Jimmy wants to start a business that makes small robot dinosaurs. He spent his time learning robotics and computer-based design in college and now wants to put it to use by creating miniature versions of the Jurassic Park animatronic dinosaurs that kids can play with. He does a few designs, for a velociraptor, triceratops and brachiosaurus and thinks that he can make and sell them for a profit. So he starts a company, Mesozoic Toys. Jimmy needs money to start building and advertising his products, however, and in doing so he needs to make sure that he doesn’t run afoul of securities laws.
Securities are typically one of two types, debt or equity. A debt security represents money that is borrowed and must be repaid, such as a corporate bond. An equity security represents an ownership interest in the company itself, a common example being stock. If Jimmy wants to fund his business through the sale of securities then he will have to follow the applicable securities laws.
In addition to the federal statutes (some of which I mention in my crowdfunding articles, here and here), different states also have their own securities laws and regulations that apply to most of the smaller offerings and companies. People try to push the limits of how a security is defined so that they can keep full control over the business without having to jump through all of the expensive regulatory hoops of complying with securities laws. It goes without saying that they don’t always succeed.
In Oregon, for example, the law generally hinges around the concept of a “investment contract.” The definition of an investment contract is where someone 1) invests their money 2) in a common enterprise 3) with the expectation of profit 4) to be made through the management and control of others. See Pratt v. Kross. A similar concept is that of a “passive investor” who enters into an investment contract as defined by Pratt and is the one not doing the managing. If ownership in Mesozoic Toys is classified as an investment contract or an investor is classified as a passive investor then Jimmy better make sure that his offering of the security complied with all of the relevant securities laws. While this seems clear, it is the forth prong, “to be made through the management and control of others” that gets litigated as sellers try to give as little management control as possible to investors but still show they have enough control that it is not classified as an investment contract.
Consider the recent case Amerivest Financial, LLC v. Malouf. Here, the Oregon Supreme Court grappled with whether “individual senior life policy settlements” (SLP) were considered investment contracts. The question hinged on whether Amerivest Financial had any control over the management of the investment. While Amerivest and Malouf entered into an agreement where Malouf was the “provider” of the SLP investments and Amerivest was the “client,” on the same day Amerivest also passed a corporate resolution naming Malouf the director of finance and investments. The finding in this case was dependent on the Oregon Supreme Court’s finding that while Amerivest contended that they were a client to Malouf, Malouf’s position of director of finance and investments gave Amerivest enough management and control over the investment decisions so that the SLPs did not satisfy the requirement that the investment be managed and controlled by another in order to be considered as a security.
While not traditionally stock in a company, interests in real estate can also be considered a security. At the federal level, the landmark case of SEC v. W.J.Howey Co. involved the sale of land that was a citrus grove. In that case, the contract also provided that a service provider would cultivate and develop the groves. The inclusion of a service contract, which gave the service provider (Howey-in-the-Hills) full and complete control over the land, in addition to the sale of the land caused the US Supreme Court to classify the transactions as sales of securities because of the lack of investor control. Securities can thus be more than simply stock in a company.
Partnerships are also not exempt from securities analysis. General partnership interests likely will not be classified as a security as the general partner has management control over the business. Limited partnership interests, however, will likely be securities because the management of the partnership is usually left completely to the general partner. See Pratt.
So let’s look at a few situations with Jimmy and discuss what securities law implications arise.
Jimmy’s first instinct may be to borrow money from his dad, Jimmy Sr. in a personal loan that he, himself owes. While this loan could be secured by collateral, it is not a security in the sense discussed here. Jimmy can borrow as much as he likes in a personal loan from Jimmy Sr. and not have any securities laws implications.
Let’s say that Jimmy has a friend, Justin who has a lot of money from being a pop star and also likes to invest in startups. Justin likes the idea of having small dinosaur robots and thus wants to invest in Jimmy’s idea and make some money. Jimmy suggests that they form an LLC that is member-managed and thus they both have control of Mesozoic Toys LLC in proportion to their contribution. In this scenario, Justin, while he may not do much work designing or building the toys, is still an active participant in the management business. Justin’s ownership interest is not a security as he has management control over the business. Therefore it did not need to be registered in any special way other than a filing with the appropriate secretary of state to ensure the company’s status as an LLC.
If instead of a member-managed LLC, Jimmy decides to make a manager-managed LLC, things get complicated. In most instances, selling an ownership interest for someone to become a non-managing owner in a company is selling a security. If Jimmy does this then he will need to either register his security or find an exemption. Justin, in this case is a multi-millionaire so Jimmy, with some paperwork and hopefully the help of a lawyer, will likely not have any trouble qualifying for a Rule 506 exemption. You can see more of my discussion on registration and exemptions in my first crowdfunding article.
Say Justin changes his mind and isn’t interested in investing in Mesozoic Toys so Jimmy decides to look elsewhere. He thinks, “Why don’t I advertise ownership in my company to whoever wants a piece?” Unless Jimmy is taking only accredited investors in a Rule 506 exemption or registered it as a security with the SEC, then this is likely a violation of securities laws. Even if Jimmy is only taking accredited investors there are still other hoops he will need to make sure that he jumps through in order to keep his offering in line with a Rule 506 exemption.
Securities case law in each state is not necessarily settled and is certainly not easy to interpret from a layman’s perspective. It is recommended that before you raise money for a business or venture, that you do the right amount of research and consult a licensed attorney to determine whether what you are selling is a security and how to follow any applicable regulations.