In my post Raising Capital for Your Business, I explained how any sale of a security must either be registered with the Securities and Exchange Commission (SEC) or qualify from an exemption from the registration requirements. Registration is the process used in a public offering, and is expensive and time-consuming, requiring the preparation of a prospectus and audited financial statements. Most start-ups and early-stage companies therefore raise capital through the “private placement” exemption provided by Section 4(2) of the U.S. Securities Act of 1933 (Securities Act) for sales of securities “by an issuer not involving any public offering.” There are also exemptions provided by other sections of the Securities Act that are sometimes used for private capital raises, which I will discuss later.
The definition of the term “security” is very broad and includes stock, bonds, evidences of indebtedness, options and warrants, among other things. It also includes “investment contracts” and “in general, any interest or instrument commonly known as a ‘security.’” This “securities” definition is very broad, and generally covers any investment structure where the investor puts up capital and does not actively participate in the management of the business. For example, units in limited liability companies and limited partnerships are almost always securities. In the 1990’s, a number of promoters started marketing movie production deals structured as general partnerships. The idea was that, unlike a limited partnership, a general partner under state partnership law has the right to participate in the management of the business, ad therefore the investors were not purchasing securities. Many of the deals were sold through boiler rooms and other operations using high pressure sales tactics and unlicensed sales personnel. A number of high profile enforcement actions eventually put these operations out of business.
The standard in this area was set by the U.S. Supreme Court in 1946 in the case U.S. v. Howey, 328 U.S. 293 (1946), which held that “an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor, was an offering of an ‘investment contract,’” and thus a security. The defendants had agued that they were merely selling tracts of real estate plus a service contract to manage the agricultural operations on the tracts. The Supreme Court held that: “The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
The courts have used this test to characterize all sorts of investment structures as securities. As in the Howery case itself, the form of the investment is not important if the substance of the transaction is that investors are contributing money to a common enterprise that is being managed by others.