Securities Laws Exposure for Business Financing

Finding a source of capital for a new or existing business is often a challenge. Consider the following scenario: Diana has a great idea for a new business and she has the experience and know-how to make it work. But, she needs capital funding. She tells her friend Deidre about her idea for a new business and Deidre thinks the idea will be successful. The partnership is formed with Diana agreeing to contribute her time and talents to run the business and Deidre will be the outsider providing the funding. Diana and Deidre agree that Diana will be the brains of the business and retain 50% ownership of the joint venture and control all management and that Deidre will be the financial backer for the affair in exchange for the remaining 50% of the joint venture. Are there any legal challenges inherent in this transaction? Yes — many. Most capital raising efforts by businesses are subject to strict state and federal securities regulations. 

Ever since the stock market crash of 1929 and the resulting Securities and Exchange Act of 1933 and the 1934 follow up Act, this situation implicates securities laws. The federal statutory scheme provides a methodology for lawfully obtaining financing for these enterprises. And, all states have followed the federal lead and have implemented state securities laws. The common misconception is that the securities laws only apply to the big, publicly-traded companies. The truth is that the laws apply regardless of the size of the business. 

 A security is broadly defined and includes not only the items we traditionally view as a security (stocks, bonds, notes) but also any profit sharing agreement, investment contracts, fractional interests in oil and mineral rights, etc. Certainly Diana’s exchange of 50% of the profits of the new joint venture in exchange for Deidre’s capital financing would constitute the sale of a security. 

This is an expansive definition and encompasses many things that most people wouldn’t traditionally see as a security. How expansive is the definition of a security? In one of the seminal cases in this area, SEC v. WJ Howey Co, 328 US 293 (1946), the court found that the Howey Company planted citrus groves in Florida, keeping half of the groves for itself and offering the other half to the public to help finance development. Howey was selling land contracts (not stock, but the land itself). There, the Court held that the land sales contract, the warranty deed and the service contract together constitute an ‘investment contract’ subject to the Securities and Exchange Act.  The Court provided the current definition of an investment contract as 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….” 

The law provides that every security (broadly defined) offered for sale must be registered with the SEC unless it falls into an enumerated exception. Registration with the SEC is prohibitively expensive for the vast majority of closely held businesses, so the key is complying with the exemption requirements. 

There are two big exemptions to the registration requirements of the Securities and Exchange Act. The first is the private offering (detailed in Rules 504 through 506 of Regulation D of the 1933 Act). The second deals with intrastate offerings under Rule 147. 

First, the private offering. The three different rules (Rules 504 through 506 mentioned above) provide exemptions from full federal registration but still require compliance with state securities laws, which often involves the filing of a notice. Depending on the applicable rule, the company can raise up to $5 Million, but must limit the number and qualification of “nonaccredited investors.”  However, there are typically no limits on accredited investors. “Accredited investors” are generally defined as individuals with more than $1 million (exclusive of primary residence) or an annual income of over $200,000 (individual) or $300,000 (married). The definition can also include the officers and directors of the company (company insiders). Advertising and solicitation are also generally limited or prohibited, again depending on the applicable exemption. However, it is notable that the 2012 Jumpstart Our Business Startups Act (JOBS Act) now allows for limited advertising and solicitation, even for larger offerings, so long as the audience of potential investors are all accredited. 

The second exemption category is the intrastate offering. The applicable rule (Rule 147) provides exemption from registration for securities offered and sold exclusively intrastate. To be eligible for this offering, the issuer (company) must have its principal office located in the state and receive at least 80% of its income in the state, it must have at least 80% of its assets located in the state, it must use 80% of the proceeds in the state, and all purchasers must be residents of the state. Here again, the issuer must still comply with applicable state securities laws. 

Failure to comply with these rules subjects the issuer to potential liability, usually in the form of a plaintiff’s attorney citing failure to comply with disclosure and antifraud provisions of the act and demanding recompense for lost value of the investment (effectively making the issuer guarantee the return on the investment). 

The bottom line is that if you are seeking financing for your venture through means other than a traditional loan, you should consult a lawyer knowledgeable in securities laws.


* Licensed, not practicing.

The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. 

Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.