“The proliferation of potentially fraudulent schemes comes at a time when the sale of legitimate private securities, which are exempt from having to be registered if they meet certain SEC guidelines, has taken off.” 1
Whether you’re just beginning to dabble in investments or are already established as an accredited investor, it’s important to approach unregistered securities dealings with caution.
Although many unregistered securities offerings are legitimate, perpetrators often hide behind these particular transactions to execute various investment scams and securities fraud.
In order to protect yourself from falling victim to these types of scams, you should understand what qualifies as unregistered securities, the exemptions that define legitimate unregistered offerings, and how to spot the red flags of a possible scam or fraudulent unregistered securities.
In this article, we explore four tips to avoid liability regarding unregistered securities and answer some crucial FAQs for victims of unregistered securities fraud.
1. Understand Unregistered Securities
Defining a Security
Securities Act Section 2(a)(1) defines the term security as:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 2
An “investment contract” is also included under the broad umbrella of securities. Although the term is not defined in the Securities Act, the United States Supreme Court has said that an “investment contract” is (1) an investment of money in (2) a common enterprise, (3) where the investor is led to expect profits solely from the efforts of the promoter or a third-party.3
Prior to the promotion, offer, or sale of any security, a company must officially register that security with the SEC unless they are qualified for an exemption from the registration requirements.
The registration requirements intend to accomplish two primary objectives: provide investors with significant financial and background information related to the securities being offered; and prevent deceit, misrepresentation, and fraudulent behavior.4
A company registering a security must fill out a registration form that requests significant information relevant to the public or a potential investor, including the following:5
- Descriptions of both the company and its business, as well as the security to be offered;
- Information regarding the managing members of the company; and
- Financial statements from the company that have been certified by third-party accountants.
The statements and forms are filed electronically and can then be accessed by potential investors via EDGAR.
💡 It is important to note that registration does not guarantee a safe investment. The SEC cannot ensure that a company’s filing is 100% accurate, nor do they evaluate the merits of an offering.
Any security offered or sold to the public without effectively registered with the SEC, whether legitimate or illegitimate, is considered “unregistered.”
2. Understand the Exemptions
There are certain special cases where a company or offering is exempt from the registration requirements, making unregistered securities legal and legitimate. In fact, exempt unregistered securities account for over $2 trillion of capital raised a year.6
Two of the most common exemptions are Regulation A Offerings and Regulation D Offerings.
Under Regulation A, companies meeting the specified criteria are able to offer and sell securities to the public with less restrictive disclosure requirements. Start-up companies can use Regulation A to efficiently raise capital.7
Under Regulation A, rather than filing a registration statement through EDGAR, the company must file an offering statement which includes an “offering circular” containing important financial disclosures to be distributed to investors and all required exhibits.8
Payment from a sale of such securities can only be accepted once these offering materials have been “qualified” by the SEC.9
💡 When it comes to scammers, “qualification” filings and actions have been misrepresented as formal approvals or registrations to mislead investors. Be sure to familiarize yourself with the type of security, exemption, and requirements you are dealing with.
Regulation A Offerings are divided under two Tiers:
“Offerings of up to $20 million in any 12-month period, including a maximum of $6 million in secondary sales by affiliates of the issuer. Offers and sales in Tier 1 offerings are subject to the blue sky registration and qualification requirements of all relevant states.”10
The financial statements in a Tier 1 offering do not have to be audited by a third-party accountant; however, they are still subject to review and qualification by the SEC and the relevant state regulators.11
“Offerings of up to $75 million in any 12-month period, including a maximum of $22.5 million in secondary sales by affiliates of the issuer. Both offers and sales in Tier 2 offerings are exempt from blue sky registration and qualification requirements of relevant states. Tier 2 issuers become subject to ongoing reporting obligations after completing their offering. Unless they are accredited investors or another exemption applies, Tier 2 offering investors are subject to investment limits.”12
Tier 2 offering financial statements must be audited by a third-party accountant.13
Regulation D is an exemption umbrella governing private placement offerings sold to pre-selected investors or institutions.14
Rather than filing registration statements with the SEC, the company or individual offering the security but file a “Form D” with the SEC immediately following the first sale. Form D is far less exhaustive than formal registration, only requiring some personal information about the company’s executives or directors and important details about the offering.15
Regulation D provides exemptions through the following two rules:
Under Rule 504, companies may sell up to $10 million in securities in a 12-month period and file Form D within 15 days. These offerings are still subject to the relevant state’s Blue Sky Laws.
Companies exempt under Rule 506 may raise an unlimited amount of capital and sell to an unlimited number of accredited investors, and up to 35 non-accredited investors.
All non-accredited investors under Rule 506 must qualify as “sophisticated,” meaning they have sufficient financial or business experience to understand the potential risks and rewards of the investment being made.16
An accredited investor is someone who:17
- had an income exceeding $200,000 (or $300,000 combined with a spouse) for both of the prior two years and is expecting the same for the current year; or
- has a net worth over $1 million, excluding their primary residence, either alone or combined with a spouse; or
- is a broker or other financial professional holding certain certifications or credentials in good standing.
3. Spot the Red Flags
Information obtained from the SEC’s “Investor Alert: 10 Red Flags That an Unregistered Offering May Be a Scam”
4. Recognize Popular Scams & Traps18
Scammers may issue press releases that exaggerate or misrepresent a company’s sales, acquisitions, and revenue projections.
Some companies pay stock promoters to recommend or “tout” the stock in supposedly unbiased or third party investment newsletters, research reports, or radio and television shows.
“Boiler Rooms” and Cold Calling
Dishonest brokers set up “boiler rooms” where a group of high-pressure salespeople make cold calls to as many potential investors as possible to persuade them into buying “house stocks” – stocks that the firm buys or sells as a market maker or has in its inventory.
The “Pump and Dump”
Promoters will claim to have “inside” information about a stock or investment or to use an “infallible” combination of economic and stock market data to pick stocks. Once the con artists create a massive buy influx, they sell their shares, and the price typically falls, causing investors to lose their money.
The Off-Shore Scam
Under Regulation S, companies do not have to register stock they sell outside the United States to foreign or “off-shore” investors.
Dishonest companies use this exemption to sell unregistered stock at a discount to scammers posing as foreign investors. These scammers then sell the same stock to U.S. investors at inflated prices and share the profits with the offering company’s insiders. The flood of unregistered stock into the U.S. causes the price to plummet and leaves U.S. investors to suffer huge losses.
5. Learn the FAQs
Can My Broker Sell Me Unregistered Securities?
This is considered broker misconduct. If you have purchased unregistered securities from your broker, you should consider consulting with an experienced investment fraud attorney.
What Should I Do If I Purchased Unregistered Securities In Florida?
To prove that a broker is selling unregistered securities, you must have evidence of the following:19
- Sale or offer to sell a security;
- The sale or offer to sell a security occurred in Florida;
- The security offered or sold was not registered under applicable law; and
- The security offered or sold was not exempt from registration or a federal covered security.
If you have purchased an unregistered security, you should consult an experienced investment fraud attorney.
What is the Penalty for Selling Unregistered Securities?
A maximum of five years federal prison.
How Do I Report Suspected Securities Fraud or Wrongdoing?
The SEC encourages you to report any suspicions of the following:20
- The offer or sale of fraudulent or unregistered securities, including things like
- Theft or misappropriation of funds or securities
- Manipulation of a security’s price or volume
- Insider trading
- False or misleading statements about a company (including false or misleading SEC reports or financial statements)
- Failure to file required reports with the SEC
- Bribery of, or improper payments to, foreign officials
- Fraudulent conduct associated with municipal securities transactions or public pension plans
You can submit any tips, complains, and referrals (TCRs) via the SEC online TCR system and complaint form found at: https://www.sec.gov/tcr.
1Bruce Kelly, Sales of unregistered securities are a growing problem that’s harming investors — and the industry, InvestmentNews (April 13, 2019), https://www.investmentnews.com/sales-of-unregistered-securities-are-a-growing-problem-thats-harming-investors-and-the-industry-79078. 2The Securities Act of 1933, as amended, 15 USCS § 77a et seq. 3SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946). 4Registration Under the Securities Act of 1933, Investor.gov (last accessed Feb. 1, 2023), https://www.investor.gov/introduction-investing/investing-basics/glossary/registration-under-securities-act-1933. 5Id. 6Rachita Gullapalli, Misconduct and Fraud in Unregistered Offerings: An Empirical Analysis of Select SEC Enforcement Actions, Division of Economic and Risk Analysis (DERA), U.S. Securities and Exchange Commission (August 2020), https://www.sec.gov/files/misconduct-and-fraud-unregistered-offerings.pdf. 7Updated Investor Bulletin: Regulation A, Investor Alerts and Bulletins, U.S. Securities and Exchange Commission (April 14, 2021), https://www.sec.gov/oiea/investor-alerts-bulletins/ib_regulationa.html. 8Practical Law Corporate & Securities, Regulation "A+" Offerings under Amended Regulation A, Thomas Reuters Practical Law (last accessed Feb. 8, 2023), ID: 6-553-7385. 9Supra note 7. 10Regulation A, Glossary, WL:4-548-0785. 11Supra note 7. 12Supra note 10. 13Supra note 7. 14Akhislesh Ganti, Private Placements: Definition, Example, Pros and Cons, Investopedia (last updated March 29, 2022), https://www.investopedia.com/terms/p/privateplacement.asp. 15Will Kenton, SEC Regulation D (Reg D): Definition, Requirements, Advantages, Investopedia (last updated Feb. 5, 2023). https://www.investopedia.com/terms/r/regulationd.asp. 16Id. 17Accredited Investor, U.S. Securities and Exchange Commission (last accessed Feb. 8, 2023), https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor. 18PENNY STOCKS HOW TO INVESTIGATE THEM AND AVOID THE TRAPS, Nicaud & Sunseri Law Firm, LLC (last accessed Feb. 8, 2023), https://nslawla.com/investment-strategies/penny-stocks-how-to-investigate-them-and-avoid-the-traps/. 19Morgan & Morgan Business Trial Group, What Should I Do If I Purchased An Unregistered Security In Florida? (Jan. 10, 2018), https://www.businesstrialgroup.com/news/unregistered-security-florida/#:~:text=Clients who are sold unregistered securities by their broker and, to file a legal claim. 20Report Suspected Securities Fraud or Wrongdoing, U.S. Securities and Exchange Commission (last accessed Feb. 8, 2023), https://www.sec.gov/tcr.