The capital markets and capital formation activities in the United States are regulated by both the federal and state governments. The federal regulatory framework governing securities was largely enacted in the 1930s in the aftermath of the Great Depression. Although federal securities laws have undergone many revisions since then in response to market developments, the structure of federal securities regulation remains largely the same nearly 100 years later.
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) are the principal federal regulatory agencies that oversee various aspects of the U.S. capital markets, periodically issue new regulations, and enforce federal securities laws across the country. The Department of Financial Protection and Innovation regulates the sale of securities in California.
If your company is planning to access the capital markets to raise money, it needs to understand federal and state securities laws and how to comply with them. To that end, make sure you have a good securities lawyer on your team before raising money. One of the first questions you should ask before soliciting investors to sell securities is whether the offering must be registered with the SEC, qualified with the State of California or qualifies for an exemption under both federal and state law. Whether you are seeking to raise capital from angel investors, venture capitalists, private equity firms, the public markets or even friends and family, federal and state securities laws apply to all of these transactions long before any investment offer is made, an agreement is signed, funds are transferred, or securities are issued.
What Does the Securities Act Regulate?
The Securities Act of 1933 regulates the offer and sale of securities in the United States. The Act’s primary purpose is to protect investors by requiring a company to provide complete and accurate information to prospective investors before offering it securities for sale. It is based on the premise that investors should receive meaningful disclosure of both financial and non-financial information about the company offering the securities so they can make informed investment decisions about whether to buy those securities.
A “security” is much broader and complex than a share of common stock traded on a public exchange like the NYSE or NASDAQ. It can include privately offered common stock, preferred stock, LLC memberships, convertible promissory notes, SAFEs, stock and options issued in equity incentive plans, and many other investment instruments, either issued and exchanged on the public markets or sold in private transactions. Your company need not be publicly traded for the Securities Act to apply to transactions involving the offer and sale of your company’s securities. If your company is selling common or preferred stock or another investment instruments in exchange for capital, you must comply with federal securities laws.
Registration Is the Default Rule
The Securities Act starts with a straightforward rule: Securities offerings must be registered with the SEC unless an exemption applies. Section 5 of the Securities Act requires an issuer to register any offer or sale of its securities unless an exemption applies. A registration statement required by Rule 404(a) of the Securities Act gives potential investors information they need to make an informed decision as to whether or not to purchase the offered security.
Section 7 and Section 10 of the Act generally specify the information required in a registration statement and prospectus, respectively. The statement must contain extensive disclosures about your company, including its business operations, financial condition, management team, market risk factors, and the securities being offered. These disclosures must be stated in detail in the registration statement and prospectus so as to allow prospective investors to evaluate the investment opportunity.
The SEC reviews these filings in detail to determine whether the required disclosures have been made. It is important to understand that SEC review is not an endorsement of the investment or a guarantee that your company is financially sound. Instead, the review process is intended to help ensure investors receive all of the information that must be disclosed to investors under the Act.
Subject to certain exceptions, a registration statement usually does not become effective until the SEC’s staff has reviewed it and taken action to make it effective. The period between the filing of a registration statement and its effectiveness is generally known as the “waiting period.”
For most privately held businesses preparing a full SEC registration statement is neither practical – because it’s expensive – nor necessary – because adequate exemptions from registration may exist. In fact, many companies that seek to raise relatively modest amounts of money from members of the public can rely on statutory or regulatory exemptions that allow them to raise capital without taking the time and money to prepare and approve a registration statement for a public offering.
Why Disclosures in a Registration Statement are So Important
The Securities Act is often described as a disclosure law rather than a merit-based law. The federal government generally does not decide whether your company is a good investment. Instead, it requires your company to provide investors with the material information they need to make that decision for themselves.
Material information includes facts that a reasonable investor would consider important when deciding whether to invest in your company. This includes detailed descriptions of your company’s management team, past financial performance, significant customer relationships, assets like intellectual property, liabilities like pending litigation, market competition, business risks, and how the investment proceeds raised by the offering will be used.
The emphasis on transparency benefits both investors and issuers. Investors receive a more complete understanding of the offering company and the investment opportunity it is offering, while a company that provides thoughtful and accurate disclosures is often better positioned to build credibility with and successfully solicit investments from sophisticated investors.
Common Mistakes Companies Make With Capital Raises
Many securities law issues arise because companies move quickly to secure funding without fully considering the legal framework governing the transaction. While every fundraising effort is different, several mistakes appear repeatedly:
- Assuming private companies are exempt from securities laws.
- Soliciting investors before consulting legal counsel.
- Making overly optimistic statements about future performance.
- Providing inconsistent information to different investors.
- Failing to maintain appropriate documentation during the offering.
Failing to address these issues can significantly increase regulatory risk and undermine your company’s relationship with investors. For instance, sections 11 and 12 of the Act impose liability on companies that offer securities in violation of disclosure or other requirements in the Act.
Section 11 provides purchasers of securities with a private right of action for damages against many persons – including the issuer, its officers and directors, underwriters, and experts – if any part of the issuer’s registration statement contains an “untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading.”
Section 12(a)(2), which covers the prospectus and oral communications, imposes on any seller of securities potential liability for material misstatements or omissions made by that seller in any prospectus or oral communication in the offer or sale of the issuer’s securities, regardless of whether those securities are exempt from registration.
Exemptions from Registration Also Allow Companies to Effectively Raise Capital
Although registration is the general rule, many successful private companies lawfully raise capital through exemptions from registration. Section 3 of the Securities Act exempts certain types of securities from the registration requirements under Section 5. These include U.S. government bonds, municipal obligations, and bank securities as just a few examples. Section 4 of the Securities Act exempts certain types of transactions from the Section 5 requirements. These include transactions involving any person other than an issuer, dealer or underwriter, issuer transactions not involving a public offering and Regulation D transactions involving accredited investors. We will discuss these exemptions from registration in more detail in future blogs.
An exemption from registration does not eliminate the obligation to provide accurate information or comply with the anti-fraud provisions of the federal securities laws. And exemptions from registration do not affect liability under Section 12 or 17 of the Securities Act or under Section 10(b) of the Exchange Act or Rule 10b-5 under the Exchange Act.
Selecting the appropriate exemption depends on several factors, including the type of investors involved, the amount of capital being raised, and how the offering is conducted. Careful planning before approaching investors is often one of the most effective ways to avoid unnecessary delays and compliance issues.
Your Attorney Can Help Your Company Raise Capital Strategically and Legally
Every company’s successful capital raise begins with more than finding interested investors. It begins with understanding the legal requirements that govern the transaction and structuring the offering accordingly. Whether your company is pursuing its first outside investment or preparing for a larger financing round, experienced legal guidance can help identify potential issues before they become obstacles.
About Finkel Law Group
Finkel Law Group P.C., with offices in San Francisco, Oakland, and Washington D.C., has 30 years of experience helping privately held companies structure transactions to reliably and legally raise capital in private and public markets across California and the United States. When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist your company raise capital in compliance with federal and state securities laws, please contact us at (415) 252-9600, (510) 344-6601, (202) 771-2008, or info@finkellawgroup.com to speak with one of our attorneys about your matter.
