Complying with Securities Regulations – Federal and State

There are many regulations we may not agree with or like.   That doesn’t negate the fact, however, that as individuals and as businesses complying with such regulations is a responsibility and obligation.  Perhaps you’ve heard that paying taxes is optional.  It’s true – but only if you look good in orange or stripes, because not paying taxes is also illegal.

Another frequently overlooked or misunderstood set of regulations are those applicable to the process for raising capital.  Whether offering debt or equity securities, before you begin the funding process it is important to understand the process, including the federal and state regulations which apply.  Before you pursue the first dollar beyond the founders’ investments, do some homework and talk to reputable, qualified, securities and/or corporate attorneys who can give you an overview of the regulations and statutes that apply to your situation – not every attorney is equally qualified.  You can also visit the websites of the Secretary of State for your particular state and the U.S. Securities and Exchange Commission (SEC) for information.

If you EVER hear from someone “Yes there are regulations (or statutes) but no one ever complies (follows, etc.) them,” keep in mind as your mother used to say “If all of your friends jumped off a cliff would you?”  Just because “everyone else” supposedly is failing to comply doesn’t mean it is legal.

Extract from NC Secretary of State Securities FAQ

While the specific language and requirements may vary state to state, each state has some requirements for raising capital within its borders.  Federal regulations may or may not apply, but a particular state where you are undertaking your financing activities will undoubtedly require something from you.  Let’s look at North Carolina as an example.  The citation below is an extract from the NC Secretary of State’s website http://www.secretary.state.nc.us/sec Frequently Asked Questions document as of April 25, 2006.

“How does the Securities Act affect me? The provisions of the North Carolina Securities Act can be summarized into the following three principles:

(a) Securities Registration: Before a security may be lawfully offered for sale or sold, that security must be either (i) registered with the Securities Division, (ii) eligible for an exemption from the registration requirement, or (iii) a “covered security” (such as a mutual fund or NYSE-listed security) to which state registration requirements do not apply.

(b) Dealer/ Salesman Registration: Before any person (whether an individual or a company) engages in the business of effecting securities offers, purchases, or sales, that person must be registered with the Securities Division as a securities dealer or securities salesman, unless the person is excluded from the definitions of “dealer” and “salesman”.

(c) Antifraud Provisions: In the course of the offer, sale, or purchase of a security:

(i) it is illegal to make an untrue statement of a material fact, or omit to state a material fact if the omission would be misleading, and

(ii) it is illegal to engage in any act, practice, or scheme which would deceive or defraud any person.

There are statutory exemptions and exclusions from the registration requirements described above, but the legal burden of showing eligibility for an exception or exclusion is on the person claiming it.  There are no exceptions or exclusions from the antifraud provisions.

The Securities Act gives persons who suffer damage as a result of a violation of certain provisions of the Act the right to demand repayment from the violator.  This right is called a right of “rescission”, and the events giving rise to it and the conditions for the exercise of it are set forth at N.C. Gen. Stat. §78A-56.  The victim has a limited time within which to demand rescission, so prompt action is of the greatest importance.

Willful violations of certain provisions of the Securities Act can be prosecuted by the State as felonies.  Criminal penalties for violations of the Act are set forth at N.C. Gen. Stat. §78A-57.”

So What Do You Know Now?

This answer to a frequently asked question contains a great deal of information, but do you KNOW what it means for you and your financing efforts?  Do you know what you can and can’t say? Does it say anything about different types of investors?  Does it matter if the investor is a family member?  What happens if you are talking to investors outside of North Carolina?????

If Not Now, When – Due Diligence for Subsequent Investment Rounds

Another point to be made is that while a company may make a business decision that it is not “necessary” to comply with securities regulations during this investment round, what happens when you go for the next round?  What happens during due diligence (the process of verifying that the information disclosed is accurate and representative and/or that ALL relevant information was disclosed so that investors may make an informed decision) with a venture capitalist, institutional investor, or a public offering and you are found to have violated securities regulations in a prior round (a “round” refers to a particular financing effort)?

“Delaying compliance” or “ignoring” the securities regulations can put your business’ existence at risk according to Donna L. Pearson, a litigation attorney with Moore & VanAllen’s Research Triangle office.  Businesses usually fail to comply because: “businesses and their principals were either given bad advice about following securities laws when they started their businesses, or they chose to ignore the laws,” says Donna.

Bad Advice – Two Sources

Frequently founders get advice from other entrepreneurs.  The advice, while well intentioned, can lead to expensive lessons and consequences.  In Donna Pearson’s experience, other entrepreneurs give advice that stems from:  “(1) someone they knew who had started a business was not in compliance and they “weren’t having any problems from the regulators;” or (2) it was cheaper and easier” to ignore the rules.”

The “no one else is doing it advisors” usually come from one of two groups:

□        other business owners who themselves are not in compliance and are in denial that anything bad will happen as a result

□        lawyers who don’t have a truly knowledgeable and skilled securities lawyer in their firms and so they pretend it is not a problem so that the client will not go elsewhere for legal services

Ask a Qualified, Experienced and Reputable Attorney!

While chances are that your business may never get “caught”, it is an huge risk to take.  After all playing the lottery is a long shot too, but every day millions of people play on the chance of winning.  Businesses that violate securities regulations are playing the odds that they won’t “win”.

Donna Pearson says:  “It is also true that securities regulators sometimes bring an action first and investigate later when they become aware of an apparent securities law violation or a fraud involving securities.  This means that it is incredibly important that businesses avoid even the appearance that they are noncompliant.  The easiest way for business owners to protect the business they have worked so hard to build from having a case brought against them for violation of the securities laws is to comply.  Compliance is relatively easy to prove – noncompliance is very difficult to defend.  Even partial compliance will not save most businesses.  The cost of mounting a defense against alleged securities law violations is exponentially higher than compliance if it is done correctly from the beginning.  Most businesses will not survive defending a serious securities violation case. I have had clients over the years who argued with me about the expense and about their perception of the necessity of securities law compliance.  My response is very simple – If they refuse to comply I will not represent them.”

What Does It Take to Comply?

Understanding what you are looking for in an attorney is critical to getting the right advice.  Mark H. Mirkin, an experienced securities attorney also with Moore & VanAllen’s Research Triangle office, who regularly counsels client companies conducting securities offerings through the maze of federal and state regulations, provides these insights:  “Although there are “self-executing” exemptions from securities registration – which means exemptions for which no exemption application needs to be filed with the state or federal government – they are narrowly drawn and therefore not available to all companies or for all investors.”  He also advises that “reviewing the law for an exemption is a quick and inexpensive means to avoid the possibility of serious non-compliance ramifications following an offering.”

In a presentation that Mark Mirkin made on Formation and Financing Early Stage Businesses (presented jointly by Moore & VanAllen and FOCUS Resources), he addressed how businesses need to lay the foundation for raising capital and getting the “housekeeping” tasks done early in the process.  Unfortunately, every business doesn’t think about how they are going to fund the business later.  Issues like the legal entity type, who is going to be investing in the business, how much money needs to be raised, and other questions aren’t asked or taken into consideration when the business is first established.  The founders may be “saving money” and doing the formation paperwork themselves or they may be working with an attorney that isn’t experienced in businesses that need to issue securities.

What To Do?

If you have already engaged in financing your business beyond the formation of the initial business without being aware of the securities regulations or if you are currently engaged in raising funds, then it is definitely time to determine where your business stands with regard to compliance.  If you are about to seek first time or additional rounds of capital, you too should be investigating the securities process in your state and at the federal level.  Don’t wait until a compliance issue arises or due diligence for a deal is underway to determine if you have issues.

Copyright ©2006 FOCUS Resource, Inc.

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