Imagine you’ve invested in a company, and now it’s being sold or its assets are being liquidated. A liquidation preference determines who gets paid first and how much they get before others receive anything. Think of it as a safety net for investors. If the sale price is lower than what they initially put in, this clause makes sure they get their money back before anyone else does.

There are two key parts to a liquidation preference: the preference itself and something called participation. The preference part means that, in a liquidation event, certain investors get paid a specified amount before others. So if you’re an early investor, you might be entitled to a 1× liquidation preference—meaning you get back exactly what you invested before others get paid.

Then, there’s the participation part, which comes into play after the initial preference is met. Depending on the terms, some investors not only get their money back but also share in any remaining proceeds, which adds an extra layer to their return.

Overall, liquidation preferences are there to protect investors, especially if things don’t go as planned and the company’s value doesn’t meet expectations. It’s a way for investors to manage risk while hoping for an eventual upside if the company does well.

I. Components of Liquidation Preference

Liquidation preference has two main parts that determine how money gets divided when a company is sold: (i) Actual Preference and (ii) Participation.

Actual Preference

This part, called the “actual preference,” is about giving certain investors—usually those who invested first or hold specific types of shares—priority to get paid before others when the company is sold. Think of it as a line where some investors get to go to the front and claim their share before anyone else.

For example, if investors hold what’s called “Series A Preferred” stock, they’re first in line to receive an agreed-upon amount—often the amount they originally invested—before common shareholders get anything. The reason for this setup is simple: these investors took an early risk by putting money into the company, and this priority treatment helps protect that risk.

An example of how this might be worded in an agreement is: “In the event of liquidation, Series A Preferred shareholders are entitled to receive their original investment back before common stockholders receive any payment.”

Participation

The Participation part of liquidation preference determines if certain investors can receive additional money beyond their initial preference. Once they’ve received their priority payout (the “actual preference”), some investors might also get to participate in any remaining proceeds. There are three main types of participation:

• No Participation. In this setup, investors receive only their initial preference amount and nothing more. For example, if someone invested $4 million with a 1× liquidation preference, they would receive just their $4 million back, even if there’s more money left after that. This type is sometimes called “nonparticipating preferred” stock.
• Full Participation. Here, investors get their initial preference amount and a share of any leftover proceeds. For example, if an investor has a 1× liquidation preference with full participation, they get back their initial $4 million, and then they also share in the remaining proceeds based on their ownership percentage, as though they held common stock. This allows them to benefit both from their priority payout and from any additional upside.
• Capped Participation. Capped participation lets investors receive their preference amount and a portion of the remaining proceeds, but only up to a specific limit or “cap.” For example, if an investor’s cap is set at 2.5× their original investment, and they invested $4 million, they can receive up to $10 million in total ($4 million preference plus up to $6 million more from participation). Once they reach this cap, they don’t receive any additional payout, regardless of how much more is available.

II. Conversion and Participation

In liquidation preferences, conversion allows investors with preferred shares to switch their shares to common stock under certain conditions. This option gives them flexibility, as they can choose to convert if it will result in a higher payout. The decision to convert usually depends on a conversion ratio, which specifies how many common shares an investor receives in exchange for each preferred share.

Let’s break it down with an example.

Imagine an investor owns preferred stock with a 1:1 conversion ratio, meaning each preferred share can be converted into one common share. If the company is being sold, the investor can either (a) stick with the liquidation preference and receive their original investment back first or (b) convert their preferred shares into common stock and receive a share of the total sale proceeds based on their ownership percentage.

Here’s a scenario to illustrate how conversion might work:

1. Example 1 “No Conversion Needed”. Suppose the investor put in $3 million and has a 1× liquidation preference. The company is being sold for $4 million. In this case, the investor would likely choose not to convert, as sticking with the 1× liquidation preference guarantees them $3 million back before anyone else is paid. Converting would only dilute their payout, so they opt to keep their preferred status.
2. Example 2 “Conversion for a Higher Payout”. Now, let’s say the company is sold for $10 million, and the investor has 25% ownership in preferred shares. With a 1× liquidation preference, they could take back their original $3 million, but converting their shares to common stock would give them 25% of the $10 million sale price, or $2.5 million. In this case, they might choose to keep their preferred stock for the guaranteed $3 million payout, rather than converting to common and receiving a lower amount.
3. Example 3 “High-Value Sale and Conversion Advantage”. Finally, imagine a big exit where the company is sold for $20 million. Now, if the investor has 25% of the company, converting to common stock would result in a $4 million payout (25% of $20 million). In this case, conversion is beneficial because they can receive more than the $3 million from sticking with the liquidation preference.

III. Examples of Participation Scenarios

Let’s go over four different scenarios that show how participation terms impact investor and common stockholder payouts in a company sale. We’ll use examples with different types of liquidation preferences: 1× nonparticipating, 2× nonparticipating, 1× fully participating, and 1× capped at a 3× multiple.

Assume:

• The investor originally invested $2 million, holding 40% of the company.
• The common stockholders own the remaining 60%.
• We’ll look at company sale values of $3 million, $10 million, $20 million, and $50 million.

Case 1. 1× Nonparticipating Preference

Terms: The investor has a 1× nonparticipating preference, meaning they can either take their initial $2 million investment back first or convert to common shares to receive 40% of the sale if it’s higher.

Sale Scenarios:

• $3 million sale: The investor takes their 1× preference, getting $2 million, leaving $1 million for common holders.
• $10 million sale: The investor could take their 1× preference ($2 million) or convert to receive 40% of $10 million ($4 million). They choose to convert, taking $4 million, while common stockholders get $6 million.
• $20 million sale: The investor converts to common to take 40% of $20 million, or $8 million. Common holders receive $12 million.
• $50 million sale: Again, the investor converts to common, receiving 40% of $50 million, or $20 million, with the remaining $30 million going to common holders.

Case 2: 2× Nonparticipating Preference

Terms: The investor has a 2× preference, which entitles them to twice their initial investment ($4 million) before common holders get anything.

Sale Scenarios:

• $3 million sale: The investor’s 2× preference entitles them to $4 million, but since the sale is only $3 million, they take the entire amount, leaving nothing for common holders.
• $10 million sale: The investor takes their 2× preference of $4 million, leaving $6 million for common holders.
• $20 million sale: The investor takes $4 million, with common holders receiving the remaining $16 million.
• $50 million sale: The investor converts to common to take 40% of $50 million ($20 million), which is higher than their $4 million preference. Common holders receive $30 million.

Case 3: 1× Fully Participating Preference

Terms: The investor has a 1× preference with full participation, meaning they first receive $2 million, and then share in the remaining proceeds based on their ownership.

Sale Scenarios:

• $3 million sale: The investor takes their $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million, while common holders get $4.8 million.
• $20 million sale: The investor takes $2 million first, then 40% of the remaining $18 million ($7.2 million), for a total of $9.2 million, with common holders getting $10.8 million.
• $50 million sale: The investor receives $2 million, then 40% of the remaining $48 million ($19.2 million), totaling $21.2 million, with common holders getting $28.8 million. 

Case 4: 1× Preference with a 3× Cap

Terms: The investor has a 1× preference with participation capped at 3×, meaning they get back their $2 million investment and can participate up to a $6 million maximum payout.

Sale Scenarios:

• $3 million sale: The investor takes the $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million. Since this is below the 3× cap, they keep it all, and common holders get $4.8 million.
• $20 million sale: The investor takes their $2 million preference and 40% of the remaining $18 million ($7.2 million), totaling $9.2 million. However, they’re capped at $6 million, so they stop there, and common holders receive the remaining $14 million.
• $50 million sale: Here, the investor also reaches their cap of $6 million, as their participation amount would otherwise exceed it. Common holders receive the remaining $44 million.

IV. Impact of Multiple Investment Rounds on Liquidation Preference

As a company raises more rounds of investment, liquidation preferences can become more complex. When multiple rounds (like Series A, B, and C) have different investors with varying priorities, there are two main ways these preferences can be structured: Stacked Preferences or Blended Preferences (also known as pari passu).

Stacked Preferences

With stacked preferences, each investment round has priority based on when it was made, with later rounds getting paid first. This structure is sometimes favored by newer investors who want assurance that they’ll recover their investment ahead of earlier rounds. Here’s how it might work in practice:

• Imagine a company has raised three rounds: Series A ($3 million), Series B ($7 million), and Series C ($10 million), for a total of $20 million in investments.
• If the company is sold for $15 million, Series C investors, having the latest round, would be paid back first. They receive their $10 million investment, leaving $5 million.
• Series B investors would then receive up to their $7 million investment from the remaining $5 million, but since that’s all that’s left, they only recover $5 million.
• Series A investors would receive nothing because the sale price doesn’t cover earlier investors’ stacked preferences.

Stacked preferences make each subsequent investment round riskier for previous investors, as they move further down the payout line if the company doesn’t achieve a high sale price.

Blended Preferences (Pari Passu)

In blended preferences, or pari passu structure, all rounds share the proceeds proportionately based on their investment amounts, without one round being prioritized over another. This approach spreads the risk more evenly among investors in different rounds.

• Using the same investment amounts as above, let’s say the company is again sold for $15 million.
• With blended preferences, the proceeds are distributed pro-rata. Here’s how it might work:
  • Series A, which contributed $3 million, would receive a proportionate share of the sale price: 15% of the $15 million, or $2.25 million.
  • Series B, which invested $7 million, would receive 35%, or $5.25 million.
  • Series C, with the highest investment of $10 million, would receive 50%, or $7.5 million.

In this scenario, all rounds of investors get some return, rather than later investors getting prioritized. Blended preferences are often seen as fairer when the company has a diverse set of investors who all took risks at different stages.

The choice between stacked and blended preferences often depends on the investors’ bargaining power and the company’s needs. Later-stage investors, like Series C, may prefer stacked preferences to maximize recovery if the exit is small. Meanwhile, blended preferences are more equitable and can appeal to early investors by giving everyone a fair share of proceeds, regardless of the investment sequence.

V. Negotiating Liquidation Preferences

When setting up liquidation preferences, companies and investors must find a balance that protects investors while also keeping employees and management motivated. Liquidation preferences should ideally provide security for investors without overly limiting the potential rewards for the team running the company.

Investors typically want liquidation preferences to secure their investment, especially in the early stages when the company’s future is uncertain. However, setting high or complex preferences can limit the amount left over for employees and management, who are usually holding common stock or options. If team members feel they won’t see significant rewards unless the company has a very high sale price, their motivation to drive the company forward may decrease.

For example:

• Suppose an early-stage company raised $1 million in a seed round with a 2× liquidation preference, guaranteeing the seed investor $2 million in a sale before any proceeds reach common shareholders.
• If the company later sells for $3 million, the investor would take $2 million, leaving only $1 million for all common shareholders, including employees and management.
• In this scenario, the small remaining payout may discourage employees, as they see limited upside unless the company achieves a very high exit.

Finding a balance often means negotiating preferences that protect investors without excessively reducing potential returns for the team. For instance, a 1× preference, rather than 2× or 3×, can offer investors downside protection while still allowing meaningful upside for common shareholders in smaller exits.

Best Practice: Keeping Preferences Simple and Lightweight in Early Rounds

In early rounds, it’s generally advisable to use straightforward and low-level liquidation preferences, such as a 1× nonparticipating preference. This simple structure ensures that investors get their initial investment back but doesn’t add layers of complexity or significantly impact the returns available to employees and management.

For example:

• A company raises $500,000 in its seed round, with a 1× nonparticipating liquidation preference. If the company is sold for $2 million, the investor would take back their $500,000 first, leaving $1.5 million to be shared among common shareholders, which includes employees and founders.
• This simple approach gives early employees and management a strong incentive, as they can see a meaningful return in even moderately successful exits.

VI. Defining a Liquidation Event

A liquidation event is any situation where a company undergoes a significant change in ownership or control, triggering the payout rights defined in the liquidation preference terms. Liquidation events often include mergers, acquisitions, and changes in control, but they can also cover situations like the sale of all or most of the company’s assets. These events are essential to define in investment agreements because they determine when and how investors receive their payouts.

Types of Liquidation Events

1. Merger. When a company combines with another entity to form a new organization. For example, if Company A merges with Company B, creating a new merged entity, it can trigger a liquidation event for shareholders.
2. Acquisition. When one company buys out another, either through a purchase of shares or assets. For instance, if Company X acquires all shares of Company Y, this acquisition is a liquidation event for Company Y’s shareholders.
3. Change of Control. When there’s a significant shift in who holds controlling interest or voting power within the company. This could be through a sale of majority shares or a voting power transfer. For example, if a new investor acquires 70% of the voting shares, it may be classified as a liquidation event, allowing other investors to receive their payouts.
4. Sale of Major Assets. If a company sells off most of its assets or business units, this can also trigger a liquidation event. For example, if a tech company sells all its intellectual property and core assets, this sale could be treated as a liquidation event.

Standard Language for Defining a Liquidation Event

To ensure clarity, investment agreements often include precise language to define what qualifies as a liquidation event. Here’s an example of standard language:

“Liquidation Event. A liquidation event includes (a) any merger or consolidation of the Company with another entity in which the Company’s existing shareholders do not retain a majority of the voting shares in the surviving entity; (b) the sale, lease, or transfer of all or substantially all of the Company’s assets; (c) the sale or transfer of more than 50% of the Company’s voting stock to a single entity or group acting together; or (d) any other transaction in which the Company’s shareholders receive cash, stock, or other securities in exchange for their shares.”

The term “security” may sound straightforward, but in law, it carries significant weight. Knowing what qualifies as a security might become critical, as it determines whether a transaction must comply with securities regulations. This distinction does not just affect buyers and sellers. It also involves brokers, advisors, and other intermediaries who play a role in these transactions. 

For businesses and individuals, identifying whether a financial instrument is classified as a security shapes how they operate. Adhering to securities laws can be complex, time-consuming, and expensive. Failing to comply can lead to severe penalties, including hefty fines or legal action. That is why it is essential to have a clear understanding of when these regulations apply and how to stay compliant. 

The Importance of Definition

When an instrument is classified as a security, several significant legal requirements and protections come into play:

• Companies issuing securities must register them with the SEC unless an exemption applies. This process involves providing detailed information about the company’s business, finances, and management to the public (See Securities Act of 1933, Sections 5 and 7).
• Issuers and related parties are subject to heightened antifraud provisions. Misleading statements or omissions of material facts can lead to severe legal consequences. For example, Section 10(b) of the Securities Exchange Act and Rule 10b-5 prohibit fraudulent activities in connection with the purchase or sale of any security.
• Brokers, dealers, and other intermediaries involved in securities transactions must register with the SEC and are subject to its rules and supervision. This oversight aims to protect investors from unethical practices (Refer to Securities Exchange Act of 1934, Section 15).
• Violations of securities laws can result in civil lawsuits, SEC enforcement actions, and even criminal charges. Penalties may include fines, disgorgement of profits, and imprisonment. The Sarbanes-Oxley Act of 2002, for instance, increased penalties for corporate fraud and imposed stricter regulations on corporate governance.

Legal Foundations of a “Security”

Federal Securities Laws

The federal securities laws, primarily the Securities Act of 1933 and the Securities Exchange Act of 1934, provide a comprehensive list of financial instruments considered to be securities. The statutes specifically enumerate certain instruments as securities. These include stocks, bonds, debentures, notes, and transferable shares. Each of these instruments represents a form of investment where individuals provide capital with the expectation of receiving financial returns.

In addition to these specified instruments, the laws include catchall terms to encompass a broader range of financial arrangements. These terms are “evidences of indebtedness,” “investment contracts,” and “certificates of interest in profit-sharing agreements.” The inclusion of these categories ensures that the laws remain adaptable to new and innovative financial products that may not fit neatly into the traditional categories. For example, an “investment contract” is a flexible term that can apply to various schemes where people invest money with the expectation of profits derived from the efforts of others. This term was intentionally left broad to prevent promoters from evading securities laws by creating novel investment vehicles not explicitly listed.

An important feature of these definitions is the phrase “unless the context otherwise requires.” This clause means that even if an instrument falls within one of the enumerated categories, it might not be considered a security if the specific context suggests otherwise. This provision allows for flexibility, ensuring that the application of securities laws aligns with the intent of the legislation and the realities of the marketplace.

Judicial Interpretation

While the statutory definitions provide a framework, courts often play their own role in interpreting these definitions, especially when dealing with unconventional investments. Two key questions arise in judicial interpretations:

1. When do unorthodox investments fall under catchall terms like “investment contract”?
2. When might instruments that fit an enumerated category not be considered securities?

To answer these questions, courts examine the economic realities of the transactions rather than relying solely on the formal titles of the instruments. This approach helps prevent individuals or companies from circumventing securities laws through creative labeling.

One landmark case that addressed the first question is SEC v. W.J. Howey Co., 328 U.S. 293 (1946) – Howey case.” In this case, the Supreme Court established the “Howey Test” to determine whether a particular scheme qualifies as an investment contract and, therefore, a security. The test considers whether there is an investment of money in a common enterprise with an expectation of profits derived primarily from the efforts of others. If these elements are present, the investment arrangement is considered a security, regardless of its form.

Regarding the second question, courts recognize that some instruments might superficially appear to be securities but, in substance, are not. For example, not all notes are securities. In Reves v. Ernst & Young, 494 U.S. 56 (1990), the Supreme Court introduced the “family resemblance” test to determine when a note is a security. This test presumes that a note is a security but allows for exceptions if the note closely resembles instruments that are not securities, such as short-term notes secured by a lien on a small business or consumer loans.
Courts consider several factors in this analysis, including the motivations of the buyer and seller, the plan of distribution, the reasonable expectations of the investing public, and the presence of alternative regulatory schemes that reduce the risk of the instrument.

The absence of a unified judicial approach arises because courts may emphasize different aspects of these factors. Some courts focus on the level of commonality among investors, distinguishing between horizontal commonality (where investors pool their resources) and vertical commonality (where a single investor’s fortunes are linked to the promoter’s efforts). Others may prioritize the degree of control investors have over their investments.

A central theme in judicial interpretations is the role of investors entrusting their money to others. When investors lack control over the management of their funds and rely on the expertise or efforts of others to generate profits, there is a heightened need for regulatory oversight to protect their interests. This situation gives rise to agency problems, where the managers (agents) may not act in the best interests of the investors (principals). Additionally, when there are many investors, collective action problems make it difficult for them to coordinate and monitor the managers effectively.

The Howey Test for “Investment Contracts”

Understanding what constitutes an “investment contract” is essential in determining whether a financial arrangement is subject to federal securities laws. One of the most significant developments in this area, as we mentioned above, is the establishment of the Howey Test, which originated from the“Howey case.”

In the Howey case, the W.J. Howey Company sold parcels of citrus groves in Florida to investors, offering them optional service contracts where Howey would cultivate, harvest, and market the citrus on their behalf. Many investors were not farmers and had no intention of working the land themselves. The Securities and Exchange Commission (SEC) argued that these transactions were “investment contracts” and should be registered as securities.

The Supreme Court agreed with the SEC and established a four-pronged test to determine when a transaction qualifies as an investment contract:

1. An investment of money;
2. In a common enterprise;
3. With an expectation of profits;
4. Derived solely from the efforts of others.

The Court emphasized that the determination should be based on the “economic realities” of the transaction rather than its form or terminology.

Detailed Breakdown of the Howey Test

Investment of Money

The first element requires that an individual invests money. This investment is not limited to cash; it can include other forms of consideration, such as services or property. The critical aspect is that the investor provides something of value with the intention of receiving a financial return. The investor is seeking profits, not merely purchasing a consumable commodity or service for personal use.

In a Common Enterprise

The second element involves a common enterprise. Courts have interpreted this in two primary ways:

1. • Horizontal Commonality. This is the majority view, where multiple investors pool their funds into a common venture, and their returns are tied to the collective success of the enterprise. For example, if several investors contribute to a fund managed by a company, and their profits depend on the overall performance of that fund, horizontal commonality exists.
   • Vertical Commonality. Some courts, though in the minority, accept vertical commonality, where an individual investor’s success is directly linked to the promoter’s efforts. There are two types:
     • Broad Vertical Commonality. The investor’s fortunes are linked to the efforts of the promoter, but not necessarily to the promoter’s profits.
     • Narrow Vertical Commonality. The investor’s profits are directly correlated with the promoter’s profits.

Regardless of the approach, the essence is that the investor is part of a venture where their financial outcome is connected to the performance of the enterprise or the promoter.

Expectation of Profits

The third element requires that the investor enters the transaction with the expectation of earning profits. These profits can come from income (like dividends or interest) or capital appreciation. The motivation should be financial gain, distinguishing investment contracts from transactions where the primary intent is to consume a good or service. Importantly, profits should be derived from the earnings of the enterprise or appreciation in the value of the investment, not merely from the contributions of additional investors (as in a Ponzi scheme).

Derived Solely from the Efforts of Others

The fourth element focuses on who is responsible for generating the profits. The investor’s expected profits must come predominantly from the efforts of someone other than themselves. Although the original wording uses “solely,” courts have interpreted this element flexibly, recognizing that investors may have some involvement. The key factor is that the managerial efforts of promoters or third parties are the essential factors in the success or failure of the enterprise. The investor’s role is largely passive, relying on the expertise and efforts of others.

The Howey Test has also been applied in various cases to determine whether certain schemes qualify as investment contracts:

• In Smith v. Gross, 604 F.2d 639 (9th Cir. 1979), promoters sold earthworm beds to investors, promising to repurchase the worms and provide marketing assistance. Investors were enticed by the prospect of high profits without needing expertise in worm farming. The court found this arrangement to be an investment contract.
• In SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974), participants paid to join a multi-level marketing scheme selling cosmetics. Profits were primarily derived from recruiting new participants rather than retail sales. The court held that such schemes are investment contracts because participants invest money with the expectation of profits from the efforts of others in the recruitment chain.

Extending Howey’s Principles Beyond Unorthodox Investments

The Howey Test is not limited to unorthodox or novel investment schemes. Courts have also applied its principles to more traditional financial instruments when assessing whether they qualify as securities. The federal securities laws list specific instruments as securities, including stocks, bonds, debentures, and notes. However, the statutes include a provision stating that these instruments are securities “unless the context otherwise requires.” This clause allows for flexibility, recognizing that not all instruments labeled as “stocks” or “notes” function as securities in practice.

Instances Where Instruments May Not Be Securities

Notes

While notes are generally presumed to be securities, the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990) established the “family resemblance” test to determine when a note is not a security. Under this test, a note is considered a security unless it bears a strong resemblance to a type of note that is not a security, such as:

1. • Short-term notes secured by a lien on a small business or its assets.
   • Notes evidencing a character loan to a bank customer.
   • Notes secured by a home mortgage.
   • Short-term notes secured by accounts receivable.

Reves v. Ernst & Young involved demand notes issued by a farmer’s cooperative. The Court held that these notes were securities because they did not fit into any recognized exceptions and investors were led to expect profits from the cooperative’s efforts.

Stocks

Although stocks are the quintessential example of securities, there are rare instances where an instrument labeled as “stock” may not be a security. The Supreme Court in United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975) examined “stock” in a cooperative housing corporation. Investors purchased shares to obtain the right to lease an apartment, not for investment purposes. The Court concluded that the shares were not securities because they lacked the characteristics of traditional stock, such as the expectation of dividends, transferability, and appreciation in value.

The key principle in securities regulation is that substance prevails over form. Simply labeling an instrument as a “note” or “stock” does not automatically make it a security. Courts scrutinize the actual characteristics and purpose of the instrument:

• If the primary intent is to use or consume the item purchased (as in purchasing cooperative housing for living purposes), it may not be a security (investor’s intent).
• Transactions resembling commercial loans or consumer financing are typically not securities (nature of the transaction).
• Securities laws aim to protect investors in situations where they are at a disadvantage due to lack of information and control over their investments (level of risk and information asymmetry).

The Risk Capital Test as an Alternative Approach

While the Howey Test is the primary method used by federal courts to determine whether an investment qualifies as a security, some state courts have adopted an alternative approach known as the Risk Capital Test. This test is particularly relevant under state “blue sky” laws, which are state securities regulations designed to protect investors from fraudulent investment schemes.

The Risk Capital Test focuses on whether an investor’s funds are placed at risk in a venture over which they have no managerial control. Unlike the Howey Test, the Risk Capital Test centers on the vulnerability of the investor’s initial capital.

This approach originated from the California Supreme Court case Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811 (1961). In this case, promoters sold memberships in a planned country club to finance the development of its facilities. The court held that these memberships were securities under California law because the investors’ funds were used to finance a speculative venture, and the investors had no control over how their money was used.

The Risk Capital Test has been utilized by courts in several states to interpret their securities laws, often leading to a broader definition of what constitutes a security compared to federal law.

The Risk Capital Test differs from the Howey Test in significant ways:

• The Risk Capital Test does not necessitate a common enterprise or the pooling of funds among multiple investors. A single investor’s capital at risk can suffice (no requirement of commonality).
• Unlike the Howey Test, which requires an expectation of profits primarily from the efforts of others, the Risk Capital Test focuses solely on the risk to the investor’s initial capital, regardless of who is responsible for generating returns (no need for profits derived from others’ efforts).
• The test centers on whether the investor’s funds are subject to the risks of an enterprise over which they have no managerial control, making them dependent on the promoter’s honesty and competence (emphasis on capital at risk).

In another case (State v. Hawaii Market Center, Inc., 485 P.2d 105 (Haw. 1971) investors purchased memberships in a discount buying club that promised future benefits contingent on the club’s successful establishment and operation. The Supreme Court of Hawaii applied the Risk Capital Test (economic realities) and concluded that these memberships were securities because the investors’ funds were used to finance the venture, and they lacked control over how their money was utilized.

Conclusion

As new financial instruments emerge—such as cryptocurrencies, alternative assets, and innovative investment schemes—they often blur the lines of traditional definitions. These advancements challenge regulators and courts to reassess and interpret the term “security” in contexts that were unimaginable when the original laws were enacted.

The dynamic nature of these investment vehicles/instruments means that courts must continually adapt. They strive to balance the need for investor protection with the encouragement of market innovation. On one hand, stringent definitions may stifle creativity and the development of new financial products. On the other hand, overly lax interpretations can leave investors vulnerable to fraud and abuse.

Looking ahead, there is potential for legislative updates or new judicial standards to address the changing and developing landscape of financial instruments. The rise of decentralized finance (DeFi), non-fungible tokens (NFTs), and other digital assets may prompt lawmakers and regulators to refine or expand existing definitions.

The need for clarity is paramount. Clear guidelines help investors make informed decisions, assist issuers in complying with regulations, and enable legal practitioners to provide accurate advice. Regulatory bodies like the SEC continue to issue guidance and engage in rulemaking to address novel financial products. For example, in recent years, the SEC has provided insights into when digital assets may be considered securities under the federal securities laws. 

The journey to define a “security” is ongoing and reflects the dynamic interplay between law, finance, and innovation. While the complexity presents challenges, it also offers opportunities for the legal system to adapt and protect investors in new ways.

Participation in the resale market for venture capital funds is crucial for investors who wish to liquidate their investments earlier than initially anticipated. This requirement might be due to diverse personal or strategic financial points like a sudden demand for liquidity or a wish to rebalance one’s investment portfolio. As an increasing number of investors demonstrate a proclivity to sell shares that do not align with the designated settlement date, there is a corresponding rise in the number of prospective purchasers who are interested in acquiring these stakes.

Venture capital entities have already effectively adapted to the growing dynamism in this secondary market. They have standardized the documentation and processes to facilitate these equity transfers efficiently. Although the process is designed to be streamlined, recent regulatory changes in the U.S. have introduced some complexities. For instance, tax regulations under Section 1446(f) of the Internal Revenue Code necessitate the withholding of taxes when shares are sold by non-U.S. investors, complicating the payout process.

Suppose there is a case involving a non-U.S. investor, who is looking to divest their venture capital fund shares. According to the IRS tax guidelines, a portion of the sale proceeds must be withheld for tax purposes before distributing the remaining funds to the seller.

Tax Implications for Non-US Investors Under Section 1446(f)

In the example we discussed, where non-U.S. investor (limited partner) wants to sell their shares in a venture capital fund, they face specific tax obligations under U.S. law, particularly under Section 1446(f). This section deals with how profits from the sale are taxed if the fund itself would have made a profit in a hypothetical situation where all its assets were sold at their current market value.

Let’s break it down: suppose a non-U.S. investor sells their interest in a venture capital fund and makes a $1,000,000 profit. If the fund, in a theoretical sale of all its assets, would have made a profit where 10% of that profit was connected to U.S. business activities, then $100,000 of the investor’s $1,000,000 profit would be considered connected to U.S. business (“effectively connected income”, or “ECI”).

For U.S. investors, this ECI designation does not really change anything; they must pay U.S. taxes on all their gains regardless. However, for non-U.S. investors, whether their profit counts as ECI is crucial. If none of their profit is ECI, they typically would not owe U.S. taxes on it. But if some of the profit is ECI, as in our example, they face U.S. tax obligations.

Under Section 1446(f), when a non-U.S. investor sells their fund interest, the buyer of that interest has to act almost like a tax collector for the IRS. Specifically, the buyer must withhold 10% of the total amount the seller gains from the sale. So in our example, if a non-U.S. investor gains $1,000,000 from the sale, the buyer needs to withhold $100,000 and send it to the IRS.

If the buyer forgets or fails to withhold this amount, the venture capital fund itself is then responsible for making sure the IRS gets its due. The fund must withhold the necessary tax from any future payments it was supposed to make to the buyer related to the investment.

Moreover, the buyer has to confirm to the venture capital fund how they have met these withholding requirements. They need to provide a formal certification detailing this compliance within 10 days after the sale.

Withholding Tax Exceptions for Non-US Venture Capital Investors 

It is also important to know that there are several exceptions to these rules under Section 1446(f) that might prevent the need for withholding tax at all.

First, let’s look at exceptions related to certifications by the non-U.S. limited partner who is selling their interest. One way to avoid withholding is if this partner certifies that their sale does not result in any actual profit or gain. Essentially, if they’re not making any money from the sale, there’s no income to tax, so no withholding is necessary.

Another way is a bit more complex but comes down to the partner’s previous tax history with the fund. If the selling partner can certify that they’ve been part of the fund for the last three tax years, and during each of those years, their share of effectively connected income (ECI) was both under $1,000,000 and less than 10% of their total income from the fund, and they have correctly reported this income and paid any taxes due on it in the U.S., then withholding can be skipped. This shows the IRS that the seller has a consistent history of small-scale involvement in terms of taxable U.S. operations and compliance with U.S. tax laws.

There are also exceptions based on certifications from the venture capital fund itself. If the fund can certify that it was not engaged in any U.S. trade or business at any point during its current tax year up to the transfer date, then no withholding is required because there’s no U.S. business activity connected to any gains.

Alternatively, if the fund can prove that even if all its assets were sold at a current market value (a deemed sale), the resulting ECI would not make up more than 10% of the total gain from such a sale, or the non-U.S. partner’s share of ECI would not be moree than 10% of total income from the sale, then again, withholding is not needed. This would indicate that a connection to U.S. business activities is really minor enough not to trigger the need for tax collection.

Section 1446(f) Challenges for Non-US Investors

Applying the exceptions from withholding taxes under Section 1446(f) can be tricky and is not always so cut-and-dried, primarily due to some qualifying conditions and the need for cooperation among different parties involved.

For instance, one significant hurdle is the requirement for a non-U.S. limited partner (the seller) to have held their interest in the venture capital fund for at least three full tax years to qualify for certain exceptions. If a partner has not met this tenure requirement, they cannot use the exception related to having minimal ECI below the thresholds of $1,000,000 or 10% of their total income from the fund. This can be quite limiting, especially for newer investors who may be looking to exit earlier than this timeframe.

Additionally, the process of obtaining necessary certifications either from the non-U.S. limited partner or directly from the venture capital fund itself often requires considerable coordination and cooperation. The transferee (the buyer) relies heavily on these other parties to provide accurate and timely certifications that confirm no withholding is necessary. Any delays or inaccuracies in this process can complicate the transaction and may inadvertently lead to withholding obligations.

Moreover, if a situation arises where the required withholding was not executed by the transferee, the venture capital fund itself becomes responsible for ensuring compliance. This secondary withholding obligation necessitates the fund to know exactly how much was realized from the sale of the non-U.S. partner’s interest—a detail that the fund might not have immediate access to. This lack of information can complicate how the fund manages its subsequent distributions, particularly when it comes to withholding the correct amounts from future payments to the transferee.

Overall, while the exceptions under Section 1446(f) provide pathways to avoid withholding taxes, the actual application of these exceptions can be complex and fraught with challenges, often depending on precise documentation and the cooperative effort of all parties involved in the transaction.

Double Tax Treaty Implications

The application of double taxation treaties (DTT) may have a significant impact on the withholding tax rate stipulated by Section 1446(f) when a non-U.S. investor disposes of shares in a U.S. venture capital fund. In the absence of a tax treaty, the default rate is 10% on the gross proceeds from the sale of partnership interests by foreign partners. However, this rate can be adjusted or waived if a tax treaty between the United States and the investor’s country of residence offers more favorable terms.
The effective application of DTTs necessitates compliance with the requisite documentation and procedural requirements. For example, non-U.S. investors may be required to submit IRS Form W-8BEN in order to certify their residence in a treaty country and qualify under the “limitation of benefits” provisions of the DTT, thus enabling them to benefit from the treaty provisions. Failure to provide this form accurately and in a timely manner can result in the automatic application of the statutory withholding rate, regardless of any treaty provisions that might otherwise reduce the investor’s tax liability.

A very recent ruling by the Supreme Court came on June 27, 2024, in Securities and Exchange Commission v. Jarkesy, which held that the Seventh Amendment to the U.S. Constitution requires the Securities and Exchange Commission (SEC) to bring a civil penalty for securities fraud in the federal district courts before a jury, not through an administrative proceeding.

The SEC charged George Jarkesy, Jr. and his investment firm, Patriot28, LLC, with fraud in connection with the operation of their investment funds. If the SEC believes that someone has violated the securities laws, it has two options: It can bring the case in federal court or handle the matter internally through its administrative proceedings. In this case, the target for alleged violations of the securities law was adjudicated by the SEC itself. Thus, the action was handled by an administrative law judge—who works for the SEC—rather than a federal court.

This raises some very serious legal questions under the Seventh Amendment, which ensures there will be a trial by jury in certain civil cases. So, the real basic legal question of this case was whether under the Seventh Amendment, Jarkesy and his firm had a constitutional right to a jury trial in light of the SEC’s decision to handle prosecution of the charges in-house.

The Supreme Court has ruled that the SEC’s internal case handling method, which does not offer a jury trial, violates the Seventh Amendment. Now this could have a significant impact on how the SEC and potentially other federal agencies enforce their rules.

The SEC’s Enforcement Action

The SEC enforcement charged several instances of allegations for fraud-related activities.

• Misrepresentation of Investment Strategies. The SEC charged Jarkesy and Patriot28 with the misrepresentation of investment strategies to misled investors.
• False Information Regarding the Auditor and Broker. Jarkesy and his firm were also charged with false representations regarding an auditor and a prime broker for the funds.
• Inflating the Value of the Funds. Another grave allegation was that Jarkesy and his firm inflated the value of the funds under their management.

The SEC took the following enforcement actions in response to the allegations:

• Civil Penalties. A civil penalty of $300,000 was imposed by the SEC on Jarkesy and Patriot28. Civil penalties include money fines that the SEC can levy to punish wrongdoing and deter wrongdoers.
• Cease and Desist Order. The Commission ordered Jarkesy and Patriot28 to cease and desist from committing or causing any violations of the antifraud provisions of the securities laws. This is a standard regulatory step to prevent the believes from continuing whatever activity is charged as illegal under securities laws.
• Disgorgement. It was ordered that Patriot28 disgorge the ill-gotten gains by returning money or property gained in an illicit manner to the parties concerned.
• Industry Bars. Jarkesy has been barred from the securities industry and penny stock offerings.
• Adjudication Process. Instead of taking it before a federal court, the SEC chose to conduct the case internally within its administrative process. It involved an administrative law judge appointed by the SEC, which created much legal controversy as to the appropriateness of such denial of a jury trial in cases relating to civil penalties against securities fraud.

Seventh Amendment Overview

The legal analysis of the Seventh Amendment claims in SEC v. Jarkesy turns on whether defendants have the right to a jury trial when the SEC decides to pursue civil penalties in its internal administrative proceedings rather than in federal district court. The question at hand was centrally located within the determination of the constitutional limits of the different administrative enforcement actions by regulatory agencies like the SEC.

The Seventh Amendment grants the right to trial by jury in civil cases at common law if the amount in controversy be greater than twenty dollars.

The power of the SEC to enforce the securities laws either through administrative proceedings or through filing actions in federal court is long-established. When administrative proceedings are initiated, they typically do not involve juries, which raises a constitutional question.

In contrast, civil penalties, which are monetary in nature, are not merely compensatory and thus punitive in nature. They are intended to punish and deter wrongful conduct, and therefore have a punitive character. While actions for penalties could be tried by a jury at common law, similar actions under modern law may also require a jury.

In Granfinanciera, S.A. v. Nordberg (1989), the Supreme Court held that a statutory action of this nature, much like an action brought at common law, does grant the defendant the right to trial by jury under the Seventh Amendment if its judgment may lead to “personal liability” for money damages. The Court distinguished between actions that primarily concern public rights and those that primarily concern private rights disputes, which are more characteristic of the common law.

In Atlas Roofing Co. v. Occupational Safety and Health Review Commission (1976) the Supreme Court had held that it was within congressional power to assign the determination of statutory rights created by Congress to an administrative agency, with no right to a jury. However, this has been interpreted to apply to cases where the statutory framework creates new legal rights and obligations distinct from traditional common law actions.

In Tull v. United States (1987) the Supreme Court again restated that the right to a jury trial depends on the remedy sought. When relief is sought through penalties or action punitive in nature—characteristics traditional to common law—the right to trial by jury is preserved.

The critical legal question of SEC v. Jarkesy lies in the query: Did the SEC’s pursuit of civil penalties through its in-house, administrative processes without providing a right to a jury violate the Seventh Amendment?

Additionally, the arguments presented in the case hinge on whether the SEC’s action can be classified as a public rights adjudication, which typically does not require a jury, or rather, a private rights dispute that is subject to a jury trial. Given that the penalties in question are punitive and that the fraudulent nature of the actions otherwise alleged is grounded in common law history, it would be strongly in line with the Seventh Amendment to call upon a jury to determine the case.

Court’s Decision and Reasoning

The Supreme Court ruled that defendants have a right to a jury trial under the Seventh Amendment when the SEC seeks civil penalties for securities fraud.

The Court noted that the civil penalties sought by the SEC are, in fact, punitive rather than remedial. The basic purpose of such penalties is not so much to compensate the victim as to punish the offender and deter others from similar wrongdoing. It is this punitive nature that brings them more accurately within the concept of traditional common law actions, where the right to a jury trial is preserved.

Additionally, the SEC’s enforcement actions were based on allegations of fraud. The Court pointed out that fraud, historically a common law claim, involves deception and misrepresentation—actions traditionally adjudicated by juries. The SEC’s use of terms like “fraud” and “deceit” in its enforcement actions invokes common law principles, which necessitate a jury trial under the Seventh Amendment.

The “public rights exception” to the Seventh Amendment allows some legal claims to be decided without a jury, namely those involving public rights that Congress commits to resolution by administrative agencies or specialized courts. But the Court held this exception did not apply here, at least for the following reasons:

• Private vs. Public Rights. The Court distinguished between public rights, which are integral to a public regulatory scheme and typically do not require jury involvement, and private rights, which involve personal interests and are closely tied to the historical use of juries. The SEC’s action, involving allegations of private misconduct (fraud) and seeking punitive penalties, was categorized as a matter concerning private rights.
• Historical Precedent and Legislative Intent. The Court considered the historical contexts in which the public rights exception was applied, namely to customs duties, public land disputes, and certain government benefits, and stated that these cases typically involve legislative or sovereign functions or statutory schemes that by their very nature are governmental in character. Conversely, securities fraud is concerned with private dealings and harm to private investors.
• Jury Trial Precedents in Comparable Circumstances. The Court relied on cases like Granfinanciera, S.A. v. Nordberg and Tull v. United States to mandate the need for a jury trial when statutory actions have elements and features of common law actions, particularly when punitive measures are pursued.

Paradigm Shift in Power

SEC v. Jarkesy raises important questions about the future of the SEC’s administrative proceedings in general, and particularly those that do not involve fraud or seek civil penalties. Along with other recent decisions of the Supreme Court in Ohio v. EPA and Loper Bright Enterprises v. Raimondo, these decisions suggest a transfer of powers by paradigm shift, from the executive branch to the judiciary and, more specifically, to the Supreme Court.

Furthermore, the Loper Bright Enterprises v. Raimondo case saw a significant shift in approach, with the “Chevron Doctrine” being removed. This suggests a reduction in deference to administrative agencies like the SEC when interpreting ambiguous legislation. It also indicates a more rigorous level of judicial review for agency decisions, which could have a significant impact on securities regulation enforcement in general.

For example, the Dodd-Frank Act contains what has been dubbed the “Volcker Rule”, which prohibits banks from making certain types of speculative investments that are not in the best interest of their clients. Previously, some regulatory agencies, including the SEC, had the ability to have discretion in interpreting and changing the details of these prohibitions to ensure they remain relevant for current financial markets and practices. But with the power of fine-tuning vested in the SEC, these investment restrictions began to be redrawn afresh with the new judicial posture invoked. This may even result in a scaling back or rigorous implication of such regulatory frameworks, impacting their flexibility within which these banks are supposed to avert risks and set an innovative financial strategy.

Additionally, these decisions reflect a broader skepticism about the “administrative state” and its power. The weakening of deference toward administrative agencies could result in a significant increase in litigation, as decisions previously left to expertise-heavy agencies will now be subject to greater judicial scrutiny. This could significantly impact the workload of the federal courts and provide an opportunity for legal professionals at a time when litigation is expected to increase.

Logic suggests that under these changes, there could be increased judicial scrutiny and control over regulatory actions; nonetheless, there is no assurance that outcomes will evidence any improvement over those produced by agency expertise. A change of this nature can fundamentally alter not only the ways in which regulatory practice takes place but also the meaning given to laws within a wide variety of areas.

Michael and Thomas Connelly were brothers who co-owned Crown C Supply, Inc., a building supply corporation. Michael held a significant majority of the company with 77.18% of the shares, while Thomas owned the remaining 22.82%. To protect the future of their business and ensure it remained in the family, they crafted a specific agreement.

This agreement was a legally binding arrangement known as a buy-sell agreement. It outlined that if either brother passed away, the other would have the first option to buy the deceased brother’s shares. If the surviving brother chose not to buy these shares, then the company was required to purchase them. This clause was crucial to prevent the shares from being sold outside the family or to other investors, maintaining control within the existing ownership.

To financially support this agreement, the brothers took out life insurance policies on each other, with the company as the beneficiary. Each brother was insured for $3.5 million. The idea was that the payout from the life insurance would provide the necessary funds for the company to buy back the deceased brother’s shares without impacting the company’s operating capital.

Event Triggering the Dispute

When Michael Connelly passed away, the agreement he had with his brother Thomas came into play. Thomas, who also acted as the executor of Michael’s estate, chose not to buy Michael’s shares in Crown C Supply. As per their earlier agreement, the company then had to buy back those shares. To do this, Crown C Supply used the $3.5 million from the life insurance policy it had on Michael, which was specifically set aside for such a purpose.

Thomas then had to deal with the tax implications of Michael’s death and the transfer of his shares. He filed a tax return for Michael’s estate, where he valued the shares that were bought back by the company at $3 million. This valuation was agreed upon amicably between Thomas and Michael’s son, avoiding an external valuation, which was originally envisaged in their agreement.

IRS Disagreement

When the IRS audited the tax return filed by Thomas, they challenged the $3 million valuation he reported for Michael’s shares in Crown C Supply. The IRS’s position was based on the belief that the entire value of the company should be considered when determining the value of Michael’s shares. This included the life insurance money, which was received upon Michael’s death and used by the company to purchase his shares.

The IRS calculated that with the additional $3 million from the life insurance proceeds added to the company’s assets, the total valuation of Crown C Supply amounted to $6.86 million. Based on this total company valuation, the IRS recalculated the value of Michael’s 77.18% shareholding and concluded it was worth approximately $5.3 million, significantly higher than the $3 million Thomas had declared.

This difference in valuation had a direct impact on the estate tax bill. The higher share valuation increased the taxable estate, resulting in a higher estate tax liability. Thomas disputed this higher valuation, leading to a legal battle over the correct interpretation of tax laws relating to estate valuation.

The central legal issue revolved around how to correctly apply the tax regulations governing the valuation of a decedent’s property. According to IRS regulations and established case law, the fair market value of an asset is generally considered to be the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts (26 CFR §20.2031–1(b)).

The IRS argued that a hypothetical buyer of the shares would consider all assets of the company, including the life insurance proceeds, thus increasing the fair market value of Michael’s shares at the time of his death.

Buy-Sell Agreement

In the Connelly brothers’ case, the buy-sell agreement stipulated that if one brother died, the surviving brother would have the first option to purchase the deceased’s shares. If the surviving brother chose not to exercise this option, then the company itself was obligated to buy back the shares. This setup ensures that the shares remain within the control of people already involved in the business—either the surviving brother or the company itself—thus preventing external parties or unwanted partners from gaining a stake.

Legally, such agreements are significant because they pre-define the handling of shares, greatly reducing potential disputes among heirs or other stakeholders. They also help in succession planning by clarifying the process and valuation methods for transferring shares, which can be particularly critical in ensuring the continuity of the business.

In implementing a buy-sell agreement, various legal considerations must be managed, such as determining the fair market value of the shares at the time of the shareholder’s death and ensuring that the terms of the agreement comply with relevant business laws. The agreement typically specifies a methodology for valuing the shares, which might involve an appraisal by an independent third party, or a pre-agreed formula or process.

In the context of the Connelly case, when Michael died, the value of his shares as determined according to the agreement (or through negotiation between Thomas and Michael’s son) was directly contested by the IRS. The IRS’s challenge highlighted that while buy-sell agreements can plan for the transfer of shares, the valuation still needs to align with tax laws, specifically the regulations that define fair market value for tax purposes. The IRS scrutinizes these valuations to ensure they reflect realistic market conditions and aren’t just favorable estimations designed to minimize tax liabilities.

Courts Decisions

The courts, including both the District Court and the Appeals Court, sided with the IRS’s interpretation of the tax laws.

The courts determined that the life insurance proceeds received by the company upon Michael’s death should be included in the company’s overall valuation. This inclusion is critical because those proceeds, even though they were earmarked for buying back Michael’s shares, were considered an asset of the company at the moment of Michael’s death.

The courts interpreted the regulations (specifically 26 CFR §20.2031-1(b)) to mean that any asset that enhances the value of the company should be included in its valuation, regardless of its designated use post-death.

Furthermore, the courts pointed out that the contractual obligation to use the insurance proceeds to buy back shares does not diminish the fact that at the time of Michael’s death, those funds increased the overall value of the company. Essentially, a hypothetical buyer of the company would consider all assets, including the life insurance proceeds, when determining how much to pay for the company or its shares.

The U.S. Supreme Court in Connelly v. United States, 602 U.S. (2024) affirmed the decision of the lower courts, agreeing with the IRS that the life insurance proceeds should be included in the valuation of Crown C Supply. The Supreme Court held that the corporation’s contractual obligation to redeem shares did not reduce the company’s value for purposes of federal estate tax. They concluded that a fair-market-value redemption of shares does not affect any shareholder’s economic interest and should not be treated as a liability that decreases the company’s value.

The Court further explained that life insurance proceeds, even if earmarked for redeeming shares, are an asset of the corporation at the time of the shareholder’s death and increase the company’s fair market value. As such, these proceeds should be considered in the estate’s valuation for tax purposes.

On June 6, 2024, New York Attorney General Letitia James initiated a significant legal action against NovaTechFx, AWS Mining, and their founders for conducting illegal pyramid schemes that resulted in substantial financial losses for numerous investors, prominently including over 11,000 New Yorkers.

Overview of the Case

The lawsuit alleges that these companies engaged in deceptive practices by promising high returns on cryptocurrency investments that were not based on genuine business profits but were instead funded by the capital of newer investors—a classic hallmark of a pyramid scheme. The legal claims focus on the violation of both federal and state laws that regulate securities and business practices

Specific Legal Allegations

1. Pyramid Scheme Violations. Pyramid schemes are fundamentally illegal under both New York State law and federal securities laws. The companies are accused of failing to engage in legitimate investment activities; instead, funds from new investors were used to pay returns to earlier investors, which is unsustainable and illegal.
2. Targeted Fraud. The companies are accused of specifically targeting vulnerable communities, using language and cultural references to gain trust. This strategy not only increased the impact of the fraud but also violated specific laws against deceptive practices that protect consumers from financial scams that exploit their cultural or religious beliefs.
3. Misrepresentation and False Advertising. NovaTechFx and AWS Mining misrepresented their operational legitimacy and regulatory compliance. They claimed to be registered hedge fund brokers and licensed to trade cryptocurrencies in the U.S., which were untrue. Such misrepresentations are clear violations of securities law, which require truthful disclosure of business operations to investors.
4. Unsustainable Financial Promises. The promised returns—ranging from 15% to 20% monthly and up to 200% returns within 15 months—were implausibly high and not backed by actual trading or mining outputs. Promising these returns without a legitimate basis can be seen as a form of securities fraud. 

Legal Consequences Sought in the Lawsuit
The Attorney General’s office is not only seeking penalties for these illegal activities but also aims to prevent the defendants from operating any similar business within New York. This includes:

• A permanent injunction that would prohibit business activities related to securities or commodities;
• Disgorgement of the funds received through these fraudulent activities, which legally compels the defendants to return the profits gained from their wrongdoing;
• Additional financial damages to compensate the defrauded investors, calculated based on the losses suffered by them.

Implications of the Case

The lawsuit against NovaTechFx and AWS Mining is poised to have lasting impact on the regulatory landscape of the cryptocurrency industry in New York. This legal action signals a definitive stance against the misuse of cryptocurrency platforms, especially pyramid schemes, which are clearly defined as illegal under both federal and state laws. By targeting companies that exploit the loosely regulated nature of the crypto sector, this case could drive a significant increase in regulatory scrutiny and enforcement across similar businesses.

For the cryptocurrency industry, which has often benefited from regulatory ambiguity, this case may lead to potentially increasing the costs of compliance but also stabilizing the market by weeding out deceptive practices. Moreover, the focus on investor protection, particularly within vulnerable communities, highlights a key role of state authorities in policing new financial technologies to prevent widespread financial harm. 

If the court sides with the Attorney General, the outcome could be pivotal for the cryptocurrency industry. A favorable ruling would not only confirm and enforce the legal boundaries against pyramid schemes but also provide much-needed clarity on what constitutes legitimate business practices within this sector. As a result, businesses could align their operations with legal standards, thereby fostering a safer investment landscape. For investors, this could translate into increased confidence, knowing that clearer regulations are in place to protect their interests and prevent fraudulent schemes. Ultimately, such a development could lead to a more robust and reliable cryptocurrency market.

The Securities and Exchange Commission (SEC) has taken significant legal actions against Mass Ave Global Inc. (MassAve) and its co-founder, CEO, and Chief Investment Officer, Winston Feng. The legal issues revolve around violations of the Investment Advisers Act of 1940 and the Investment Company Act of 1940. Here is a detailed breakdown of the legal implications:

Violations of the Investment Advisers Act of 1940

MassAve and Feng made materially false and misleading statements about the holdings and exposures of their flagship fund and other related funds from February 2020 through August 2022. These violations involved the dissemination of inaccurate information in various investor communications, such as monthly tear sheets, summary portfolio snapshots, and reports on top ten contributors and detractors to fund performance.

According to the SEC, MassAve’s actions violated Section 206(2) of the Investment Advisers Act, which prohibits any investment adviser from engaging in transactions, practices, or courses of business that operate as a fraud or deceit upon clients or prospective clients. The SEC determined that MassAve’s and Feng’s actions were fraudulent, as they knowingly provided false information to investors. This can be established through negligence, not necessarily intent. Furthermore, Section 206(4) and Rule 206(4)-8 of the Investment Advisers Act make it unlawful for any investment adviser to a pooled investment vehicle to make any untrue statement of material fact or to omit necessary information, resulting in misleading statements to investors. MassAve and Feng’s modifications to the underlying portfolio data, which were not reviewed by compliance, led to significant misrepresentations.

From at least September 2022 through February 2023, MassAve failed to disclose a significant conflict of interest. This conflict arose from the operation of a separate hedge fund in China by MassAve’s other co-founder, which overlapped with MassAve’s investment activities. Investment advisers are required to disclose any material conflicts of interest to their clients. The failure to inform investors about the co-founder’s separate hedge fund, which diverted attention and potentially impacted MassAve’s operations, constituted a breach of this duty. By not disclosing this conflict, MassAve and Feng again violated the antifraud provisions, misleading investors about the integrity and focus of their investment management.

MassAve also failed to adopt and implement adequate policies and procedures designed to prevent inaccurate information from being disseminated to investors. This failure was evident in the unreviewed modifications made by Feng, which were then shared with investors. Section 206(4) and Rule 206(4)-7 of the Investment Advisers Act require registered investment advisers to establish and enforce written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act. MassAve’s inability to enforce these procedures allowed for the distribution of false information, violating this requirement.

Remedial Sanctions and Cease-and-Desist Orders

The SEC has imposed several sanctions on MassAve and Feng. MassAve is ordered to cease and desist from committing or causing any further violations of the Advisers Act and related rules. The firm must also pay a civil money penalty of $350,000 and has been formally censured. Winston Feng is similarly ordered to cease and desist from any future violations of the relevant provisions, must pay a civil money penalty of $250,000, and is suspended from association with any investment adviser, broker, dealer, and other financial entities for 12 months. This suspension prevents him from serving in various key roles within the financial industry.

Additionally, both MassAve and Feng cannot argue for offsetting their penalties in related private investor lawsuits, preserving the deterrent effect of these penalties. For purposes of bankruptcy proceedings, the findings in these orders are admitted by Feng, ensuring these penalties are not dischargeable.

Press Release

Location: Brooklyn, New York

We are pleased to announce that Ishimbayev Law Firm, P.C. has achieved a significant victory on behalf of our client, Elena Khotovitskaya, in the United States District Court for the Eastern District of New York. In the case of Elena Khotovitskaya v. Albert Shimunov and David Shimunov (18-CV-7303), the Honorable Judge Nicholas G. Garaufis granted summary judgment in favor of our client, awarding a total of $4,885,982.86.

Case Overview

Our client brought a breach of contract action against the Defendants related to promissory notes and guaranties with a principal amount of $2,000,000. These notes, executed between December 2012 and September 2014, were due for repayment by December 2015 with an interest rate of 8% per annum. Despite the clear terms of the promissory notes, the Defendants failed to repay any portion of the principal or interest.

Court Findings

The court found in favor of our client, establishing that:

• The promissory notes were valid and enforceable.
• Our client was the rightful holder of these notes.
• The Defendants defaulted on their payment obligations.

The Defendants’ argument that the transactions were investments rather than loans, and their claim of being fraudulently induced to sign the notes, were thoroughly examined and found unsubstantiated by clear and convincing evidence.

Award and Next Step

The court awarded our client $2,000,000 in principal, $2,883,034.86 in pre-judgment interest, and $2,948 in costs related to attending a second deposition. The total judgment amounts to $4,885,982.86. Additionally, the court granted leave for our client to file an application for legal fees and costs within thirty days of the entry of this judgment.

This judgment underscores the importance of holding parties accountable to their contractual obligations and reinforces the principle that financial agreements must be honored as written, correctly qualifying these transactions as loans rather than securities or investments. We are proud to have represented Ms. Khotovitskaya in this matter and to have secured a just outcome on her behalf.

Contact Information

For further information, please contact Mr. Kemal Lepschoque at kl@ishimbayev.com.

The Commodity Futures Trading Commission (CFTC) took action against Falcon Labs Ltd. for operating as an unregistered Futures Commission Merchant (FCM) and providing U.S. customers access to digital asset derivatives trading platforms without the required registration. This is the first instance of the CFTC targeting an intermediary for such violations.

Case Background
Falcon Labs offered a product called “Edge,” providing institutional customers, including U.S. clients, with direct access to digital asset exchanges for trading derivatives. They created main accounts on exchanges and sub-accounts for customers, allowing trading without disclosing customer identities. This practice generated significant revenue from U.S. customers.

Findings and Violations
From October 2021 to March 27, 2023, Falcon Labs solicited and accepted orders for digital asset derivatives from U.S. customers. Acting as an intermediary, Falcon Labs provided direct access to digital asset exchanges but failed to register as an FCM, violating Section 4d(a)(1) of the Commodity Exchange Act (CEA). They also did not disclose customer identities to the exchanges, further breaching regulatory requirements.

According to the CEA, any entity that accepts orders for futures or swaps and accepts money to margin trades must register as an FCM. Falcon Labs’ activities fit this definition, making their unregistered status a clear violation. 

Enforcement and Compliance
The CFTC’s action against Falcon Labs sets a precedent for enforcing compliance among intermediaries. By cooperating with the investigation and enhancing their customer identification processes, Falcon Labs received a reduced penalty. This cooperation included improving their Know-Your-Customer (KYC) procedures and off-boarding non-compliant customers.

Penalties and Settlement
Falcon Labs agreed to cease its unregistered activities and pay $1,179,008 in disgorgement and a $589,504 civil monetary penalty. These penalties reflect the profits made during the violation period and the reduced amount due to Falcon Labs’ cooperation and remediation efforts. They also committed to fully cooperating with the CFTC in any related investigations or proceedings.

For businesses operating in the digital asset market, this case is another wake-up call. It shows just how crucial it is to be properly registered and to follow CFTC regulations. If your company is taking orders for digital asset derivatives from U.S. customers, you need to be registered as a Futures Commission Merchant (FCM). Not doing so can lead to hefty fines and legal actions.

Falcon Labs’ situation also teaches an important lesson: cooperating with regulators and improving compliance can help reduce penalties. It’s a good idea for businesses to take a hard look at their practices and strengthen their compliance programs. By doing so, you can avoid similar pitfalls and ensure you’re meeting all regulatory requirements.

The Securities and Exchange Commission (SEC) and the Financial Crimes Enforcement Network (FinCEN) have jointly proposed new regulations requiring registered investment advisers (RIAs) and exempt reporting advisers (ERAs) to create and maintain detailed customer identification programs (CIPs). This initiative is part of a broader effort to enhance the fight against money laundering and the financing of terrorism within the U.S. financial system.

The proposed rules would oblige these advisers to establish procedures to effectively identify and verify the identities of their clients. The aim is to ensure that RIAs and ERAs can confirm the true identities of their customers, thereby making it harder for individuals using false identities to use financial advisers for illicit activities such as laundering money, financing terrorism, or other criminal acts.

This proposal complements another from February 2024, which suggested labeling RIAs and ERAs as “financial institutions” under the Bank Secrecy Act. This designation would subject them to additional anti-money laundering (AML) and counter-financing of terrorism (CFT) obligations, such as the requirement to report suspicious activities.

What does this mean for the industry?

• Increased Compliance Costs. Investment advisers will likely face higher costs due to the need to implement and maintain these new identification systems and procedures.
• Enhanced Oversight. The proposals indicate a move towards stricter regulation and oversight of the investment adviser sector, which could lead to more rigorous examinations and audits.
• Market Entry Barriers. New and smaller advisories might find these new requirements more challenging, potentially raising barriers to entry in the sector.
• Improved Industry Reputation. By helping to ensure that the investment adviser sector is not a vehicle for financial crime, these measures could improve the overall reputation of the industry.
• Operational Changes. Firms will need to adjust their operational processes to comply with these rules, which may include upgrading technology systems or training staff to handle new compliance tasks.

If implemented, these regulations will significantly change the operational landscape for investment advisers by mandating thorough identity verification measures. The rules will require investment advisers to adapt by developing sophisticated systems to ensure they know the true identities of their clients, aligning them more closely with the stringent regulatory standards applied to other financial institutions.