COVID-19 Update: The Indiana Stay-at-Home Order of March 18 designates law firms as essential businesses, and we are still open and actively working. We have numerous resources to allow us to meet with you, sign documents electronically, and hold hearings all remotely. We look forward to working with you during these unprecedented times. In an effort to reduce the financial burden on clients, we are currently running 30% off our estate plans.


What are Securities?

A security is an investment, or more precisely, an investment that meets certain criteria. The definition was established by the United States Supreme Court in 1946 in Securities Exchange Commission v. Howey and modified by subsequent court decisions. The Howey Test says that a security is:

  1. An investment of money or other value;
  2. In a common enterprise;
  3. With the expectation of receiving profits;
  4. That result primarily from the efforts of others.

Securities are regulated at both the federal and state level. Although the Howey decision is directly relevant to federal securities statutes (e.g., the Securities Act of 1933, or the ’33 Act, and the Securities Exchange Act of 1934, or the ’34 Act.), most state securities laws, including those of Indiana, also follow the Howey Test.

Types and Examples of Securities

Securities can be divided into three types: equity investments, debt, and derivatives. Although it is usually not necessary to decide which category a security falls in, the categories are helpful aids in understanding how securities work and how they are regulated.

Equity investments represent ownership. Generally, equity investors have both economic rights and some degree of voting rights, such as the right to vote in elections of directors or veto power over some types of business decisions. If the business dissolves, equity investors generally do not receive any distributions until all the business’s debts have been paid. Common examples of equity securities include corporate stock, membership interest in limited liability companies (or LLCs), and partnership interest in limited partnerships (LPs).

In simple terms, a debt security represents a loan from the investor to the business. The person who holds a debt security has economic rights but usually no voting or management rights. If the business dissolves, the holders of debt securities generally get paid before the holders of equity securities get their money back. Common examples of debt securities are corporate bonds and promissory notes. Even though loans from banks may well satisfy they Howey Test, they are they are usually excluded from regulation by statute.

Derivative securities do not represent ownership in a business or a loan to a business. Derivative securities are contracts that derive their value from other securities. Stock options are probably the most familiar derivative securities. A stock option is a contract between the person who issues or “writes” the option and the person who buys it. The person who writes the option makes a promise to the person who buys the option to either buy or sell a certain number of shares of stock in a company at a specified price. The person who buys the option can exercise it at any time before it expires. The person who buys the option can sell it to another person before it is exercised, and its value depends on the underlying stock price. An option to buy stock at $50 a share is worth more when the stock is selling at $60 than when the stock is selling at $52. In other words, the option’s value depends upon, or is derived from, the value of another underlying security. Thus, the name “derivative.”

How are Securities Regulated?

The primary means of regulating securities is registration, which entails the submission of a registration statement to the Securities Exchange Commission or, in some cases, to the appropriate state agency. In Indiana, that official is the Securities Division of the Office of the Indiana Secretary of State. The security may not be sold until the registration is approved. Registering a security is a relatively large and expensive undertaking.

Fortunately for small and medium-sized businesses, there are several exemptions from the requirement to register securities, discussed more below. Some exemptions apply to the securities themselves; some exemptions apply to securities transactions. If you or your business is going to issue or sell a security, it must be registered or subject to an applicable exemption. Or, as one securities lawyer we know puts it, “There are three types of securities: registered, exempt, and illegal.”

The second way that securities are regulated is through laws at both the federal and state levels prohibiting securities fraud. Loosely put, a person commits securities fraud by making false or misleading statements, or in some cases by failing to disclose certain information even if no false statements are made, in connection with the transfer or offer to transfer a security. Securities fraud is a serious matter, with the possibility of civil lawsuits and criminal charges. Unlike registration requirements, there are no exemptions from the securities fraud laws.

How Does this Affect Business Owners, and How Can Hand Ponist Help?

You should consider the potential applicability of securities laws anytime your business accepts any sort of investment from anyone, including its original owners. Common situations with securities implications include:

  • Forming a new LLC, corporation, or partnership.
  • Adding new members to an LLC or issuing new interest to existing members.
  • Adding new shareholders to a corporation or issuing new stock to existing shareholders.
  • Borrowing money from anyone other than a bank or similar lending institution.

If you are doing anything that may possible have securities implications, we at Hand Ponist can help you answer two all important questions.

The first question is whether you or our business is issuing, selling, or transferring a security. Some investments, for one reason or another, simply are not within the definition of a “security.”

What if that’s not the answer to the first question? What if securities involved? In that case, we can help you answer the second question: Is there an exemption that will avoid the need to register the securities, either with the SEC or with one or more states?

Examples of Securities Exemptions

You might wonder if every person who starts a new business is aware of the potential applicability of securities laws? The answer is no. Many people starting new businesses are completely oblivious to securities law. Does that mean they’re doing something illegal? No, not at all, because there are some common exemptions that automatically apply to many small businesses. In other words, they’re just lucky. On the other hand, some are not so lucky. Businesses and business owners can be in gross violation of securities laws without knowing it, at least not until they are sued or something else goes wrong. Unfortunately, in many of those cases an exemption was available, but the businesses and their owners did not do everything necessary to avail themselves of the exemption.

The law of securities exemptions is filled with jargon: Reg. D; Form D; Rule 506(b), Rule 506(c), Rule 141, Rule 141A, private placement memo (or PPM), prospectus, Form 1-A, etc. We can help you sort through the possibilities and determine if there’s an available exemption that you can take advantage of.

Private Placement Memoranda

Complying with the conditions for some exemptions can be almost as complicated as complying with the registration requirements themselves. Indeed, some of the exemptions require disclosures to investors that include essentially the same information that would be included in a registration statement. Those disclosures are often called Private Placement Memos or PPMs. We strongly discourage anyone from attempting to write a PPM without legal advice, whether it is from us or other lawyers. Even so, the exemptions are still beneficial because there is no requirement to submit a Private Placement Memo to the SEC or to wait for approval.

If you are considering any of the steps mentioned earlier that involve investments from other people, even if it seems straightforward to you, we invite you to contact our business and securities lawyers to help you comply with all the relevant securities requirements and avoid the traps for the unwary.