Principal stockholders of closely held corporations need to understand basic securities law concepts when considering the sale of securities to raise capital for their business. Generally speaking, a company which solicits funds from individuals who are not intimately involved in the company's management must consider the applicability of state and federal securities laws. Importantly, closely held businesses involved in raising capital from outside sources, be they relatives, close friends or the general public, often run afoul of state and federal securities laws, thereby unwittingly subjecting the principals of the issuing company to the risk of civil and criminal sanctions. These problems usually arise well after the securities have been sold, when disappointed investors instruct their attorneys to identify ways to recover investments that have gone sour.
The federal securities laws arose out of the wild stock market speculation leading to the stock market crash in 1929. During the 1920s, stocks and bonds were often sold on the basis of empty promises of windfall profits, without disclosure of useful information to investors. The Securities Act of 1933 (the "Act") requires a company to make "full disclosure" of all material facts in the context of offering its securities for sale to the public. A company must offer its securities
for sale by disclosing sufficient and accurate information about the business which it intends to conduct.
Section 5 of the Act requires that a registration statement be filed with the SEC before securities are offered for sale to the public. With proper planning, a closely held company can almost always identify exemptions from the registration requirements of both state and federal securities laws. Importantly, however, even in offerings which are exempt from the registration requirements, various filings are required to secure those exemptions, and purchases or sales of securities remain subject to the anti-fraud provisions of the state and federal securities laws. Moreover, in securities law parlance, the definition of fraud includes the mere omission to furnish an investor with information that a reasonable investor would consider material in making his or her investment decision. Companies issuing securities, and in some cases the principals of the issuing company, are responsible for false or misleading statements (whether oral or written) in the context of the sale of securities. If all conditions of the exemptions are not met, purchasers may seek to have their purchase price refunded. Investors who are harmed by false or misleading statements in the context of a sale of securities may seek redress through private or governmental legal action, including criminal sanctions.
The anti-fraud provisions in state and federal securities laws therefore require that a company issuing securities even to only a handful of investors, such as business acquaintances or friends and relatives, give careful consideration to the applicability of state and federal securities laws, the manner of qualifying for available exemptions from registration requirements, and the degree of information which needs to be furnished to investors in order to minimize the risk of liability under the anti-fraud provisions. Proper planning allows the issuing company's corporate attorney and accountant to design an offering process which fits the company's budget, while achieving legal compliance.
Parenthetically, it should be noted that Section 2 of the Securities Act of 1933 defines the term "security" to include investment vehicles that are outside of the familiar concept of notes, stocks and bonds. For example, the definition of security includes "investment contracts". The breadth of this term is illustrated by the U.S. Supreme Court case of SEC v. W.J. Howey Co. In that 1946 case, the W.J. Howey Company offered prospective investors a land sales contract for an acre or more of orange grove tracts and a service contract to cultivate and harvest the growing crop. For a specified fee plus the cost of labor and materials, Howey was given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. The investors never participated in the grove operations. At the end of the harvest season, Howey allocated a portion of the net profits of the orange grove tracts to each purchaser based on the size of the investor's holdings. The Supreme Court held that an acre of orange grove, together with the contract to service the property, was a security. In essence, the Supreme Court held that the definition of "security" includes any arrangement in which a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise were evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
In conclusion, when a company seeks to raise capital from investors other than individuals who have intimate familiarity with the issuing company by virtue of their involvement in the management of the company, the company should carefully examine the requirements for (i) qualifying for an exemption from the registration requirements of the Federal Securities Act of 1933, (ii) qualifying for an exemption from the requirement to register securities under applicable state securities laws and (iii) taking reasonable measures by way of disclosure to avoid liability under the always applicable anti-fraud provisions of both state and federal securities laws. Small companies raising capital from a small number of investors are often able to satisfy all of these requirements by making simple filings with state and federal securities enforcement agencies and by providing to investors a basic disclosure document describing the company's business plan, the legal and financial structure of the company, risk factors associated with the investment, the tax implications of investing in the company, the qualifications of officers and directors of the company, the lack of marketability of the securities to be issued and any investor suitability standards.
*George F. Eaton II, Esq. is a partner with Rudman & Winchell. He concentrates his practice in the areas of business planning, corporate and securities law.