Securities: Registration and Exemption

Business owners and startups beware, the issuance or sale of securities often implicates complex state and federal securities laws. If the securities laws apply, the consequences of non-compliance can be significant. Specifically, an illegal sale of securities can result in civil lawsuits and potentially even criminal charges, not to mention that investors may rescind their purchase of the securities. Further, a debt resulting from the issuance of an illegal security may not be discharged in bankruptcy. In light of these serious ramifications, the threshold issue is whether your entity is issuing a security in the first place. Indeed, if there is no security issuance, there will be no securities violation.

Luckily, in the seminal case, SEC v. W.J. Howey Co., 328 U.S. 293, 298 (1946), the U.S. Supreme Court has defined a security as an arrangement “where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves.”  In an attempt to avoid securities filings and violations, it is no surprise that most issuers first try to qualify their equity issuance as a non security. This is especially true in the context of member-managed LLC interests which have been held not to be securities. See Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981). This is so because although the members of an LLC are “individuals […] led to invest money in a common enterprise with the expectation that they would earn a profit,” because the members manage the LLC themselves they do not meet the last part of the securities definition; specifically, “through the efforts of the promoter or of some one other than themselves.”

On the other hand, a manger-managed LLC, similar to the structure of a limited partnership, would implicate a security since the members of the LLC like a limited partner have passive interests that derive profits through the efforts of someone else. Similarly, corporations are considered to be issuing securities when issuing shares. Accordingly, whether the issuance of an interest is held to be a security requires a totality of factors consideration.

Moving on, if the issuance is deemed a security, it can fall into one of three categories; illegal security, registered security, or exempt security.

Without going into too much detail, an illegal security is a security that has neither been registered nor qualified as exempt. Moreover, unless a securities exemption is available, all offers or sales of securities are required to be registered and qualify under the Federal Securities Act of 1933 and the California Corporate Securities Law of 1968.

Now to discuss securities exemptions. First, contrary to popular misconception, there is no automatic exemption for securities that are issued or sold to family members or friends; don’t be the unwary business owner who ends up being sued for issuing illegal securities. Fortunately, both Federal and California laws provide for advantageous exemptions. As a side note, I think its appropriate to explain that an exemption still requires a filing, that’s because the exemption applies to a security, whereas, as discussed above, an issuance of interest that is not considered a security is excluded from any filings.

To continue, at the federal level, you may qualify for filing an exemption under Regulation D (i.e., Rule 504, 505, 506(b), 506(c)). Keep in mind that federal securities laws only apply to the interstate offer and sale of securities; that is, if you are only offering and selling securities in California, no federal registration or exemption is necessary.

At the state level, you may qualify for filing an exemption under California securities laws. The most frequently used exemptions are the Limited Offering Exemption Notice (LOEN), Cal. Corp. Code section 25102(f), which will exempt you from qualifying the offer under the more complicated requirements of Cal. Corp. Code section 25110. The LOEN must be filed within 15 days of securities issuance. Another option is the Small Offering Exemption Notice (SOEN) which will exempt a corporation, offering or selling voting common stock, from the requirements of Cal. Corp. Code section 25110. The SOEN must be sent to the Commissioner of Corporations within 10 days of securities issuance and must be signed by a member of the State Bar of California, containing the attorney’s opinion that the exemption is available.