Why Are Securities Laws Such a Big Deal?

When it comes time to line up capital for a new corporate enterprise, often the key questions are: How much do we need? From whom can we get it?

Many business owners mistakenly assume that these two basic questions sum up the capital challenges for a startup or thriving privately owned business. But there’s a third, and in many respects, a more fundamental question – how do we do it legally?

Since the fallout of the great crash of 1929, our laws have recognized that selling a security is not like selling a used car. The former is an intangible; it’s not possible to get the load out by kicking the tires, looking under the hood, or taking a test drive. So over the past 7+ decades, a body of federal statutory securities laws have developed to provide special protection for those entrust their investment dollars with others. All states have followed suit with their own statutory schemes. The purpose of these laws is to protect the public from some of the risks inherent in investing money in intangible assets such as stock. Various means are used to accomplish this overriding purpose including mandated disclosure requirements, industry player regulation, government law enforcement, and expanded causes of action for private litigation.

The Securities Act of 1933 often referred to as the ’33 Act established the general requirement that any security offered for sale must be registered with the Securities and Exchange Commission before it is sold. Only a tiny fraction of closely held corporations would ever consider going through the expense and hassle of such a registration process. For this reason, the important registration issues for a closely held business in need of investors are the exemptions to the registration requirement.

Is there an applicable exemption that fits so that the money can be raised without enduring the burdens of registration? There are two big statutory exemptions that become the ball game for most closely held corporations that want outside investors. The first is commonly referred to as the private offering exemption. The second is commonly referred to as the intrastate offering exemption. The challenge is to know what it takes to qualify for one of these exemptions.

The SEC has published rules that set forth specific standards for meeting the exemptions. Rules 501 through 506 of Regulation D deal with private offering exemptions. SEC Rule 147 deals with the intrastate offering exemption. Generally speaking, and I do mean generally, most privately owned corporations seek to qualify under Rule 506 because an exemption under 506 preempts all state securities law registration requirements. This can save a great deal of time, hassle, and expense for a company that intends to raise money from investors who live in various states.

There are a few key 506 requirements. There can be any number of accredited investors. Generally, those are individuals with a net worth of at least $1 million or an annual income of $200,000 for the last 2 years. The income number jumps to $300,000 for a married couple. Plus, there can be 35 non-accredited investors if and only if each non-accredited investor or his or her authorized representative receives appropriate disclosure information and each non-accredited investor must have knowledge and experience in financial and business matters and be capable of evaluating the risks of the investment.

All advertising and general solicitations are prohibited under 506. A Form D should be filed with the SEC and with the corporations’ commissioner in each state where stock is sold. All who buy stock should sign an appropriate investment agreement confirming that they are buying the stock for investment purposes, that there are serious restrictions on the resale of the stock and that they will not attempt to resell the stock without the approval of the company.

Beyond the registration exemptions are the anti-fraud prohibitions. SEC Rule 10b-5 makes it unlawful for any person directly or indirectly in connection with the purchase or sale of a security to make any untrue statement of a material fact or to admit to state a material fact necessary in order to make statements made in the light of the circumstances under which they were made, not misleading. This rule takes all dealings in securities to a higher level. The seller has an affirmative duty to accurately state material facts and to not mislead. And the buyer has a solid cause of action if the seller blows it.

The key protection here in nearly all cases is a quality private placement memorandum which spells out all of the details and the risks of the investment. Rule 10b-5 and its state counterparts keep our courts packed with countless disgruntled investors who believe that they were unfairly deceived when things didn’t go as planned. The root cause of most trouble with the securities laws is ignorance. The business just didn’t understand or didn’t stop to think or ask for advice before charging ahead.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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