Law in the Marketplace: New federal rule expands the number of potential investors in existing and start-up New Hampshire businesses

For the Monitor
Published: 9/14/2020 2:37:52 PM

Because of the coronavirus pandemic, many business people in New Hampshire and nationwide are hesitant to start new businesses or to expand existing ones until the pandemic is under control. But many of these people are using the pause in business activity resulting from the pandemic to plan for their businesses.

A key issue in this planning is how to obtain needed business investment from third parties. On Aug. 26, the Securities and Exchange Commission (SEC), the principal federal regulator of securities investments, amended the definition of the key SEC term “accredited investor” and thus significantly expanded the range of potential investors. The amendment (which I’ll refer to here as the “Amendment” or the “SEC Amendment”) may be important for, among other business people, would-be founders and owners of New Hampshire LLCs.

For a complete explanation of the amendment, visit www.sec.gov/rules/final/2020/33-10824.pdf. Warning: The SEC Explanation is lengthy and highly technical. But speaking as a tax lawyer who has to spend substantial time reviewing federal tax regulations, I find the SEC Explanation to be written not only clearly but even gracefully. But it’s not good beach reading.

In the paragraphs that follow, I’ll briefly summarize the existing SEC law relevant to securities investments, and then I’ll briefly address the amendment itself and its practical meaning for New Hampshire business people who need business investments. In doing so, I’ll do my best to use only plain English; but please realize that investment securities is a complex area of federal and New Hampshire law. Before you consider offering securities investments on the basis of the amendment, you’ve got to consult in detail with a securities law expert.

Here are the key things you should know about the securities investment process:

■Under current investment law, an “investment security” is, in essence, any stock or debt offered to investors or owned by them in a for-profit enterprise.

■The purpose of the SEC is to protect investors – and especially unsophisticated investors – from being deceived by unscrupulous investment promoters; but also from securities offerers whose intentions are honest but who simply aren’t providing enough information to potential investors to enable them to make wise investment decisions.

■Violations of SEC rules can result in severe penalties for offerers of investment securities, including a duty to restore the entire loss suffered by an investor because of these violations.

■The general SEC rule is that if you want to offer investment securities in a new or existing business lawfully, you must first register it with the SEC (and often also with state law securities regulators). The registration process requires the offerer to assemble and to provide to the SEC, and to potential investors, extensive financial and other documentation about the business in question. A SEC registration can be time-consuming, and it can also be very expensive in legal, accounting and other professional fees.

■However, there are certain types of investment arrangements that offerers do not have to register. By far the most common such arrangement is – excuse the technical jargon – a Rule 506(b) offering under SEC Regulation D. Rule 506(b) provides an exemption from registration for offerings of an unlimited dollar amount of securities to “accredited investors” and up to 35 non-accredited investors.

■Until August 26, a potential investor would be an accredited investor only if he or she had a net worth of at least $1 million or individual income of more than $200,000 (or $300,000 jointly with the individual’s spouse) in each of the last two years. The theory underlying the SEC definition of accredited was, at least in part, that individuals who met these requirements were likely to be able to understand investment risks on their own without the information provided by SEC registrations. In the classic phrase, they could, in making investments, “fend for themselves.”

■I should note, however, that if you were offering securities to the above 35 non-accredited investors, you would be prudent to provide them with written “private placement memos” (PPMs) that clearly identified all of the risks associated with the relevant securities. The SEC Amendment doesn’t change this requirement.

■My law practice is focused not only on helping business owners maximize their federal income tax deductions under Internal Revenue Code section 199A but also on forming single-member and multi-member LLCs and restructuring existing LLCs. The prospective members of LLCs being formed by my clients or owned by them sometimes include accredited investors, but they also often include unaccredited investors who will be purely passive members of the LLC, and who, in some cases, may be contributing investment amounts that, for them at least, are substantial and would be painful to lose. I feel a duty to protect these unaccredited investors, even if, as often happens, they are close relatives of the business owners in question, and I advise the owners that, to provide protection to these investors and also for their own protection, they should provide them with comprehensive PPMs. Indeed, I think it is good practice to provide PPMs even to accredited investors. PPMs are challenging and fascinating to draft, but clients for whom I draft them tend to hate them because, of necessity, they disclose so many potentially deal-killing investment risks.

The SEC Amendment hasn’t revolutionized the securities offering process, but it has significantly liberalized it. Specifically:

■The SEC Amendment includes in the definition of accredited investor individuals who cannot meet the above net worth or income requirements but who have professional certifications that make clear their ability to evaluate investments. These individuals include most types of certified investment advisers. They do not include CPAs or lawyers, even though these professionals often have a sophisticated understanding of securities investments and the investment process.

■They include various types of entities previously ineligible to be accredited investors. These include LLCs and other businesses whose business purpose is not to invest in securities but that have a net worth of at least $5 million.

■They expand the above income requirements for accredited investor status beyond spouses in the traditional sense to include “spousal equivalents.” “Spousal equivalent” for SEC purposes is a broad term with many meanings. However, among other things, it includes an individual who cohabits with another individual, who may or may not be of the same gender as that other individual, and who shares a long-time sexual relationship with the other individual. In today’s world, millions of individuals qualify as spousal equivalents.

To sum up: If you own an existing business or if you want to start one, the SEC Amendment may provide you with a significant number of legally permissible investors in your business that, before the issuance of the SEC Amendment, would have been entirely unavailable to you.

 

John Cunningham is a Concord tax and businesses lawyer and estate planner. He has published Drafting Limited Liability Company Operating Agreements and Maximizing Pass-Through Deductions under Internal Revenue Code Section 199A. Both are the leading books in their fields. If you have business or tax questions you’d like addressed in this column, call John at (603) 856-7172 or e-mail him at lawjmc@comcast.net




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