ComplianceLegalFinanceDecember 09, 2020

Don't run afoul of securities laws

Every corporation issues securities and a growing body of law suggests that non-manager interests in an LLC are also considered to be securities. Even so, most small businesses do not need to be concerned with federal and state security laws. However, if you plan to raise capital through "public offerings" or via the internet, then you should have a basic understanding of securities laws so that you can work effectively with your professional advisors.

You must consider numerous legal issues before starting business operations if you want to effectively limit liability in your business structure. One issue worthy of some discussion is securities law because it can affect the issuance of interests in the limited liability company (LLC) and corporation. An awareness of securities issues is essential to prevent future claims against the business and to allow you to exploit capital markets as the business expands.

Federal and state securities rules are extremely complex.

The goal of this article is to provide some basic information on key topics so that you are aware of when you need to seek experienced, profession guidance from a business advisor or attorney.

At the very least you should have a familiarity with the following topics:

  • whether or not the entity is issuing "“securities”
  • whether the offering must be registered or may be exempt
  • whether you can/should take advantage of Regulation D, Rule 504/SCOR (small corporate offering registration) offering--a common route small businesses use to raise up to $1 million from the public
  • whether you would be better served by an alternative route termed a Regulation A/SCOR offering which can be used to raise $1 million from the public, with the added advantage of being able to "test the waters" before actually making the offering
  • whether you should get involved with Internet offerings of securities

In addition to the federal securities law, you must also pay attention to the securities law for the state in which your form the business. Unfortunately, each state's securities laws (termed "blue sky laws") are unique—even though they are modeled after the federal laws.

Some states may require that a simple notice of a sale be filed when sales are made to individuals who are not organizers of the business, even though all of the conditions for the exemption described above are met. If you are offering securities under this set of circumstances, it is wise to first check with the state agency that regulates securities offerings in the particular state involved.


From the perspective of limiting exposure to liability in your business structure, it is extremely important that the small business owner either properly register an offering of securities with the federal and state governments, or ascertain that an exemption applies. Failure to comply with federal and state securities laws can result in large civil fines and the likelihood of personal liability for losses suffered by investors.

If a small business owner has raised capital from investors and the business fails, there is a likelihood that the business owner will be sued. One of the first things a plaintiff's lawyer will examine is whether the business owner complied with federal and state securities laws. If there is a failure in this respect, the small business owner will likely lose. Conversely, if the owner has complied with these laws, the small business owner will likely win, even though the investors suffer a total loss.

Is your business entity issuing securities?

Whenever a corporation is formed, "securities" are issued. The term "security" includes covers common stock, which will always be issued by a corporation as evidence of ownership. However, preferred stock and bonds, usually issued by larger businesses, also constitute securities.

A limited partnership interest in a limited partnership (LP) may is a security. More importantly for the small business owner, a non-manager interest in an limited liability company (LLC) may be deemed a security. The key in both of these cases is that the investor puts up capital, expecting a return to be derived solely from the efforts of others (i.e., the manager-owner of the LLC or the general partner in the LP). For example, while Delaware law clearly provides that any interest in an LLC will not be deemed a security unless it is traded on a securities market, this kind of clear-cut rule is lacking in many other states.

A corporation may present a better alternative than the LLC for type of business entity if you intend to make a general and widespread public offering of securities, such as through an Internet offering. There are two reasons why the corporation may be superior:

  • Securities law was developed primarily to govern offerings by corporations. Thus, the law there is more settled.
  • Both potential investors, and federal and estate regulators, are more familiar with, and thus may be more receptive to, a sale of common stock in a corporation, as opposed to an interest in an LLC.

However, this recommendation would not apply in the case of a small offering made among a group of private investors. In addition, this issue will seldom be a factor for the small business owner.

Know SEC registration and exemption rules

Fortunately for the small business owner, most small, privately held corporations are exempt from the need to register with the SEC.

An issuance of securities to yourself, your immediate family members and a few other investors will usually be totally exempt form both federal and state securities laws. In this case, the exemption generally is “self-executing”—that is, the exemption is automatic. In fact, a self-executing exemption does not require the filing of any documentation with the federal or state governments.

Generally, an automatic or self-executing exemption will apply when the offering of securities has all of these attributes:

  • limited to 10 or fewer individuals who are all organizers of the business or who, alternatively, invested through direct in-person solicitation
  • did not involve any use of the mails, telephones or the Internet in solicitations
  • limited to one state

If you are required to register with the SEC, there are two common ways to do this:

  • Regulation D Rule 504 combined with a SCOR filing
  • Regulation A combined with a SCOR filing

Methods for registering securities

A federal Regulation D, Rule 504 (Rule 504) exemption coupled with a uniform state small corporate offering registration (SCOR) filing is the most common route taken for small businesses that are interested in raising capital from the public by issuing securities.

Both the federal exemption and the state filing limit the amount raised to $1 million in a one-year period. To prevent abuse, a second offering cannot be made for six months after the first 12 months expire. Effectively, the small business owner could rely on this combination to raise $1 million every 18 months.

The Rule 504 exemption contains no onerous restrictions (other than the $1 million limitation). The issuer is free to advertise the securities and to solicit potential investors. In addition, there are no restrictions on the number or type of investors. Nor are there any resale restrictions on the securities.

The SEC requires that Form D be filed after the first sale, notifying the SEC that the issuer has used the exemption. However, it is wise to file this form prior to offering the securities for sale, in case the SEC has any questions related to registration and exemption, and refrain from any advertisements, offers or sales until the SEC approves the form.

The intent of Rule 504 has always been that the issuer registers the securities in each state in which they are offered for sale and comply with the strict registration requirements imposed by the states. This is why under Rule 504, the issuer faces no real federal restrictions related to the sale—the states are supposed to be the watchdogs.

The current rules effectively limit the use of Rule 504 to those offerings made only in states where registration is required or is exempt only with severe restrictions, such as bans on general advertising of the securities, limits on the numbers and types of investors, etc. The result is that, today, an issuer who wants to raise capital from the public through a general solicitation, and rely on Rule 504, will have to register the securities in the states through a SCOR filing.

States vary in scrutiny of SCOR filings

The state SCOR filing is an actual registration, rather than an exemption. Unlike other aspects of state securities laws, the SCOR form is uniform, meaning that one form can be completed and submitted to each state that accepts the form.

States not accepting SCOR filings.

While nearly all states accept the SCOR filing, the following states do not accept it, at this time:

  • Alabama
  • Delaware
  • Florida
  • Hawaii
  • Kentucky
  • New York

Non-merit review states.

The following states do not conduct a merit review of a SCOR filing:

  • Connecticut
  • Georgia
  • Illinois
  • Maryland
  • New Jersey
  • New York
  • Vermont
  • Washington

In non-merit-review states, the offering will automatically be approved, provided all of the information on the forms is complete and accurate. Note that "non-merit review" is also the policy embodied in federal securities law.

Merit-review states.

Although the form used for a SCOR registration is uniform, the registration request is not treated identically when it reaches the individual states. Most states are "merit-review" states. They review the offering to determine whether it is "fair" to investors. In the merit-review states, if the regulators believe the offering is not fair to investors, they will not approve it. However, even within the merit-review states, there is a wide range of scrutiny accorded the SCOR form.

The following merit-review states have a reputation as being progressive toward SCOR filings:

  • Arizona
  • South Carolina
  • Iowa
  • Washington

The following merit-review states have a reputation as being hostile toward SCOR filings:

  • California
  • Massachusetts
  • Texas

The small business owner making a public offering of securities may want to consider offering the securities only in the non-merit-review states and the merit-review states with a progressive stance toward SCOR offerings.

Using Regulation A and SCOR to register securities

Regulation A allows small business owners to use a simplified form to gain an SEC exemption when issuing securities. While Regulation A is technically an exemption, it is best thought of as a simplified registration because a filing must be made with the SEC before any offers to sell securities can be made (unlike Regulation D, Rule 504).

Regulation A permits an issuer to raise up to $5 million in a 12-month period. However, because the state SCOR registration has a $1 million limit, Registration A effectively is limited to this same amount when it is combined with a SCOR registration in each state.

The most significant advantage of using Regulation A (rather than Regulation D, Rule 504) is that it allows issuers to test the waters for investor interest before undertaking the arduous and expensive process of preparing the required SEC documents for registration.

Because of the expense of preparing federal and state documentation, testing the waters may be essential, if the small business owner intends to make a public offering of securities.

Testing the waters is only available under Regulation A, which may make it a better alternative than Regulation D, Rule 504. The fact that an Internet site—using a coupon that can be e-mailed, or printed and mailed, to the issuer—can qualify under the rules also makes this option very attractive.

The Regulation A form, designated Form 1-A by the SEC, can be prepared in several versions, including a simplified question-and-answer version that uses the SCOR Form U7. This simplified format, which is a recent option, overcomes what previously had been the biggest impediment to using Regulation A rather than Regulation D, Rule 504—the added complexity and expense of preparing the standard Form 1-A.

If the offering is limited to $1 million, Regulation A can be coupled with a state SCOR filing, further simplifying the process of registration.

Requirements imposed on “testing the water.” The SEC imposes strict requirements on an issuer who will be testing the waters under Regulation A. These rules dictate that:

  • Solicitation of interest may take the form of written documents or scripted radio or television broadcasts (this would allow the use of a web site on the Internet as a means of determining whether there is sufficient interest to justify an offering).
  • Solicitations of interest may not be made after the filing of the Regulation A Form 1-A offering statement.
  • No offers, sales or exchange of consideration can take place during the testing process. Sales may not be made until 20 calendar days after the last publication or delivery of the document or radio/television broadcast.
  • Any written document under this section may include a coupon, returnable to the issuer, indicating interest in a potential offering, revealing the name, address and telephone number of the prospective investor.
  • On or before the date of its first use, the issuer must submit a copy of any written document or script of any broadcast to the SEC's main office in Washington D.C. (Attn: Office of Small Business Policy).
  • Oral communications with prospective investors and other broadcasts are permitted, after this submission. Further, the rules require that the written document or broadcast must contain specific information, including:
    • the name and telephone number of a person able to answer questions about the document or broadcast
    • a statement that no money or other consideration is being solicited and, if sent in response, will not be accepted
    • a statement that no sales of securities will be made or commitment to purchase accepted until delivery of an offering circular that includes complete information about the issuer and the offering
    • a statement that an indication of interest made by a prospective investor involves no obligation or commitment of any kind
    • a disclosure of identity of the chief executive officer of the issuer, as well as a brief and general description of the business and its products

Testing the water and state law. Not all states have provisions that allow testing of the waters. However, the following states do allow issuers of Regulation A to gauge interest beforehand:

States Allowing “Testing of the Waters”

Colorado New York Vermont
Illinois North Dakota Virginia
Indiana Oregon Washington
Iowa Pennsylvania Wisconsin
Nevada Utah  

The small business owner should limit testing of the waters to residents of these particular states. If an Internet web site is used, a disclaimer can be used to accomplish this objective.

It is possible other states may follow suit in the future. The following states are considering the adoption of such a provision:

  • Arizona
  • Maine
  • Michigan
  • Rhode Island

Offering securities via the internet

Many small businesses are turning to the Internet when issuing securities and raising capital because it represents a centralized and inexpensive way to solicit potential investors from all across the country.

While the issues regarding securities law in this area are evolving, it is important the small business owner understands that a view is emerging in the law--an Internet offering is an offering of securities in every state, unless certain conditions apply. The Internet offering will not be subject to a state's jurisdiction if the offering:

  • specifically and expressly disclaims that the securities are being offered to residents of that particular state (e.g., those not accepting the SCOR registration); in that event, no registration or exemption would be necessary in those particular states
  • is registered under federal securities laws or relies on some federal exemption, other than Rule 504

Because Rule 504 will be the most common exemption used by the small business owner making an Internet offering, satisfying the second condition is unlikely.

Consequently, the small business owner intending to solicit using the Internet will have to first register the securities in every state or find an exemption in each particular states. A uniform state SCOR registration could be made in the states that accept it.


A complete discussion of securities law is beyond the scope of this section. For example, other exemptions are available, subject to more restrictions than Rule 504, which allow the issuer to raise more capital. However, you should keep the following in mind:

  • The SCOR registrations, Form U-7 and the Rule 504 Form D, while simplified as far as securities registrations are concerned, are in fact complex and technical. Their preparation will normally require the use of an attorney. In any case, where the small business owner questions whether an offering is subject to registration, or eligible for an exemption, it is wise to first consult an attorney.
  • The SCOR registration must be completed and approved before any offering can be made. Subsequently an offer must be accompanied by a prospectus, which is part of the SCOR Form U-7.
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