The metaphysics of the second step

No, not a novel by Gabriel Garcia Marquez, but some musings on an aspect of the more complicated aspects of securities law relating to what needs to be registered under the Securities Act of 1933, part of what we law bores refer to as “the metaphysics.”

Some investments happen in two stages. You buy convertible notes and then they convert into shares. You are issued warrants and you exercise those warrants. You get the idea. The important thing from the point of view of registration under the Securities Act is that there are usually two separate transactions, and you have to examine both of those transactions to make sure each is registered under the Securities Act or made in compliance with an available exemption from registration.

Sometimes it’s easy. If the convertible notes were sold to accredited investors under Rule 506(c), that rule is probably still going to be available for the conversion. Section 3(a)(9) may also be available for some sorts of exchanges and conversions.

Where it gets a lot more difficult is when both transactions are deemed to take place at the same time and the initial transaction is an exempt public offering under Regulation A or Regulation CF. If the second step may take place within the next year, or if it happens only at the option of the issuer, the SEC reckons that investors are making an investment decision with respect to both the security they are buying and the “underlying” security it converts into or is exchangeable for. If that underlying security already exists, easy peasy. You include and describe the underlying security in the description of the securities your Form C or Form 1-A covers.

If, however, the underlying security doesn’t exist yet, because its terms will only be set by some future investor, or will carry rights and functionality yet to be determined, how do you describe those securities sufficiently to comply with the disclosure requirements of Form 1-A or Form C? You are going to have to include enough information about the underlying security in order to permit the investor to make an informed investment decision at the time he or she buys the overlying security

In some cases (such as SAFTs), you might hope that the underlying security isn’t actually going to be a security after all, which may be a form of magical realism in itself.

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