Securities Law

What is securities law?

Securities regulation in the United States is governed at both the state and federal level, and with certain exceptions, securities underwriters and promoters must comply with both their state and federal law.

Federal securities regulation is governed chiefly by two acts of Congress: the Securities Act of 1933, which governs newly issued securities, and the Securities and Exchange Act of 1934, which governs secondary markets and creates the Securities and Exchange Commission (“SEC”), among other laws.

State securities laws, also known as “blue sky laws,” can often be more cumbersome and restrictive than federal laws; however, the federal SEC does offer one safe-harbor exception in Regulation D that overrides state law and requires states to accept the filing.

Why do we care about securities law?

As we will find out below, just about any financial arrangement can be called a security, if one party puts up the money and the other does the work. It’s important to be aware of these laws and make the right decisions when seeking investors. Making a mistake in this environment can be very costly.

Compliance with securities law is not simply a matter of making the SEC happy — if we don’t do it, we can get into trouble in civil court as well. Several securities laws not only make it illegal to sell a security without registration, but also afford the buyers of your security a private right of action in state or federal court, as well as the right to demand their money back from the promoter or original seller of the security.

Generally, everything is all well and good until the security stops performing well, and then the investor starts looking for ways to use the legal system to get their money back. If you haven’t complied with securities law to the letter, they are almost sure to win a judgment against you in court.

What is a security?

The Supreme Court has provided us a good definition of what a security is for federal purposes in the 1946 case SEC v. Howey Co. In this case, the Court defines an “investment contract,” as governed under the Securities Act, with a three part test later to become known as the Howey test. The elements are as follows:

  1. An investment of money
  2. An expectation of profits
  3. A common enterprise
  4. Which profits depend solely through the efforts of another.

For those keeping score, the direct quote is as follows:

For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby 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 are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

The lesson from Howey, then, is that if anyone contributes any money to an enterprise and expects a manager or promoter to generate profits for them, they have bought a security and the promoter has sold one.

How do we avoid securities law?

There are several strategies for structuring transactions to avoid securities laws, not the least of which are debt transactions which may avoid the definition of “investment contract,” depending on how they are characterized and the details involved.

The most popular way to “avoid” securities law is to take advantage of the SEC’s Regulation D exemptions from cumbersome securities registration. Click here to find out more about Regulation D.

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