Understanding Securities Law
The business professional's guide to securities laws
 

If your company is selling stock, you obviously know that what you are selling, an ownership interest in you company – stock – is a security and is subject to the provisions of Section 5 of the 1933 Selling Stock Act, all as described in detail above.

However, the sale of other forms of securities, called investment contracts, may also involve the regulated sale of securities. An investment contract, as defined by the Supreme Court in a case named Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). In that case, the Court formulated one of the U.S. Supreme Court’s earliest tests to determine whether an instrument qualifies as an “investment contract” for the purposes of the 1933 Securities Act.

• An investment contract involves:
  • An investment.
  • In a common enterprise.
  • With a reasonable expectation of profits.
  • To be derived from the entrepreneurial or managerial efforts of others.

The most common investment contracts other than stock are:

• Promissory Notes/Loans
• Non-Corporate Interests

Promissory Notes/Loans

Here’s the easiest way to determine if you are selling securities if you are seeking loans rather than equity or stock investments.

Assume your company needs $2,500,000 to advance its business plan.

• This is not a security: You go to a bank or other federally or state regulated financial institution and you borrow the entire amount. You sign a standard set of loan documents. You agree to pay interest at commercial terms for these types of loans made by the institution to similar borrowers.
• This is a security: You go to multiple potential investors, most if not all of which are not regulated entities. You ask them each to loan you a small part of the $2,500,000. You draft the loan documents. The terms are whatever you propose.

Non-Corporate Interests

Your business may not be a corporation. It may be a partnership, a limited liability company, a joint venture or similar structure.

If you are selling an interest in one of these non-corporate entities, the test of whether or not the interest in your entity is or is not a security is based upon on aspect of the Howey doctrine described above:

Does the investor have an expectation of profits from efforts of others?

• If the investor, by virtue of the interest the investor acquires, participates actively in the management of your business, then the interest is not a security. For example, a Manager interest in a limited liability company or a general partner in a general partnership may not be deemed to be buying a security.
• By contrast, a limited partner, a member of a limited liability company or a non-management member of a joint venture is probably buying a security.