@198 CHAP 11 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � SECURITIES LAW CONSIDERATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� @Q "To the child and the stockbroker, all @Q things are possible." -- Eric Hoffer Yet another factor to take into account in choosing the le- gal form of a business is the potential application of fed- eral and state securities laws if the new business is to have more than one owner or should it become necessary to raise capital for an existing business. Because of the po- tentially dire consequences of violating federal or state securities laws, it is important to consult with a business attorney as early as possible when considering issuing or transferring a security. Note that corporate stock and lim- ited partnership interests are generally considered securi- ties, and even a general partnership interest can be a se- curity in appropriate circumstances, as can certain kinds of debt instruments. @IF901xx]Since your business is not yet in existence, you may need to @IF901xx]comply with state or federal securities laws if you need to @IF901xx]sell ownership interests in @NAME. @IF901xx] @IF125xx](NOTE: So long as you are the sole owner of the business, @IF125xx]you are unlikely to have to be concerned with securities @IF125xx]law problems. SEC and state "blue sky" laws will only be- @IF125xx]come a consideration if or when you should decide to take @IF125xx]in other investors who buy an interest in your business, @IF125xx]generally speaking.) @IF125xx] Since the Securities Act of 1933, federal law has required registration as a prior condition to the issuance or trans- fer of securities. The law exempts various types of securi- ties and certain types of transactions. The most important of these exemptions for small or new businesses have been the exemptions for securities sold to persons residing within a single state and transactions by an issuer not deemed to involve any public offering. The Securities and Exchange Commission (the SEC) from time to time has issued regulations exempting small securities issues, attempting to balance the needs of small businesses to raise capital against the public policy of protecting investors. In 1982, the SEC adopted Regulation D as its primary method of regulation of securities offerings by small businesses (although not to the exclusion of other exemptions which might apply in a given case). These regulations were re- vised in April 1988 and again in April 1989. RULE 504: -------- Rule 504 under Regulation D exempts the issuance of securi- ties by an entity if the aggregate offering price of all exempt securities sold by the entity during a 12-month per- iod does not exceed $1,000,000. (Limited to $500,000 if the securities are not registered under any state securi- ties law.) The securities cannot be offered or sold by any form of general solicitation or general advertising, and the securities so acquired cannot be resold (generally) without registration or an exemption from registration. This rule does not require any specific information to be given to the purchasers of the securities. However, since the anti-fraud provisions of the securities laws apply even though the transaction is exempt from registration, it is helpful to memorialize in writing the material information regarding the offering. RULE 505: -------- Rule 505 exempts offers and sales of securities if the of- fering price for all exempt securities sold over a 12-month period does not exceed $5,000,000. To obtain this exemp- tion, the issuer must reasonably believe that there are not more than 35 purchasers, other than "accredited investors." Examples of "accredited investors" include banks, insurance companies, a natural person whose net worth (or joint net worth, counting spouse) at the time of purchase is in ex- cess of $1,000,000 or who has individual income in excess of $200,000 (or joint income, with a spouse, in excess of $300,000) in each of the two most recent years and expects the same in the current year, or corporations, partnerships or business trusts having total assets in excess of $5 mil- lion (unless formed for the specific purpose of acquiring the securities). For purposes of Rule 505, the issuer must furnish extensive information and certified financial statements to the in- vestors, unless securities are sold only to accredited in- vestors. The prohibition against advertising and solicita- tion applies to this rule, as do the anti-fraud provisions of the securities laws. RULE 506: -------- Rule 506 is similar to the exemptions provided by Rule 505, except that the five million dollar limitation does not ap- ply. The 35 purchaser limitation does apply (with the ex- ception for accredited investors), but a separate limita- tion requires that the issuer must reasonably believe im- mediately prior to making any sale to a non-accredited investor that such investor, either alone or with a repre- sentative, has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment. The pro- hibitions against advertising and solicitation also apply under this rule, as do anti-fraud provisions of the secur- ities laws. FILING OF NOTICE UNDER REG. D: ------------------------------ An issuer that relies upon any of the above Regulation D exemptions must file Form D with the SEC, generally not la- ter than 15 days after the first sale of securities and at other specified times thereafter. (However, failure to file Form D will no longer disqualify an issuance of se- curities, in general, that otherwise meets the Rule 504, Rule 505 or Rule 506 requirements, unless the issuer has been enjoined by a court for violating the filing obliga- tion. -- Rule 507, as interpreted in SEC's Securities Act Release No. 6825, March 14, 1989.) STATE "BLUE SKY" LAWS: ---------------------- Keep in mind that the exemptions available under the feder- al securities laws are more liberal than those available under the securities laws of many states. In connection with any issuance or transfer of securities, it is neces- sary to consider the possible application of securities laws in the state where the business entity is established or operates, and, if different, the states where purchasers of the securities live. @CODE: CA @CODE:NF 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 � COMPLIANCE WITH CALIFORNIA SECURITIES LAWS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸 When your newly-formed corporation issues shares of its stock to you and to any other shareholders, you must be ve- ry careful to comply with BOTH federal and California secur- ities laws. Otherwise, you will be an inviting target for lawsuits from disgruntled investors in your corporation and could also be subject to criminal prosecution. In the case of the typical small corporation startup, you will probably be able to qualify for exemptions from the burdensome and costly procedures of registering with the SEC under federal securities laws (under one of the exemp- tions described above) or "qualifying" with the California Dept. of Corporations under California securities laws. In general, when a corporation issues stock in California, the issuance must be approved (qualified) by the Corpora- tions Commissioner, unless the stock issuance meets one of the exemptions provided under the California securities laws. However, most new corporations issuing their origin- al shares of stock can qualify under at least one of the two main exemptions for small corporations noted below. LIMITED OFFERING EXEMPTION--Section 25102(f) of the Cali- fornia Corporations Code. This is the exemption that most new corporations issuing stock in California will want to come under. To be able to meet the requirements of this exemption, a stock issuance must comply with all of the following restrictions: . Stock must not be issued to more than 35 "counted" shareholders. . Certain shareholders don't have to be counted, such as officers or directors of the corporation, certain relatives of uncounted persons (living at the same address), promoters of the corporation, and certain wealthy or sophisticated individuals. . Each shareholder must come within one of three "suitability" categories. They must be either one of the following: . Uncounted shareholders; . Persons who have certain types of pre-existing personal or business relationships to direc- tors or officers of the corporation (or to "controlling persons" -- such as a promoter or founder); or . Certain "sophisticated investors" with busi- ness or financial experience (or who are repre- sented by professional advisers), who have a net worth of over $500,000 and who are able to bear the economic risks of the transaction. . No advertising of the stock offering is allowed, by radio, mail, TV, seminars, etc. . Each shareholder who buys shares must sign a "repre- sentation letter" stating that he or she is buying the stock for his or her own account, and not for resale or distribution. . Stock can only be issued for cash, real estate, or tangible or intangible personal property. It may not be issued for a promise to render future ser- vices or (in general) in exchange for a promissory note from the purchaser. . A Notice of Transaction form must be filed with the California Department of Corporations within 15 days after the first sale of stock occurs, together with a filing fee of $25 to $300 (which varies based on the value of the securities sold). SMALL OFFERING EXEMPTION--Sec. 25102(h) of the California Corporations Code. While less frequently used, this exemp- tion may be available in some situations where the "limited offering exemption" is not, such as where you have a purch- aser who cannot meet the 25102(f) "suitability" standards. Note that in order to use the small offering exemption, an attorney must sign a statement that the stock issuance qualifies under the Sec. 25102(h) exemption and file it with the Dept. of Corporations. Thus, under this exemption you cannot self-incorporate without paying at least some legal fees to an attorney. There are numerous technical requirements that your attorney must determine that the issuance meets in order to qualify under this exemption. Finally, any issuance of securities under California law, whether under one of the above exemptions or not, is sub- ject to Section 25401 of the California Corporations Code. This section makes it unlawful to offer or sell a security in the state by means of any written or oral communication which includes an untrue statement of a material fact or fails to state a material fact that is necessary to make sure that the statements made are not misleading. In short, be completely honest and do not withhold any un- favorable information from any prospective investor in your company's stock or you may be in BIG trouble from a securities law standpoint.