When Making Your Fractional Racing Ownership Business Plan, Don t Overlook the Securities Laws

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1 When Making Your Fractional Racing Ownership Business Plan, Don t Overlook the Securities Laws By Russell C. Williams Owning a racehorse or a racing stable is a risk venture requiring a large financial investment. Fractional ownership is one way for individuals to own an interest in a horse or stable that they might not be able to afford otherwise. The purchaser of a fractional interest makes a relatively modest fixed investment, pays a predetermined amount of racing expenses, and earns a predetermined amount of net racing income. The United States Trotting Association has registered stables and multiple ownership of horses since the beginning of its existence. But even though fractional ownership is a familiar business concept within the racing industry, whether it is a regulated security under the Security and Exchange Act of 1933 ( the Act ) or under state securities laws (sometimes referred to as blue sky laws ) has rarely been discussed. This article provides a very brief overview of state and federal securities regulation and the issues you should consider if you plan to either offer or purchase fractional racing interests. The USTA is not giving legal advice by publishing this piece, nor should anything in it be used as legal advice. Nothing in this piece expresses any USTA policy. However, we believe that our obligation to serve our membership requires us to point out certain considerations regarding fractional racing ownership that might otherwise be overlooked.

2 The most important of these considerations is that anyone planning to offer fractional interests in racehorses or racing stables should obtain advice from an attorney experienced in securities law as part of a prudent business organization process. This is particularly important if one of the goals is to bring in new owners. This aspect of good business planning is so important that it will be repeated several times below. Fractional Ownership: A Security? In the United States, both the federal government and the states have laws intended to protect the public in the issuance and sale of anything that meets the definition of a security. This definition encompasses many types of investment, including stocks, bonds, and investment contracts. In Securities Exchange Commission v. W.J. Howey Co., the U.S. Supreme Court defined an investment contract as (1) an investment of money (2) in a common enterprise (3) with the expectation of profits (4) due to the efforts of a third party. Under this definition, a fractional racing interest is a security, whether it involves one or more horses, whether it is large or small, and whether it was acquired by purchase, by gift, or as a prize. Fractional ownership in horses or stables is, therefore, subject to federal and state securities law. The Registration Requirement Under the Act, any offer or sale of securities must either be registered with the Securities and Exchange Commission ( SEC ) or qualify for an exemption from the Act s 2

3 registration requirements. In addition, the sale of securities must comply with any applicable state securities laws, which also typically require registration unless an exemption applies. The purpose of registration is to (1) provide potential investors with a wealth of information that they can use to make a well-informed purchase decision, and (2) prevent fraud in the sale of securities. Securities registration, however, is burdensome and very expensive. The registration rules and regulations provide a few specific exemptions designed to benefit small businesses that are seeking to raise smaller amounts of capital, or that are looking to solicit investment from a narrowly-defined group of private individuals rather than the general public. Issuers must do specific things and meet certain requirements in order to qualify for an exemption. There will probably be some legal expense involved in making sure that all necessary steps are taken and all requirements are met. The effort and expense are worth it, because the severe penalties that apply to securities issuers could put you out of business. Every year the SEC brings enforcement actions against companies that have failed to comply with the securities laws. Moreover, securities purchasers who suffer losses have significant recovery rights if they can prove lack of legal compliance or inadequate disclosure. An attorney with experience in these matters can make sure that the issuer and the purchasers of fractional racing interests are protected under the applicable law. 3

4 Exemptions from the Registration Requirement Rule 504 under the Act exempts offerings by non-public companies of up to $1 million in securities in a twelve-month period. However, this exemption does not allow companies to solicit investment or advertise their securities to the public. Furthermore, the securities are restricted, meaning that purchasers may not be able to sell their investment without SEC registration or use of another exemption. Rule 504 has special provisions designed to coordinate with state securities law in appropriate cases, which can make the exemption easier to obtain. Obviously, professional legal advice could answer the questions that would arise in various states. Another key provision for an issuer to look at is Rule 506, especially Rule 506(c). Under this rule, fractional ownership investments can be solicited, and advertised to the general public, if: The purchasers of fractional interests are all accredited investors, and The offeror has taken reasonable steps to verify that all investors are, in fact, accredited investors within the meaning of the securities regulations. For a natural person (that is, not a corporation or other business entity), an accredited investor is one who meets certain requirements regarding income or net worth. The income and net worth requirements get modified from time to time, as economic conditions change and regulatory policy evolves. The SEC has published general guidance on the steps that should reasonably be taken to verify investors status. 4

5 This could include reviewing W-2 s, tax returns, bank and brokerage statements, credit reports, and the like. If your fractional racing ownership offering qualifies for an exemption under Rule 506, you will still need to file a Form D with the SEC within 15 days of the date of sale of the securities. Form D is a brief notice filling that includes some details about the offering and the offeror, such as the name and contact information of the company s officers and directors, but it contains little other information about the company. Note that purchasers receive restricted securities in a Rule 506 exempt offering, meaning that certain conditions must be met if a purchaser later desires to sell a fractional racing interest. As mentioned above, you will also need to consider the requirements for an exemption under state law. A particular offering may be exempt under the Act, but not necessarily exempt under state law. For example, among several registration exemptions, the State of Ohio exempts the sale of securities to ten or fewer Ohio residents who are purchasing for investment purposes. There is no limit to the amount of money that can be raised, but general advertising is not permitted. Ohio also exempts transactions that comply with Rule 506, described above, but a Form D must be filed with the Ohio Division of Securities within 15 days of the date of sale in Ohio, along with a filing fee of $100. This is only one example: every state in which potential new owners reside has its own laws and regulations. 5

6 Our primary message bears repeating: if you are issuing fractional interests in a racehorse or stable, you should seek legal advice to determine whether your offering meets any applicable federal and state exemption requirements. An attorney who is experienced in securities regulation can help you structure your offering to meet an exemption and complete the necessary documentation while, at the same time, satisfying investors concerns about their financial privacy. Ongoing Requirements: Resale Rule 144 under the Act provides the most commonly used safe harbor for investors to sell restricted securities. It has several conditions, including a six-month or, in some cases, a one-year holding period. In addition to SEC requirements regarding resale, an issuer may impose contractual restrictions at the time of investment that may prevent free transfer of the fractional interest. It would be important to make sure that investors know about restrictions on sale. A well-drafted purchase agreement could spell this out, along with a host of other points adding up to a complete and useful understanding among new owners, old owners, the trainer, and the promoter of the fractional-ownership stable. Conclusion 6

7 Fractional ownership is a great way to get new people involved in racing without requiring a large, open-ended investment. Securities law compliance is just another aspect of good business planning that should not be an unexpected obstacle for any responsible enterprise. 7