Is an Investment in Your Company a Security?
By Caleb A. Williams
SAALFELD GRIGGS PC
When people think of transactions which involve a security, what usually comes to mind is a purchase or sale of stock in publicly held companies such as General Electric or Microsoft. The securities laws, however, are much more broad, reaching into investments in General Electric or Microsoft, but also governing the purchase of an ownership interest, and perhaps even debt, in a small, closely held company. It is important for every business owner and investor in those businesses to be aware of the laws governing securities, and how their specific transactions will fit within those laws.
Securities laws are found at both the state and federal levels, so it is necessary to consider both federal and state laws when dealing with a security. The definition of “security” is substantially the same under both Oregon and federal law. Specifically, a security includes among a number of other things, a stock, bond, note, debenture, or any instrument commonly known as a security. Thus, for purposes of the applicability of the securities laws, even the purchase of one share of stock in the smallest of closely held corporations would be treated as security.
Both the federal and state statute also include within the definition of security is an “investment contract.” The United States Supreme Court has defined an investment contract as “an investment of money in a common enterprise with an expectation of profit, solely from the efforts of others.” The Oregon Supreme Court has a similar definition of investment contract under Oregon Securities Law, that is “an investment of money (or money’s worth) in a common enterprise with the expectations of profit to be made through the management and control of others.” It is important to realize that these definitions are so broad as to reach both equity and debt interests.
It is generally accepted that an investment in a manager-managed limited liability company is an “investment contract” and therefore a security. This is because such an investment falls squarely within the definition of “investment contract.” First, an investment of money clearly exists when one transfers cash or other property to the LLC in return for an ownership interest. Second, as long as there is more than one member in the LLC, there is a shared goal or common enterprise in the operation of the LLC. Third, a member generally invests in an LLC in order to receive a profitable return on that investment from the operation of that LLC. Finally, a manager-managed LLC places a majority of the decision making and effort in the operation of the LLC on one or more persons who may not be an investor in the company. Following this analysis, it is important to note that a member-managed LLC may also be considered an investment contract if the majority of the members do not actively participate in the management of the company.
Once it has been determined that you are either purchasing or selling a security, several additional considerations must be made. First, the anti-fraud provisions of the securities laws prohibit the presentation of misleading information or the omission of a material fact in a transaction involving a security. It is thus vital that when your company is offering or selling either an equity or debt instrument (e.g., stock or note), that it provide potential investors with complete information pertaining to the security and the business. Second, all securities must be either registered with the state and federal government or meet a specific exemption from the registration requirements.
Fortunately, a majority of investments in small businesses, whether corporations or LLCs, meet one of the exemptions from the registration requirements of the securities laws. Under federal law, the most common exemption relied upon by small businesses is a “transaction by an issuer not involving any public offering.” Because the federal statute states this exemption so vaguely, the Securities and Exchange Commission has established safe harbors that a purchaser or issuer of a security can rely upon to ensure that they are meeting the exemption. To take advantage of a safe harbor, the business issuing the security must file a form with the SEC, identified as Form D, in which the issuer provides the SEC with some information about the company and the specific security. Often, a Form D filing is not necessary because the courts and SEC have repeatedly recognized that a limited number of investments in a small company are clearly within the exemption without having to rely on a safe harbor.
Under Oregon law, the most commonly used exemption for small businesses is the offer or sale of a security to ten or fewer Oregon residents in a twelve-month period. It is important to note that even if a transaction involving a security meets an exemption from registration under Oregon or federal law, that transaction is still subject to the anti-fraud provisions discussed above.
A third consideration for those participating in a transaction involving a security is the persons that can be liable for a violation of the securities laws. These persons may include the seller of the security, the purchaser of the security, the company issuing the security, as well as officers, directors, members, or partners of the company issuing the security. In addition, those professionals that aid or assist in a transaction involving security may also be liable. This could include investment advisors, lawyers and accountants, among others. Liability for a violation of the securities laws includes civil or criminal action by the SEC or the Oregon Office of Corporate Securities as well as a potential lawsuit by an individual that was harmed in the securities transaction. Moreover, a disappointed investor can demand the return of their investment if the business does not do well merely because of some form of achieved non-compliance.
The securities laws, and the rules, and regulations administered under such laws are broad and complex. It is extremely important to seek the advice of a professional when you are either selling or purchasing either an ownership interest or debt instrument of a company, whether incorporated or not, or if the company that you are involved with is seeking to raise additional capital through the issuance of securities.