Capital Raising by Privately-Held Business Firms — Spring 2007
1. Defining “Securities”
a. General Definitions
i. 1933 Act, § 2(a)(1) — “Security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, pre-organization certificate or subscription, transferable share, investment contract . . . or, in general, any interest or instrument commonly known as a “security”.
ii. 1934 Act, § 3(a)(10) — “Security” means [same as 1933 Act] . . . but shall not include any note which has a maturity . . . not exceeding nine months. . . .
i. Traditional common stock bearing both the name and usual characteristics of stock is plainly covered by the Acts with no further analysis. Landreth Timber Co.
ii. Characteristics usually associated with common stock are:
1. Right to receive dividends contingent upon apportionment of profits.
a. Shares with no potential for profit are not “stock” under the Acts. Forman.
2. Negotiability of the instrument.
3. Ability to be pledged or hypothecated.
4. Ownership confers voting rights proportional to number of shares owned.
5. Capacity to appreciate in value.
iii. Policy — purchasers of stock might assume that securities laws apply and rely on that assumption as a consideration prior to purchase. Forman. (Odd reasoning with little practical application.)
i. Unlike stock, “note” is a broad term encompassing instruments with varying characteristics, depending on whether issued in a consumer or investment context. Reves.
ii. Short-Term Debt (notes with maturities less than nine months) —
1. 1933 Act, § 3(a)(3) – exempts short-term debt from the registration requirements [§ 5(a)(1)] but not the antifraud provisions [§ 12(a)(2)].
a. Applies only to 1 prime quality negotiable commercial paper 2 of a type not ordinarily purchased by the general public, 3 used to facilitate well-recognized types of current operational business requirements 4 and of a type eligible for discounting by Federal Reserve banks. Sanders.
i. Policy – such paper has record of safety second only to government bonds. No need for additional enforcement measures.
2. 1934 Act, § 3(a)(10) – exempts short-term debt from definition of “security”, estopping application of both the ’34 registration requirements and antifraud provisions [Rule 10b-5].
a. Same application as under ’33 act.
iii. Long-Term Debt (notes with maturities greater than nine months) —
1. “Family Resemblance” Test (adopted by S. Ct. in Reves)
a. Begin with presumption that a note is a security.
b. Issuer of note can rebut presumption by showing that the note “bears a strong family resemblance” to an item on a judicially crafted list of exceptions.
i. Sample exceptions – consumer financing note; home mortgage; short-term note secured by lien on a small business or its assets; note evidencing a “character” loan to a bank customer; short-term note secured by assignment of accounts receivable; note formalizing an open-account debt incurred in ordinary course of business (especially if collateralized); loan by commercial bank for current operations.
c. If no suitably similar item, issuer can ask the court to add a new instrument to the list by analyzing the character of the note.
i. Motivations. Examine transaction to assess motivations that would prompt a reasonable seller and buyer to enter into the deal. Note is most likely a security if seller is raising capital for general use in a business or to finance substantial investments and buyer is interested primarily in the profit the note is expected to generate.
1. “Profit” here is merely a “valuable return on an investment” and includes gains from interest. (Defined more broadly than under Howey in order to include notes paying a rate of interest not keyed to business earnings.)
ii. Plan of Distribution. Instrument need only be offered and sold to a broad segment of the population; it need not have been traded on an exchange.
iii. Reasonable Public Expectations. Economic analysis of the particular transaction at issue cannot overwhelm general public perspective.
1. Advertisements soliciting investment favor a security.
iv. Risk Reducers. Existence of another regulatory scheme significantly reduces the risk of the instrument and renders application of the Act superfluous.
1. Existence of collateral and/or insurance is a risk reducing factor(s).
2. Other Tests No Longer Used
a. Investment vs. Commercial Test – evaluate whether underlying transaction was more like a commercial transaction or more like an investment transaction. Test was difficult to apply with little guidance given to fact finder.
b. Risk Capital Test – evaluate whether note holder was subject to normal risks involved in commercial financing or was subject to the kind of risk associated with risk capital (aka investments). Even less guidance given to fact finder under this test.
d. Investment Contracts
i. “A contract, transaction or scheme whereby a person 1 invests his money in a 2 common enterprise and is led to 3 expect profits 4 solely from the efforts of the promoter or a third party. . . .” Howey.
ii. Howey Test
1. Investment of money.
2. Common enterprise.
a. Lovitch Analysis — 1 multiple investors; 2 pooled funds; 3 profit-making activity; 4 in any period, all investors either gain or lose; 5 share of gain/l
aves so little power in hands of general partner that power is distributed as would be in a limited partnership.
b. Exception Two – General partner is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently expressing his partnership powers.
i. However, even a general partner who otherwise satisfies Exception Two may still exercise powers by seeking advice/assistance from other more knowledgeable partners or his lawyers, accountants, etc. Rivanna.
c. Exception Three – General partner is so dependent on some unique entrepreneurial or managerial ability of another general partner that he cannot replace that partner or otherwise exercise meaningful partnership powers.
iv. Limited Partnership Interests – Usually securities in that limited partners are reliant on general partners’ managerial decisions. If a limited partner has exercised substantial control over management of the partnership that limited partner has not profited solely from the efforts of others and that partner’s interest is not a security. Steinhardt.
1. Judicial trend towards allowing defendants to show that a limited partner participated in management, rendering that limited partner’s interest not a security.
2. A limited partnership interest owned by a general partner would likely not be a security as that partner has management powers. Frazier.
3. “Investment contract” may include limited partnership interest. KSA 17-12a102(28)(E).
f. Interests in Limited Liability Companies
i. LLC interests are “stock-like” in nature but are not traditional stock, thus Landreth doesn’t apply.
ii. No per se rule that LLC interests are not securities. Great Lakes. (C.f., general partnership interests.)
1. Policy – members of LLCs are entitled to limited liability and may be uninvolved in management. Delaware LLC Act.
iii. No presumption that members are passive investors. Great Lakes. (C.f., limited partnership interests.)
1. Policy – state LLC statutes permit members to be active participants in management and still retain limited liability. Delaware LLC Act.
iv. Terms of the particular LLC Operating Agreement determine whether membership interests in that LLC are securities. Apply the Howey test to determine if LLC interests are investment contracts.