In People v. Landes, 84 NY2d 655 (1994), the New York Court of Appeals clarified when an offering or selling of securities is “to the public” This is significant because if the sale is to the public, it will be subject to registration requirements under New York's Blue Sky Law.
The case provides guidance on factors to consider in making this determination. If you are a startup founder, startup counsel, or investor, it's important to understand what this decision means for you. In this article, we will discuss the case and its implications.
The term ‘blue sky law' refers to state securities laws that are designed to protect investors from fraud.
These laws vary from state to state, but they all share the common goal of protecting investors from fraudulent and/or illegal securities transactions.
Article 23-A of the New York General Business Law (NYGBL) regulates the offer and sale of securities in and from New York. Section 352-c, added in 1955 provides for criminal liability for the “fraudulent practices,” defining these as cover acts that are “deceptive or misleading even absent proof of scienter or intent.”
New York General Business Law Article 23-A, Sections 352–353, also known as the Martin Act, is a state securities law that gives the attorney general broad powers to investigate and prosecute securities fraud.
As mentioned, the Martin Act does not require proof of scienter or intent to deceive, making it easier to bring charges under this statute than under federal securities laws.
Widely considered to be the most severe blue sky law in the U.S, the Martin Act has been used to bring charges against some of the largest financial institutions in the world.
It should be noted that there is no New York State requirement for registering securities before selling them.
However, under Section 359-e of the New York General Business Law, those selling securities “to the public” that they themselves had issued, are required to register with the New York State Department of Law.
To generate a fuller understanding of the import of the Landes decision, some context is necessary.
The case arose from an indictment of the defendants for, among other offenses, securities fraud. In 1988, the owner of the Four Seasons health food store and cafeteria in Saratoga decided to attempt to distribute Nutri-King, a health food product, and obtained sole distribution rights in the United States.
In order to finance this venture, the defendant sold interests in the business to investors who would provide cash in exchange for capital stock in a corporation he planned to form.
The defendant sold a total of $100,000 worth of interests in the business to 12 people. The defendant did not register the sale of these securities with the State of New York.
The attempted import and sale of Nutri-King failed and the defendant spent the monies received on personal expenses. No accounting, refund, or stock was ever issued.
Part of the defendant's indictment alleged that the defendant had sold unregistered securities to members of the public in violation of New York's Blue Sky Law. In response, the defendants argued that the sale did not constitute a “public offering” and was therefore exempt from the registration requirement.
The trial court agreed with the prosecution, and the defendant was convicted of fraud in the sale of securities and unregistered sale of securities, as per New York's Blue Sky Laws.
The defendant appealed, and the Supreme Court, Appellate Division, Third Department upheld the decision of the trial court.
The Appellate Division found that the sale did constitute a “public offering,” and, therefore, the defendant was required to register the sale of their securities with the New York State Department of Law.
Critically, the Appellate Division rejected the defendant's argument that he was not subject to the General Business Law's registration requirements because the transactions in question represented personal sales of stock in a private corporation and not a public offering of securities.
In the absence of a controlling New York authority that has established what constitutes a “public offering” the Appellate Division reached for Federal case law to provide guidance.
In the case Securities & Exch. Commn. v Ralston Purina Co. (346 US 119), the United States Supreme Court had already examined what constituted a public offering in addressing the private offering exemption of the 1933 Securities Act.
In this case, the Supreme Court concluded that the underlying purpose of the 1933 Securities Act was to “to protect investors by promoting full disclosure of information thought necessary to informed investment decisions.”
The key takeaway from the Ralston case was that the Supreme Court decided that the “the exemption question turns on the knowledge of the offerees.”
This established that if potential investors do not have access to information that would allow them to make an informed investment decision, then the offering is potentially considered public and therefore subject to the registration requirements of the 1933 Securities Act.
In Doran v. Petroleum Mgmt. Corp., 545 F.2d 893 (5th Cir. 1977), the Fifth Circuit Court of Appeals further defined the question by establishing four deciding factors:
- The number of offerees and their relationship to each other and to the issuer
- The number of units offered
- The size of the offering
- The manner of the offering
The Doran court concluded that the case's critical factor was the information disclosed, or available, to the offerees and the number of offerees and their relationship to each other and the offeror.
The one available relevant New York case, People v Glenn Realty Corp., 431 N.Y.S.2d 285 (1980) also used the Doran and Ralston cases to establish the same four relevant factors when considering a sale of cooperative interests in realty and whether the filing of a prospectus was required in connection with selling cooperative interests in realty.
In translating Federal case law into a State context, the Appellate Division in People v. Landes used the same four factors established in the Doran case, but without the same emphasis on the availability of information being virtually determinative.
People v. Landes established the use of the four critical factors outlined in the Doran and Ralston cases as a legal framework for determine whether an offering of securities is a public or private offering for the purpose of the securities registration.
In the Appellate Division's consideration of the record, the number of offerees and their relationship to each other and to the issuer was a critical factor. Specifically, the Appellate Division concluded that the following evidence in the record supports a finding that the offering was public:
- The vast majority of the investors had no access to information on the background of the defendant, who had been a teacher prior to managing health food stores and training racehorses.
- The investors were also not privy to the fact that the sole asset of the corporation was a single contact in India which the defendant planned to use to acquire stock of Nutri-King and sell it in the United States.
- A larger number of the investors were induced to invest by friends of the defendant and had no personal relationship with the defendant.
- The investors were also not treated equally, with some receiving their shares free of charge, while others were charged $500 or $1,000 a share for their stock.
- The investment contracts given out were also significantly different, with some not receiving the executed contract until they had given the defendant their money. In one case, one of the investors received a contract that denied him voting rights in the corporation.
These factors speak to the lack of information available to the investors, and their informal relationship with the defendant.
While the evidence of this lack of information was not considered controlling, it did indicate a lack of a close enough relationship between the offerees and the defendant to obviate the protections established under the Martin Act to protect the public from “fraudulent exploitation in the offering and sale of securities and the protection of investors from such practices.” (See Landes, 192 A.D.2d, at 4)
For the purposes of this article, the most important takeaway from the Court of Appeals' decision is its use of the four factors analytical framework articulated in the Doran and Ralston cases for the determination of whether the sale of securities can be considered a “public offering” for the purpose of complying with the New York Blue Sky securities registration requirement.
This distinction is critical because, as mentioned earlier, public offerings of stock need to be registered with the New York State Department of Law, while private offerings do not.
For startup founders and startup counsels, People v. Landes establishes a criterion through which a stock offering can be considered a private or public offering.
These critical factors; the number of offerees and their relationship to each other and to the issuer, the number of units offered, the size of the offering, and the manner of the offering, represent guidance on to what extent and stock offering can be considered a public offering and whether it will therefore need to be registered.
For investors, this case provides some clarity on what protections they might have when they are approached to invest in a startup.
For example, if you are a sophisticated investor and are approached by a close friend of a friend who is starting a company and looking for investments from a select number of people and provides you with all the required information on themselves and the company, you can be reasonably certain that this will not be considered a public offering.
On the other hand, if you are approached by a company or individual, you have never heard of before and are soliciting a large number of unsophisticated investors, this will likely be considered a public offering.
In short, the People v. Landes is a cornerstone in the definition of a “public offering” under New York law, and the manner in which the Court of Appeals decided if the offering in question was a “public offering” provides greater clarity for entrepreneurs, issuers and investors alike.
HAN LLP offers startups and emerging companies a full range of legal services, from entity formation to securities law compliance. Our attorneys have the experience and knowledge to help you navigate the complexities of New York securities laws and regulations. Contact us today for a consultation.