How to Avoid Trouble with Security Law

Posted on May 21, 2012


Entrepreneurs often need to raise funds to correctly capitalize their business. In all likelihood, the funds will not come strictly from their personal wealth. They may be able to get a bank loan, but again, chances are they are going to need money, and that money will be coming from other people. Money from other people means selling a security, and selling securities involve state and federal regulations; let us try to give some practical guidance for avoiding serious trouble down the road.

As a threshold matter, taking money from other individuals implicates certain fiduciary duties. This is not a matter of regulation or a matter of government intervention; this is a matter of civil common law. If you violate these duties or if you make statements that people relied upon in making their investment that turn out to be false, you open yourself up to civil liability.

The first rule of avoiding trouble is to be honest about the risk, err on the side of disclosure, and be as transparent as possible. In my experience, when people take business risk and that business risk does not pan out, investors will tolerate a good deal of business failure as long as the individual is being honest and transparent and has gone above and beyond the call of duty. However, if there is a real or perceived lack of honesty, transparency or diligence on the part of the entrepreneur, the investor’s ire rises. In particular, this applies to self-dealing by the entrepreneur. A business owner is much more exposed if he or she received excessive benefits or perceived excessive benefit during the course of the business operations.

While fulfilling fiduciary obligations to investors is all well and good, entrepreneurs and business people still have to contend with state and federal securities regulations. As we have discussed in early articles, anyone who is selling securities must comply with both state and federal securities law. Failure to do so can (1) jeopardize future capital raising, (2) increase civil liability, and (3) potentially involve criminal acts.

One of the larger issues that I see in government regulation today is the potential inability at the state level to properly regulate the sale of small business securities. The regulations are designed for larger raises and Ponzi schemes, but they are broadly written and inevitably snare smaller businesses with small capital raises into the regulatory web. Accordingly, no matter how much money you are taking, if you are taking money from outside parties, you must be certain to comply with both state and federal securities law.

My first piece of advice is to keep the number of investors very limited. On a federal law level, a small number of investors makes the capital raise falls within the 4(2) extension, which exempts private offerings from registration. On the state level, a small raise often falls within the following statute:

(9) Any transaction which is part of an issue of which there are no more than 10 purchasers [other than those designated in subdivision (a)(8) of this section] wherever located, of securities from the issuer during any period of 12 consecutive months if:

a. The issuer reasonably believes that all the buyers are purchasing for investment and not with a view to distribution, and such issuer exercises reasonable care to assure this investment intent, which reasonable care shall be presumed if the following conditions are satisfied:

1. Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or herself or for other persons;

2. Written disclosure to each purchaser prior to sale that the securities have not been registered under the act and, therefore, cannot be resold unless they are registered under the act or unless an exemption from registration is available;

3. Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the act and setting forth or referring to the restrictions on transferability and sale of the securities; and

b. No commission or other remuneration is paid or given directly or indirectly for soliciting any prospective buyer; and

c. No public advertising or general solicitation is used in connection with the issue of which the transaction in reliance on this exemption is a part.

Alabama Code Section 8-6-10(9)

You will first as a matter of course notice the number 10 in the statute. This is a key metric, because most practitioners believe that if you are under 10 shareholders, you do not have to file within the states1. I agree with that, but you need to be careful. First, I think that you have to be very inclusive about how you count to that number 10. I count everyone involved in the deal because little guidance exists on the subject matter and the Alabama security commission seems to construe the statute very strictly. Accordingly, I count all the owner-operators, the investors, and anyone else owning stock. If a couple holds the stock jointly, that counts as two people. If a family holds stock, I count each individual family member.

Accordingly, this aggregates the number of investors very quickly. Because of this, I generally only rely on this exemption when I have five or fewer investors. If you have more than that, you need to consult with a lawyer to be sure that you do not have a security law issue.

The statute also contains several additional provisions which can blow the exemption. In particular, you should know that you cannot have a finders’ fee or brokers’ fee in the transaction. There is also language about what needs to be contained in the stock certificates. A lot of deals utilize this exemption, and in order to be able to facilitate capitalism, you have got to be able to utilize this exemption. However, you need to be sure that you strictly comply with the intention and err on the side of safety.

My second rule for easy compliance with the securities law is to keep all investors within the state of Alabama. I use Alabama because of my own familiarity with the Alabama laws. Most of the states have a similar law, and you can potentially utilize a similar statute as the one above. However, before you do, you need to go look it up or find it in the state in question. This costs time or money. Accordingly, I recommend staying in one state.

My final rule with respect to how to easily stay compliant with securities laws is to deal with rich people. In the federal securities law, there is an exemption called rule 506 in Reg D. That rule has certain requirement that if met exempt you from public registration, which is vital to any small business because it is inconceivable that a small business can handle the regulatory burden of being public. Part of this exemption is that you only sell to accredited investors, which are broadly defined as people with a net worth over a million (excluding primary residence) or making in excess of $200,000 (or $300,000 if a couple) (a.k.a. rich people). This exemption is crucial because in addition to allowing you to comply with federal law, if you comply with Rule 506, then your offering is also preempted from state securities law. As we have demonstrated, this preemption is key. Remember, however, that you need to comply with the Rule (which includes making a filing and making sure that all other requirements are met.

So in summary, be honest, sell to fewer than five, rich Alabamians, and you should be alright.

Mike Goodrich
Goodrich Law Firm, LLC

1 While most practitioners believe this is self-fulfilling, the Alabama Securities Commission has not indicated as much in some of its administrative orders.