Raising Investment Capital - Securities Basics...
42
Transcript of Raising Investment Capital - Securities Basics...
Brad Jacobsen• BYU 1993 (summa cum laude)
• NYU Law 1996 (Morgan Stanley Intern)
• Practiced in NYC, D.C., Boulder & SLC
• Corporate, Securities, M&A
• Officer of Securities Law Section of Utah Bar
• Partner in the Michael Best Salt Lake City Office
• I like to SCUBA, take walks with my wife and bore people
The Basics
• 61-1-7 - Registration before sale
• Prior to offering or selling a security in
Utah, the security or transaction must be:
- Registered;
- Exempt from registration; or
- Be a federal covered security for which a
notice filing has been made (if required by
rule).
Definition of Security–UCA 61-1-13(1)(ee)(i)
• "Security" means any: [Note: the below is only an excerpt]- note;
- stock;
- bond;
- debenture;
- evidence of indebtedness;
- certificate of interest or participation in any profit-sharing agreement;
- preorganization certificate or subscription;
- transferable share;
- investment contract;
- commodity contract or commodity option;
- interest in a limited liability company;
- viatical settlement interest; 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.
"Security" does not include UCA 61-1-13(1)(ee)(ii):
• (B) an interest in a limited liability company in which the limited
liability company is formed as part of an estate plan where all of the
members are related by blood or marriage, or the person claiming this
exception can prove that all of the members are actively engaged in
the management of the limited liability company;- evidence that members vote or have the right to vote, or the right to information concerning the business
and affairs of the limited liability company, or the right to participate in management, may not establish,
without more, that all members are actively engaged in the management of the limited liability company
• [Old rule used to state limited liability company interests with less than 5
members - Abused is an understatement]
• Federal Law – a Security is still a Security
Definition of Investment Contract
• "Investment contract" includes:
- any investment in a common enterprise with the expectation of profit to be
derived through the essential managerial efforts of someone other than the
investor; or
- any investment by which:
- an offeree furnishes initial value to an offeror;
- a portion of this initial value is subjected to the risks of the enterprise;
- expectation of a profit; and
- passivity.
• Howey Test – 1946 Supreme Court Opinion
- In 1946, the U.S. Supreme Court stated in Howey that the test of an investment
contract involving ORANGE GROVES is "whether the scheme involves an
investment of money in a common enterprise with profits to come solely from
the efforts of others.”
- HOT TOPIC – ICOs, Cryptocurrencies – SEC constantly referring to “Howey
Test” in multiple recent actions
Security Broadly Defined
• Horizontal Commonality
- Pooling of Assets - fortunes of investors tied to each other
• Vertical Commonality
- Fortunes are tied to promoter’s success or expertise [multiple LLCs, LPs or
Investment Contracts]
• Edwards – U.S. Supreme Court 2003
- "Encompass virtually any instrument that might be sold as an investment“• Pay Phones
• Orange Groves
• Live Beavers
• Bitcoins (ICOs)
• Short Answer:
- If you are asking the question, it probably is a security
(1) Registration
• Securities Registration
- Registration by Coordination • Any security for which a registration statement or a notification under Regulation A/A+ has been filed
under the Securities Act of 1933 may be registered in Utah by coordination.
• Time consuming and expensive
- Registration by Qualification • Any security may be registered by qualification. Securities should be registered by qualification when no
other method is available
• Intrastate Offering
• Time consuming and expensive
- Registration by Notification • Very Narrow Qualification
• Time consuming and expensive
Regulation A+ has two different tiers• Tier 1
- Raise up to $20 million
- Anyone can invest(non-accredited)
- No limit on the number of investors
- 2 years of GAAP financials (do not need to be audited)
- Testing the waters period where you can market the deal before you file with the commission
- Not state exempt, so it could require blue sky filings
- No ongoing reporting requirements after the 1-Z report which is filed 30 days after you close the offering –
essentially you get to do a public offering without becoming a public company
• Tier 2
- Raise up to $50 million
- Anyone can invest, but non-accredited have limitations
- No limit on the number of investors
- 2 years of audited GAAP financials
- Testing the waters period before you file with the Commission
- State exempt
- Some ongoing reporting requirements, but not as burdensome as becoming a fully reporting company with
the SEC
• Brokerage Firm- 6-10% of the money raised
• Legal Fees- $100,00+ depending on the comment process with the SEC, the level of reliance on counsel to
draft the documents, and the offering tier
• Audit fees - $10,000-$25,000
(2) Exemption From Registration
• The Utah Uniform Securities Act provides about 30 exemptions from
registration. The Division has created about 5 additional exemptions by
rule.
• Any person that relies on an exemption has the burden to prove they
qualify for the exemption.
• There are no exemptions from the anti-fraud provisions of the Act.
An exemption only permits a person to offer or sell a security without
registering the security. Accordingly, individuals offering or selling exempt
securities may have additional disclosure requirements to satisfy the anti-
fraud provisions.
Exemption Table
Statue/Rule Description Type Available to Filing Required
(1)(a) Government Security Issuer & Non-issuer Self-executing
(1)(b) Foreign Government Security Issuer & Non-issuer Self-executing
(1)(c) Bank Security Issuer & Non-issuer Self-executing
(1)(d) Savings & Loan Security Issuer & Non-issuer Self-executing
(1)(e) Credit Union Security Issuer & Non-issuer Self-executing
(1)(f) Public Utility Security Issuer & Non-issuer Self-executing
(1)(g) Exchange Listed Security Issuer & Non-issuer Self-executing
(1)(h) Non-Profit Organization Security Issuer & Non-issuer Self-executing
(1)(i) 9 Month Commercial Paper Security Issuer & Non-issuer Self-executing
(1)(j) Employee Benefit Plan Security Issuer Self-executing
(1)(k) Blue Chip Investment Company Security Issuer & Non-issuer Filing Required
(1)(l) Discretionary Security Issuer & Non-issuer Filing Required
(2)(a) Isolated Transactional Issuer & Non-issuer Self-executing
(2)(b) Manual Listing Transactional Non-issuer Filing Required w/
exceptions
(2)(c) Unsolicited Transactional Non-issuer Self-executing
(2)(d) Underwriter Transactional Issuer Self-executing
(2)(e) Real Estate Transactional Issuer Self-executing
(2)(f) Court Ordered Transactional Non-issuer Self-executing
(2)(g) Bona Fide Pledgee Transactional Non-issuer Self-executing
(2)(h) Institutional Investor Transactional Issuer & Non-issuer Self-executing
Exemption Table (Cont.)
Statute/Rule Description Type Available to Filing Required
(2)(i) Preorganization Transactional Issuer Self-executing
(2)(j) Existing Securities Holder Transactional Issuer Self-executing
(2)(k) Red Herring Transactional Issuer Self-executing if
registration pending
(2)(l) Dividend of Issuer Transactional Issuer Self-executing
(2)(n) Non-Public Offering Transactional Issuer and
Non-Issuer
Self-executing
(unless seeking
safe harbor)
Exemptions Are Complicated, Seek Advice!
Securities Act of 1933 §4(a)(2) Exemption
• SEC. 4. (a) The provisions of section 5 [Registration] shall not apply to—
- (2) transactions by an issuer not involving any public offering.
• SEC v. Ralston Purina Factors (US Supreme Court 1953)
- Do the prospective offerees need the protection from the 33 Act registration
process? • The more sophisticated the offerees are in investing, the more likely §4(a)(2)exemption applies
- Are the prospective offerees capable of fending for themselves?• Both offeree sophistication and access to information must be demonstrated
• Other factors to consider
- The number of offerees (Number not very important – ONE person can violate the “Private Exemption”)
- The nature, scope, manner and size of the offering
- The relationship of the offerees to the issuer and to each other
(3) Federal Covered Security
• A security that is exempt from state registration because either
- it is registered with the Federal government under the Securities Act of 1933
(Includes securities listed or authorized for listing on the New York Stock
Exchange, Nasdaq National Market System, American Stock Exchange..,
- it is exempt from federal registration under the 1933 Act (i.e., intrastate
exemptions, non-profit exemptions, municipal/govt. bonds/securities).
- securities that are exempt from Federal registration (Regulation D, Rule 506).
- Securities issued by an investment company registered under the Investment
Company Act of 1940.
• Status as a federal covered security is not a preemption of the licensing
or anti-fraud laws.
• Any person that sells a federal covered security must be licensed as a
broker-dealer or agent and must also comply with the anti-fraud
provisions or qualify for an exception (owners/officers of issuer – next
slide)
Rule 3a4-1 Safe Harbor – The “Issuer Exemption”
• Permits Sales of Securities by Officers, Employees and other Associated
Persons of the Issuer. Preliminary Requirements:
- The person must not be compensated in connection with the sale of the issuer’s
securities PERIOD.
- The person can’t be affiliated with a B/D.
- The person primarily performs substantial duties for or on behalf of the issuer
otherwise than in connection with transactions in securities.
- The person does not participate in selling an offering of securities for any issuer
more than once every 12 months (unless above remains true) – Start-Up CEO
always raising funds.
- Other rules apply.
Reg. D/Rule 506(b) & (c) Exemptions
• Safe Harbor for compliance with §4(a)(2)
- Noncompliance with Rule 506 does not mean §4(a)(2) exemption is unavailable.
Rule 506(b) – Old Rule; 506(c) – JOBs Act
• No dollar limit on size of offering
• Issuer must make available to prospective offerees at a reasonable time
prior to the sale the opportunity to ask questions and receive answers
concerning terms and conditions of offering
Rule 506(b) or 506(c) – Which Rule to Use
506(b) Offering 506(c) Offering
Communications with Investors Companies may not advertise
their security offering. Generally,
companies may approach
potential investors if there is a
substantive, pre-existing
relationship.
General advertising
permitted. Companies may
advertise via social media,
email, or offline. No
substantive, pre-existing
relationship with potential
investors required.
Rule 506(b) or 506(c) – Which Rule to Use (Cont.)
Eligible investors Accredited investors
and up to 35 non-
accredited investors
who meet sophistication
requirements.
Only accredited
investors.
Accreditation Process Self-certification via a
questionnaire is the
general standard.
Companies must take
reasonable efforts to verify
accredited investor status.
Self-certification via a
questionnaire is not
permissible. The SEC
issued examples of
reasonable steps for
verification.
Rule 506(b) or 506(c) – Which Rule to Use (Cont.)
Disclosure Companies must decide on
what information to provide to
accredited investors, but that
information must not violate
antifraud prohibitions. If non-
accredited investors are
included, companies must
provide those investors with
disclosure documents that are
generally the same as those
used in small registered
offerings. If a company provides
information to accredited
investors, it must make that
information available to non-
accredited investors as well.
Companies must be available to
answer questions from potential
investors.
Companies must decide on
what information to provide to
accredited investors, but that
information must not violate
antifraud prohibitions.
Companies must be available to
answer questions from potential
investors.
Hard Work and Luck – Legal Issues help avoid bad luck
Founder Equity Considerations
• The Roles Each Team Member Will Play
• The Level of Contribution Each Team Member Makes
• The Duration of Each Team Member’s Involvement
• The Capital Contribution of Each Team Member
• Option Plan Rule of Thumb
Welcome to the World of Securities Compliance
Securities Laws Apply – Surprise! – Not.
• Federal and state securities laws and regulation apply to companies
regardless of size and whether or not a company is a SEC reporting
company.
- Registration; or
- Exemption
• Before a start-up company awards equity compensation to an employee
or other service provider, it must ensure that the planned award complies
with both federal and state securities regulation.
Stock Plans - Federal Securities Law Exemptions
• Start-up companies primarily rely on one of three exemptions from SEC
registration when granting compensatory equity awards. These include:
- Rule 701 under the Securities Act. Rule 701 is by far the most commonly-relied
on exemption for start-up equity awards (See Next Slide). „
- Rule 506(b) of Regulation D under the Securities Act. Rule 506(b) is used
primarily for awards to directors and executive officers. „
- Section 4(a)(2) of the Securities Act. While it is available under some
circumstances, companies rely on the statutory Section 4(a) (2) registration
exemption infrequently for equity awards [The Oops, I forgot Fall Back].
RULE 701 EXEMPTION
• Rule 701 exempts certain compensatory equity awards that are made
under a written compensatory benefit plan or compensation contract
by a company.
• Under Rule 701, a compensatory benefit plan is any purchase, savings,
option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred
compensation, pension or similar plan.
• Additional Requirements:
- During 12 month period, can’t exceed„ greater of $1 million.15% of the
company's total assets or„ 15% of stock being sold (if over $5m, disclosures);
- Applicable to natural persons – not entities;
- Cannot be for capital raising purposes;
- Other Issues
Rule 701 Awards and Blue Sky Laws
• Securities issued in Rule 701 transactions are not Federal Covered
Securities under NSMIA – Blue Sky Laws Apply
• State securities laws differ, and counsel must always review current state
law when advising its client. However, generally speaking: „
- Some states' blue sky laws include an exemption from registration or
qualification requirements that is analogous to Rule 701.
- However, unlike Rule 701, these exemptions may require that, before a
company makes awards to state-resident service providers, the company must: • „clear a transaction with the state regulator; or „
• make certain filings with the state regulator. „
- Some states' securities laws include an exemption from registration
requirements for transactions involving compensation plans that meet certain
Internal Revenue Code (Code) requirements. • limits the total number of securities issuable and eligible participants; „
• places restrictions on the transferability of the issued securities and exercise period of options; „
• has been approved or will be approved by a required percentage of the issuer's stockholders; and „
• provides for certain security holders to receive annual disclosure, including company financial
statements.
Ethics Portion
Licensing Requirements
• Issuer Agent
• Investment Advisor
• Broker Dealer
Issuer Agent
• Utah Uniform Securities Act 61-1-13 (2)
(2) "Agent" means any individual other than a broker-dealer who
represents a broker-dealer or issuer in effecting or attempting to effect
purchases or sales of securities.
Investment Advisor
• Any person who, for compensation, engages in the business of advising
others…, as to the value of securities or as to the advisability of investing
in, purchasing, or selling securities,
• 'Investment advisor' also includes financial planners and other persons
who, as an integral component of other financially related services,
provide the foregoing investment advisory services to others for
compensation and as part of a business or who hold themselves out as
providing the foregoing investment advisory services to others for
compensation.
Broker-Dealer
• Utah Uniform Securities Act 61-1-13 (3)
(3) "Broker-dealer" means any person engaged in the business of
effecting transaction in securities for the account of others or for
his own account…
• Utah Uniform Securities Act 61-1-13(19)
(19) "Person" means an individual, a corporation, a partnership, a limited
liability company, an association, a joint-stock company, a joint venture, a
trust where the interest of the beneficiaries are evidenced by a security, an
unincorporated organization, a government, or a political subdivision of a
government.
Civil Liabilities
61-1-22 Rescission Offering Statute
• (1) (a) A person who offers or sells a security in violation of Subsection 61-1-3(1)
[using unlicensed persons], Section 61-1-7 [not registering or qualifying for an
exemption],.., or offers, sells, or purchases a security in violation of Subsection
61-1-1(2) [material facts] is liable to the person selling the security to or buying the
security from him, who may sue either at law or in equity to recover the
consideration paid for the security, together with interest at 12% per year from the
date of payment, costs, and reasonable attorney's fees, less the amount of any
income received on the security, upon the tender of the security or for damages if
he no longer owns the security. (b) Damages are the amount that would be
recoverable upon a tender less the value of the security when the buyer disposed
of it and interest at 12% per year from the date of disposition.
(2) The court in a suit brought under Subsection (1) may award an amount equal to
three times the consideration paid for the security, together with interest, costs, and
attorney's fees, less any amounts, all as specified in Subsection (1) upon a showing
that the violation was reckless or intentional.
61-1-22 Rescission Offering Statute
PIERCING THE CORPORATE VEIL
• (4) (a) Every person who directly or indirectly controls a seller or buyer
liable under Subsection (1), every partner, officer, or director of such a
seller or buyer, every person occupying a similar status or performing
similar functions, every employee of such a seller or buyer who materially
aids in the sale or purchase, and every broker-dealer or agent who
materially aids in the sale are also liable jointly and severally with and to
the same extent as the seller or purchaser, unless the non-seller or non-
purchaser who is so liable sustains the burden of proof that he did not
know, and in exercise of reasonable care could not have known, of the
existence of the facts by reason of which the liability is alleged to exist.
Time Restrictions
• 61-1-22. Sales and purchases in violation - Remedies - Limitation of actions.
(7) (a) No action shall be maintained to enforce any liability under
this section unless brought before the expiration of five years after
the act or transaction constituting the violation or the expiration of
two years after the discovery by the plaintiff of the facts
constituting the violation, whichever expires first.
Criminal Liabilities
▪ “It’s the S.E.C. How do you plead?”
61-1-21 – Criminal Penalties for Violations
• A person is guilty of a third degree felony (0-5 years) who willfully violates...[the
State Securities laws] (other than 61-1-1)
• A person who willfully violates Section 61-1-1 (basically fraud or you make any
untrue statement of a material fact or to omit to state a material fact necessary in
order to make the statements made, in the light of the circumstances under which
they are made, not misleading)
- is guilty of a third degree felony (0-5 years) if.. [security] was worth less than $10,000;
- is guilty of a second degree felony (1-15 years) if:
• …[the amount] was worth $10,000 or more; or
• …[the amount] was worth less than $10,000; and
• in connection with that violation, the violator knowingly accepted any money representing (i) equity in a person's
home; or (ii) a withdrawal from an IRA or other retirement account.
- is guilty of a second degree felony punishable by imprisonment for an indeterminate term of
not less than three years or more than 15 years if:
• … [the amount] was worth more than $10,000; and
• in connection with that violation, the violator knowingly accepted
any money representing (i) equity in a person's home; or
(ii) a withdrawal from an IRA or other retirement account.
Just Don’t Go There!
Brad R. Jacobsen
Michael Best & Friedrich LLP
6995 Union Park Center, Suite 100
Salt Lake City, UT 84047
Phone: (801) 833-0500
Fax: (801) 931-2500
