How a Business Can be Subject to the Securities Laws

Whenever a business entity issues ownership interests, whether it is to existing owners or new investors, one must be aware that such issuance can be deemed an issuance of securities and that the securities laws may come into play.  If so, there could be restrictions on to whom and how the securities are offered and sold.

Let us look at what constitutes a security.  A start-up, for example, may want to raise capital by issuing stock, partnership interests or limited liability company member interests.  The start-up may also want to raise capital by taking on debt in the form of promissory notes or other indebtedness.  The question then becomes whether any of these methods of raising capital constitute a security for securities law purposes.

Shares of stock in a corporation, whether common or preferred, is the clearest example of a security.  But just naming an investment instrument a “stock” will not automatically make it a security.  The stock must have certain aspects that make it a “security” under the law.  Such aspects include (i) the investors’ having the right to receive dividends in accordance with corporate profits, (ii) the stock’s negotiability, (iii) whether the stock can be pledged as collateral (i.e. hypothecated); (iv) right to vote in proportion to how many shares are held, and (v) the ability for the stock to appreciate in value.

If the business is structured as a partnership, the partnership interests are securities if the partnership is a limited partnership and then only as to the limited partner interests.  General partnership interests are not securities but there can be problems if the owners give up some decision making power.  For example, if the partners agreed to leave some general partners without the power to make important decisions, that could potentially show that the partnership is really a limited partnership and possibly subject to the securities laws.  Another way a general partnership can be seen as having issued securities is when some partners are so inexperienced or unable to effectively participate in the management of the partnership that they have to rely on other partners.

If the business is set up as a limited liability company (LLC) the analysis will be similar to that of a partnership.  Therefore, if all the LLC members actively participate in the management and control of the LLC, the member interests are likely not deemed securities.  On the other hand, if some LLC members do not really participate in the management or control of the LLC, the LLC is treated similarly to a limited partnership and the member interests will be considered securities.

Finally, debt can also be a security.  If one goes to the bank to obtain a business loan, that would clearly not involve the issuance of a security.  However, if the business decides to issue notes or other debt instruments to investors who will loan money to the business, that might be a security issuance.  The more that the offer and sale of a debt instrument looks like the offer and sale of stock, the more likely that such offer and sale of indebtedness is subject to regulation.

As can be seen, any business that issues ownership interests to investors, or that issues debt instruments, for the purpose of raising capital potentially triggers the requirements of the securities laws.  Because of this, the owners of a business must ensure that any investments are handled according to governing federal and state law.  This means that the potential parties to whom investments can be offered could be limited and whether or not advertisements can be used could be a problem.

This discussion is not legal advice, a solicitation of you as a client, nor the engaging in the practice of law in any jurisdiction.  This discussion is merely for information/education and should not be relied upon for legal advice by anyone because the facts discussed may be different from your own situation.  If you need legal advice, consult a qualified attorney.  For more information please visit my website at www.palacioslawoffice.com.

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About Elio Palacios, Jr.

Attorney Elio Palacios, Jr., represents individuals, corporations, entrepreneurs, small businesses, startups and early stage businesses, physicians, dentists, and healthcare businesses in corporate, business and commercial transactions and litigation. He also counsels employers and individuals on visa, immigration and naturalization matters. Visit www.PalaciosLawOffice.com to learn more.
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