th, 2012 § 7 comments § permalink

This last week, the Senate passed the “JOBS Act,” leaving it one step away from final passage by Congress and Signature by President Obama.  The JOBS Act contains a number of provisions which are aimed at reducing the securities compliance burdens of small companies and startups.  One of the major provisions within the JOBS Act is the so-called “crowdfunding” provision.

Crowdfunding has an enthusiastic following online and within the entrepreneurial community.  Obviously, that following is very excited about the bill’s Senate passage.  Unfortunately, I don’t think they should be popping the champagne corks anytime soon.  Before passing the bill, the Senate passed an amendment to the bill substituting a new version of the crowdfunding law by Senators Merkley, Bennet, and Brown in place of the one written by Rep. Patrick McHenry.  All signs point to the Republican leadership in the House conceding to the Senate’s amendment this week in order to get the bill to the president’s desk for signature as soon as possible.

And I believe the Senate’s amendment kills crowdfunding.  The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers.  While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison.  Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use:

  • In the new version, the exemption from registration only applies if the aggregate amount sold to any investor by an issuer (that is, ANY issuer) does not exceed certain caps, which vary depending on the investor’s income.  That’s right, if you use the crowdfunding exemption, it may not apply depending on whether your investors have invested in OTHER startups using the exemption — something you have no control over.  Hopefully, the SEC, in regulations, will provide a safe harbor for issuers to make this determination (both as to income and the amounts invested in other crowdfunding offerings), but you can never count on the SEC making anything simple. [Update 4/19/12: see comments below.  One commenter had pointed out that from first blush the limits may not apply in the aggregate.  However, a separate portion of the bill does confirm that the limits apply in the aggregate, but the funding portal will have the obligation to enforce this.  That said, there still may be significant consequences to the issuer if the funding portal fails fulfill their responsibilities.]
  • In the new version, the offering can only be made through a registered broker-dealer or a new “funding portal” which also must be registered with the SEC and, apparently FINRA.  In the McHenry version, an issuer could use an unregistered “intermediary” but was not required to.  This additional requirement will greatly increase the costs of conducting a crowdfunding offering.
  • The new version requires that the issuer of any crowdfunding offering of over $500,000 have audited financials, again significantly increasing the compliance costs on issuers.  It also prohibits any advertising to promote the offering.
  • The Merkley amendment creates a new cause of action against a crowdfunding issuer, and its directors and officers.  Traditionally, in Federal securities fraud suits (at least those involving non-public securities), the plaintiff has to prove that the defendant acted knowingly or recklessly.  In any suit involving a crowdfunded company, the burden of proof will be on the defendants and they will need to prove they didn’t know about any misstatements nor in the exercise of reasonable care could not have known about the misstatements.  Good luck finding competent directors for your crowdfunded company.

In all, the statute that provides for the crowdfunding exemption expanded from 12 pages to 24 after the substitution of the Merkley version.  For a crowdfunding exemption to work, it must be simple.  Small companies cannot afford the significant compliance burdens placed upon them by the crowdfunding exemption that was passed.  Therefore, my prediction is that entrepreneurs will quickly find that the new exemption is too expensive to utilize and is more trouble than it is worth and that it will rarely be used.  As I’ve stated in the past, there are some significant practical obstacles to crowdfunding even with the McHenry bill.  The Senate’s solution certainly didn’t help.   Therefore, I believe the Senate may have just effectively killed crowdfunding.  I may be wrong; the SEC may implement the bill well through regulation and save crowdfunding.  Anyone want to take a bet that this happens?

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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