Do I Need a Private Placement Memorandum?
You’ve got a great investment idea, but you can’t fund it yourself, and you don’t want to take out a loan. You want to get others involved to finance your investment.
You’ve known other business owners and entrepreneurs who have raised money to start a business or invest in real estate. They’ve told you about all the paperwork and steps they had to go through and the money they spent to comply with SEC and state laws involving securities.
You think that’s a lot of work and money. There must be some way around it.
Is a PPM Necessary?
I am going to offer an extreme word of caution right here…
If you’re taking money from investors, chances are you’re offering a security and when you’re offering a security and taking money from investors, you’ll need to comply with federal and state securities laws and regulations.
Taking money in violation of these rules will result in severe civil and/or criminal consequences.
The Securities Act of 1933 (the “Act”) was launched in the aftermath of the stock market crash that plunged the country into the Great Depression.
The Act was created to protect investors – to ensure they received adequate and comprehensive information and disclosures regarding a potential investment before buying. The basic spirit of the Act is that investors can only adequately evaluate the merits of a securities offering if they are provided with accurate and complete information regarding the company and the offering itself.
To ensure prospective investors receive accurate and complete information about an investment opportunity, the Act requires companies seeking capital to either register through the expensive IPO process or qualify under an exemption for a private offering.
The most common exemptions relied on by companies are found in Regulation D of the Act. In either case, capital seeking companies are expected to deliver investors adequate documentation with all required disclosures before taking their money.
For public offerings, this documentation is the form of a prospectus and for exempt private offerings, this documentation is in the form of a Private Placement Memorandum (PPM).
Companies and entrepreneurs who have been unwilling to take the steps or willing to pay the costs of raising capital the right way and ignored or tried to skirt the securities rules have usually met with disastrous results. Understand that the SEC has proven time and time again that where there’s ambiguity, it will side with the investor every single time.
If you’re wondering whether your transaction or arrangement is a security, here’s the basic rule:
Anytime you take money from investors where the returns are generated by your efforts (in other words, investors are passive and you do the work), you’ll need to either register the security with the SEC or find an exemption from registration.
If you try to get cute with what you call your arrangement or the terms of the arrangement to get around the SEC, know that when you appear on their radar, they will have broad powers and discretion to snag you.
The first question you need to ask in all of this is if what you’re offering is a security. So what is a security?
According to the Act, a security is “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, or investment contract.”
It’s that SEC definition that entrepreneurs tried to get around in the early days. If it’s not one of those items listed then it must not be a security, right?
In 1946, the SEC decided to hit entrepreneurs trying to get cute with the meaning of a security. So, it decided to make the term “investment contract” a catch-all. It did it through the landmark 1946 Supreme Court case, SEC v. Howey, where it came up with a four-part test for determining whether a scheme was an investment contract and, therefore a security.
The test – come to be known as the Howey Test and still used today – used four factors for determining whether a transaction was a security.
According to the test, to be considered an investment contract, the following conditions must be met:
- An investment of money.
- In a common enterprise (pooled money with other investors).
- With an expectation of profits.
- Derived from the efforts of a third party.
Despite the Howey test, if human nature has taught us anything, it’s that rules are meant to be bent. So what have been some of the ways entrepreneurs have tried to get around the definition of a security?
Some will get cute with the structure or name of the investment opportunity. “It’s not a security, it’s a participation certificate, partnership agreement, personal loan, or joint venture interest.”
In 2017, in a federal case in Texas, the court sided with the SEC to discourage this cutesy word-playing to get around the definition of securities. If there was any confusion about what constituted a security before, the court in SEC v. Mieka Energy Corporation cleared up a lot of that confusion.
In concluding that a joint venture interest was a security, the court in Mieka focused on the fourth part of the Howey Test, “derived from the efforts of a third party.” The court looked through the name or structure of the transaction to focus on the arrangement between the parties:
- Who’s calling the shots?
- Who has control and the final say?
The court concluded that if a third party or manager is actually in control, then any investment funds are considered securities, and those who sold them in violation of the rules are accountable.
For those entrepreneurs who think they can get around the “third party control” test by “wink wink” granting their investors with written authority but with no real practical power – beware!
The court in Mieka concluded that if any of the following situations exist, it will be enough to fulfill the last element of the Howey Test regarding the efforts of a third party:
- An agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement distributes power as would a limited partnership;
- The partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or
- The partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
So what’s the lesson from Howey and Mieka?
The SEC has broad discretion for determining whether a transaction is a security. Just about anything can fall within the definition of a security, the improper sale of which could be subject to civil and criminal penalties. Ignorance is not a defense.
The only way to keep out of being considered a security is if all of you are ACTIVELY involved in the deal and, ideally, all co-managers of the LLC. However, the larger the number of co-managers, the more likely you’ll attract the attention of the SEC. Usually, this will only work if you have one or two other investors and all of you put money in the deal and actively participate.
It will be your burden to prove to the SEC that your other partners are actively involved. As I said, ignorance is not a defense. There is no workaround to the SEC laws. They have locked that down six ways from Sunday, as many people before us have learned the hard way to try to game the system.
The SEC has what I call the “mom and dad” rule; whatever they say is what it is on any given day. Don’t matter how many ways you slice it up or how many beers you kick back with someone; the law still applies. They can and will step through whatever scheme you set up and bust you by looking at your intent.
Unless the investors are putting in work themselves, you need to register/file your offering. That being said, I’ve seen more people trying to skirt the securities rules in recent years than I can recall, including attorneys.
Some know the rules and just figure they’ll roll the dice to avoid SEC detection. They’ll do small deals with family, friends, and local business owners and just take the risk – nothing mass scale – to avoid detection.
In no way am I suggesting you break the law here – because you can get in some serious trouble – but people only start complying with the rules and syndicating when they get over the legal cost, which can get very expensive.
But the cost of defending a lawsuit is much more expensive than the cost of a PPM. And don’t think just having a PPM will save you. Don’t go pulling a template off the internet and think that’s going to save you. Besides the disclosure rules, there are rules about who you can make offers to, how you can make offers and certain requirements about reporting to the SEC and state authorities.
For those thinking about skirting the law by calling the arrangement a partnership, private loan, or something else to avoid detection, here’s what I’ve seen happen from personal observation:
- You mail out or advertise online, and a financial planner receives the advertisement… they see this as competition and simply report it…
- Your investor is 69 years old, and their son finds out about their latest investments… they report it…
- An interested investor inquired with the State Securities commissioner to validate the investment… they just reported it…
- The syndication misses one projected return, and the investor reports it…
The lesson from all this is that getting on the SEC’s radar doesn’t take much. All in all, it can get reported by a variety of means. I’m not telling you to be cautious; I’m telling you to comply with the laws to avoid serious consequences.
Case in point. A potential client came to us and informed us right off about how they were already advertising their investment – WITHOUT a PPM. Besides failing to use a PPM, they ignored any other rules covering the offering.
Great news!! Not long after, they got full press coverage by the State of Colorado with a Cease and Desist Letter. A quick Google search of the company serves up the cease and desist on the first page.
Do you think this helps them or hurts them?
I’ll tell you it not only hurts them today but also a long time into the future. This stuff doesn’t go away.
Bottom line: If you take money from others and pool that money, your investors are expecting a passive position to profit, and you’re the expert and doing the work; you need a PPM.