If you are contemplating seeking money from investors for your business (corporation, limited liability company, partnership, sole proprietorship or any other type of business), you must determine if federal and state securities laws affect the offer and sale of the investment . If so, you must comply with applicable federal and state securities laws before making an offer or selling the investment. Some people mistakenly believe that they are not offering or selling a security when they seek investor funds from people or entities in exchange for a membership interest in an limited liability company. LLC membership interests can be securities that are regulated under the securities law.
Many people are unaware of federal and state securities laws and how the laws affect businesses that seek money from investors. Securities laws are intended to protect investors from unscrupulous money seekers and impose stiff penalties on businesses and people involved in the offer and sale of unregistered securities. If your business will offer and/or sell a security, it must comply with applicable federal and state securities laws.
The primary reason people violate securities laws is ignorance of the law. The next most common reason is a misunderstanding of what constitutes a security. Most people recognize that corporate stock is a security, but they do not realize that the securities laws will find that a security is involved almost everything a promoter says to a passive investor, “Give me your money. I’ll invest it in my business. You’ll make a profit while relaxing on your couch.” In one of the most famous securities law cases, the United States Supreme Court found that the sale or real property in Florida was a sale of a security subject to federal and state securities laws.
Securities & Exchange Commission v. W. J. Howey Co.
The following is from the text of the Supreme Court’s opinion:
The respondents, W. J. Howey Company and Howey-in-the-Hills Service Inc., are Florida corporations under direct common control and management. The Howey Company owns large tracts of citrus acreage in Lake County, Florida. Duringt he past several years it has planted about 500 acres annually, keeping half of the groves itself and offering the other half to the public ‘to help us finance additional development.’ Howey-in-the-Hills Service, Inc., is a service company engaged in cultivating and developing many of these groves, including the harvesting and marketing of the crops.
Each prospective customer is offered both a land sales contract and a service contract, after having been told that it is not feasible to invest in a grove unless service arrangements are made. While the purchaser is free to make arrangements with other service companies, the superiority of Howey-in-the-Hills Service, Inc., is stressed. Indeed, 85% of the acreage sold during the 3-year period ending May 31, 1943, was covered by service contracts with Howey-in-the-Hills Service, Inc.
The land sales contract with the Howey Company provides for a uniform purchase price per acre or fraction thereof, varying in amount only in accordance with the number of years the particular plot has been planted with citrus trees. Upon full payment of the purchase price the land is conveyed to the purchaser by warranty deed. Purchases are usually made in narrow strips of land arranged so that an acre consists of a row of 48 trees. During the period between February 1, 1941, and May 31, 1943, 31 of the 42 persons making purchases bought less than 5 acres each. The average holding of these 31 persons was 1.33 acres and sales of as little as 0.65, 0.7 and 0.73 of an acre were made. These tracts are not separately fenced and the sole indication of several ownership is found in small land marks intelligible only through a plat book record.
The service contract, generally of a 10-year duration without option of cancellation, gives Howey-in-the-Hills Service, Inc., a leasehold interest and ‘full and complete’ possession of the acreage. For a specified fee plus the cost of labor and materials, the company is given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. The company is well established in the citrus business and maintains a large force of skilled personnel and a great deal of equipment, including 75 tractors, sprayer wagons, fertilizer trucks and the like. Without the consent of the company, the land owner or purchaser has no right of entry to market the crop;2 thus there is ordinarily no right to specific fruit. The company is accountable only for an allocation of the net profits based upon a check made at the time of picking. All the produce is pooled by the respondent companies, which do business under their own names.
The purchasers for the most part are non-residents of Florida. They are predominantly business and professional people who lack the knowledge, skill and equipment necessary for the care and cultivation of citrus trees. They are attracted by the expectation of substantial profits. It was represented, for example, that profits during the 1943—1944 season amounted to 20% and that even greater profits might be expected during the 1944 1945 season, although only a 10% annual return was to be expected over a 10-year period. Many of these purchasers are patrons of a resort hotel owned and operated by the Howey Company in a scenic section adjacent to the groves. The hotel’s advertising mentions the fine groves in the vicinity and the attention of the patrons is drawn to the groves as they are being escorted about the surrounding countryside. They are told that the groves are for sale; if they indicate an interest in the matter they are then given a sales talk.
Section 2(1) of the Act defines the term ’security’ to include the commonly known documents traded for speculation or investment.3 This definition also includes ’securities’ of a more variable character, designated by such descriptive terms as ‘certificate of interest or participation in any profit-sharing agreement,’ ‘investment contract’ and ‘in general, any interest or instrument commonly known as a ’security.” The legal issue in this case turns upon a determination of whether, under the circumstances, the land sales contract, the warranty deed and the service contract together constitute an ‘investment contract’ within the meaning of § 2(1).
. . .
In other words, an investment contract for purposes of the Securities Act means 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical as ets employed in the enterprise.
. . .
It 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. . . . The transactions in this case clearly involve investment contracts as so defined.
The Bottom Line: If you seek money from other people or entities and the investment is not a pure arms length loan on reasonable terms, you should consult with an experienced securities law attorney and follow his or her advice before offering or selling the investment.
For more about his important topic, see the article on Business Law Blog called “Federal Securities Laws Basics.”
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