The Lawyer's Guide to Raising Capital for Business People: The Tools Insiders Use to Raise Capital

By Louis Amatucci, Jason Powell and Steve Forbes

Every year, small, medium and large businesses require investment capital for running their day-to-day operations or for growth. Some of these businesses turn to raising investment capital from individual investors, broker dealers, or institutional investors. This book provides a detailed summary of the multitude of securities exemptions availab

• Language: English
• Publisher: by Louis Amatucci, Jason Powell, Steven Forbes
• Release date: Jan 10, 2024
• ISBN: 9798218352172

Louis Amatucci

Louis Amatucci is the managing partner of Centarus Legal Services, PC, anationally recognized corporate and securities law firm. He is a corporate,securities, and regulatory defense attorney who has more than 20 years oflegal experience and 15 years of prior staff-level and executive-level businessexperience at several large national and multinational corporations to includeUnisys, NTK, Varta, and Motorola. Over the decades, Louis has defendedmany referred clients in front of the Securities and Exchange Commission, theIllinois State Securities Department, and the Commodities and Futures Trading Commission. Louis is a true "business lawyer" since he is among a smallpercentage of attorneys that possess diverse business experience prior to becoming an attorney.This includes prior experience in the technology, banking, and real estate industries. Louis holdsa Bachelor of Science degree in mechanical engineering from New York Institute of Technology, aMaster of Science degree from New York University-Polytechnic Institute, a Master of Arts degreefrom Dartmouth College, and a Juris Doctor degree from University of Illinois School of Law atChicago, where he received an academic scholarship and graduated with Dean's List honors. Heis also a member of the Illinois and New York Bar associations, and he is a former graduate-levelcollege professor of corporate law.

Book preview

Copyright © 2023 by Louis Amatucci,

Jason Powell, Steven Forbes

Dedications

Louis Amatucci, Author:

I dedicate this book to my friend mommy (as my boy James now refers to his mommy), Virginia Amatucci. She suddenly died of cancer two years ago, and I think of her and miss her every day. I also thank my dad for providing for us financially and for being my role model for drive and achievement. I so wish they could be here to see their grandchildren flourish as they are. God, my mom, and my dad made everything possible for me as a boy and as a young man. I also dedicate this book to my beloved wife, Beckie, and to my two wonderful children, James and Isabella. I love you all more than words. Be forever close to one another, and please don’t hold grudges, even in the face of disagreements. Family is always first. I fear this may be the only book I ever write, and by the time James and Isabella are old enough to truly know their father, I will be gone physically or mentally. Therefore, I relish the opportunity to get this out on paper while I am still able.

Jason Powell, Author:

I dedicate this book to my family and friends who have given me unconditional love, support and friendship along my life’s journey. Who and what I am today would not be possible without each and every one of you.

Steve Forbes, Author:

I dedicate this book to the two most important people in my life, my beautiful daughters Olivia and Samantha. They inspire and motivate me to be the best that I can be. My favorite moments are those I can spend with my girls. While the topics contained in this book are unlikely to be of much interest to Oliva and Samantha, in small part, this book may give my girls a small, concrete glimpse into the career I have forged. I love them more than they will ever know.

Amany Awad, Co-Author:

I dedicate this book to my father, Ahmad Awad, who has been and always will be my greatest supporter. I love you and will forever be grateful for all the sacrifices you’ve made. I would also like to dedicate this book to my mother, husband, and children. I love you all and thank God for surrounding me with such a caring family.

Acknowledgement

I, Lou Amatucci, want to acknowledge Jason Powell, Steve Forbes, Amany Awad and Tomasz Barczyk, the lawyers who together with me authored and co-authored this book. I have worked with you all now for years, and you guys are really great lawyers and great writers. I have enjoyed working with you, and I feel honored to have had this opportunity to work together. In addition, you stuck with this project through its many starts and stops and you all never went dark.

I also want to acknowledge my friend and law firm Vice President of Operations and Book Project Manager, Frank Constant, who allowed us to finally complete this project. He spent many hours and months dealing with multiple proofreads, cover redesigns, and sub-contractor flakeouts. Thank you for all your work.

Finally, I’d like to thank my wife, Rebeka, for proofing the book four times and finding new errors each time. I love you.

This book is a unique work product because it approaches this legal material in a way that summarizes the legal avenues available to raising capital so that a lay person can understand and implement.

Author and Co-Author Bios

Authors:

Louis Amatucci, Esq.

Louis Amatucci is the managing partner of Centarus Legal Services, PC, a nationally recognized corporate and securities law firm. He is a corporate, securities, and regulatory defense attorney who has more than 20 years of legal experience and 15 years of prior staff-level and executive-level business experience at several large national and multinational corporations to include Unisys, NTK, Varta, and Motorola. Over the decades, Louis has defended many referred clients in front of the Securities and Exchange Commission, the Illinois State Securities Department, and the Commodities and Futures Trading Commission. Louis is a true business lawyer since he is among a small percentage of attorneys that possess diverse business experience prior to becoming an attorney. In his case, this included prior industry experience in technology, banking, and real estate. Louis holds a Bachelor of Science degree in mechanical engineering from New York Institute of Technology, a Master of Science degree from New York University-Polytechnic Institute, a Master of Arts degree from Dartmouth College, and a Juris Doctor degree from University of Illinois School of Law at Chicago, where he received an academic scholarship and graduated with Dean’s List honors. He is also a member of the Illinois and New York Bar associations, and he is a former graduate-level college professor of corporate law.

Jason Powell, Esq.

As a results-oriented dealmaker, Jason Powell enjoys creating solutions that bring together great people, projects and capital. When working on sophisticated business and financing transactions, Jason focuses on the big picture to ascertain his clients’ strategic business direction and formulate risk mitigation strategies to protect corporate capital and profitability. His extensive experience includes advising businesses, lenders, investors, startups, and real estate investment companies and developers across the United States, on business transactions from formation to exit, acquisition, due diligence, real estate securities offerings, joint ventures, disposition and financing of real estate. Jason earned his law degree from University of Montana School of Law. In addition, he holds a Bachelor’s degree in Finance and Economics and a Master’s Degree in Sports Management from Montana State University. Jason is currently licensed to practice law in Montana, Idaho, Washington, and Oregon.

Steve Forbes, Esq.

Steve Forbes has been a practicing attorney for over 25 years. In addition, he was formerly a Certified Public Accountant. His practice concentration is corporate and securities law, and he has represented many public and private companies acting as acquirors or sellers in mergers, stock and asset acquisitions and divestitures, takeovers (negotiated and contested), venture capital transactions, restructurings, joint ventures and other strategic alliances. Mr. Forbes also has been involved in numerous initial public offerings, debt and equity underwritings and private placements, representing companies issuing securities and investment banking firms acting as underwriters or placement agents. He holds a BAA and an MBA from University of Wisconsin, and a JD from University of Wisconsin School of Law.

Co Authors:

Amany Awad, Esq.

Amany Awad is a legal publisher and senior editor at a global regulatory information services monitoring and consultancy firm. She has extensive expertise in analyzing proposed and finalized laws and regulations, guidance, enforcement actions and other legal content for the financial services industry.

Specifically, she focuses on federal and state regulators in the banking, securities and investment, and insurance industries across the US, as well as international regulators in Canada and the Middle East. Amany earned her Juris Doctor degree from Chicago-Kent College of Law and has a Bachelor’s degree in Biology with a minor in Mathematics.

Tomasz Barczyk, Esq.

Tomasz Barczyk founded and manages a solo practice, serving primarily as a one-stop-shop for all client legal trademark needs throughout the entirety of the brand development cycle; counsel clients on nuanced issues such as online platform and other third-party liability, IP protection tools offered by e-commerce platforms, gray market goods enforcement, and the ownership and protection of NFTs and AI-created content; advise clients on copyright and other IP and related business matters; negotiate and draft various IP agreements such as licensing, settlement, and coexistence agreements; draft and respond to cease and desist letters involving IP infringement claims. He holds a Bachelor of Arts from Northwestern University, and a Juris Doctorate from University of California at Berkeley.

Table of Contents

1.What is a Security?

2. When is a Promissory Note a Security?

3. When Would I Want to Rely on a Private Placement Exemption?

4. Which Public Offering Exemptions Exist?

5. When Would I Want to Undertake an Initial Public Offering?

6. What is Involved in Reselling Restricted Securities?.

7. What is Necessary to Raise Capital From Investors in a Private Offering?

8. Who Can Sell My Securities and Raise Capital For Me For a Fee?

9. Funds and Investment Advisors

10. When Should an Offering be Updated or Supplemented and When Should it be Rescinded?

11. Sample Forms

Chapter 1

What is a Security?

A. Introduction

B. What is a Security?

i. Security as Defined by Federal Securities Laws

a. The Securities Act of 1933

b. The Securities Exchange Act of 1934

c. Exempt Securities and Transactions

ii. Security as Defined by the United States Supreme Court (the Howey Test)

a. The Investment of Money

b. In a Common Enterprise

I. Horizontal Commonality

II. Vertical Commonality

c. With an Expectation of Profits

d. Derived Solely from the Efforts of Promotors or Third Parties

I. State Securities Laws

C. Why Should an Early-Stage Business Care?

A. Introduction

The commercial world is run in large part by an infinite number of diverse financial and investment instruments. Those instruments, accorded the status of a security under U.S. federal and state securities laws, are subject to extensive regulations in the United States, such as depending on the type of security and method of issuance, potential expensive registration requirements, complex disclosure and reporting standards, and antifraud provisions.

Businesses often offer and sell financial instruments as a means to raise capital and grow. However, determining whether a particular instrument is a security under applicable securities laws can be a difficult task. It is, therefore, essential for businesses to familiarize themselves with U.S. federal and state securities regulations. This is necessary to avoid the damaging consequences of running afoul of these laws, and to understand the rights and remedies available to investors under these laws if a business commits violation in the offer and sale of securities.

The initial question of what is a security is, therefore, imperative to the application of U.S. federal and state securities laws. Non-U.S. securities laws are beyond the scope of this book.

B. What Is a Security?

i. Security as Defined by Federal Securities Laws

After the stock market crash of 1929 and during the ensuing Great Depression, the U.S. Congress passed several comprehensive acts regulating securities, the two most important ones being the Securities Act of 1933 (the 1933 Act) and the Securities Exchange Act of 1934 (the 1934 Act).

Additional U.S. federal securities laws include, among others, the Investment Company Act of 1940 (the Investment Company Act) and the Investment Advisor Act of 1940 (the Investment Advisers Act). Both laws regulate the organization of companies engaged primarily in trading and investing in securities and in investment advisory services, respectively. Both laws will be discussed in further detail in Chapters 8 and 9.

The 1933 Act and 1934 Act regulate the offer, purchase, and sale of most securities in the United States. Both the 1933 Act and the 1934 Act contain broad definitions of a security.¹ The definitions set forth a long list of straightforward financial instruments, such as stock, as well as instruments that are susceptible to varying interpretations, such as an investment contract. Despite the breadth of the statutory definitions, they are nonetheless lacking, because they simply list several types of instruments that will constitute a security as opposed to actually defining what a security is. For example, while a stock is clearly a security, and, therefore, subject to federal regulations, an investment contract can take on many elusive forms involving all manner of assets, thereby making it difficult to determine whether an investment contract is actually intended in a particular situation. As the Tenth Circuit Court of Appeals put it: a security is not always an easily recognized creature.²

Because of the many ways capital can be transferred and the lack of clear guidelines from the 1933 Act and 1934 Act, courts struggled to apply the statutory definitions of a security. Consequently, the Supreme Court of the United States further elaborated on the definitions on several occasions.³ The result is an extensive framework meant to aid in determining when a financial instrument is a security, thus, prompting application of U.S. federal and state securities regulations.

Before delving into Supreme Court cases and the ensuing judicial interpretations, an introduction to the actual text of the 1933 Act and 1934 Act is provided below.

a. The Securities Act of 1933

The first U.S. federal securities law enacted was the 1933 Act. Essentially, the 1933 Act requires that any offer or sale of securities in interstate commerce first be registered with the U.S. Securities and Exchange Commission (the SEC) unless the security is exempt from registration pursuant to applicable statutory exemptions.

The registration process, which is a one-time affair, is meant to provide full and fair disclosure concerning the risks associated with the security and the issuer, which generally includes, but is not limited to, vital information about the security, the issuer of the security, and significant aspects of the business of the issuer.⁴ The goal of the 1933 Act is to provide a reasonable investor with all material information needed to make an informed judgment regarding the value of an investment prior to making the decision to purchase the offered security.

Furthermore, the 1933 Act prohibits misrepresentations, fraud, and deceptive practices in any offer or sale of securities.⁵ The Act provides for civil remedies for purchasers of securities who suffer losses if they can prove that there was incomplete or inaccurate disclosure of material information.⁶

b. The Securities Exchange Act of 1934

The 1934 Act extends the 1933 Act disclosure requirements to subsequent security exchanges and trading markets, i.e., the purchase and sale of securities already issued and outstanding. The 1934 Act requires periodic reports from certain types of companies, referred to as reporting companies, which will later be discussed in Chapter 5.

The definition of a security under Section 3(a)(10) of the 1934 Act is essentially identical to the definition provided in the 1933 Act, the exception being that evidence of indebtedness as articulated in the 1933 Act is not included among the 1934 Act terms, and the following exclusion is added:

The term security shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.

As discussed earlier, the two definitions under the 1933 Act and 1934 Act are quite broad, in an attempt to encompass the countless types of instruments used in the commercial world. The expansive nature of the definitions, however, is what led to the need for extensive judicial interpretation of the statutes.

c. Exempt Securities and Transactions

As discussed earlier, the 1933 Act requires all securities to be registered with the SEC unless a statutory exemption exists. Sections 3 and 4 of the 1933 Act provide for two types of exemptions from registration: (1) exempt securities⁷ and (2) exempt transactions.⁸

Under the former, the securities themselves are exempt from registration. Exempt securities never have to be registered with the SEC, even if they are re-sold after they are first issued. Examples of exempt securities include government-issued securities, bank-issued securities and insurance policies. This book will not discuss exempt securities.

Exempt transactions, on the other hand, involve non-exempt securities, but because of the nature of the underlying transaction, the non-exempt securities need not be registered. However, non-exempt securities initially sold through an exempt transaction cannot be resold unless they are subsequently registered or another exemption exists. Examples of exempt transactions include intrastate offerings and private placements.

It is important to note, however, that the exemptions under Sections 3 and 4 of the 1933 Act do not negate the application of the entirety of the 1933 Act and the 1934 Act, and therefore, the securities are still subject to the antifraud provisions of the 1933 Act and 1934 Act.⁹ The various types of exemptions are discussed in further detail in Chapter 3 and Chapter 4.

ii. Security as defined by the United States Supreme Court (the Howey Test)

The landmark Supreme Court case, Securities & Exchange Commission v. Howey, set out to establish criteria for identifying whether an instrument is actually an investment contract.¹⁰ If an instrument meets the criteria to be considered an investment contract, then under the 1933 Act and the 1934 Act, those instruments are considered securities. The result is a four-pronged test, subsequently referred to as the Howey test. However, if an instrument does not satisfy all four prongs of the Howey test, then it is not an investment contract and, as a result, not a security under federal securities law. The Howey test states that that an investment contract exists when a person:

[1] invests money;

[2] in a common enterprise;

[3] with the expectation of profits;

[4] solely from the efforts of the promoter or a third party.¹¹

The defendant in Securities & Exchange Commission v. Howey, Howey, was an entrepreneur who sold tracts of citrus trees coupled with a ten-year service contract under which he cultivated, harvested and marketed the fruit. Howey marketed his real estate deals through promotional materials and promised large profits to investors. The SEC filed suit against Howey for the sale of non-exempt unregistered securities. Howey contended that the real estate deals were not securities and, therefore, not subject to the registration requirements of the 1933 Act. After applying the four prongs of the Howey test, the Supreme Court held that the sales did in fact constitute investment contracts and were, therefore, subject to the 1933 Act’s disclosure and antifraud provisions. The individuals purchasing the citrus tracts (1) invested money; (2) in a common enterprise; (3) expected profits; (4) solely through the efforts of the defendant.

The Supreme Court continued to state that the 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 Such a definition permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security.¹³

It is important to keep in mind that the Howey test is meant to determine whether a particular instrument is an investment contract and, consequently, a security. The test is not meant to apply to the other types of securities in the statutory definitions. As the Supreme Court in Landreth Timber Co. v. Landreth held, stock is easily identifiable as a security, and so it is considered a security, regardless of whether the four prongs of the Howey test are satisfied or not.¹⁴

The Howey Test Applied

a) The Investment of Money

Although cash ventures clearly fall within the first prong of the Howey test, courts have expanded this prong to include any type of consideration with value, such as assets or property of almost any nature.¹⁵

b) In a Common Enterprise

The Supreme Court in Howey did not explain what the phrase in a common enterprise means. As a result, subsequent case law is not consistent in defining what constitutes a common enterprise. Two views have emerged among the federal circuit courts:

I. Horizontal Commonality. The majority of federal courts follow the horizontal commonality approach in which a common enterprise exists for purposes of the Howey test if the enterprise involves a pooling of the investors’ assets so that the investors share in the profits and losses of the business.¹⁶ Because investor assets are pooled, generally there must be more than one investor for horizontal commonality to exist.¹⁷

II. Vertical Commonality. Under the vertical commonality approach, which the courts further divided into broad and narrow views, "it is not necessary that the funds of investors are pooled; what must be shown is that the fortunes of the investors are linked with those of the promoters."¹⁸ Because vertical commonality does not require proportional sharing of profits and losses between investors, it can exist even if there is only one promotor and one investor.

Under a broad vertical commonality view, a common enterprise exists for purposes of the Howey test if the success of an investment depends on the promotor’s expertise.¹⁹

Under a narrow vertical commonality view, a common enterprise exists for purposes of the Howey test if there is a direct correlation between the profits and losses of the promoter and the investor- that is, the two parties share the risks of the venture, regardless of the promotor’s expertise.²⁰

c) With an Expectation of Profits

Satisfaction of this prong requires a finding that an investor is participating in a venture because he or she is motivated by a return on their investment. For example, an employer’s contribution to its employees’ compulsory pension fund does not constitute an investment contract because there is no expectation of profit from the fund.²¹

Consequently, "when a purchaser is motivated by the desire to use or consume the item purchased there is no expectation of profits for purposes of the Howey test.²² For instance, a contract to purchase residential or recreational property solely for the prospect of acquiring a place to live, as opposed to a return on investment, is not a security."²³

However, courts have found that contracts to purchase condominiums can be securities if, for example, the sale of a condo was advertised with an emphasis on economic benefit such as capital appreciation due to promotor developments, the offer to purchase a condo involved shared ownership such as time share arrangements, or the offer to purchase a condo involved a rental pool arrangement.²⁴

d) Derived Solely from the Efforts of Promotors or Third Parties

Subsequent Supreme Court cases have modified this prong to require that profits of an investment be derived predominantly from the efforts of promotors and others as opposed to solely from the efforts of promoters and others.²⁵ The reason being that a literal approach to an expectation of profits solely from the efforts of others would permit promotors to bypass securities laws simply by requiring that investors apply minimal effort in the management of the investment. In doing so, the promotor would not be solely managing the investment.

Courts now look to the totality of the circumstances to determine whether a promotor was actually seeking investors who would participate in the management of the venture or if the investors were really meant to be passive investors.²⁶ If the managerial efforts of the promotors or third parties are undeniably significant so as to affect the failure or success of the enterprise, then the fourth prong of the Howey test is satisfied and a security likely exists.²⁷

For example, interests in a general partnership are typically not considered securities because general partners actively participate in managing the partnership and, therefore, do not rely solely on the efforts of others.²⁸ It is important to note that designation as a general partnership alone is insufficient to escape the securities regulations. Courts will look to the actual functions of the partnership to determine if the partners did in fact actively participate in managing the partnership.

On the other hand, interests in limited partnerships are typically securities since limited partners are essentially passive owners and lack managerial powers. As a result, limited partners do rely on the efforts of others for the management of the limited partnership (a LP).²⁹

Regardless of the particular form an entity takes, it is important to note that the Supreme Court stresses substance over form in evaluation of what constitutes a security.³⁰ While general partnership interests typically are not securities and LP interests typically are, exceptions arise when the substance of the agreement between the investor and promotor differs from the form or written instrument.³¹ The substance over form evaluation tends to arise often when evaluating interests in limited liability companies or LLCs, which can be member-managed or manager-managed. Whether an LLC interest is considered a security turns on the rights and duties of members and managers as set forth in the governing documents and in practice regardless of the type of LLC.³²

I. State Securities Laws

States have their own securities laws which are often referred to as Blue Sky laws. While state securities laws share some similarities to their federal counterparts, they nonetheless vary from state to state and are, therefore, too expansive of a topic to be discussed in this book. However, it is necessary for businesses to comply with both state and federal securities laws and to be mindful of both bodies of law to avoid exposure to civil or even criminal liability.

C. Why Should an Early-Stage Business Care?

The most common sources of startup capital include existing capital of business owners, business owner credit card advances, home equity loans, and loans from friends and family members. When these sources are exhausted or unavailable, entrepreneurs commonly seek capital through the sale of securities from private sources, such as wealthy individuals and venture capital funds. The securities offered are usually styled in the form of debt, equity, or a combination of both.

The requirements for an entrepreneur to raise capital through the sale of securities while remaining in compliance with applicable securities laws and regulations can be quite onerous. The entrepreneur will be required to navigate the confusing set of laws and regulations involved with a private sale of securities. In addition, the entrepreneur will have to carefully consider what it will disclose to investors, to ensure that no misleading statements are made and nothing is omitted so as to cause other statements to be misleading. The result is generally the creation of a private placement memorandum by the entrepreneur, which is used in connection with the sale of the securities, and that contains relevant disclosures regarding the issuer and the security. Usually, this is only accomplished with the assistance of a skilled and experienced securities attorney.

At the extreme end, it is possible that the company and its principals can face criminal charges (both state and federal) for violating applicable securities laws in connection with the sale of securities. Even if no criminal charges are brought, the SEC or a state securities commissioner can, and often does, bring claims for civil penalties, such as monetary fines, disgorgement, and injunctions against any further capital raising activity. Additionally, when a company sells securities in violation of applicable securities laws and investors lose their capital investment, it is not uncommon for investors to hire counsel to sue the company and its principals to have the securities offering rescinded. An adverse judgment against the company could require the company to return investor capital (potentially out of the principals’ own personal assets if the company no longer has the cash). Furthermore, many debts due to violations of securities laws are non-dischargeable in bankruptcy.

Again, the consequences of an entrepreneur ignoring securities laws and regulations and not taking appropriate steps to ensure securities offering compliance goes beyond civil penalties, fines, and injunctions and extends to criminal liability. In fact, when a company issues securities improperly and intends to issue exempt securities but, either intentionally or negligently, fails to follow the guidelines necessary to qualify for such an exemption, the result is termed a busted exemption. This essentially means that the issuer has failed to attain an exemption from registration, and has, in fact, illegally issued securities that were neither exempt nor registered. By doing so, if investors clamor for a return of their investment capital, and if the company can return the investment as part of a rescission offer, most investors and some regulators will be satisfied. However, a more common situation is where investors’ capital has been spent and, therefore, cannot be returned. This is extremely dangerous for company principals, because they have essentially illegally accepted investors’ capital, and if this illegal action is pursued by an enforcement agency such as the U.S. Attorney’s office, such action may be considered criminal and felony fraud. Every year many company principals are prosecuted for such violations in the United States.

In addition, violating securities laws in the early rounds of fundraising for an entrepreneur could impact future efforts to raise capital. Once the entrepreneur goes beyond the seed or friends and family rounds, it will likely seek to raise money from angel investors, high-net-worth individuals, broker dealers, and venture capital firms. The problem is that venture capital investors, broker dealers, and some high-net-worth individuals will likely perform due diligence on the company and its principals. This will include reviewing any past sales of stock or debt. When sophisticated investors discover the securities violations, they will either lose interest in the company and its principals, or they will reduce the company valuation to take into account the contingent liability that should be added to the company’s balance sheet to address potential lawsuits or civil penalties. At a minimum, non-compliance with the securities laws will be expensive, because the entrepreneur will have to pay lawyers to clean up the damage that has already been done.

Furthermore, an important law that was passed in an effort to limit the participation of companies and principals that have failed to issue compliant securities offerings in the past is the Dodd-Frank Act (Dodd Frank). Dodd-Frank became law on July 21, 2010, and was intended to disqualify bad actors from conducting private offerings using specific exemptions from registration. These rules have been known as bad boy prohibitions.

Essentially, Dodd-Frank disqualifies issuers from the use of registration exemptions available under Rule 506 of Regulation D³³ if the issuer or persons involved in the offering have been convicted of securities fraud or are subject to court injunctions or orders relating to securities transactions. The bad actors covered by Dodd-Frank include, among others, the issuer, directors, officers, promotors, general or managing partners of the issuer, and beneficial owners of 20% or more of the issuer’s outstanding voting equity securities. Consequently, in order to ensure compliance with Dodd-Frank, issuers must carefully examine all those associated with any Rule 506 offerings.

In conclusion, entrepreneurs should endeavor to comply with all applicable securities laws in the capital raising process at the onset. If an early-stage company and its principals intend to raise money from investors, even a small amount on initial rounds, it is in their interest to expend the time, financial resources, and effort to ensure that the capital raise is conducted in a manner that is compliant with the securities laws.

Chapter 2

When is a Promissory Note a Security?

A. Introduction

B. When is a Promissory Note a Security and When is it Not?

i. Duration of the Note

ii. Judicially Crafted Exceptions

iii. Family Resemblance Test

a. Motivation of the Parties

b. Plan of Distribution

c. Reasonable Expectation of the Public

d. Other Regulatory Schemes

C. Why Should an Early-Stage Business Care?

A. Introduction

It is no secret that the vast majority of early-stage businesses rely on outside capital for growth. Promissory notes are not only typically used when borrowing money from commercial lenders, but they are also a common financial instrument to memorialize loans from family and friends, which is a frequent method of financing for many early-stage businesses. While Chapter 1 discusses the definition of a security generally, this chapter explains the nuances related to promissory notes as this is a common security issued by an early-stage business.

At its core, a promissory note is simply a financial instrument issued by one party (the issuer) that contains a written promise to pay another party (the lender) a fixed amount of money by a certain date or upon the occurrence of a certain event.³⁴ It is vital for such businesses to know whether the note qualifies as a security—and thus requires compliance with securities laws.

Although promissory notes are technically securities under the 1933 Act and 1934 Act, they might not be considered securities if they qualify for certain exceptions or are exempted from registration if their issuance abides by certain criteria. As this chapter outlines, the inquiry as to whether a note qualifies as a security requires some analysis.

B. When is a Promissory Note a Security and When is it Not?

As noted in Chapter 1, both Section 2(a)(1) of the 1933 Act³⁵ and Section 3(a)(10) of the 1934 Act³⁶ classify notes as securities. However, this classification is subject to a number of statutory and judicially created exceptions.

i. Duration of the Note

Generally, a promissory note on which payment is due in full within nine months or less, exclusive of days of grace, is presumed to not qualify as a security under either the 1933 Act or the 1934 Act and is instead typically known as commercial paper.³⁷ More specifically, the 1934 Act excludes such a note from the definition of a security, and the 1933 Act exempts such notes from registration.³⁸ While both an exempted security and a note that is excluded from the definition of a security are not subject to the registration and disclosure requirements of the 1933 Act or the 1934 Act, an exempted note under the 1993 Act is still subject to the 1933 Act’s fraud provisions. In contrast, a note that is excluded from the definition of a security under the 1934 Act is not subject to the fraud provisions of the 1934 Act.³⁹ If, alternatively, the duration of the promissory note exceeds nine months, courts presume that the note is a security.⁴⁰ While this distinction has been challenged, it stems from the U.S Congress’ belief that short-term notes were safe, both because they were virtually riskless and because they were generally unavailable to the average, unsophisticated investor; registration of commercial paper would be harmful to business; and the Federal Reserve Board could adequately regulate such short-term credit instruments.⁴¹

ii. Judicially Crafted Exceptions

Even if a note has a duration of greater than nine months, the presumption that the note is a security may be rebutted using the framework laid out by the Supreme Court in Reves v. Ernst & Young.⁴² Notably, if a note is found not to be a security under the Reves approach, it is not subject to either the 1933 Act or the 1934 Act.⁴³

In Reves, an agricultural cooperative sold promissory notes to support its general business operations.⁴⁴ After the cooperative went bankrupt, the holders of the notes sued the firm that audited the cooperative’s financial statements, claiming that it failed to follow generally accepted accounting principles in violation of the 1934 Act, as well as state securities laws.⁴⁵ To determine whether the 1934 Act applied, the Supreme Court analyzed whether the note met the definition of a security.⁴⁶ While the Supreme Court acknowledged that when defining the scope of the market that it wished to regulate, the U.S. Congress painted with a broad brush,⁴⁷ it also explained that in enacting the 1934 Act, the U.S. Congress did not intend to provide a broad federal remedy for all fraud.⁴⁸ Rather, it explained that Congress’s purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.⁴⁹

To eliminate much ambiguity, the Supreme Court recognized seven judicially crafted exemptions that exempt a promissory note from being deemed to be a security:

1. A note delivered in consumer financing.

2. A note secured by a mortgage on a home.

3. A note secured by a lien on