Some thoughts on securities laws

Caveat (short for “lawyer paranoia”):  This post is for law students.  It should not be taken as legal advice.  I am a bankruptcy lawyer, not a securities lawyer.  Every simple rule set forth below probably has many exceptions.  Do not try this at home.

The basic “blue skies” rule is, a person may not offer or sell a security without registering it unless the transaction is exempt.  The registration is required by federal law, i.e., the SEC, and state law, certainly California.  Exemptions are provided by federal and state law.  The issue must be analyzed separately under federal and under state law.

There are many exemptions under both federal and state law.  For one, all transactions that take place on a national stock exchange are exempt.   But the basic exemptions we study in class are:

  • Federal:  the transaction is exempt if it is not made to the “public.”  Securities Exchange Act Section 4(2).
  • California:  the transaction is exempt if it meets the requirements of CA Corps Code section 25102(f).  Of the several requirements, the most important for our purposes is that the offer or sale must be
    • made to a person who has a “pre-existing business or personal relationship” with the corp or its promoters
    • or, who has advisers with lots of sophistication,
    • or, who has lots of money (rich).

As to what is a security, we will deal primarily with stock and investment contracts.  Stock is a security.  Figuring out what an investment contract is a much bigger problem.

An investment contract, for securities laws purposes at least, is the handing of money from one person to another where there is an expectation of profit which will come solely from the efforts of the other guy.  This includes loans.  If Fred loans money to my corporation expecting to earn interest and get his money back, that is an investment contract.  If I sell Fred an apartment building and tell him I will run it for him and give him the profit – I tell him he doesn’t need to do anything but wait for the checks, that is probably an investment contract even though he got a building for his money.

As to exemptions, the “offer or sale” is generally “to the public,” if the hander of the money has no basic knowledge of what’s he’s getting into AND/OR the hander is basically a stranger to the promoter.    In the loan example above, unless Fred has significant info about the corp, or is some sort of business or personal friend of mine, the sale of the security (and that is what it is) violates federal and state securities laws.

As to the requirement of “registration,” for federal purposes that generally means preparing a prospectus that is reviewed by the SEC in advance and given to the investor before the offer or sale is made.  The preparation of the prospectus costs, I believe, a good few millions of dollars.  There are streamlined registration procedures in some cases as I understand it.

The state of California generally allows registration (which it calls “qualification”) by “coordination” meaning the state will accept a copy of what ever is already being done with the SEC.  The most common exemption under California law when there is no federal registration is section 25102(f) which the student should read.  Qualification under this section requires that a form be sent to the Commissioner of Corporations (now known as the Department of Business Oversight).  A fee is required of course.  Every corporation that issues stock even to a single owner must complete the form, and send it in.

A final note:  there are “issuer” transactions and “non-issuer” transactions.  An issuer transaction is one between the issuer of the security and the investor.  A non-issuer transaction is between a person who owns a security (issued usually by a corporation) and is selling it to someone else.  When Apple sells its stock, that is an issuer transaction.  When I sell the Apple stock I own to you, that is a non-issuer transaction.  I did not issue the stock.  The general rules above apply to the transaction whether it is issuer or not.

Another final note:  once the stock is registered it does not stay registered.  Just because Apple registered its stock before it offered it to the public does not mean the above rules can be ignored when I “offer or sell” my Apple stock to you.

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