Implications of securities laws on cooperatives
Securities laws remain complex,
nuanced and vary across state lines and the federal government. Their
implications are often difficult to understand and navigate alone, especially
as a cooperative. Without an applicable exemption, securities need to be
registered with the federal Securities and Exchange Commission (SEC) and/or a state
securities agency. Registration requires additional time and funds, which
carries a larger administrative burden on your end, a burden that could be
detrimental to your co-op as you’re getting it off the ground.
Securities law implications on cooperatives are not always clearly
defined, especially at the state level. This is likely due to the fact that
several states do not mention shares in a cooperative in their definition of
securities. And because securities laws vary across states (and there remains no presiding federal cooperative statute), what might be true regarding treatment of shares in a cooperative in one state may not be true in another state. When I mention treatment, I don’t just mean if an interest in a cooperative constitutes a security in the first place, but also if there is an applicable exemption from registration.
This
post aims to explore how securities regulations might affect your cooperative
at the federal and state level. It provides some considerations on the
structure of cooperative interests to avoid securities issues at the federal
(and possibly the state) level. There aren’t clear lines or clear answers, but
hopefully you will better understand what securities are and what’s at stake
for your co-op because of them. This article does and will not replace legal
advice; if you have any concerns, please consult a licensed attorney.
In
reviewing this article, please read it with a grain of salt, specifically read
it through a salty grainy lens of risk assessment and management. This is
because chances of agency enforcement over unregistered securities runs low as
long as you’re not engaging in fraudulent behavior. But more on that later. To
get things started…
What are securities?
Generally speaking, any proof of ownership or debt that (1) has some assigned value and (2) can be
The
government wants to protect investors. It wants to protect grandpa from the
seedy door-to-door salesman preying on him with some get-rich scheme that
invariably ends up with grandpa’s savings drained. In short, they want to
protect people from fraud.
My
co-op’s not trying to scam grandpa, it wants to help him. Why should I care
about securities law then?
The
federal and state governments unfortunately can’t intuit your intent, but in
many aspects the co-op’s work can assuage worries the SEC and state securities
agencies may have. Additionally, what may be considered securities in a co-op
seems to be slightly more flexible than other kinds of entities. This is
because co-op members’ main goal when joining a co-op is not strongly tied to making
significant profit, but rather to obtain affordable, high quality goods or
services. This is actually a huge consideration the Supreme Court has
used in finding membership interests not securities.[i]
But this reasoning comes from the federal level; there is much less guidance at
the state level, and again, it could vary from state to state. With your regular
members, and the majority of folks involved in the co-op in the first place, the
likelihood that their interests will be found as securities remains low.
If
something is a security is that the end of the road? Do I need to register?
Not
necessarily. Alongside their respective securities laws and regulations, the
federal and state governments utilize exemptions under specific circumstances
that relieve you of the requirement to register financial instruments that
would otherwise be considered securities. Note, however, that just because you
have an exemption doesn’t mean you don’t have to follow the securities law’s
antifraud provisions.
If
you don’t qualify for an exemption, the road doesn’t end there either. The SEC
and state securities agencies issue no-action letters that essentially say even
though this is a security, and it doesn’t qualify for an exemption, we’re not
going to treat it as such and require registration. These no action letters
are helpful, but not required, nor are they guaranteed or binding—you’re not
entirely insulated from securities litigation if the SEC or state securities
issues believe fraudulent behavior might have occurred.
How
could I structure cooperative interests to not be securities?
If you’re still in the process of
structuring your co-op, there are strategic ways to mitigate securities
implications that will hopefully coincide with your co-op’s goals. Since the
federal government provides some of the clearest guidance (via the Supreme
Court) applicable to all readers that is what I will focus on. Please note that
some state securities laws (also called “blue sky” laws) have some iteration of
this analysis, but some do not.
To
mitigate the risk that membership interests are considered securities at the
federal level, you could consider:
(1)
If
there is an expectation of profit from investing in the co-op. Are members
joining hoping to make a profit solely off the efforts of others? If so, then
the membership interests are likely to be found securities under SEC v. W.J.
Howey Co. Note that issuing a refund of the cost of membership to a person
wishing to leave the co-op does not constitute a profit (these are
called patronage refunds).
(2)
The
motivations of a person joining the co-op. If the motivation derives mainly
from desiring to use the goods or services offered, then it will likely not be
considered a security at the federal level as set forth by the Supreme Court in
United Housing Foundation v. Forman.
(3)
The
dividends are not paid based on the amount a member has invested, but on
their patronage (the quantity or value of business done by members with the
co-op). This reduces the likelihood that
cooperative interests are securities.
(4)
Only
in the case of succession may the cooperative interests be transferred to
another. This also reduces the likelihood that these interests are securities.
Just
because cooperative interests are securities does not mean they won’t be
subject to an exemption. For example, the federal government has an intrastate
offering exemption, which provides a SEC securities registration exemption
if no membership interests are sold across state lines and a substantial amount
of business is conducted within that state. You would then only need to
consider your state’s treatment of these interests.
What
are the chances the SEC or state securities agency will investigate me?
It’s important to end the article with this: I’m not
trying to scare you. Yes, running afoul of securities regulations at either the
federal or state level can open you up to civil and criminal prosecution, but
the SEC and state securities agencies don’t pull entities out of a hat at
random to proceed with enforcement. Something usually happens to trigger their
notice. Often, something fraudulent. Litigation typically occurs when there are
disgruntled investors, stockholders or members with some kind of fraud occurring
on the entity’s end.
By:
Natalie Vicchio
[i]
See SEC v. W.J. Howey Co., 328 U.S. 292 (1946); United Housing Foundation,
Inc. v. Forman, 421 U.S. 837 (1975).