Most family business owners might live their entire lives without running into securities law issues or problems. Many probably believe that there is an automatic exemption applicable to a family business from the registration and antifraud requirements under the federal and state securities laws, which are designed to protect investors.
Well, it’s not quite that simple. Let’s take a short true/false quiz on how the securities laws might impact a family business under certain circumstances:
True or False?
- A share of the stock in a family-owned corporation, or an LLC interest in a family LLC, is a security. [True, generally. Certainly a share of stock is a security, and most regulators consider an LLC interest to be a security unless it is a member-managed LLC and the members are all actively involved in managing the LLC.]
- A sale of stock to a family member is a securities transaction that must either be registered or subject to an exemption from registration. [True. Although you might have heard of “friends and family” rounds of equity financing, there is no “family” exemption under federal or state securities laws. The same rules apply to sales of stock to family members that apply to other sales of stock.]
- Stock sales in a family business are automatically exempt from registration because they are private transactions. [False. The statutory “private offering” or “nonpublic offering” exemption from registration that is present in federal and most state securities laws has been judicially interpreted to apply to sales of securities where the purchasers are, because of wealth, experience, financial sophistication, or other circumstances, able to “fend for themselves” in negotiating the purchase. It’s possible that not all family members purchasing stock will have the required characteristics to meet the private offering requirements. And the burden of proving that a stock transaction is exempt from registration is on the company selling the stock.]
- Gifts of stock in a family business are exempt from the registration requirements. [True. A bona fide gift is not considered a “sale” of securities. But be careful! Courts have held that a gift of stock is not a gift if there are conditions attached to the gift, such as accepting employment with the company, or providing services to the company.]
- Family members who buy stock don’t need to be “accredited investors” or financially sophisticated. [True. But there are substantial disclosure requirements that must be satisfied under federal Regulation D and its state law counterparts, if even one purchaser of securities in an offering is not accredited. Generally, accredited status for an individual investor means having a net worth of at least $1 million, not including home equity, or individual annual income of $200,000 (or $300,000 with a spouse). The most used provision of Regulation D provides a “safe harbor” exemption from securities registration if all of its conditions are met, including, very importantly, a prohibition on general solicitation and advertising.]
The federal and state securities laws are complex, and state “blue sky” laws vary significantly from state to state. Many times, the existence of an exemption is based on a review of all of the facts and circumstances under which securities were offered.
What happens if you sell stock in the family business without knowing anything about the securities laws? Well, possibly nothing at all. If the business is successful or otherwise meets the expectations of the purchaser, there will be no complaint. If the family relationships are strong, one family member will not sue another. However, if things start to deteriorate within the family business (and the family itself), or even worse, if purchasers of stock in the family business were deceived about business risks or problems within the business, they may look for a way to cash out their investments. In that regard, the securities laws provide them with powerful leverage to require the business to buy them out or suffer the threat of litigation.