Securities Issues


Securities Issues Print
This article is an overview and is not intended to be a comprehensive analysis of a securities offering, registration, or exemption from registration.  This article is not a substitute for competent legal representation.  Anyone considering issuing a security should consult with legal counsel, accountants, and investment bankers regarding the specifics of various alternative methods of raising capital and the application of those methods to the specific facts and circumstances of the issuance.  Issuers and anyone considering issuing a security should not rely on the accuracy of this article, but should carefully review all applicable statutes and regulations.Companies seeking to raise capital should weigh all the alternatives very carefully and obtain advice from experienced securities attorneys.  This is a very complicated area of law and there are serious consequences for failing to properly structure the transaction.

One of the first considerations for a corporation or an LLC when it is considering selling its shares or a membership interest is whether or not the stock or membership interest is considered a security.  The United States Supreme Court set forth the test to determine whether an interest in a business entity constitutes a  security under the Securities Act of 1933 and the Securities and Exchange Act of 1934 (collectively, “Securities Law”).  The three part test considers a business interest a security if it represents:

  1. Investment of money,
  2. In a “common enterprise,”
  3. The investor is led to expect profits solely from the entrepreneurial or managerial efforts of others.

The United States Supreme Court instructed that, in defining the term “security,” form should be disregarded in favor of substance, and the emphasis should be on the economic reality.   In a nutshell, if the purchaser of the stock or membership interest will be a passive owner, relying on someone else’s efforts or conduct in order to make money on the investment in the stock or interest, then the purchase of the interest is probably a security.

Under Federal and Arizona law, the issuance of stock in a corporation or a membership interest in a limited liability company issued to a passive (non-managing) member may constitute a transaction involving a security.  There was a 1998 case in Arizona that involved a member managed LLC with almost 300 members. The court found LLC interests sold to passive investors constituted a security as the sale involved an investment contract, which is a security because the investor expects profits solely from the efforts of the promoter or a third party.  The courts discussed that generally a general partnership interest is not the sale of a security, but in reviewing whether LLC members expected profits solely from efforts of the promoter or a third party, the facts indicated passive members had little management power and were inexperienced and not knowledgeable in the business affairs of the business of the LLC. The court’s decision found such LLC investors to be without specialized knowledge of the business and so were precisely the vulnerable investors securities laws are designed to protect.

Under Arizona law, which includes the Arizona Securities Act, various administrative rules enacted by the Arizona Corporation Commission, and case law, unless a valid exemption exists, a security must be registered with the Securities Division of the Arizona Corporation Commission and any dealer or salesman offering or selling the security must likewise be registered with the Securities Division.  The purpose of the registration is to protect the public from speculative and fraudulent schemes advanced by promoters by requiring publication, through the registration process, of material information concerning the securities before they are offered for sale.  The Securities Act does not intend to protect those who are able to “fend for themselves.”  Similarly, the United States Supreme Court has held that the purpose of securities laws is to protect investors by requiring offerors (those who are offering the stock)  to give offerees (those to whom the stock is being offered for sale) full disclosure of the information necessary in order to allow an offeree to make an informed investment decision. If the investors are able to “fend for themselves,” the offeror may be able to obtain an exemption from the registration process.  Exemptions from the registration provision exist where the nature of the transaction or security exempted is either sufficiently protected from the possibility of fraud, or where the need to trade freely outweighs the risk of fraud.  Based on the serious need to protect the public, there must be strict compliance with the requirements of the registration exemption.

One of the most commonly used exemptions from the registration provisions of the Arizona Securities Act is the non-public offering exemption.  The thrust of the exemption is that it relates to persons (new business owners) not needing protection and who are able to fend for themselves. In order to fall within the statutory exemption, persons offered a business interest must have full access to accounting and other information and must be sophisticated. “Sophistication” has been held by the courts to require exceptional business experience. If the appropriate circumstances exist, the statutory exemption not involving any public offering is automatic. However, keep in mind all investors must be experienced (sophisticated) and fully informed, and it is best if the investor is able to withstand the financial loss of all funds invested.

A United States Supreme Court decision discussed the statutory exemption, not for public offering, and focused on the number of offerees, the sophistication of the offerees, the size and manner of the offering and the relationship of the offerees to the issuers. The Ninth Circuit, which is the federal appellate jurisdiction that governs Arizona, likewise has adopted a four-part test to analyze the validity of an asserted non-public offering exemption, which focuses on the same four factors.

There is no hard and fast number of offerees to whom an issuer can make a non-public offering, but generally the more offerees, the more likelihood that the offering is public.  The investor must be sophisticated and have an excellent understanding of the venture.  Traditionally, if the offering is small and made directly to offerees, rather than through the public distribution, courts are more likely to find the offering to be non-public and exempt from the registration process.  Finally, the closer the relationship between the offerees and the offeror, such as family members or employees, or other close relationships, would indicate the ability of the offeree to effectively obtain access to the information that registration would otherwise provide.

The exemption not involving any public offering generally relates only to sales by the issuer, which would mean when the business is formed, but not upon later resale of a business interest which constitutes a security (such as the resale of stock or a limited partnership interest or a member interest). For example, if a shareholder agreement provides that third party sales are allowed (with or without a right of refusal in other shareholders), and if a sale takes place to a third party, the not for public offering/statutory exemption would NOT be available, as the issuer (the corporation) would not be making the sale. 

In summary:
  1. The “not involving any public offering/private placement exemption” is available only to the issuer (meaning it does not apply to any resale transaction).
  2. The “not involving any public offering statutory exemption” applies only to investors that can fend for themselves and that ability depends on access to information.
  3. The statutory exemption allowance is more likely to apply if the offering involves a smaller rather than larger number of investors as well as a smaller offering price and if there is a relationship between the offerees and the issuer (such as a corporation or LLC).
  4. Basically the statutory exemption applies only when making offers and sales to a handful of purchasers in a negotiated transaction not involving any solicitation.

Some other important points regarding securities and exemptions are the following.  For the statutory exemption to be available, NO solicitation must take place, and, of course that means no advertising or marketing such as sending information about the investment by utilization of a mailing list. The longer and closer the relationship of the investor to the person extending the offer, the more likely the statutory exemption will be available. The test for the Federal and Arizona statutory exemption is substantially the same.  Additionally, it appears that the statutory exemption applies to any offeree and not just actual purchasers and, therefore, every person with whom the investment opportunity is discussed must meet all of the tests for the statutory exemption to apply. Thus, it would seem the sophistication of an individual should be discussed before the offer is made to determine if the individual has vast business experience and is able to evaluate financial and other information, which would only then be disclosed regarding the investment opportunity. The relevant inquiry is whether or not the potential investor is able to understand and evaluate the nature of the risk based upon the information supplied.

Furthermore, it would seem the statutory exemption would only be available to investors who participate in forming the business plan, the accounting projections, and who will then be involved in active management of the business.  Additionally, it is best if the investor is able to sustain a complete loss if the business fails. It is recommended that if the statutory exemption is to be utilized that the owners sign an acknowledgment that the statutory exemption not involving any public offering applies to all investors as they have been involved with pre-opening planning and realize business success is subject to risk of loss and risk factors, such as fluctuations in the economy, changes in technology and customer preferences, price of resources and lack of marketability and transfer restrictions on the ownership interest itself. As addressed above, for the statutory exemption to apply, no general solicitation for investment funds must have taken place.  Based on the above, it would seem the exemption would only apply in a situation involving relatively few sophisticated investors who have fully and truly participated in formulating the business plan and financial projections.

Arizona law has what is called the “Safe Harbor” provision of the securities act.  If issuers comply with the requirements of this provision, their offering is deemed a non-public offering exempt from the registration provisions of the Arizona Securities Act.  Under the Safe Harbor provision, the number of purchasers of the offering is limited to 35 sophisticated persons.  Accredited Investors are not included in the 35 limit.  An Accredited Investor falls into several categories, but the most applicable are:  natural persons whose net worth at the time of purchase exceeds $1 million; natural persons who had individual income in excess of $200,000 in each of the two most recent years or joint income in excess of $300,000 in each of those years and who have reasonable expectations of reaching the same income level in the current year.  If the issuer sells only to Accredited Investors, there is a no requirement to provide specific information.  If the issuer sells to Accredited Investors and Non-Accredited Investors, there is certain information specified in the statute which must be provided to the investor.  Additionally, prior to making any sale to a non-accredited purchaser, the issuer must make a determination that each non-accredited purchaser, either alone or with his purchaser representative, has sufficient knowledge and experience to evaluate the merits and risks of the offering.  In addition, the issuer must make some filings regarding notice of sales with the Corporation Commission within 15 days after the first sale of securities within Arizona and within 30 days after the last sale of securities under the offering.  Again, offerings CANNOT be made through means of a general solicitation. 

Lastly, a word of caution to the issuer: a person claiming the applicability of any exemption to the registration provisions of the Arizona Securities Act has the burden of proof that the exemption is applicable and in addition to complying with the requirements of the Arizona Securities Act, there must also always be full compliance with applicable federal securities laws.

In the event the Company violates securities requirements, the following are the consequences.  A sale or contract for sale of any security in violation of Arizona statute is voidable at the election of the purchaser.  The purchaser may bring a private action for rescission plus interest, court costs and reasonable attorney fees.  There is joint and several civil liability for all persons who “made, participated in or induced” the unlawful purchase or sale.  In addition to private civil liability, the Arizona Corporation Commission (ACC) may issue an order, after notice and hearing, directing a person to take corrective action, including restitution and rescission.  Additionally, the ACC may seek administrative penalties in the amount of $5000 per violation, injunctive relief, civil restitution, and appointment of a conservator or receiver. 

For more information, see the 2005 article published by the Arizona Corporation Commission entitled:  “Raising Capital:  Overview of the Registration of, and Exemptions from Registration for, Securities Offerings”