The state of California is prosecuting a movie producer that solicited loans to finance movie productions.  This case makes it clear why the securities laws do not exempt loans, even though (or maybe because!) loans sound like a safer investment.

According to the Attorney General’s press release, “More than 150 individuals from across the country made “movie production loans” to Alliance Group Entertainment, which has produced four B-movie flops since 2005, including “Confessions of a Pit Fighter” (2005) starring rapper Flavor Flav . . . .”

By soliciting loans without filing with the California Department of Corporations, he violated California securities laws.  His seeming intent to defraud investors made him subject to criminal prosecution.

Let’s say you decide to do a private placement of securities under the federal exemption from registration requirements Regulation D, Rule 504.  Under Rule 504, you can raise up to $1 million.  Let’s say you raise $950,000 under this offering.

Two months later you decide to do another securities offering under Rule 504 and your raise another $950,000.

Chances are, you will have violated the requirements of Rule 504.  Why?  Because the SEC will integrate the two offerings into one and you will have raised $1.9 million total which exceeds the $1 million maximum of Rule 504.

How can you prevent two separate securities offerings from being integrated?

The SEC looks at the following factors when determining whether two offerings should be integrated:

1. Whether the two offerings are part of a single plan of financing
2. Whether the two offerings are for the same class of securities
3. How close together the two offerings are in time
4. Whether the same type of payment for the securities is being received in both offerings
5. Whether the two offerings are for the same general purpose

It may be difficult to tell whether two offerings are likely to be integrated by the SEC.  Luckily, there is a “safe harbor” rule you can use to make sure that two offerings will not be integrated.  As long as the end of one offering is separated by at least six months from the beginning of another offering, they will not be integrated.

When talking to potential investors for your business, if you offer an investment to anyone other than an “accredited investor,” there are lots of disclosure requirements that can be quite expensive to comply with.  That is why savvy small business owners need to check on whether their potential investors are accredited or not.  Unfortunately, offering an investment to even one unaccredited investor without the proper disclosures is a violation of the state and federal securities laws.

We have discussed the definition of an accredited investor elsewhere.

A recent change in the law has narrowed the definition.  The recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act adjusted the “accredited investor” definition to exclude the value of an investor’s primary residence from the current $1 million net worth threshold.  This change went into effect immediately upon passage of the Act.

By Christen Lee, Esq.

I. State statutes governing contests in general

State laws regulating contests are found in Bus. & Prof. Code § 17539 et seq.  Section 17539.3 grants an exemption to some tax-exempt nonprofits. However, it is recommended that a nonprofit use these rules as a guideline when designing and publicizing a contest to help avoid violating false advertising and unfair trade practices laws.

The following summary is adapted from the CA Department of Consumer Affairs: Rules for Operation of Contests and Sweepstakes, available at: http://www.dca.ca.gov/publications/legal_guides/u-3.shtml

Generally, rules governing contests are found in CA. Bus. & Prof. Code 17539-17539.3, 17539.35.

A “contest” is any game, puzzle, scheme, or plan which offers prospective participants the opportunity to receive or compete for gifts or prizes on the basis of skill and/or chance, and which is conditioned on some payment of value.

The law requires every person who conducts a contest to disclose on each entry blank the submission deadline.

All contest and promotional puzzles and games must clearly and conspicuously include the following:

•           Contest description, number of anticipated contestants, and the nature and value of the prizes.

•           All the rules, regulations, terms and conditions of the contest.

•           The maximum number of puzzles or games which may be necessary to complete the contest and determine winners.

•           The maximum amount of money, including postage and handling fees, which a participant may be asked to pay to win each of the prizes offered.

•           The date(s) upon which the contest will terminate, and upon which all prizes will be awarded.

•           Whether future contests or tie-breakers, if any, will be significantly more difficult than the initial contest, and the method of determining prize-winners if a tie remains after completion of the last tie-breaker.

Misrepresenting in any manner the odds of winning any prize is prohibited. All prizes of the value and type represented must be awarded and distributed. The opportunity to win a prize cannot be conditioned on a minimum number of entries or contest participants.

Also, the contest sponsor must retain for at least two years following the completion of a contest the following information:

(1) Copies of all contest solicitations and puzzles.

(2) All puzzles and correspondence sent by a contestant or copies or records disclosing details thereof and records of replies thereto.

(3) Adequate records which disclose the names and addresses of all contestants, the approximate date each contestant was sent each puzzle or game, the number of prizes awarded, the method of selecting winners, the names and addresses of the winners, and facts upon which all representations or disclosures made in connection with the contest are based and from which the validity of the representations or disclosures can be determined.

II. Deceptive Mail Prevention and Enforcement Act (39 U.S.C. 3001 et seq)

•   Federal statute that regulates advertisements sent through U.S., including contest materials.

•   Requires the contest sponsors to disclose in a clear and conspicuous way:

•           the terms, rules and conditions of the contest.

•           how many rounds of the contest you must achieve to win the grand prize.

•           the time frame for the winner to be determined.

•           the name of the contest’s sponsor.

•           an address where you can reach the sponsor to request that your name be removed from the mailing list.

•           Mailings for skill contests or promotions must:

1.        State all terms and conditions, including rules and entry procedures in language that is easy to find, read and understand and;

2.        Provide a name and the business address where the sponsor can be contacted.

•           Skill contest mailings must disclose:

3.        The number of rounds or levels of the contest and the cost to enter each level;

4.        Whether subsequent rounds will be more difficult to solve;

5.        The maximum cost to enter all rounds;

6.        The estimated number or percentage of entrants who may win, or have won the sponsor’s last three contests;

7.        Qualifications of the judges if the contest is not judged by the sponsor;

8.        The method used in judging and;

9.        The date prizes will be awarded, how many, the nature and estimated value of each prize, and the payment schedule.

•           Ads for sweepstakes, skill contests, and facsimile checks that appear in magazines, newspapers and other periodicals can be mailed as long as the advertisements are not personalized and do not offer a way to make a payment or order a product or service.

What state will you be operating in?  Will you have operations in more than one state?  Will you have members that live in more than one state?

What will be the main activities of the co-op?  How will it earn revenue?

Does it need to raise capital?  If so, how will it raise capital?  Through member contributions and/or through outside investors?

Will all the workers be members?  (in other words will there be employees that never become members?)

Will there be a probationary period before a worker can become a member?  If so, how long?

Can the co-op pay all the workers at least minimum wage from the very beginning and pay all the other costs associated with having employees like employment tax, workers comp, etc.?

Will all the workers have the legal right to work in the United States?

Will the workers be more like employees or independent contractors?

How do you want the co-op to be governed?  By a board elected by the members, by the members themselves, by one or more managers?

Would it bother you to have to observe certain “formalities” (such as holding regular governance meetings, complying with rules about meeting notice, keeping meeting minutes, having elections, having officers)?

How will decisions be made?  Majority vote, super-majority, consensus, modified consensus?  Will different decisions be made in different ways?

If you will have a board, what do you want the term of office to be?  Do you want term limits?  Do you want to have any qualifications for who can serve on the board?  Can only members serve on the board?  How many board members do you want?  Do you want staggered terms?

If you have officers, what officers do you want to have and what will be their duties and qualifications?

Do you want to have committees?  If so, what powers do you want them to have?

How do you want to distribute excess revenues?  Do you want some of it to be able to be held within the co-op and not become the property of the members?  Do you want to pay dividends to the members?  Do you want to pay dividends to investors?  How will you decide how much of excess revenues to allocate to various uses?  How will you decide how much of the patronage dividend to pay in cash versus an allocation to the member’s capital account?

How will you allocate losses?

How will you set member capital contributions?  Do you want there to be a limit on how much they can increase from year to year?

Do you want to have member capital accounts?  If so, do you want to pay “interest” on the balance in the member accounts?  How often do you want to redeem member accounts?

When a member leaves the co-op how will their capital account be redeemed?

What do you want to happen with the assets of the co-op upon dissolution?

Given your business plan, what are your biggest concerns about taxes?  Dividends being taxed twice (at the entity and investor level)?  Having to pay a tax on gross receipts?  Having to pay employment tax on distributions?  Having to deal with “pass through” tax treatment?

Who will have check signing authority?  Who will have the authority to sign contracts on behalf of the co-op?

Would it bother you to have an entity that is not well understood by most lawyers and accountants?

Is it important to you to use the word “cooperative” in your name?

How will you decide whether to admit new members?

How will you decide whether to remove members?  How will you decide whether to remove managers, directors, officers?

Do you want the founders to receive some sort of extra benefit to compensate them for the risks they took?

How will you decide on amending your governing documents – a majority of members, 2/3 of members . . . .?

By Gabrielle Lessard, Esq.

About a quarter of the non-profit sector just got another chance.   The IRS is providing one-time relief that will allow small exempt organizations to come back into compliance and retain their tax-exempt status even though they failed to make required annual filings for three consecutive years.   This one-time relief benefits Form 990-N (e-Postcard) and Form 990-EZ filers only.

When a tax-exempt organization that is required to file an annual return (e.g., Form 990) or submit an annual electronic notice to the IRS does not do so for three consecutive years, the organization automatically loses its federal tax exemption.  On April 22, the New York Times reported that as many as 25% of existing tax-exempt organizations were at risk of losing their exempt status because they had failed to make their annual filing.  This situation apparently developed because many managers of small organizations overlooked a change in the law.   In the past, organizations with gross annual revenues under $25,000 were exempt from annual filing requirements. The Pension Protection Act of 2006 imposed a new requirement that they make a brief electronic annual filing on From 990-N, also called the e-postcard.  http://www.irs.gov/charities/article/0,,id=169250,00.html

The IRS website has a list of organizations at risk of losing their tax-exempt status because, according to IRS records, they have not filed for 2007, 2008 and 2009. The list contains the name of the organization and its last-known address. Check this list to see whether your organization is at risk of automatic revocation and can avoid this consequence by following IRS guidance.  If an organization loses its exemption, it will have to reapply to regain its tax-exempt status. Any income received between the revocation date and renewed exemption may be taxable.

Note: The IRS website warns that the list may be incomplete, and the list may include organizations that were required to file Form 990 or Form 990-PF and are not eligible for the relief program.

A private placement is a fundraising strategy that is exempt from the full securities registration process and therefore much simpler and cheaper to do within the law.  The basic rule of private placements is that you may not solicit investment from the general public – you can only solicit people you already know.  Generally, you must have a pre-existing relationship with them dating from before you start to offer securities.

What is and is not general solicitation can get tricky!  Especially if you decide to make your private offering of securities using a third party web-based platform.  Beware!  Don’t assume that these services know what they are doing and are in compliance with the law.  If they screw up, you could be on the hook to return the money you raised using their platform.

What questions should you ask before deciding whether to use one of these platforms?

1. Is the operator of the platform a licensed broker-dealer?  If not, it can be risky to post your private placement on their site.

Section 15 of the 1934 Exchange Act requires persons that effect securities transactions on behalf of others to register as broker-dealers.  However, if the web-based platform is merely serving as a passive intermediary that facilitates the introduction of buyers and sellers, it may be able to operate legally without a broker-dealer license.  The types of activities to watch out for if the platform does not have a license include offering advice and information, handling funds, assisting with negotiations, and receiving fees based on a percentage of the purchase price.

2. How is the operator of the platform finding investors for the site?  Is it being done in a way that could look like general solicitation?  For example if the public web site invites potential investors to view specific offerings, this could be a general solicitation and all un-registered offerings on the site would be illegal.

3. Is access limited to accredited investors?  If not, it is necessary to provide an extensive private placement memorandum to potential investors and there is more risk of runnning afoul of the law.

4. How are investors screened?  How does the platform ensure that investors are really accredited and are making other required representations such as a statement that they are not purchasing for re-sale?  Generally speaking a lengthy questionnaire is required to determine whether the potential investor is suitable – having them check a box stating that they are accredited is not enough.

5. Once investors are given access to the site, are they allowed to view offerings that were already listed?  If so, this could be deemed general solicitation.

6. Are detailed records kept to ensure that the requisite pre-existing relationships can be documented if necessary?

7. Has the platform secured a “no action letter” from state and/or federal regulators assuring that the regulators will not bring an action against them?

Excerpted from a memo authored by Kathleen Kenney, U.C. Davis School of Law third year student and Sustainable Economies Law Center summer intern

Under the intrastate exemption (Section 3(a)(11) of the Securities Act of 1933), an issuer is exempt from the federal securities registration requirements.  To be eligible for the exemption, all investors must reside in a single state and the issuer must be incorporated in and doing most of its business in that state.

If the securities are offered, sold, or re-sold within nine months of the initial offering to even one out-of-state investor, the exemption may be lost.  Losing the exemption means the issuer could be required to return all the investors’ money.

The best way to ensure compliance with Section 3(a)(11) is to take advantage of the safe harbor provision in SEC Rule 147.  A safe harbor is a set of conditions that, if you comply with them, you can be assured that you will meet the requirements of an exemption.  However, it is not necessary to comply with the safe harbor conditions to comply with the exemption.  The conditions required to meet the safe harbor are as follows:

1. 80% of the company’s assets are located in the state in which the offering is made;
2. 80% of the company’s revenue comes from the state in which the offering is made; and
3. 80% of the proceeds from the offering will be used within the state in which the offering is made.

The intrastate exemption is self-executing.  The issuer is not required to file any paperwork with the SEC.

To prevent the inadvertent loss of the exemption, the issuer should do the following:

1. Place a legend on the certificate evidencing the security stating that the securities have not been registered under the Act and setting forth the limitations on resale;
2. Issue stop transfer instructions to the issuer’s transfer agent or make a notation in the appropriate records of the issuer; and
3. Obtain a written representation from each purchaser as to his residence.

Even if an offering qualifies for the intrastate exemption to federal registration, it is still necessary to comply with the securities regulations of the state in which the offering is made.

Example of the Use of the Intrastate Offering Exemption

Saranac Lake Community Store

After the town’s general store closed, members of the Saranac Lake community decided to open their own store.  They are offering shares to the public using the federal intrastate exemption and a special New York state registration process designed for issuers using the federal intrastate exemption.

Investors can purchase as little as one share for $100, with a maximum purchase of 100 shares. As of June 24, 2010, the Community Store has raised $442,900 from over 400 investors all over the state of New York.  The offering will close when $500,000 has been raised.  The Community Store organization has engaged the local community by holding “share parties” – small gatherings in homes and other intimate venues where potential investors can discuss the business plan with the interim Board of Directors and invest in shares if they choose.

By Christen Lee, Esq.

Although raffles can be a great fundraising opportunity for some nonprofits, most states consider raffles to be a type of illegal gambling. Many states, including California, carve out an exception for nonprofits. The following is a brief summary of the California exception.

Charitable Raffles in California

California Penal Code section 320.5 carves out an exception to the general prohibition against gambling in California. This exception allows “eligible organizations” to “conduct raffles for the purpose of directly supporting beneficial or charitable purposes or financially supporting another private, nonprofit, eligible organization that performs beneficial or charitable purposes if the raffle is conducted in accordance with this section.”

Definition of an eligible organization

Generally, an eligible organization is a private nonprofit organization that is exempt from California income tax and has been qualified to conduct business in California for at least one year prior to conducting a raffle.

Definition of a raffle

A raffle is a scheme to distribute prize(s) by chance among people who purchase paper tickets that provide the opportunity to win the prize(s). The paper tickets must have a detachable stub/coupon. Each paper ticket and its corresponding stub/coupon must have a unique and matching identifier. The prizes are awarded by a random drawing from all the purchased tickets; the drawing must be conducted under the supervision of a natural person who is at least 18 years old.

Note: California law prohibits raffles from being operated or conducted over the Internet, although the organization conducting the raffle may advertise the raffle over the Internet. Also, federal law prohibits multi-state raffles, so a nonprofit should only sell tickets inside California.

The 90/10 rule

At least 90 percent of the gross revenue from the sale of raffle tickets must be used to benefit or provide support for beneficial or charitable purposes. “Beneficial purposes” excludes purposes that are intended to benefit officers, directors, or members of the eligible organization. The funds may not be used to fund any beneficial, charitable, or other purpose outside of California.

Registration and reporting requirements

Unless specifically exempted, nonprofits that want to conduct raffles must register with the California Department of Justice. They also have to comply with annual reporting requirements to disclose information such as gross raffle ticket sales, expenses, and how the revenue was spent. Registration and reporting forms are available at http://ag.ca.gov/charities/raffles.php.

Educational institutions, religious institutions, and hospitals are exempt from raffle registration and raffle reporting requirements but must otherwise comply with all the other regulations.

Taxes and withholding

A raffle ticket purchase is not tax-deductible. Prizes are considered taxable income to the winners.

Mailings and advertisements

The Federal Deceptive Mail Prevention and Enforcement Act prohibits deceptive mailing practices for sweepstakes, contests, and raffles. If the nonprofit plans to use the U.S. Postal Service to mail advertisements or raffle tickets, it must comply with this act, which requires certain disclosures on each mailing. When drafting the raffle rules, it is helpful to include these disclosures in the raffle rules. For more information, see http://www.dmaresponsibility.org/Sweepstakes/.

In California, business personal property (which means any kind of property that is not real estate) is subject to an annual tax.  Business owners must file Form 571-L with the county in which they are located every year.  Business owners must file this property statement which details costs of all supplies, equipment and fixtures at each location.  The form for Alameda County businesses can be downloaded at www.acgov.org or it is possible to e-file via the SDR (standard data record) system at www.calbpsfile.org.  However, you must first set up a business account with the Assessor’s office to complete the filing.  You can contact the Alameda County Assessor’s Business Property Tax office at (510) 272-3836 for more information or to set up an account.