Was the Investment an Unregistered Security? Rescission in Texas

Why the label matters

Calling an investment a security brings three consequences. The seller needed a Texas permit or an exemption before selling it, and the person selling needed to be registered as a dealer or agent unless exempt. The seller is liable for any untrue statement without proof of intent. And a buyer of an unregistered, non-exempt security can unwind the deal and recover the price under Texas Government Code section 4008.051. Many Dallas deals are sold by people who never considered the question: a founder raising money from friends, a sponsor pooling investors for a building, a promoter selling well interests. The law applies to them whether or not they knew it.

What is a security under Texas law

Texas Government Code section 4001.068 defines a security to include a share or stock, a note, bond, debenture or other evidence of indebtedness, a limited partner interest in a limited partnership, a certificate or instrument representing an interest in or under an oil, gas or mining lease, fee or title, a certificate representing an interest in the capital, property, profits or earnings of a company, an investment contract, and any other instrument commonly known as a security, whether or not evidenced by a writing. The federal definition in 15 U.S.C. § 77b(a)(1) is similar and expressly includes a fractional undivided interest in oil, gas or other mineral rights.

The items on the list that cause disputes are notes and investment contracts, because a note can be an ordinary commercial loan and an "investment contract" is not defined. Stock and limited partnership interests are securities by name.

The Howey test for investment contracts

The reference point for "investment contract" is the Supreme Court's 1946 decision in SEC v. W.J. Howey Co., where buyers of small citrus-grove plots who left the cultivation and marketing to the seller were held to have bought investment contracts. The test asks whether the scheme involves an investment of money in a common enterprise with profits to come from the efforts of others. Three questions follow:

1. Did you put in money or other value? Almost always yes.
2. Was it a common enterprise? Were your returns tied to the promoter's success or pooled with other investors' money?
3. Were the profits to come from someone else's efforts? If you were a passive investor relying on a manager, sponsor or operator, yes. If you ran the business yourself, no.

The test looks at substance, not labels. A "joint venture" in which one party supplies all the money and the other does all the work is usually an investment contract. A "loan" that pays a share of profits instead of fixed interest often is. Texas's list also catches many deals before the test is reached: a limited partner interest is a security by statute regardless of how active the limited partner was.

Registration, and the exemptions sellers rely on

Section 4003.001 makes it unlawful for a dealer or agent to sell securities in Texas unless the Securities Commissioner has issued a permit, the securities were registered by notification or coordination, or the transaction or security is exempt under chapter 4005. Section 4004.051 separately requires the dealer to be registered before selling. The exemptions are where most of the fight happens:

• Federal Rule 506 offerings. An offering that meets Rule 506 of Regulation D is a "covered security" under 15 U.S.C. § 77r, so Texas cannot require registration, only a notice filing. But the offering must actually meet Rule 506: no general solicitation under 506(b), no more than 35 non-accredited purchasers who are sophisticated, all-accredited and verified under 506(c), and no disqualified bad actors. An offering that misses a condition is not covered and is not exempt in Texas unless a state exemption applies.
• Texas exemptions. Chapter 4005 and the State Securities Board's rules exempt various limited offerings and isolated sales, each with conditions on the number of buyers, advertising and commissions.
• Exemption does not excuse fraud. Every exemption leaves the antifraud rules in place. A valid exemption defeats the registration claim, not the misstatement claim, which is covered in the Texas Securities Act guide.

The rescission claim and what it returns

Under section 4008.051 the seller of a security sold without the required permit, registration or exemption, or sold by an unregistered dealer or agent, is liable to the buyer, who may sue for rescission or, if the buyer no longer owns the security, for damages. Section 4008.056 fixes the rescission recovery: tender the security and recover the consideration paid plus interest at the legal rate from the date of payment, less any income received. The buyer does not prove a false statement, reliance or loss causation. The seller's defenses are limited to showing an exemption, a compliant rescission offer that the buyer failed to reject properly, or that the three-year deadline in section 4008.062(a) has passed.

Example

Suppose a Garland restaurateur is approached by a neighbor raising money for a short-term rental business. Twelve investors each put in $50,000 in exchange for "Class B units" in an LLC the neighbor manages, with investors having no role in operations. The neighbor advertises the opportunity in a community Facebook group and pays a friend a 5% commission for each investor he brings in. No permit, no Form D, no Texas filing. Two years later the business is failing. The units are investment contracts under Howey: money, a common enterprise, profits from the manager's efforts. The public posts defeat Rule 506(b), the commissioned friend was an unregistered agent, and no Texas exemption fits a 12-investor advertised deal with commissions. The restaurateur tenders his units and sues for $50,000 plus legal interest, less distributions, under section 4008.051, with the neighbor liable as seller and, if the friend acted with the required state of mind, the friend as an aider. He does not need to show the neighbor said anything false.

Who is liable

The seller is the first defendant. Section 4008.055 then adds anyone who directly or indirectly controlled the seller, jointly and severally unless that person proves it did not know and could not have known the facts, and anyone who materially aided the sale with intent to deceive or defraud or with reckless disregard for the truth or the law. In an unregistered offering the founders and managers are typically control persons and the paid finders are the aiders. Secondary liability has its own guide.

For sellers: fixing it before it becomes a lawsuit

A company that discovers its offering did not qualify for an exemption has one statutory tool: the rescission offer under section 4008.058. A compliant offer, with funds in escrow or a bank commitment and the required disclosures, gives each buyer 30 days to reject in writing and reserve the right to sue; a buyer who does not reject properly loses the claim, and one who rejects has one year to file. Done early, it caps the exposure at the money raised plus interest, less distributions. Done badly, it restarts the problem. The guide on defending an investor suit covers the company's side in more detail.

When to involve a litigator

For a buyer, when the deal starts to fail and you realize no one ever mentioned registration, because the three-year clock runs from the sale, not from discovery. For a seller, the day you learn a condition of your exemption was missed. Tina Wysk represents investors and issuers in Texas Securities Act registration and rescission disputes in Dallas; her securities and investment practice covers both sides.