Securities law legends on convertible promissory notes

I recently reviewed a convertible promissory note on behalf of a client who was considering making an investment in a start-up technology company. The note omitted part of the securities law legend that usually appears at the top of the note. This omission turned out to be an editorial accident or oversight by the issuer (whose regular counsel was not involved in the editing of the note). If an issuer fails to include the appropriate legend (even by accident), it may lose access to an important securities law safe harbor and expose itself to liability under the securities laws.

This blog post discusses legends and other securities law “boilerplate” in convertible promissory notes sold by start-ups and other issuers. I’m going to limit commit in this post to legends and boilerplate designed to help the issuer offer and sell the note in a transaction exempt from registration. In another post I hope to address securities law boilerplate designed to limit risk under the anti-fraud provisions of the securities laws.

A convertible promissory note, just like a share of common stock, is a security under Federal and state securities laws. These laws generally require that offers and sales of securities must be registered unless there is an available exemption from registration. Since registration is expensive and inappropriate for a start-up business, start-up companies (and others) generally try to offer and sell convertible promissory notes under one or more of the applicable exemptions from Federal and stated securities registration. There are several choices. Regulation D offers a safe harbor from registration under the Securities Act of 1933 that many issuers rely upon. For an offer of securities (including convertible promissory notes) to comply with Rule 505 or Rule 506 of Regulation D, the offer must comply with Rule 503(d) Limitations on Resale (and other requirements not discussed in this post). Rule 503(d) provides in part that

“The issuer shall exercise reasonable care to assure that the purchasers of the securities are not underwriters within the meaning of section 2(11) of the Act, which reasonable care may be demonstrated by the following:

(1) Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons;

(2) Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and

(3) Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities.”

Legends at the top of convertible promissory notes generally address the requirements of Rule 503(d)(2) and (3) (above) and also often address related state securities law requirements. As you can see from the text of Rule 503(d), the rule does not specify the precise words that must be used, but only the substantive content that should be covered.

Issuers facilitate compliance with Rule 503(d)(1) by having the purchaser represent to the issuer that the purchaser is purchasing for his or her own account and not on behalf of another person. This representation is often but not always accompanied by a statement that the purchaser is buying for investment and not with a view to resale. These purchaser or investor representations can be found in a subscription agreement, note purchase agreement or even in the convertible note itself (but is not usually part of the legend).

If you are issuing convertible promissory notes or other securities, consider double-checking the legends and other terms of your convertible notes with your legal counsel.