We have blogged before (“Memberships as Securities”) about how in some states, the definition of a security is so broad that almost any attempt to raise money including pre-selling, no interest loans, memberships, gift certificates, etc. could fall within the purview of the securities laws. California was the first state to adopt this alternative, broader definition of a security, and 16 jurisdictions have followed. The test used in these states is called the risk capital test and basically says that any time an offering is made to the public that asks people to put money at risk to fund a business venture, it will be considered a security. (Note that states that use this test also use the more common test of whether there is an expectation of a profit – they apply both tests and if something meets the definition of a security under either test, it will be deemed a security.) To illustrate the principle, here is a summary of two cases in which the courts found the capital raising strategy to NOT be a security. The take home message seems to be that you need to have something valuable like diamonds or gold securing your investors’ money if you want to fall outside the securities laws in California!
In Moreland v. Department of Corporations, the court found that the sale of gold ore and a contract to refine the ore was not a security under the risk capital test even though “the promotional materials given to the public by appellant included the following statement: ‘The reason for selling the gold at this price is to raise the capital for a new milling and refinery plant . . . .’” The Department of Corporations argued that the intended use of the proceeds demonstrated by this statement satisfied the requirement under the risk capital test that the funds “be used for a business venture or enterprise.” The court disagreed, stating, “Superficially, this may be so since the construction of a mill and refinery is essential to the conduct of appellant’s intended mining, milling and refining operations. However, it is equally true that every purchaser of a product from a seller, who reinvests the proceeds of the sale in his business operations, contributes to a seller’s business capital. Notwithstanding, such a contribution is an investment in the purchased product and not a contribution of risk capital to a business enterprise within the normal scope of securities regulation.”
In Hamilton Jewelers v. Department of Corporations, the court held that the following offering did not constitute a security under the risk capital test: “’Hamilton Jewelers invites you to invest in a ONE CARAT DIAMOND for only $500, and if anytime [sic] within a three year period you elect to return the Stone, Hamilton will return to you the full purchase price plus 5% interest calculated daily from the date of purchase. A diamond investment of $500 will return $578.81 in cash at the end of a three year period.’” The court reasoned that even though the offer to pay interest on an investment would normally fall within the definition of a security, in this case the investor’s capital was not at risk because the investor had a diamond worth at least $500. The court stated, “The customer, being adequately secured, would have placed no ‘risk capital’ with Hamilton; and, therefore, the transaction would not come within the regulatory purpose of the Corporate Securities Law even though 5 percent interest might ultimately be paid to the customer.”