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@198 CHAP 11
┌─────────────────────────────────────┐
│ SECURITIES LAW CONSIDERATIONS │
└─────────────────────────────────────┘
"To the child and the stockbroker, all things are
possible." -- Eric Hoffer
Yet another factor to take into account in choosing the legal form of
a business is the potential application of federal and state securities
laws if the new business is to have more than one owner or should it
become necessary to raise capital for an existing business. Because of
the potentially dire consequences of violating federal or state securi-
ties laws, it is important to consult with a business attorney as early
as possible when considering issuing or transferring a security. Note
that corporate stock and limited partnership interests are generally
considered securities, and even a general partnership interest can be
a security in appropriate circumstances, as can certain kinds of debt
instruments.
Since the Securities Act of 1933, federal law has required registration
as a prior condition to the issuance or transfer of securities. The
law exempts various types of securities and certain types of transac-
tions. The most important of these exemptions for small or new busi-
nesses have been the exemptions for securities sold to persons residing
within a single state and transactions by an issuer not deemed to in-
volve any public offering. The Securities and Exchange Commission (the
SEC) from time to time has issued regulations exempting small securi-
ties issues, attempting to balance the needs of small businesses to
raise capital against the public policy of protecting investors. In
1982, the SEC adopted Regulation D as its primary method of regulation
of securities offerings by small businesses (although not to the ex-
clusion of other exemptions which might apply in a given case). These
regulations were revised in April 1988 and again in April 1989.
RULE 504:
--------
Rule 504 under Regulation D exempts the issuance of securities by an
entity if the aggregate offering price of all exempt securities sold
by the entity during a 12-month period does not exceed $1,000,000.
(Limited to $500,000 if the securities are not registered under any
state securities law.) The securities cannot be offered or sold by any
form of general solicitation or general advertising, and the securities
so acquired cannot be resold (generally) without registration or an
exemption from registration. This rule does not require any specific
information to be given to the purchasers of the securities. However,
since the anti-fraud provisions of the securities laws apply even
though the transaction is exempt from registration, it is helpful to
memorialize in writing the material information regarding the offering.
RULE 505:
--------
Rule 505 exempts offers and sales of securities if the offering price
for all exempt securities sold over a 12-month period does not exceed
$5,000,000. To obtain this exemption, the issuer must reasonably be-
lieve that there are not more than 35 purchasers, other than "accred-
ited investors."
Examples of "accredited investors" include banks, insurance companies,
a natural person whose net worth (or joint net worth, counting spouse)
at the time of purchase is in excess of $1,000,000 or who has individ-
ual income in excess of $200,000 (or joint income, with a spouse, in
excess of $300,000) in each of the two most recent years and expects
the same in the current year, or corporations, partnerships or business
trusts having total assets in excess of $5 million (unless formed for
the specific purpose of acquiring the securities).
For purposes of Rule 505, the issuer must furnish extensive information
and certified financial statements to the investors, unless securities
are sold only to accredited investors. The prohibition against adver-
tising and solicitation applies to this rule, as do the anti-fraud
provisions of the securities laws.
RULE 506:
--------
Rule 506 is similar to the exemptions provided by Rule 505, except that
the five million dollar limitation does not apply. The 35 purchaser
limitation does apply (with the exception for accredited investors),
but a separate limitation requires that the issuer must reasonably be-
lieve immediately prior to making any sale to a non-accredited investor
that such investor, either alone or with a representative, has such
knowledge and experience in financial and business matters that he is
capable of evaluating the merits and risks of the prospective invest-
ment. The prohibitions against advertising and solicitation also apply
under this rule, as do anti-fraud provisions of the securities laws.
FILING OF NOTICE UNDER REG. D:
------------------------------
An issuer that relies upon any of the above Regulation D exemptions
must file Form D with the SEC, generally not later than 15 days after
the first sale of securities and at other specified times thereafter.
(However, failure to file Form D will no longer disqualify an issuance
of securities, in general, that otherwise meets the Rule 504, Rule 505
or Rule 506 requirements, unless the issuer has been enjoined by a
court for violating the filing obligation. -- Rule 507, as interpreted
in SEC's Securities Act Release No. 6825, March 14, 1989.)
STATE "BLUE SKY" LAWS:
----------------------
Keep in mind that the exemptions available under the federal securities
laws are more liberal than those available under the securities laws of
many states. In connection with any issuance or transfer of securities,
it is necessary to consider the possible application of securities laws
in the state where the business entity is established or operates, and,
if different, the states where purchasers of the securities live.
@CODE: CA
@CODE:NF
┌────────────────────────────────────────────────┐
│ COMPLIANCE WITH CALIFORNIA SECURITIES LAWS │
└────────────────────────────────────────────────┘
When your newly-formed corporation issues shares of its stock to you
and to any other shareholders, you must be very careful to comply with
BOTH federal and California securities laws. Otherwise, you will be an
inviting target for lawsuits from disgruntled investors in your corpor-
ation and could also be subject to criminal prosecution.
In the case of the typical small corporation startup, you will probably
be able to qualify for exemptions from the burdensome and costly pro-
cedures of registering with the SEC under federal securities laws
(under one of the exemptions described above) or "qualifying" with the
California Dept. of Corporations under California securities laws.
In general, when a corporation issues stock in California, the issuance
must be approved (qualified) by the Corporations Commissioner, unless
the stock issuance meets one of the exemptions provided under the
California securities laws. However, most new corporations issuing
their original shares of stock can qualify under at least one of the
two main exemptions for small corporations noted below.
LIMITED OFFERING EXEMPTION--Section 25102(f) of the California
Corporations Code. This is the exemption that most new corporations
issuing stock in California will want to come under. To be able to
meet the requirements of this exemption, a stock issuance must comply
with all of the following restrictions:
. Stock must not be issued to more than 35 "counted" shareholders.
. Certain shareholders don't have to be counted, such as officers
or directors of the corporation, certain relatives of uncounted
persons (living at the same address), promoters of the corpora-
tion, and certain wealthy or sophisticated individuals.
. Each shareholder must come within one of three "suitability"
categories. They must be either one of the following:
. Uncounted shareholders;
. Persons who have certain types of pre-existing personal
or business relationships to directors or officers of
the corporation (or to "controlling persons" -- such as
a promoter or founder); or
. Certain "sophisticated investors" with business or fin-
ancial experience (or represented by professional
advisers), who have a net worth of over $500,000 and who
are able to bear the economic risks of the transaction.
. No advertising of the stock offering is allowed, by radio, mail,
TV, seminars, etc.
. Each shareholder who buys shares must sign a "representation
letter" stating that he or she is buying the stock for his or
her own account, and not for resale or distribution.
. Stock can only be issued for cash, real estate, or tangible or
intangible personal property. It may not be issued for a promise
to render future services or (in general) in exchange for a
promissory note from the purchaser.
. A Notice of Transaction form must be filed with the California
Department of Corporations within 15 days after the first sale
of stock occurs, together with a filing fee of $25 to $300 (which
varies based on the value of the securities sold).
SMALL OFFERING EXEMPTION--Sec. 25102(h) of the California Corporations
Code. While less frequently used, this exemption may be available in
some situations where the "limited offering exemption" is not, wuch as
where you have a purchaser who cannot meet the 25102(f) "suitability"
standards. Note that in order to use the small offering exemption, an
attorney must sign a statement that the stock issuance qualifies under
the Sec. 25102(h) exemption and file it with the Dept. of Corporations.
Thus, under this exemption you cannot self-incorporate without paying
at least some legal fees to an attorney. There are numerous technical
requirements that your attorney must determine that the issuance meets
in order to qualify under this exemption.
Finally, any issuance of securities under California law, whether under
one of the above exemptions or not, is subject to Section 25401 of the
California Corporations Code. This section makes it unlawful to offer
or sell a security in the state by means of any written or oral commun-
ication which includes an untrue statement of a material fact or fails
to state a material fact that is necessary to make sure that the state-
ments made are not misleading. In short, be completely honest and do
not withhold any unfavorable information from any prospective investor
in your company's stock or you may be in BIG trouble from a securities
law standpoint.