Federal and State Securities Laws
By Richard R. Hammar, J.D., LL.M., CPA
© Copyright 1991, 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m85
Laws regulating the sale of securities have been enacted by the federal government1 and by all 50 states.2 The term security is defined very broadly by such laws. The Uniform Securities Act, which has been adopted by a majority of the 50 states, defines a security as
any note; stock; treasury stock; 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; certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under such a title or lease; or in general any interest or instrument commonly known as a “security” . . . .3
This definition is broad enough to include many instruments utilized in church fundraising efforts.
Securities laws were enacted to protect the public against fraudulent and deceptive practices in the sale of securities and to provide full and fair disclosure to prospective investors. To achieve these purposes, most securities laws impose the following conditions on the sale of securities:
1. registration of proposed securities with the federal or state government in advance of sale
2. filing of sales and advertising literature with the federal or state government
3. registration of agents and broker--dealers who will be selling the securities
4. prohibition of fraudulent practices
Although the federal government and most states exempt securities offered by any organization “organized and operated not for private profit but exclusively for religious . . . purposes” from registration,4 it is important to note that some states do not exempt the securities of religious organizations from registration;5 others impose conditions on the exemption;6 many require that an application for exemption (or “notice” of exemption) be submitted and approved before a claim of exemption will be recognized;7 a few states require churches and religious denominations that “issue” their own securities to be registered as issuers or issuer--dealers;1 and all securities laws subject churches and other religious organizations to the antifraud requirements. Churches therefore must not assume that any securities that they may offer are automatically exempt from registration or regulation. Church securities always will be subject to some degree of regulation. The question in each case is how much.
In the minority of jurisdictions in which a church must register its securities, registration ordinarily is accomplished by filing a registration statement with the state securities commission setting forth the following information: the name and address of the church; the date of incorporation; a description of the general character of the church's operations; a description of the church's properties; the name, address, and occupation of each director, and the compensation, if any, that each receives from the church; the kind and amount of securities to be offered; the proposed offering price for each security; estimated commissions and finding fees; and estimated cash proceeds to the church from the sale of registered securities. In addition, the following materials must accompany the registration statement: a copy of any prospectus, offering circular, or other sales literature; a specimen copy of the securities being registered; a copy of the church's articles of incorporation and bylaws; a copy of any trust indenture under which the securities are being offered; a signed opinion of legal counsel as to the legality of the security being registered; written consent of any accountant having prepared or certified a report or valuation which is used in connection with the registration statement; a balance sheet; profit and loss statements for each of the preceding three fiscal years; a check to cover the filing fee; and such other material as the securities commission may require.2
The method of registration described above is referred to as registration by qualification. Most states provide for two other methods of registration: registration by coordination and registration by notification. Churches will rarely if ever utilize registration by coordination, since this method assumes registration of an issuer's securities under the federal Securities Act of 1933 and churches are exempt from registration under this Act. Registration by notification is available to securities issued by a corporation that has been in continuous operation for at least five years if the corporation satisfies a minimum net earnings test. A registration statement similar to that described in connection with registration by qualification must be filed for a registration by notification.
The registration statement ordinarily is prepared on a form provided by the state securities commission. Considerable effort has been expended to standardize securities laws and related forms among the 50 states. Most states now permit issuers to register their securities on a uniform application developed by the American Bar Association. This uniform application is called Form U--1.
Generally, the filing of a registration statement with a state securities commission constitutes registration of the security unless the commission objects to the registration statement within a prescribed period. A state securities commission retains the authority to suspend or revoke a registration of securities on the basis of a variety of grounds, including fraud, unreasonable commissions, illegality, omission of a material fact in the registration statement, and willful violation of any rule, order, or condition imposed by the securities commission.3 Registration of securities generally is effective for one year, although some state laws stipulate that a registration will expire when the securities described in the registration statement have been sold.
Most securities laws that exempt church securities from registration also exempt churches from the requirement of filing sales and advertising literature with the securities commission. Again, churches must not assume that they are exempt from the filing requirement, since some state securities laws contain no such exemption. Furthermore, even if a church is exempt from the requirement of filing its sales and advertising literature with a state securities commission, it may be deemed to have entered into fraudulent transactions with investors if at or before the time of a sale or an offer to sell it does not provide each investor with a prospectus or offering circular containing sufficient information about the securities to enable an investor to make an informed investment decision.
The North American Securities Administrators Association has developed guidelines for a church to follow in drafting a prospectus or offering circular.4 In general, these guidelines require certain basic information on the cover page, and in addition require a full description of the history and operations of the church; the church's prior borrowing experience; risk factors associated with investment in the church's securities; how funds will be held during the offering period; anticipated use of proceeds; current financial condition of the church, accompanied by financial statements for the past three years; the church's properties; the type and amount of the securities to be offered, including interest rates, maturity dates, payment dates, and paying agent; the plan of distribution; pending or threatened legal proceedings against the church; tax aspects of ownership of the church's securities; and the church's leadership.
It is important to observe that most states require that persons who sell or offer to sell securities be registered with the state securities commission. Registration involves submitting a detailed application5 and, in most cases, the successful completion of a securities law examination. Many states that exempt the securities of religious organizations from registration do not exempt persons selling or offering to sell such securities from the salesman registration requirements.6
No state securities law exempts religious organizations from the antifraud provisions. The antifraud provisions of the Uniform Securities Act are set forth in section 101:
It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly(1) to employ any device, scheme, or artifice to defraud;
(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading; or
(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
This section is substantially the same as section 17(a) of the federal Securities Act of 1933. Section 17 expressly states that the Act's exemption of nonprofit organizations from the registration requirements does not apply to the antifraud provisions.
The antifraud provisions of federal and state securities laws are very broad. They have been construed to prohibit a wide variety of activities, including making false or misleading statements about church securities; failing to disclose material risks associated with securities; manipulating the church's financial records in order to facilitate the sale of securities; failing to establish a debt service or sinking fund reserve out of which church securities will be retired; making false predictions; recommending the sale of securities to investors without regard to their financial condition; inducing transactions that are excessive in view of an investor's financial resources; borrowing money from an investor; commingling investors' funds with the personal funds of another, such as a salesman; deliberately failing to follow an investor's instructions; making unfounded guarantees; misrepresenting to investors the true status of their funds; representing that funds of investors are insured or “secure” when in fact they are not; representing that investments are as safe as if they had been made in a bank, when this is not the case; and representing that securities have been approved of or recommended by the state securities commission or that the commission has passed in any way on the merits or qualifications of the securities or of any agent or salesman.
In a leading case, the federal Securities and Exchange Commission brought an action in federal court seeking to enjoin a church and its leader from violating the antifraud provisions of the Securities Act of 1933.7 The church had solicited funds through investment plans consisting essentially of the sale of interest--bearing notes to the general public. The notes were promoted through advertising literature extolling the security of the investment. For example, one advertisement stated in part:
You may be a Christian who has committed his life into the hands of God, but left his funds in the hands of a floundering world economy. Financial experts everywhere are predicting a disaster in the economy. They say it is only a matter of time. . . . God's economy does not sink when the world's economy hits a reef and submerges! Wouldn't it be wise to invest in His economy?
The Securities and Exchange Commission argued that the church had defrauded investors by such representations when in fact it had a substantially increasing operating deficit that had jumped from $42,349 to $203,776 in the preceding three years. This fact was not disclosed to investors.
The church argued that religious organizations are protected by the first amendment from the reach of securities laws. In rejecting this contention, the court observed: “Defendants constantly emphasize that they are engaged in `God's work.' No court has ever found that conduct, by being so described, is automatically immunized from all regulation in the public interest.”8 The court quoted with approval the United States Supreme Court's earlier observation that “[n]othing we have said is intended even remotely to imply that, under the cloak of religion, persons may, with impunity, commit frauds upon the public.”9 The court found it irrelevant that investors had a “religious” motivation, that most investors were “believers,” and that the church did not intend to defraud or deceive anyone.
In another case, a minister was found guilty of engaging in fraudulent practices through failing to disclose to investors of church securities that he had $116,000 in unsatisfied debts, that he had incurred $700,000 in unsatisfied debts on behalf of a previous church through the sale of securities, and that the church's financial statements were in error.10
A church engaged in a chain distributor scheme of marketing ministerial credentials was found guilty of a fraudulent practice.11 The church, whose archbishop was an attorney who had been disbarred for tax fraud in connection with the activities of the church, encouraged persons to become members by purchasing ministerial credentials for $3,500. Once the fee was paid, the minister would name and establish his own church chartered by the parent church. He could then either make donations to his church or take a vow of poverty placing all his property in the name of his church and then pay all personal and family expenses through the church's account, thereby avoiding all taxes. Each minister was given the right to act as a “missionary representative” and was entitled to a 10 percent commission for each new member he recruited into the church. After recruiting two fully paid members in one month, the missionary representative was granted advancement to the “missionary supervisor” level and thereby became eligible to receive a special bonus of $500 for each new fully paid minister recruited. After the missionary supervisor level, one could become a “director” and receive a 40 percent commission. Ministers were enticed through a demonstration of number doubling. Two became four, eight became sixteen, thirty--two became sixty--four, and commissions mounted from $350 to a total of $1,023,500 when 2,047 new recruits were added. A chart was prepared to give dramatic visual impact on how to become a millionaire. A court summarily concluded that such a scheme was fraudulent, and that application of state securities law to the church did not violate the first amendment.
Many other churches have been investigated by the federal Securities and Exchange Commission and by state securities commissions. In most cases, the investigation was prompted by the complaint of an investor.12
Churches that violate state securities laws face a variety of potential consequences under state and federal securities laws. These include investigations, hearings, subpoenas, injunctions, criminal actions, cancellation of sales, suits for monetary damages by aggrieved investors, monetary fines, and revocation of an exemption, or registration, of securities.
Finally, it is important to recognize that “good faith,” lack of an intention to deceive, or lack of knowledge that a particular transaction is either fraudulent or otherwise in violation of securities law does not necessarily insulate one from liability. One court has held, for example, that the sale of unregistered securities in violation of state securities law is punishable despite the innocent intentions of the seller.13 It is the prevailing rule of law, however, that private actions by aggrieved investors alleging fraud in the sale of securities must demonstrate an actual intent to deceive or defraud.14
For related information on this topic see the following articles:Regulation of Charitable Solicitations
Limitations on Charitable Giving
Judicial Resolution of Church Disputes
The Civil Rights Restoration Act of 1987
Americans with Disabilities Act
Political Activities by Churches and Other Religious Organizations