What do a promissory note, an investment contract and a stock have in common?
Each is considered a security, which means they’re regulated by special securities laws.
The Utah Uniform Securities Act’s definition of a security “is a laundry list of about 20 different things,” running the gamut from bonds to interest in a limited liability company, says Wayne Klein, director of the Utah Department of Commerce’s Division of Securities. “The key is that a lot more things are securities than you think about in the beginning.”
In fact, a common reason for businesses to come under scrutiny by the division’s investigators is because the owners improperly raise money from outside investors, Klein says.
Business owners often think that receiving investment money from family and friends isn’t regulated by securities laws, Klein says, “and they’re wrong. Unfortunately, people only find out after the fact that they raised money from too many people. Or they did public solicitation and therefore there is no exemption available for them. Sometimes people say, ‘Oh, I only have 12 investors,’ but it turns out they paid a commission to somebody. Or they advertised in the paper to try to get these investors, and they don’t qualify for that exemption.”
The securities act lists 39 exemptions, and business owners should be aware that their company type will determine how the law is applied, says Brad Bertoch, president of the Salt Lake City-based Wayne Brown Institute, a non-profit organization that helps emerging high-tech companies find access to capital.
“The securities law is the same, but it applies to a different extent to high-growth companies versus the butcher, baker and candlestick maker. But when in doubt, everything is a security unless you’re told otherwise. Once you start taking outside money from friends and family, you have to be cognizant of the fact that you’re offering a security. And it’s very important that things be done correctly.”
The consequences of improperly offering a security include being required to pay back the money at 12 percent interest, and the possibility of jail time, Klein says. “That’s why it’s so important that people make sure they do it the right way on the front end. And it’s easy enough to do.”
The division’s Website (www.securities.utah.gov
) contains a wealth of information for those wanting to ensure they’re in compliance with the law, and “We’re happy to walk people through it,” Klein adds. “We can help them understand what the different exemptions are and they can decide how they can tailor their offering so that it can meet their need with the easiest regulatory burden on them.”
Another complication in the law is that not only must the security be qualified for sale by the securities division, but in most cases, the person selling the security must be licensed.
“There are certain situations where the securities may qualify for an exemption and there also is an exemption for the salesman,” Klein says, “but you ought to start with the presumption that you have to be licensed, unless you can find an exemption for the seller.”
The division requires that sellers be licensed for several reasons, including that the person be knowledgeable “so that they know they cannot make misrepresentations; they have to give full disclosure and that the investment will be suitable,” Klein says. “Also, the license requires that they undergo a background check. It is astounding to me how many cases we investigate where one or more of the sellers have prior criminal convictions. During 2006, 44 percent of the enforcement cases brought by the division had one or more of the promoters who had a prior criminal conviction.”
Bertoch recommends that, before seeking outside investment, business owners contact an attorney with experience in securities law. “It’s just better to be smart rather than practice law on your own,” he says.
Utah has more than 30 seasoned securities attorneys, a number that compares favorably to intensely high-tech areas on the East and West coasts, Bertoch says.
For business owners who wish to engage an attorney regarding securities matters, the lawyer’s experience in the area should be a key consideration, says John Weston, a partner with the regional law firm Snell & Wilmer.
Business owners who are just starting out should ensure that the company has been formed correctly, Weston says. “In starting a new business, there is always a need to control legal and professional service fees. However, correcting securities problems is far more expensive than doing it correctly at the beginning stages.”
Klein agrees. “If you’re going to raise any money from investors, either come talk to us, or engage a competent securities counsel to help you do it the right way, because the consequences of doing it the wrong way are so severe.”
An existing company should ensure that it has complied with applicable securities laws, and can do so by reviewing its capitalization, subscription and disclosure documents and filings, Weston says. “Prior securities problems can create significant stumbling blocks when companies are considering an exit strategy or raising additional capital.”
If a company finds it is not in compliance with the securities laws, Weston recommends that the owners proactively correct the problem because of possible penalties. “This is a complex legal area. Anyone in this situation should consult with its legal counsel to evaluate if a rescission is necessary,” he says.
The worst thing a business owner can do in this situation, Klein says, “is ignore it and hope nobody finds out. The problem is that with investments, it almost never turns out that nobody will find out. The stock may go down, or you have an unhappy investor or an unhappy employee or an unhappy ex-spouse who is going to rat you out.”
If the securities division receives a tip that a business isn’t in compliance, it will send a letter to the company asking for information. If the business owner doesn’t cooperate, the division has other options.
“We have subpoena authority and investigators who are trained to get that information,” Klein says. “We’ll subpoena bank records and we’ll find out what happened. The best option is to come to us either directly or through an attorney and lay everything on the table and say, ‘We screwed up. How do we fix it?’ We can then work with them to find a resolution that’s going to get them back into compliance while protecting the investors.”
Often, the division sends letters to the investors, giving them the option of receiving their money back or offering the proper disclosure documents, Klein says. “We give the best deals to people who come in and lay everything on the table… Any time there is money, there are crooks coming in willing to try and steal it. Every dollar that is lost to fraud is a dollar that can and should be invested helping a company trying to grow, employing new people.”