The Supreme Court has said that the following will be considered a security: “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

So what if someone invests in a venture with the expectation of receiving a beautiful gift basket at the end of one year – could that be considered an “expectation of profits”?

Unfortunately, this issue has not been addressed directly by the courts.  Crowdfunding web sites like IndieGoGo and Kickstarter are based on the assumption that giveaways would not be considered “profit” and therefore subject to securities regulations.

At what point might a reward be valuable enough that it could be seen as a financial return on investment?  Just because it is not paid in cash surely could not be the determining factor – that would be a loophole big enough for a mack truck!

The Supreme Court has already held that the initial investment does not have to be in cash – it could be in the form of goods or services.  Can the decision that profits can be in the form of goods and services be far behind?

Because of this uncertainty, if you are conducting a non-securities funding campaign and providing giveaways to your donors, it is best to structure it so that the primary motivation is not the giveaway but other intangible benefits of supporting a wonderful venture.

First, a cooperative formed under the law of any state that sells securities to its members in Colorado is exempt from the Colorado registration requirement.  (Note that it will still be necessary to qualify for a federal exemption – in this case, probably the intrastate exemption would be used.)

Second, securities offered and sold in compliance with a federal exemption for small or private offerings (such as Reg D) is exempt from Colorado registration.  All that is required to qualify for this exemption is the filing of a simple notification of exemption with the Colorado Division of Securities along with a $75 fee.  If used in conjunction with federal Rule 504, this means that a company can conduct a private placement (no general solicitation) for up to $1 million to an unlimited number of accredited AND unaccredited investors.

The form is fairly straightforward and not that difficult to complete.  It asks questions like

• Describe the business of the Company, including its products or services.
• Describe how the Company produces or provides these products or services and how and when the Company intends to carry out its activities.
• Is the Company dependent upon a limited number of suppliers?
• Does the Company have any major sales contracts?
• Name the Company’s principal competitors and indicate their relative size and financial and market strengths.
• Describe how the Company plans to market its products or services during the next 12 months, including who will perform these marketing activities.
• Indicate any benefits or incentive arrangements the Company provides or will provide to its employees.
• Is the Company’s business subject to material regulation by any governmental agency?

If you can answer questions like these as well as provide professionally prepared financial statements for your company, you may want to consider using the SCOR form to raise funds for your company!

There are some complications that must be dealt with first.  You must determine what exemption from federal securities law you will be using (probably  Rule 504 or the intrastate exemption) and then complete any required filings related to the federal exemption.  You must determine what kind of security you want to sell (common stock, preferred stock, notes, convertible notes, a share in the profits . . . .) and prepare the proper documentation for that instrument.

Once you have taken care of all this and completed the SCOR form, you file the form in each state where you want to sell your securities.  The state securities regulators of those states will probably make comments and ask for changes and additional information.  They are likely to require other protections for investors such as an impound account where you keep investment dollars until a minimum amount is raised.  Once the relevant states have approved the form and you have complied with any requirements they have imposed, you can offer your securities in those states.  In most cases, you can advertise to the general public and you do not have to worry about whether your potential investors meet any requirements of wealth, income, or sophistication.

If you want to use the form in more than one state, you may be able to use regional coordinated review.

If you choose to request coordinated review, you will generally only have to work with one of the states, the lead jurisdiction, that will coordinate the review and comments of all states within the region in which you want to offer your securities.  Note that each state will charge fees, so choose your states wisely!

The following is a list of the groups of states that do coordinated review.

CR-SCOR-Mid-Atlantic: Delaware, Maryland, New Jersey, Pennsylvania, Virginia, and West Virginia

CR-SCOR-Midwest: Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, South Dakota, and Wisconsin

CR-SCOR-New England: Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, and Vermont

CR-SCOR-Southwest: Arkansas, Oklahoma, Texas

CR-SCOR-West: Alaska, Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, Oregon, Utah, Washington, and Wyoming

Unfortunately, California does not encourage the use of the SCOR form and New York does not accept it.  Future postings will discuss how to do public securities offerings in these states.

The following are some helpful links:

Information about the SCOR program and links to the SCOR form and instructions

Information about the coordinated review program

But Rule 504 has a whole other side to it that most people don’t know about. Used in conjunction with certain state securities laws, Rule 504 can be used to make a public offering of securities (i.e. a general solicitation to the public).
If a company is making a securities offering that qualifies to use the federal Rule 504 exemption (raising up to $1 million), and the company registers the offering under the securities law of a state that requires the public filing and delivery to investors of a substantive disclosure document, that offering can be made to the public in the state where the registration was completed.

But what if you want to offer your securities in a state whose securities laws do not require the public filing and delivery to investors of a substantive disclosure document (like New York)? As long as you complete the registration process in a state that does have these requirements, you can also offer securities to the public in states that do not have this requirement as long as you deliver the disclosure document to all potential investors (assuming you comply with all of the laws of the states in which you are making the offering).

The federal Rule 504 exemption can be used in conjunction with state registration accomplished through a SCOR form. The SCOR form was developed by the North American Securities Administrators Association (the association of state securities law administrators). Most states accept the form. It is a fairly straightforward disclosure document that can be completed without much help from a lawyer.

This is a fairly simple and low cost way to legally raise money from the public! Unfortunately, this does not work in California! Watch for upcoming posts about the special case of California.

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.

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.

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.

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?

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.

The following are characteristics that will make it more likely that a court will consider an instrument to be a security, and therefore subject to securities regulations:

1. the right to receive dividends contingent upon an apportionment of profits;
2. negotiability (i.e., transferability);
3. the ability to be pledged or hypothecated (i.e. used as collateral);
4. the conferring of voting rights in proportion to the number of shares owned;
5. the capacity to appreciate in value;
6. the motivations of the seller and buyer – the seller’s purpose is to raise capital and the buyer’s purpose is to earn a profit;
7. the plan of distribution - there is “common trading for speculation of investment” and the instrument is offered and sold to a broad segment of the public;
8. public perception – the public reasonably perceives the instrument as an investment;
9. the instrument poses a risk to the investing public.