Before even thinking about raising capital for any type of venture, it is essential to understand the securities laws. Even some of the most experienced business attorneys make the mistake of assuming that securities laws don’t apply to small isolated transactions, to loans, to investments by friends and family, or to nonprofits. But this could not be further from the truth! Securities laws apply in almost any situation involving funding for a venture.

The securities laws were passed early in the last century to protect investors from slick pitch artists who traveled across the country selling worthless investments. Kansas adopted the first securities law in 1911 to “keep ‘Kansas money in Kansas’ and help local farmers and small businesses rather than enriching ‘New York Stock Exchange speculators and gamblers.’”^[1] Ironically, these laws now make it almost impossible to invest in small businesses in our communities and pretty much compel us to invest in the New York Stock Exchange (which is where companies that can afford the millions of dollars required to do the compliance work to sell to the public are listed). In the name of protecting investors, securities laws now make it very difficult to raise community capital for small local independent business.

Any capital-raising activity will need to comply with both federal securities law AND the securities laws of any states in which capital-raising is taking place. So, for example, a venture in California that is soliciting investors in Oregon and Washington will have to be concerned with four separate securities law regimes: California, Oregon, Washington, and federal.

WHAT IS A SECURITY?

Not every attempt by every venture to raise money will implicate securities laws. For example, a nonprofit 501(c)(3) soliciting donations is not subject to securities laws. But the definition of a security is incredibly broad, and attorneys must be able to spot a security from a mile away, since even the offering of a security (without any sale taking place) can be a securities law violation.

Securities Definition Under Federal Law

The term “security” is defined in the federal Securities Act of 1933^[2] as follows:

[A]ny note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.^[3]

This definition is not very helpful without more detailed definitions of each item listed. In determining what is a security under federal law, it is necessary to look to case law.

Investment Contracts

Over the years, many schemes for raising capital have been devised in attempts to avoid application of the securities laws. These schemes have been analyzed by the courts to determine whether they are “investment contracts,” and therefore “securities” under the Act.^[4]

The Howey Test

The leading case on the definition of an investment contract is the U.S. Supreme Court case, SEC v. W. J. Howey Co.^[5] In Howey, the “scheme” in question was the sale of land containing fruit trees as well as “service contracts” to cultivate and market the crops, with an allocation of the net profits going to the purchaser.

Under the Howey test, an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise^[6] and is led to expect profits solely from the efforts of the promoter or a third party.”^[7]

The “investment of money” prong of the Howey test requires that the investor commit his or her assets to the enterprise in such a manner as to subject the investor to financial loss.^[8] The focus of the inquiry is on what the purchasers were offered or promised. “The test [for determining whether an instrument is a security] is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”^[9]

The U.S. Supreme Court has defined “profits” as “either capital appreciation resulting from the development of the initial investment […] or a participation in earnings resulting from the use of investors’ funds.”^[10] The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”^[11]

The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”^[12] The courts have rejected attempts to narrow the definition of a security. As one opinion put it, “in searching for the meaning and scope of the word ‘security’ […] form should be disregarded for substance and the emphasis should be on economic reality.”^[13]

Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security. If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.

Other Characteristics of a Security Under Federal Law

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:^[14]

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.

When the Investor’s Primary Motivation Is Consumption of a Commodity or Service

An important Supreme Court case for the sharing economy is United Housing Foundation v. Forman.^[15] In that case, residents of a cooperative housing project sued the developer for, among other things, sale of unregistered securities (shares in the cooperative). To be able to rent an apartment, a prospective resident was required to buy 18 shares of stock for each room desired at $25 per share. Each apartment had one vote regardless of the number of shares purchased by the residents. Residents also paid monthly rent.

The Court in Forman noted that even though the instruments in question are called stock and the word “stock” is included in the definition of a security, the economic realities of the transaction are what need to be considered in light of the purposes of the securities laws. The Court stated:

In holding that the name given to an instrument is not dispositive, we do not suggest that the name is wholly irrelevant to the decision whether it is a security. There may be occasions when the use of a traditional name such as “stocks” or “bonds” will lead a purchaser justifiably to assume that the federal securities laws apply. This would clearly be the case when the underlying transaction embodies some of the significant characteristics typically associated with the named instrument.^[16]

The Court reasoned that

people who intend to acquire only a residential apartment in a state-subsidized cooperative, for their personal use, are not likely to believe that, in reality they are purchasing investment securities simply because the transaction is evidenced by something called a share of stock. […] [T]he inducement to purchase was solely to acquire subsidized low-cost living space; it was not to invest for profit.^[17]

Importantly, the Court concluded that “when a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.”^[18]

Forman was very important for cooperatives and similar enterprises throughout the country. It clarified that the purchase of a membership in a cooperative, when the purchaser was motivated by a desire to use the goods and services of the cooperative, would not be considered a security. As we shall see, however, many states have rejected the Forman reasoning.

Notes: The Family Resemblance Test

The definition of a security includes “notes.” Does this mean that all loans are covered by securities law? The Supreme Court has said that the phrase “any note” in the statutory definition of a security should not be interpreted to mean literally “any note” but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.

How does a court determine whether a note is a security? Federal courts apply the “family resemblance test.” This is how the Supreme Court articulated the test in Reves v. Ernst & Young:

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.”

Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.”

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction.

Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.^[19]

To summarize the above test,

1.  If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.”

2.  If there is a plan to distribute the notes for trading and investment, the notes are likely to be considered securities.

3.  If investors reasonably expect that the notes will be treated as securities, the courts are more likely to do so.

4.  If some other regulatory scheme reduces the risk of the note, the courts are likely to find the application of the securities laws unnecessary.

The types of notes that are not “securities” include

the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized).^[20]

Securities Definition Under State Law^[21]

As noted above, it is necessary to comply with both state and federal securities law. So, let’s say you want to raise money in Utah. You need to determine whether the instrument you are using is a security under federal law and under Utah law. It is possible that something that is not a security under federal law will be a security under state law.

The Risk Capital Test Used by a Minority of States

In 1959, some enterprising developers bought land in Marin County to develop a country club. To pay for some of the costs of building the club, they sold charter memberships in the club. The members would not share in the profits or ownership of the club but would have the right to use club facilities. Under the federal definition, these memberships would not be securities because the members joined the club to get the benefits of membership, not for a financial return. But the California Supreme Court, in a landmark case called Silver Hills Country Club v. Sobieski,^[22] found that these memberships were securities.

The court formulated a new test for whether something is a security, called the risk capital test, which considers:

•  Whether funds are being raised for a business venture or enterprise;

•  Whether the transaction is offered indiscriminately to the public at large;

•  Whether the investors are substantially powerless to effect [sic] the success of the enterprise; and

•  Whether the investor’s money is substantially at risk because it is inadequately secured.

In Sobieski, the court held that the sale of membership to a country club was a security because it fell under the purview of the regulatory intent of the California securities act.^[23] On that point, the court held that courts have to look through form to substance to protect the public from schemes to attract “risk capital,” which it found in this case.^[24] The court found that the investors were risking their capital in expectation of receiving the benefits of club membership, which was in the control of the issuers of the membership.^[25] Notably, the court stated the “act extends even to transactions where capital is placed without expectation of any material benefits.”^[26]

Since Sobieski, the risk capital test has been applied by courts, with each case emphasizing different components of the test. The test is stated broadly as condemning a transaction that involves raising “funds for a business venture or enterprise; an indiscriminate offering to the public at large where the persons solicited are selected at random; a passive position on the part of the investor; and the conduct of the enterprise by the issuer with other people’s money.”^[27] Most generally, the risk capital test “focuses retrospectively on what the investor stands to lose rather than prospectively on what he expects to gain.”^[28]

The broad formulation of the risk capital test emphasizes that the test eliminates the profit requirement of the federal Howey test.^[29] “The risk capital test has two major advantages when contrasted with the federal test. First, it does not define a benefit as narrowly as the federal test defines a profit. The benefit need not be a material benefit.”^[30]

A couple of examples of fundraising schemes that were not found to be securities under the risk capital test might help clarify the test. First, in Moreland v. Department of Corporations, the court found that the sale of gold ore and a contract to refine the ore was not a security under the risk capital test even though “the promotional materials given to the public by appellant included the following statement: ‘The reason for selling the gold at this price is to raise the capital for a new milling and refinery plant.’”^[31] The Department of Corporations argued that the intended use of the proceeds demonstrated by this statement satisfied the requirement under the risk capital test that the funds “be used for a business venture or enterprise.”^[32] The court disagreed, stating,

Superficially, this may be so since the construction of a mill and refinery is essential to the conduct of appellant’s intended mining, milling and refining operations. However, it is equally true that every purchaser of a product from a seller, who reinvests the proceeds of the sale in his business operations, contributes to a seller’s business capital. Notwithstanding, such a contribution is an investment in the purchased product and not a contribution of risk capital to a business enterprise within the normal scope of securities regulation.^[33]

In Hamilton Jewelers v. Department of Corporations, the court held that the following offering did not constitute a security under the risk capital test:

Hamilton Jewelers invites you to invest in a ONE CARAT DIAMOND for only $500, and if anytime [sic] within a three year period you elect to return the Stone, Hamilton will return to you the full purchase price plus 5% interest calculated daily from the date of purchase. A diamond investment of $500 will return $578.81 in cash at the end of a three year period.

The court reasoned that even though the offer to pay interest on an investment would normally fall within the definition of a security, in this case the investor’s capital was not at risk because the investor had a diamond worth at least $500. The court stated, “[t]he customer, being adequately secured, would have placed no ‘risk capital’ with Hamilton; and, therefore, the transaction would not come within the regulatory purpose of the Corporate Securities Law even though 5 percent interest might ultimately be paid to the customer.”^[34]

The risk capital test has been adopted in some form in 16 jurisdictions (in addition to California):^[35]

•  By the Supreme Court of Hawaii (1971);

•  By the Supreme Court of Arkansas (1987);

•  By the District Court of Guam (Appellate Division, 1981);

•  By the Court of Appeals of Ohio (10th District, 1975);

•  By the Supreme Court of Oregon (1976);

•  By statute in Alaska, Georgia, Michigan, North Dakota, Oklahoma, and Washington;

•  Through regulatory rule in Illinois, New Mexico, North Carolina, Wisconsin, and Wyoming.

For example, Washington’s statutory definition of a security includes “investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture.”^[36]

The Hawaii Supreme Court devised a test that is a combination of the Howey test and the risk capital test established in Sobieski. This test states that an investment contract (and security) is formed when

(1) An offeree furnishes initial value to an offeror, and

(2) A portion of this initial value is subjected to the risks of the enterprise, and

(3) The furnishing of the initial value is induced by the offeror’s promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, and

(4) The offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.^[37]

The Hawaii test softens the harsh application of the risk capital test by specifying that the benefit has to be “over and above the initial value” and “as a result of the operation of the enterprise.”^[38]

Some jurisdictions have applied the risk capital test less broadly. For example,

•  In Hacker v. Goldberg,^[39] the court found that a sale of membership was not a security where “no financial profit or income could be derived under the charter.”^[40]

•  In Creasy Corp. v. Enz Bros. Co.,^[41] the court held that the state securities law was not enacted to protect against the sale of membership that would render a service available to them with no rights to the capital or profits of the company.^[42]

•  The New York Court of Appeals held that the sale of membership in recreational campgrounds is not a security where members acquire no legal interests in the company, no right to their business, any share of income, or any right to participate in management.^[43] Rather than a financial interest, the court found that members acquired membership solely for their own personal enjoyment and not for resale or profit.^[44] The court stated that the Howey test is the test of choice in New York; however, it also acknowledged the use of the risk capital test.^[45] The court found application of the risk capital test irrelevant because the memberships were being sold for an established business instead of to raise capital for a new enterprise.^[46] On this basis, the court failed to consider whether or not the risk capital test would be a useful addition to the Howey test in New York.^[47]

•  In Dunwoody Country Club of Atlanta, Inc. v. Fortson,^[48] the court found that an investment in exchange for a membership certificate and use rights to social and recreational facilities was not the type of investment that the Securities Act meant to protect. Because the country club in question was a nonprofit organization, the court distinguished the present case from Sobieski.^[49]

Even states that do not exclusively employ the risk capital test acknowledge its utility.^[50]

There is some degree of judicial uncertainty regarding how the risk capital test should be applied.^[51] In particular, California Appellate Courts, following the California Supreme Court, have avoided establishing an “all-inclusive formula” to test the facts of every case.^[52] More specifically, the California Court of Appeals found that “[t]he ‘risk capital’ test is […] not applicable in all situations,” even though the parameters of its application are left unexplained.^[53]

The only cases in which California courts find something not to be a security are those where the investments are sufficiently collateralized and/or where the investors are actively involved in the venture. For instance, in Reiswig, the court held that a CD-with-bonus package was not a security under the risk capital test, in part, because the CDs were FDIC insured, and there was therefore no substantial risk.^[54]

Generally, courts in states that apply the risk capital test will use both the Howey test and the risk capital test to determine whether something is a security. If an instrument meets the definition under either test, the court will conclude that it is a security. States that do not apply the risk capital test will generally apply the Howey test only.

Investor’s Participation in the Enterprise

As we’ve seen, there are two tests for whether an investment scheme is a security, the Howey test and the risk capital test. They have in common one thing that is particularly relevant for the sharing economy: both of the tests require that the investor not be actively involved in the management of the venture for the investment to be considered a security.^[55]

This means that if a group of ten people get together and start a business and all ten of them invest money in the business and actively participate in the management of the business, arguably their investment is not covered by securities law. This is a great “loophole” for participants in the sharing economy!^[56]

Requesting No Action Letters

Because the definition of a security can vary so much from state to state, it is essential to look at the relevant state’s statutes, regulations, and judicial and regulatory opinions on the subject. When in doubt, it may be advisable to request a “no action letter” from the regulators. Such a request would describe the manner in which money is being raised, provide legal arguments about how the money-raising scheme is distinguishable from opinions where securities law was found to apply, and conclude with something like the following sentence:

We respectfully request your confirmation that the [name of regulatory body] will not take enforcement action if [name of money-raising instrument] are offered and sold in the manner described herein without registration under [citation for law requiring registration of a securities offering].

What is NOT a security? Pre-selling Products and Services

The Supreme Court has said, “What distinguishes a security transaction […] is an investment where one parts with his money in the hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption […] .”

So what if a business sells something to its customers and there is a separation in time between the customer making the purchase and the business delivering the commodity? That can be a way to raise funds that falls outside of securities law!

For example, let’s say a café (this is a true story) wants to expand to a larger space. The café needs to raise $50,000 to cover the costs of this expansion. The café can sell gift cards to its customers in large denominations. Let’s say the café sells 50 $1,000 gift cards to its 50 most loyal customers. The customers will use the cards over time but the café has the $50,000 now to complete its expansion.

This model is used quite a bit by small farms and is sometimes referred to as community supported agriculture (CSA). In these models, customers pay up front for a whole year’s worth of produce, which provides the farmer with enough money to cover the costs of the planting season.

One restaurant in Oakland sold the right to be a “seatholder” for $500. Seatholders receive 20 percent off their tab, priority reservations, and invitations to special events.

There are some caveats with this model. Remember that some states have adopted the risk capital test for the definition of a security. Under this definition, an arrangement like this could be seen as a security if the purchasers’ money is “at risk.” In the states that apply the risk capital test, it is not advisable to use this method for raising capital.

Also, what if you sell the pre-purchased gift card at a discount? For example, you sell a gift card worth $1,000 for $800. There is a possibility that could be considered a security since there is a financial return on the “investment.” When in doubt, it is best to contact the relevant securities regulators and request a no action letter.