Purpose of the Securities Laws

The federal securities laws came into being as a result of the 1929 stock market crash and the perceived need for greater regulation of the financial markets. The main objective of the federal securities laws is to provide full and fair disclosure to investors. Afterall, "sunshine is said to be the best of disinfectants; electric light the most efficient policeman." L. Brandeis, Other People’s Money 92 (1914).

The two main federal securities laws are the 1933 Securities Act and the 1934 Securities Exchange Act. The Securities Act established the procedures for ensuring that investors are provided with material information regarding the securities offered for public sale and for ensuring that misrepresentation and fraud is prevented in the sale of securities. The Exchange Act extends this disclosure to securities listed and registered for trading on the securities exchanges such as the New York Stock Exchange and NASDAQ and to those securities otherwise required to provide periodic reports under the securities laws. It also governs periodic corporate reporting such as annual and quarterly reports, proxy solicitations, tender offer solicitations, insider trading, exchange regulation, and broker-dealer regulation.

Federal securities laws are administered by the U.S. Securities and Exchange Commission, whose mission is to "protect investors and maintain the integrity of the securities markets." The SEC is organized into four divisions: Enforcement, Corporate Finance, Market Regulation, and Investment Management. In addition, there are various offices, most notably the Office of General Counsel and Office of the Chief Accountant.

State securities laws are not, for the most part, preempted by the federal securities laws, and the states are actively engaged in regulating and enforcing their own securities laws. The state securities laws are similar to the federal securities laws in that all sales of a security must be registered unless there is an exemption from registration available. State laws also prohibit fraud in much the same manner as federal securities laws.

Identifying a "Security"

The Securities Act defines a security 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.

See Sec. 2(1), Securities Act of 1933.

Be aware that under Landreth Timber, a sale of all of the outstanding stock of a company is a sale of a security and thus is subject to the federal securities laws. However, in Minnesota, the sale of 100 percent of the stock in a closely held company, subject to certain conditions, is not a sale of a security. See Minn. Stat. § 80A.14, subd. 18(a)(2).

Minnesota’s definition of a "security" under Minn. Stat. § 80A.14, subd. 18, is essentially the same as the federal definition under the Securities Act, except that Minnesota provides two exclusions from its definition:

(1) any insurance or endowment policy or annuity contract under which an insurance company promises to pay money either in a lump sum or periodically for life or for some other specified period; or

(2) stock of a closely held corporation offered or sold pursuant to a transaction in which 100 percent of the stock of that corporation is sold as a means to effect the sale of the business of the corporation if the transaction has been negotiated on behalf of all purchasers, and if all purchasers have access to inside information regarding the corporation before consummating the transaction.

A common misconception is that "founders" stock is somehow not a security, or is otherwise exempt. There is no legal distinction related to "founders" stock, and under the securities laws, any stock issued by a company, no matter to whom or at what stage of the company’s existence, is a security subject to regulation.

Selling a Security

Under both the federal law, Securities Act of 1933, § 5, and Minnesota law, Minn. Stat. § 80A.08, the sale of securities is prohibited unless the securities or their sale is registered under the securities laws or there is an exemption available to the securities or the sale.

Registration

Exemptions

Because not all businesses can afford to undertake a registration of their securities in order to raise money and not all investors need the high degree of protection afforded by registration, there are options for selling securities without registration. Like the registration process, both the SEC and state securities authorities have their own exemptions from registration. Every sale of a security, if exempt, must meet both applicable federal and state exemptions. There are two types of exemptions, the first based on the type of security to be sold and the second based on the type of transaction in which the securities will be sold.

Federal exemptions based on the type of security include, but are not limited to:

1. securities such as those issued by or pursuant to federal or state governmental authority;

2. commercial debt instruments with a maturity not exceeding nine months in length;

3. any security issued by a religious, educational, benevolent, fraternal, charitable, or reformatory organization not for pecuniary profit;

4. any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange;

5. any security that is issued in exchange for one or more bona fide outstanding securities, claims, or property interests, or partly in such exchange and partly for cash, where the terms and conditions of such issuance and exchange are approved, after a hearing by any court or other governmental authority expressly authorized by law to grant such approval; and

6. any security that is a part of an issue offered and sold only to persons resident within a single state or territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such state or territory.

See, generally, Section 3 of the Securities Act of 1933.

Minnesota exemptions based on the type of security cover many of the same types of securities covered by federal law, but also include securities listed or approved for listing on the NYSE, NASDAQ, American Stock Exchange, or other major exchanges. See Minn. Stat. § 80A.15, subd. 1(f). Each state will have its own list of securities exempted from registration.

Exemptions based on the type of transaction, versus the type of security, are more commonly used by companies. Transactional exemptions are based on how the security is offered and to whom. An understanding of some terms commonly used in this type of exemption is required before the exemptions can be understood. These terms are used by both the SEC and the states, though sometimes with minor differences.

One of the most important concepts is that of an "accredited" investor. An accredited investor is a person, who, by virtue of high income, net worth, assets, or knowledge of the company, is able to protect his or her own interests.

An "accredited" investor, in brief, is:

1. any natural person who earned $200,000 the last two years and reasonably expects to do so this year;

2. any natural person, together with their spouse, who earned $300,000 the last two years and reasonably expects to do so this year;

3. any natural person with $1,000,000 of net worth, with or without their spouse;

4. any director, executive officer or general partner of the issuing company;

5. any corporation, partnership or business trust with total assets in excess of $5,000,000 not formed for the purpose of acquiring the securities offered;

6. any trust with assets exceeding $5,000,000 not formed for the purpose of acquiring the securities offered and directed by a "sophisticated" person; and

7. any entity in which all the equity owners are accredited investors.

See Regulation D, Rule 501(a).

A "sophisticated" investor is a person who, while not accredited, either alone or with an investor representative, possesses such knowledge and experience in financial and business matters that he or she is capable of evaluating the risks and merits of a potential investment. See Regulation D, Rule 506(b)(ii). This is a subjective standard and it is the company’s responsibility to determine that a person is "sophisticated."

Transactional exemptions may also be subject to "integration," Regulation D, Rule 502(a), and "aggregation," Regulation D, Rule 504(b)(2) and Rule 505(b)(2)(i), rules. These rules effectively combine similar offerings of securities and subject what the issuing company might see as different offerings to the requirements of one exemption. For example, an offering of $1,000,000 of common stock made within four months after closing on a debt offering of $500,000 by the same company will likely be integrated and both offerings, on a combined basis, must meet an exemptions requirement.

Integration is based on five factors: (1) Time, generally offerings separated by six months are not integrated; (2) type of security, two or more offerings of equity securities are more likely to be integrated than offerings of debt; (3) purpose of offerings, offerings that are for the same or similar general purpose are more likely to be integrated; (4) type of consideration received; and (5) whether there is a single plan of financing involved with the various offerings.

Aggregation rules apply only to offerings under Rules 504 and 505. The regulation states that the dollar amount of an offering will be aggregated with the dollar amount of other Rule 504 and 505 offerings conducted within the last 12 months. For example, a Rule 504 offering, which has a $1,000,000 offering amount limit, is conducted in August 2002. The same company conducts another Rule 504 offering for $1,000,000 in June 2003. There is no integration as the offerings are more than six months apart, but the dollar amount of the offerings would be aggregated and the company could not sell any securities under Rule 504 until after August 2003.

Federal Exemptions

The most commonly used transactional exemptions are found in Regulation D adopted by the SEC under the Securities Act. Under Regulation D, Rule 506 is probably the most widely used and was adopted pursuant to section 4(2) of the Securities Act.

Rule 506 provides that a company can sell an unlimited dollar amount of securities, with no aggregation concerns, to an unlimited number of accredited investors and up to 35 non-accredited investors, providing that if a sale is made to a non-accredited investor, certain information about the company and the offering must be made available to the investors. Even if only accredited investors are involved, a company would be well advised to provide investors with information about the company, the offering, its business, and the risks involved because of the application of anti-fraud rules described below. Advertising and general solicitation is prohibited under Rule 506, so the investors are limited to people with whom the company or its agents have pre-existing relationships. One of the best things about a Rule 506 offering is that the U. S. Congress in 1996 decided to preempt state regulation of offerings that fall within Rule 506. See National Securities Markets Improvements Act of 1996. Therefore, any offering that falls within the requirements of Rule 506 is automatically exempt in every state, subject to notice filing requirements.

Rule 504 is perhaps the second most widely used offering and was adopted under section 3(b) of the Securities Act. Rule 504 has a $1,000,000 amount limit that is subject to aggregation. Rule 504 offerings are also subject to integration. Rule 504 offerings allow companies to sell securities to an unlimited number of investors of all types; however, state securities exemptions almost always impose a limit on the number of investors, so the practical value of this is limited. Rule 504 offerings can be made through public advertising and general solicitation if the offering is registered in the states where the public advertising is taking place or the state has an exemption that allows for general advertising that correlates with Rule 504. The SCOR, or Small Corporation Offering Registration, offering is designed to take advantage of this allowed advertising by permitting an offering that is exempt under the federal rules while subject to a supposedly streamlined state registration process.

Regulation A is also an exemption from registration pursuant to section 3(b) of the Securities Act, but provides an exemption for offerings of up to $5,000,000. The offering must be filed with and qualified by the SEC, basically an abbreviated registration process. The offering still must be either registered or exempt from registration in each state where investors are located. One of the benefits of a Regulation A offering is that it allows public advertising, but this usually means that the offering has to be registered with the states as well. Regulation A is subject to aggregation with other Regulation A offerings and integration with other offerings made less than six months after the completion of a Regulation A offering. There are specific information delivery requirements for a Regulation A offering that are similar to a small company registration statement.

Regulation S is an exemption for sales outside of the United States in an offshore transaction. While this rule is quite complex, the gist of it is that sales of securities to persons outside of the United States are
exempt, with limited restrictions on dollar amount, type, and number of investors. Regulation S offerings are not subject to integration or aggregation with other offerings.

Minnesota Exemptions

Minnesota’s transactional exemptions are found primarily in Minn. Stat. § 80A.15, subd 2. The one major exemption that is not listed there is the Rule 506 exemption found at § 80A.122, subd. 2. The other major Minnesota exemptions are located at § 80A.15, subd. 2(a), and provide exemptions for sales to a limited number of investors. Section 80A.15, subd. 2(a)(1), provides for an exemption for up to 10 sales in Minnesota during a 12-month period, subject to certain conditions. This exemption does not require a filing and accredited investors are excluded from the count of investors. Section 80A.15, subd. 2(a)(2), provides an exemption for up to 25 sales, exclusive of sales made under § 80A.15, subd. 2(a)(1), during a 12-month period, subject to certain conditions. This exemption does require a filing be made with the Department of Commerce, but again, accredited investors are excluded from the count of investors. Neither of these exemptions requires the delivery of an offering document to the investors,
but the anti-fraud rules still apply, so it is always a good idea to prepare some type of document with information about the company and the offering to give to investors.

It is very important to remember that even if a company has identified a federal exemption that works for its offering, a state exemption must be identified and complied with as well to avoid state securities problems.

Liability for Violations

Failure to sell pursuant to an exemption or registration is a bright-line violation where the only question is "did the company comply with the terms of the applicable registration or exemption provision?" If yes, there is no violation. If not, the company and its officers and directors could be subject to both civil and criminal sanctions. The company could be forced to conduct a rescission offering whereby it would have to contact every person who purchased its securities in the illegal offering and offer to repay them. The securities regulators could also impose fines and sanctions on the company, making it difficult for the company to conduct further offerings to raise more money. Officers and directors can likewise be subject to fines and sanctions, including being held liable for any rescission offer, if such person knew or reasonably should have known of the facts that gave rise to the liability. It is possible that a company could be subject to liability under the federal laws and the laws of each state in which securities were sold.

The anti-fraud provisions of the Securities Act as well as similar provisions in state law require companies to disclose material information to investors and prohibit disclosure of materially false or misleading information in all cases. In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), and Basic Inc. v. Levinson, 485 U.S. 224 (1988), the U.S. Supreme Court held that a fact is material if there is a substantial likelihood that a reasonable investor would attach importance in making a decision because the fact would significantly alter the "total mix" of available information. Materiality is judged through the eyes of a reasonable investor. Even though an exemption may not require the disclosure of information to investors, the anti-fraud rules de facto require that investors be made aware of at least basic information about the company, including its business plan, its management team, its proposed use of proceeds, and the risks related to its business.

Conclusion

There are many more provisions in the securities laws, but the above discussion should provide an explanation of the major securities law issues facing small businesses. Subjects such as resale of restricted securities, public company reporting and compliance, proxy solicitation, tender offers, Sarbanes-Oxley compliance, and broker-dealer representation are left for the next brave soul. Good luck.