But is it a security?
A look at offers from start-up companies
By Jeffrey A. Blomberg and Henry E. Forcier
A business is being launched and something is being
sold. Could it be a security? Who regulates the
transaction?
Today, issuers that offer and sell their securities are
subject to a high level of scrutiny, both at the federal
and state level. The principal job of these regulatory
authorities is to protect the public from issuers that
take advantage of unwary investors.
These transactions predominantly involve raising
capital. Typically, a securities offering of this nature
requires full and fair disclosure by the issuer to
offerees and the making of any requisite filings with
the Securities and Exchange Commission or any state
regulatory authorities. Also, the offer and sale of
securities — whether in a public offering or a
private placement — are subject to the anti-fraud
provisions of the Securities Exchange Act of 1934, as
amended, designed to protect the investing public. When
an issuer is involved purely in fund raising, it is
usually clear that such an undertaking is a securities
offering and must be treated as such.
But what happens when the offer and contemplated sale do
not strictly constitute fund raising? Moreover, what if
a business enterprise is merely launching a product or a
service and the only capital involved is payment for
future goods or services?
For example, some business enterprises, such as those
involving the sale of luxury consumer-related items,
frequently offer some sort of product or service that is
under development. This is particularly common with
startup businesses that sell their products or services
to the public but may be at a juncture where what they
promise for the future is more than they can presently
deliver.
One type of such a consumer transaction that has been
analyzed by courts to determine if it should be treated
as a security is the offer and sale of country club
memberships. However, the types and forms of other
consumer-related transactions that also could be
susceptible to such inquiry are virtually limitless.
Examples include a business offering the use of certain
luxury cars (some of which may not yet have been
procured) for an up-front fee, a company that proposes
to offer charter flight services to multiple
destinations some of which it may not have the capacity
initially to provide or the purchase by collectors of
gold coins, the proceeds from which will be used to mint
the coins.
Transactions similar to some of these examples have
already been scrutinized by courts as potential
securities offerings. The examples discussed throughout
this article constitute only a small portion of the
myriad transactions and schemes that may be subjected to
a court or regulatory authority as involving the offer
and sale of securities.
In each of the cases described above, the company
involved may not realize that what it proposes to do or
what is already has done may constitute an offering of
securities, even if the intention was not to address the
"investing public." Accordingly, the
principals of a business enterprise must question
whether they are involved in the offer and sale of
securities and whether they may be subject to such
regulatory scrutiny in the event the company fails.
On the other hand, if an issuer moves too quickly and
assumes that its conduct constitutes a securities
offering, such a false assumption can be just as
damaging. By deeming an interest to be a security that
otherwise would not be (if properly analyzed), an issuer
in effect gives purchasers all of the rights associated
with the purchase of securities and assumes all of the
requisite obligations of an issuer of securities.
What all of this means is that we must go back to
basics. In order to have an offering of securities, what
is being offered and sold must constitute a
"security" and that definition itself is not
universally accepted or applied. The term
"security" is one that continues to evolve
based on, among other things, statutory and case law and
regulatory enforcement.
The purpose of this article is to remind business
enterprises, especially startups, to be sure to analyze
their proposed conduct to see if it constitutes an
offering of securities under applicable law and to alert
such persons to the benefits and detriments of
misclassifying business conduct as not involving the
offer and sale of securities or as a securities offering
when the facts do not warrant such a label.
As a starting point, let's review why this is such an
important issue. Under Section 5 of the Securities Act
of 1933, as amended, the offer and sale of securities
must be registered (among other things) or there must be
an exemption available from such registration.
Similarly, most state securities laws (called "blue
sky" laws) require that an offer and sale of
securities be registered at the state level or an
exemption from such registration be available. This
concept can be confusing. Even many lawyers think that
when companies do initial public offerings they register
shares so they can be sold on a national securities
exchange or an inter-dealer quotation system. That is
not legally accurate.
Under the Securities Act, issuers register transactions
(that is, the offer and sale of shares), not shares.
Shares get registered under the Exchange Act typically
in connection with being listed on a national securities
exchange or an inter-dealer quotation system. This
distinction is important, because it is the conduct or
transaction of a business enterprise that must be
examined to determine if it involves the offering of
securities and whether the Securities Act and applicable
blue sky registration or notice filing requirements
apply.
Many business startups offer the promise of a consumer
product for an up-front fee. Membership clubs present an
excellent example of this. Whether it is a country club
that has a golf course that is being built, a luxury
auto club that will enable you to select among exotic
sports cars and use them for pure pleasure at certain
times during the year, a fruit-of-the-month club or wine
club that promises to deliver fine foods or wines that
you might not otherwise be able to easily acquire, these
are clearly products intended for consumer consumption
that may have elements of risk and promise in the event
the business venture fails.
It is not simply the purchase of an item for cash where
the transaction (subject to any return or warranty
policy) for all intents and purposes has concluded when
the purchaser walks away with the goods purchased or
when the services procured are performed. Keep this in
mind as we discuss the analysis for what constitutes a
security.
While the Securities Act and Exchange Act contain
slightly different definitions of the term
"security," each statute recites a litany of
highly technical and fairly specific interests,
instruments and rights, all of which are deemed to be
securities. Each statute does expressly identify a more
general term — an investment contract — as
constituting a security.
For example, acquiring a membership and becoming a
member of a private country club typically would
not be considered the offer of a security by the
club or the purchase of a security by the member. As
mentioned earlier, this has serious legal implications
for both parties. As opposed to the offer and sale of
notes, stock, bonds, debentures or options, all of which
usually signify some form of transaction involving
capital raising or the acquisition of an ownership
interest for investment purposes, acquiring a membership
in a country club or luxury automobile club is generally
considered as consumer consumption for federal
securities law purposes.
The analysis does not end there. Even though the
National Securities Markets Improvements Act of 1996 has
preempted many state securities laws, which prior to its
enactment often had provisions that imposed additional,
onerous requirements on issuers of securities, many blue
sky laws and state securities law regulators may treat
these types of transactions differently.
From a federal securities law perspective, the
definition of a "security" is derived from the
application of the economic realities test first
espoused by the U.S. Supreme Court in SEC v. W.J.
Howey Co., 328 U.S. 293 (1946), as refined by
subsequent decisions. Under the Howey Test, an interest
will be classified as a security only if the following
three elements are present:
an investment of money has been made, in a common enterprise and the investor has the expectation of profits, which
profits are expected to arise solely, or substantially,
from the efforts of the promoter or third party.
Although the Howey Test represents the position of the
Supreme Court and the Securities and Exchange Commission
as well as a majority of the states, there are a
significant number of states that apply an additional
test. This is known as the "risk capital" test
set forth by the California Supreme Court in Silver
Hills Country Club vs. Sobieski, 361 P.2d 906 (Cal.
1961) in determining whether an interest constitutes a
security.
The risk capital test looks at whether the money being
put to work in a given venture will be used to develop
or acquire the business or enterprise in which the
interest is offered. If that test is satisfied, then
such interest is deemed to be a security.
Thus, a key factor under the risk capital test in
determining whether what is offered and sold constitutes
a security can be the extent of the development of the
business at the time the interest is purchased. This is
why a startup business venture that has the purpose of
providing goods or services for consumer consumption,
such as a luxury automobile club, could be deemed to be
engaged in the offer and sale of securities by merely
launching its products.
This also means that, when analyzing the purchase of a
country club membership, it is possible that otherwise
identical club memberships may be a security in the
hands of one member and not in the hands of another
member depending on the time the member acquired the
membership and the maturity of the club itself at such
time. It is very likely, particularly with respect to
the offer and sale of any type of club memberships, that
the application of the risk capital test will result in
the treatment of such an interest as a security more
often than if simply applying the Howey Test.
Why does it matter if an interest, such as a club
membership or the purchase of collectible coins yet to
be minted, constitutes a security? The simple answer is
that the entire landscape changes for the offeror and
the offeree or the seller and the consumer. From the
issuer's perspective, the level of disclosure required
will be radically different in the context of a
securities offering because, among other things, the
issuer will be subject to the anti-fraud provisions of
the Exchange Act in connection with the offer and sale
of such securities. For the investor, the purchase of
the interest becomes an investment decision, with the
protections afforded under applicable securities laws,
including potential rescission rights.
For a prospective organizer of a business enterprise to
avoid having such interests treated as securities, it is
necessary to avoid having any of the attributes of
securities (based on applicable statutes, case law and
federal and state no-action letters) in the relevant
jurisdictions. If it is not clear that exemptions from
registration are available, such organizations should
consider seeking no-action letters from the Securities
Exchange Commission and from all of the jurisdictions in
which the interests will be offered. In jurisdictions
where no-action letters are obtained, it is likely that
purchasers of such interests will not be able to avail
themselves of the remedies available under applicable
securities laws if they end up losing their
money.
Be mindful, however, that the state no-action process
can take on a life of its own. Even in states where
courts have explicitly adopted the Howey Test and not
endorsed the risk capital test, state securities
regulators may still apply the risk capital test when
determining whether a proposed transaction involves the
offer and sale of securities.
For example, in the matter of Manhattan Woods Golf
Club, LLC, State of New York, Office of Attorney
General No-Action Letter (May 15, 1998), the New York
Bureau of Real Estate Financing initially refused to
issue a state no-action letter in respect of membership
deposits to be collected by a proposed golf club despite
representations that all offerees were advised:
that the memberships should not be viewed as
investments, that they should not expect to derive any profits from
their memberships and that a member could transfer his membership only by
surrendering the membership to the club, which would
then reissue the membership subject to certain
conditions concerning full membership in the club.
At the time of the no-action request, New York courts
had endorsed the Howey Test and rejected the risk
capital test. Notwithstanding the apparent absence of
the third crucial element of an expectation of profit
resulting from the efforts of a third party necessary
under the Howey Test, the New York State Real Estate
Financing Bureau required the developer to agree to
conditions seemingly designed to satisfy the risk
capital test including the developer's agreement to
escrow the membership deposits with 75 percent of such
deposits available for release from escrow only after
the golf course was completed and the remaining 25
percent of the deposits available for release only after
issuance of a certificate of occupancy for the
clubhouse. On the developer's agreement to such
conditions, the bureau agreed to issue the requested no-
action letter.
If the business enterprise is unable to obtain a no-
action letter from a certain jurisdiction, it should
consider registering the offer and sale of the interests
with, or obtaining an exemption from registration from,
that jurisdiction. With the use of a legally sufficient,
well-drafted and protective private placement
memorandum, said business enterprise should be able to
protect itself from liability in connection with the
offer and sale of the securities.
If the business enterprise expects that its interests
will constitute securities, in addition to preparing a
private placement memorandum, it will likely also need
to file a Form D with the SEC and make notice or other
"blue sky" filings with each of the relevant
jurisdictions in which it offers and sells such
interests. Such actions will mean that purchasers of the
interests will be able to avail themselves of the
protections afforded under securities laws but they will
serve to protect the business enterprise from federal
and state law claims that it offered and sold securities
without registration or exemption.
If an issuer fails to implement either of the above
approaches or some combination, it may not only be in
violation of securities laws but runs the risk of
liability (including personal liability of its
principals) for civil and criminal penalties.
The most readily apparent conclusion to the question of
whether an interest will be regarded as a security and
thereby subject to regulatory scrutiny drawn from the
above is that there is no clear answer. What is clear is
that determining whether such an interest constitutes a
security will require a highly fact-specific analysis
and will depend on the jurisdiction or jurisdictions in
which the interests are offered.
One reassuring offshoot of this lack of certainty is
that an organization should be able to tailor the
attributes of its interests and make the necessary
disclosures and securities law filings to avoid facing
penalties worse than a failed business venture —
the wrath of securities regulators and the potential
corporate or personal liability for having to refund
money to consumers who never believed that they had such
a right.
Blomberg is a partner and Forcier a partner at
Martin, Lucas & Chioffi, LLP, in Stamford, Conn.
Blomberg's e-mail is jblomberg@mlc-law.com. Forcier's is
hforcier@mlc-law.com
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