Securities Regulations for Investment Clubs

Forming an investment club with a group of friends or colleagues can be an engaging way to learn about investing and potentially grow your wealth. However, investment clubs are subject to a complex web of securities regulations at both the federal and state level. Failure to comply can result in stiff penalties, or even force dissolution of your club.

In this post, we’ll provide an overview of key securities laws investment clubs must follow, including registration requirements, exemptions, and reporting rules. Understanding these regulations is essential for ensuring your club avoids running afoul of securities regulators.

Do Investment Clubs Need to Register as Investment Companies?

The first major securities law question for any investment club is whether it must register as an “investment company” under the Investment Company Act of 1940. This important Act regulates organizations like mutual funds, closed-end funds, and other companies primarily engaged in investing in securities.

What Constitutes an Investment Company?

Under the 1940 Act, an “investment company” essentially means any issuer that:

• Is engaged primarily in the business of investing, reinvesting, or trading in securities;
• Is issuing or proposing to issue securities and owns or invests on a non-transient basis in securities exceeding 40% of the issuer’s total assets
• Is engaged or proposes to engage in the business of investing in securities and owns or proposes to acquire investment securities exceeding 40% of the value of the issuer’s total assets.

Since most investment clubs exist specifically for the purpose of investing and trading in stocks, bonds, and other securities, they can easily fall under the definition of an “investment company”.

Investment Company Registration Requirements

Registering as an investment company under the 1940 Act involves extensive, complex disclosures with the SEC. It also subjects a company to myriad regulations related to governance, transactions, capital structure, and more. The regulatory compliance burden would essentially prevent most casual investment clubs from functioning.

Fortunately, the 1940 Act contains exemptions that allow most investment clubs to avoid full registration.

Investment Club Exemption under 1940 Act

Section 3(c)(1) of the 1940 Act exempts any investment company that is beneficially owned by no more than 100 persons and is not making or proposing to make a public offering of its securities. This is the exemption that permits almost all small investment clubs to avoid full investment company registration.

To qualify for the “100-person exemption”, an investment club must:

• Have 100 or fewer members
• Not offer its membership shares on any public trading platform or to the general public
• Use private solicitation when offering membership shares

As long as your investment club satisfies these requirements, it does not need to register with the SEC as an investment company under the 1940 Act. This spares your club from an enormous regulatory burden.

Do Investment Club Members Need to be Accredited Investors?

Another key exemption investment clubs rely on is found under Rule 506 of Regulation D in the Securities Act of 1933. This exempts a company from registering its securities federally so long as:

• The company does not use general solicitation or advertising to market the securities
• The investors are “accredited investors” or the issuer reasonably believes they have sufficient knowledge/experience in financial matters to evaluate the risks
• Certain filing requirements are satisfied

Rule 506 allows investment clubs to avoid federal registration and sell membership shares to their members without an IPO. But it leads to a common question – do investment club members need to be “accredited investors” under Rule 506?

The short answer is no. While having all accredited investors does simplify things, investment clubs can admit non-accredited members under Rule 506. The club just needs to personally determine those members have the requisite sophistication to evaluate the risks.

Who is Considered an Accredited Investor?

While not required, having accredited investors as members does help investment clubs rely on the Rule 506 exemption. Under SEC rules, an individual accredited investor is someone who:

• Has $1 million net worth excluding primary residence (either individually or jointly with spouse)
• Has income exceeding $200,000 each of past two years ($300,000 jointly with spouse) and expects same for current year

Since these requirements are quite stringent, most investment club members likely do not qualify as accredited investors. Again, this is not fatal to relying on Rule 506, but may require clubs to perform additional diligence when admitting non-accredited members.

State Registration Exemptions for Investment Clubs

In addition to complying with federal securities laws, investment clubs need to ensure they are exempt from registration under applicable state blue sky laws. Much like the federal exemptions discussed above, most states have exemptions designed for investment clubs that allow avoiding state registration.

For example, California Corporations Code Section 25102(f) exempts non-public investment clubs with no more than 35 members. Other states like Colorado exempt clubs with up to 15 members. Clubs should carefully review the relevant exemption in their state.

Ongoing Reporting Obligations for Investment Clubs

While registration exemptions allow investment clubs to form and solicit members without SEC approval, clubs do still have some ongoing reporting requirements at both the federal and state level.

Federal FILING Requirements

Investment clubs relying on Rule 506 still need to file “Form D” electronically with the SEC within 15 days after first securities sale. This short notice provides basic information about the offering and the club. Clubs must also file an amended Form D for any material changes and renew the notice annually.

Under the Securities Exchange Act of 1934, investment clubs may also have an ongoing duty to file Schedule 13G disclosures if they acquire more than 5% beneficial ownership in a public company. Schedule 13G provides information about the club’s membership, organizational structure, and aims in purchasing the securities.

State Investment Club Reporting Requirements

States may also impose additional reporting rules on investment clubs, even when an exemption applies. For example, in California investment clubs are required to file a one time “Charitable/Investment Club Statement” on Form F-95 within 30 days of receiving funds from anyone. This provides details on the club’s leadership, activities, and offerings.

Clubs in California must also annually file Form 199, an informational return for tax-exempt organizations. Other states like Virginia and Hawaii may have similar annual reporting requirements.

Consequences for Violating Securities Regulations

Given the complex web of overlapping federal and state securities rules, mistakes or non-compliance by investment clubs can unfortunately occur. What are the potential consequences?

The penalties for violations can be severe:

• Rescission rights for investors – members may have right to demand refund and exit club
• Civil fines and injunctions – regulators may impose sizable monetary fines and ban individuals from securities industry
• Criminal liability – charges like securities fraud, control person liability
• Forced dissolution – regulators can apply to dissolve the club if violations are extreme

While not all infractions will incur the most extreme penalties, investment clubs should strive to comply strictly with all applicable securities regulations. Consulting with competent legal counsel from formation onward can help identify any potential pitfalls and keep your club on the right side of these complex rules.

Key Takeaways – Securities Regulations for Investment Clubs

• Most investment clubs avoid federal registration under the Investment Company Act 1940 via the 100-member private offering exemption. But membership shares still constitute securities.
• Federal and state exemptions allow clubs to sell securities to members without registration. But clubs must comply with rules like limits on members, advertising, etc. to qualify for these exemptions.
• Ongoing reporting obligations like Form D, Schedule 13G, and state requirements still apply to exempt investment clubs.
• Consequences for violations can include rescission demands, fines, injunctions, and criminal liability. So compliance is critical.