The Long Arm of the (Securities) Law

by Craig Butler on March 10, 2009

The Long Arm of the (Securities) Law

In the world of securities law what you don’t know can hurt you.  Securities laws reach significantly more transactions than most companies or legal practitioners realize and the failure to properly comply with these laws can have dire consequences.

Securities laws can be confusing and convoluted for both companies and legal practitioners alike.  However, this does not make the subject any different from several other complex legal subjects.  But unlike other areas of the law, where the applicability of the law is known and the confusion arises in the context of how the law applies the confusion surrounding securities law often causes companies and legal practitioners to fail to realize that their transaction is even governed by federal and state securities laws at all.  The purpose of this article is to provide companies and attorneys with a brief overview of what types of transactions are impacted by federal and state securities laws.  Unfortunately, due to the brief nature of this article, it is not possible to discuss what needs to be done to comply with the numerous federal and state securities laws for each of these transactions.  Treatises are written to address those issues.  The purpose of this article is to get you to the first, and most important step, in the process, which is to realize that your company’s, or your client’s, transactions may have securities laws ramifications that need to be addressed.  Getting to that first step should lead you in the right direction with the proper legal advice.  If your company or client is engaging in any of the transactions listed in this article, or similar transactions, chances are very good there is a securities law issue that needs to be addressed and you should speak with a securities law attorney.

There are few simple but very important concepts to remember when determining if your transaction may involve securities laws.  First, securities laws govern securities transactions for all private and public companies regardless of size, and are not just applicable to publicly-traded companies.  As an attorney practicing securities law for over eight years the most common mistake many companies and attorneys make regarding securities law is the belief that securities laws only apply to public companies.

Second, it is important to understand what constitutes a “security.”  For the purposes of this article a “security” is common stock, preferred stock, limited liability membership units, and any instrument convertible into common stock, preferred stock or limited liability membership units, such as a convertible promissory note.1

Third, every transaction involving the offering or transfer of a security is governed, to some extent, by federal and state securities laws.  A list of some regular corporate transactions is listed below and you may be surprised to learn which ones are governed by federal and/or state securities laws.

Fourth, every offering or sale of a security must either be registered at the federal and/or state level, or meet the requirements for an exemption from registration.  The registering of securities offering and sales, or complying with a proper exemption, is covered in numerous treatises and cannot be discussed within the confines of this article.

Out of these four basic concepts a few questions usually arise:  i) What type of transactions are governed by the securities laws?; ii) What could possibly happen if I don’t comply with the securities laws?; and iii) My company engaged in one or more of these transactions and didn’t have a securities law attorney review the transaction, what can I do?

To answer the first question lets take a look at a number of typical activities by a fictitious business called ABC, Inc.  For the purpose of this example let’s assume ABC, Inc. incorporates in California, and then undertakes the following as a private company:

 

  • ABC, Inc. issues shares of its common stock to its three founders.
  • ABC, Inc. sells shares of its common stock to several friends and family members of its three founders in order to raise money for operations.
  • ABC, Inc. receives a loan from an unrelated third party and in exchange issues a promissory note, which, at the request of the lender, is convertible into common stock of ABC, Inc. in the event the note is not timely repaid.
  • ABC, Inc. hires a director of marketing to assist with advertising its products.  In the employment agreement, ABC, Inc. gives the employee a warrant to purchase X number of shares of ABC’s common stock at a fixed price.
  • ABC, Inc. enters into a share exchange agreement with XYZ, Inc., wherein each company agrees to exchange shares of its common stock in exchange for the other company’s common stock.
  • ABC, Inc. is ready to start manufacturing its widgets and needs cash for the manufacturing.  As a result they offer up to 30% of the company’s stock to third party investors in exchange for money to cover manufacturing costs.
  • One of the founders of ABC, Inc., distributes a portion of his shares to several third party investors in order to avoid dilution to investors of ABC, Inc., which would occur if they purchased shares directly from ABC, Inc.

 

Which of the above transactions is governed by federal and state securities laws?  The answer is all of them.  For each of the above transactions a review of applicable securities laws needs to be completed, and in some cases federal and/or state filings may be required.  This securities law review should be completed prior to any of the above transactions being initiated.  Additionally, in order to meet federal and state securities laws related to offerings of securities, certain disclosure documentation, such as a private placement memorandum and/or financial statements, may need to be provided to investors prior to their investment.

This leads to the second question for most companies: “I didn’t have the required securities law research done and did not do any federal and state securities filings, but I have not heard from any federal or state agencies, what is the possible impact on my business?”  This question is difficult to answer.  The impact could be varied.  If you only issued shares to the founders of the company, although filings may be required, the failure to make the filings may not be detrimental.  However, for companies with an eye towards growth and that took outside investor money, or companies that may attempt to sell their business, or attempt to go public at some in the future, the impact can be devastating. For instance, after the founders of ABC, Inc. have spent countless hours growing their business with a goal of being acquired by a larger player in the industry, when that opportunity finally comes the failure to have properly researched and complied with federal and state securities laws may cause the possible acquiring company to pass on the opportunity to acquire ABC, Inc.  Another possible result could come from a disgruntled shareholder who complains that at the time they made their investment certain information about the company and the risks involved with their investment were not disclosed to them and may file a lawsuit seeking a return of their investment and additional damages.  A third possible result could come from the company with an eye to becoming publicly-listed.  If federal and state securities laws were not complied with at the time investors purchased their shares then when the company goes before the Securities and Exchange Commission and other regulatory authorities to register its securities the SEC may question the offerings and validity of the shareholders, or question the failure to register certain offerings of securities, and may leave the company in the unenviable, and very expensive, position of having to admit to the SEC that federal securities laws were not followed and may have rescind the previous non-compliant stock offerings and sales by offering to its shareholders to repurchase the shares they purchased.

This leads to the third question:  “My company completed one or more of the above transactions but did not have a securities law attorney review the transactions, what can I do?”  While it is ideal to seek advice prior to any offering or issuance of stock, obviously this does not always occur.  However, all is not lost.  Many times there are actions and filings that can be completed after the transaction in question to remedy many of the deficiencies created by failing to do so before the transaction, so long as they are done prior to any federal or state inquiries or a complaining shareholder.

In conclusion, both private and publicly-traded companies alike need to seek out and obtain legal advice regarding any issuance of securities to help avoid issues with federal and state regulators, as well as shareholders.  Ideally, this advice should be obtained prior to the issuance of the securities.  However, even if it was not obtained ahead of time, the advice should be sought as soon as possible to determine any issues and attempt to remedy and problems as soon as possible.

The Lebrecht Group, APLC provides comprehensive advice on a variety of corporate and securities law matters.  Please contact us if you have any questions.

Craig V. Butler, Esq. is an attorney with The Lebrecht Group, APLC, located in Irvine, California and Salt Lake City, Utah.  He can be reached at (949) 635-1240 or via e-mail atcbutler@thelebrechtgroup.com with questions or comments.  Please visit our website at www.thelebrechtgroup.com for future updates and other information.


1 It should be noted that the Securities and Exchange Commission’s definition of a security is much broader:  “The term “security” means 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, The Securities Act of 1933, as amended.

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