Are You Practicing Securities Law and Don’t Know It?
If you don’t know, you probably are.
By Patrick C. Clary

– If you are forming business organizations for clients, including corporations, limited partnerships and limited-liability companies, and preparing documentation, including minutes of meetings, stock purchase agreements, limited partnership agreements, and operating agreements respectively, which provide for the issuance of debt or equity interests in such business organizations, including corporate stock, limited liability interests and limited-liability member interests;
– If you are negotiating and preparing for clients financing-related agreements, including, again, stock purchase agreements, limited partnership agreements, operating agreements and even joint-venture agreements;
– If you are advising clients regarding financing arrangements and agreements for their business or advising other clients who are, directly or indirectly, providing financing for business enterprises;
– If you have been involved in business or residential real estate transactions which involve clients who sell, or clients who buy, debt or equity interests in such real estate projects that are financially more complicated than a mere direct sale or purchase of a real estate ownership interest; or
– If you are representing clients who are acting as intermediaries in financial transactions but are not licensed broker-dealers of securities;

THEN, for the reasons set forth below, you probably are practicing securities law perhaps without even knowing it. If so, you may be failing to advise your clients about the enormous impact that the securities laws have on people and entities who are on both sides, or even in the middle, of financing transactions!

What is or is not a “security?”
Not only is a “security” specifically defined in the federal securities laws as what a person unsophisticated in securities law would consider a security to be, such as “stock, treasury stock, preorganization certificate or subscription, and voting-trust certificate,” but it is also, for example, a note, bond, debenture, evidence of indebtedness, investment contract, option, and fractional undivided interest in oil, gas or other mineral rights.” Section 2(1) of the Securities Act of 1933, as amended (“the Securities Act” or “the ‘33 Act”), 15 U.S.C. §77a(1), and Section 3(a)(10) of the Securities Exchange Act of 1934, as amended (“the Exchange Act” or “the ‘34 Act”), 15 U.S.C. §78c(10). For example, Nevada’s Uniform Securities Act also expressly includes in the definition of a “security,” “a limited partnership interest” and “an interest in a limited-liability company,” in order to make it clear that, unbeknownst to some, those interests are clearly “securities.” NRS 90.295.

Under SEC v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny, the “catch all” (as I put it an “investment contract”) is a “security” when a person invests his money in a common enterprise with the expectation of profits from the significant efforts of others. I won a case in the Ninth Circuit and beyond in Hocking v. Dubois, 88 F.2d 1449 (9th Cir. 1989), cert. denied 494 U.S. 1078 (1990), where a condominium in Hawaii was held to be a security under the circumstances under which it was offered and sold, because it met the foregoing Howey test. Hocking, supplemented by its progeny, still stands as the leading case in the Ninth Circuit with respect to real estate securities.

Registering securities vs. complying with an exemption from registration
While the “heart” (in my opinion) of the Securities Act is full and accurate disclosure, more specifically its “thrust” is what I call the “11th Commandment,” namely: “Thou shall register thy securities.” However, to go through the full registration process to raise capital is often too costly and time-consuming, especially for small businesses, which I have mostly represented, so the alternative for a prospective issuer of securities is to comply with an exemption from the registration requirements of the Securities Act.

Congress empowered the United States Securities and Exchange Commission (“the SEC”) to implement and enforce rules and regulations under the federal securities laws. Regulation D, which was originally adopted by the SEC in 1982 under the Securities Act, provides the most commonly used method of complying with an exemption from registration and to provide a “safe harbor” for issuers. Regulation D was adopted under both the small offering exemption provided by Section 3(b) and the private, or non-public, offering exemption provided by Section 4(2) of the Securities Act, 15 U.S.C. §77c(b) and §77d(2), respectively.

Rule 501 of Regulation D, 17 CFR §230.501, provides definitions of terms, and the most commonly used definitions for an “accredited investor” are: (1) a director, executive officer, or general partner of an issuer; and (2) a natural person with a net worth exceeding $1,000,000 or with an individual income in excess of $200,000 or joint income with that person’s spouse in excess of $300,000, subject to certain other details.

Rule 504, 17 CFR §504, is the easiest to comply with and permits the offer and sale of securities not exceeding an aggregate of $1,000,000 in any 12-month period to an unlimited number of offerees and purchasers, none of whom need be accredited investors. Rules 505 and 506, 17 CFR §§ 505 and 506, permit offers and sales to not more than 35 investors who are not accredited investors, the rest of whom must be accredited, with Rule 505 limited to $5,000,000 but with Rule 506 having no monetary limitation. While full and complete disclosure is always required, Rule 504 has no specific disclosure requirements, but Rules 505 and 506 do have specific informational and financial disclosure requirements but not if the securities are offered only to accredited investors.

There also must be compliance with a securities or transactional exemption under the securities or “blue sky” laws of the states in which the offerees and purchasers reside.

Liabilities under the securities laws
There are basically three types of liabilities that can arise under the securities laws, (1) criminal liabilities, (2) civil liabilities resulting from actions brought by governmental agencies and (3) civil liabilities to investors and others. While the federal and state governments are empowered to prosecute criminally, in their respective names, violators of securities laws, the SEC is empowered, in its name, to bring civil enforcement actions in the federal courts seeking injunctions, disgorgements, and other relief, and certain state securities agencies can also file administrative and court actions. For example, the Securities Division of the Secretary of State of the State of Nevada is empowered to issue cease and desist orders against securities violators. NRS 90.360.

Nevertheless, the most common action that issuers should actively seek either to avoid by compliance, or successfully to defend in litigation, are civil actions brought by investors, generally seeking recovery of the amount of their investments, interest thereon, and attorneys’ fees against issuers and their officers, directors and controlling persons. See Section 18 of the Securities Act, 15 U.S.C. §77(o), and Section 20 of the Exchange Act, 15 U.S.C. §78(t), as well as NRS 90.660, et seq., which impose civil liability of controlling persons. Furthermore, unlike the normal rule in civil cases where the plaintiff has the burden of proof, when the issuer asserts as a defense compliance with an exemption, the burden of proof shifts to the defendant(s) to prove such compliance. See NRS 90.690(1).

Moreover, broker-dealers of securities are required to be licensed (see Section 15 of the Exchange Act, 15 U.S.C. §78o). Intermediaries in financing transactions, who charge compensation (e.g. brokerage commissions or finder’s fees) but who are not so licensed, also can incur severe liabilities.

“Substance” over “form”
Unlike other areas of administrative law, where it could be argued that “form” over “substance” prevails, under the securities laws it is clearly the opposite: “substance” over “form” prevails. See Hocking, supra.

In Preliminary Note No. 7 to Regulation D, the SEC states as follows: “In view of the objectives of these rules and the policies underlying the [Securities] Act, Regulation D is not available to any issuer for any transaction or chain of transactions that, although in technical compliance with these rules, is part of a plan or scheme to evade the registration provisions of the [Securities] Act. In such cases, registration under the [Securities] Act is required.” How do you explain that to a client? I can tell you that it is not easy.

Conclusion
Business practitioners who are not familiar with or have not fully recognized the complexities of the securities laws should surely be wary and circumspect when getting involved in financing transactions. Yet, do not fear! When I graduated from law school and went to work for Sam Lionel and Grant Sawyer on March 1, 1967 (the day they started Lionel & Sawyer), I had never taken a course in securities law or ever worked for the SEC or any state securities agency. So I started my learning process in the field a year or so later, and here I am now. Just don’t try to learn it overnight, and get some help. You’ll sleep better at night.

Many years ago some corporate lawyer in California opined that, when it was required for the board of directors of a corporation to adopt a resolution to create Section 1244 stock under the Internal Revenue Code (no longer a requirement), it was malpractice, particularly in a new corporation involving speculative investments, not to do so. In representing issuers of securities, may I offer the proposition that failing to evidence at least the minimal compliance with Rule 504 of Regulation D when forming a new corporation and issuing stock, for example, may amount to the same thing? Let’s pull together and try to avoid the possible professional problems of failing our clients and ourselves by at least recognizable and reasonable compliance with the securities laws.

Patrick C. Clary, a native Las Vegan, who holds bachelor of arts and juris doctor degrees from The American University in Washington, D.C., has practiced law in Nevada for 40 years.