Key point 9-04. Federal and state laws regulate the offer and sale of securities for the protection of the investing public. In general, an organization that issues securities must register the securities, and the persons who will be selling the securities, with state and federal agencies. In addition, federal and state laws contain a broad prohibition on fraudulent activities in the sale of securities. Churches are exempt from some of these requirements in some states. However, they remain subject to the prohibition of securities fraud in all 50 states, and under federal law.
A federal court in Maine found that a promoter of Christian concerts had violated federal securities laws as a result of his offer and sale of unregistered securities and fraudulent statements made to prospective investors.
Ministry seeks investors to repay debt
A Christian ministry (the “defendant”) promoted, organized, and hosted Christian music concerts and festivals. In order to host a music concert or festival, the defendant paid certain expenses upfront, such as deposits for artists and venues, radio promotions, and other production-related costs. Its primary source of revenue was ticket sales, which included advance sales on its website as well as direct sales at the music venue.
As early as 2014, the defendant began borrowing money from companies that provide short-term cash advances to small businesses in need of immediate cash flow. It borrowed approximately $700,000 from more than one dozen cash-advance companies.
The defendant was unable to repay on schedule all of the debt incurred from cash advances. To raise needed funds, the defendant began offering investments in promissory notes. From January 2014 through October 2018, the defendant raised more than $3.1 million from 149 investors.
The defendant solicited promissory-note investors through a number of different in-person and electronic means, including email blasts to solicit investors, using the email addresses obtained through online ticket sales and through the entry of email addresses by those who visited the defendant’s website to indicate interest in becoming “financial partners.”
A typical mass solicitation email stated: “Become a financial partner with our summer festivals. Help us spread the message of Christ plus earn 20% on your investment. To learn more please e-mail [us].”
The defendant did not have any information about these individuals’ finances or level of sophistication in making investments at the time it sent these email blasts. Similarly, prior to accepting investor money and executing promissory notes, it did not ask investors about their finances or investment experience.
The defendant contacted potential investors who showed interest in learning more about the specific terms of the offered investment by email and phone. The defendant falsely represented that investor money would be used exclusively for costs associated with its music concerts and festivals.
Some promissory notes specified the particular concert or festival for which the investor’s funds would exclusively be used, while others were more general. The defendant never implemented any mechanism to track the use of investor funds to ensure that they were used exclusively for the stated purpose.
The defendant “guaranteed” the repayment of the promissory notes in monthly installments with a fixed annual return ranging from 10 percent to 25 percent. It told prospective investors that the promissory notes were “secured,” explicitly stating to some investors that repayment of principal plus interest was not dependent on the success of any concert or music festival. And it claimed that all prior investors had been paid back 100 percent of the money invested. However, by at least 2016, the defendant had failed to fully repay some investors and had failed to pay a single installment to others.
The defendant did not disclose to investors its deteriorating financial condition from declining ticket sales, its growing debt to other individual investors and commercial lenders, or that the only way it could repay potential investors was if the concerts and festivals were profitable. It obtained investor funds as a result of these misstatements and omissions.
The defendant did not register the promissory notes with the Securities and Exchange Commission (SEC).
The SEC claims the defendant committed fraud
The SEC sued the defendant claiming that it had committed fraud in the offer or sale of securities and sold unregistered securities in violation of the federal Securities Act. A federal court ruled summarily in favor of the SEC. The court permanently enjoined the defendant from the sale of securities and ordered it to pay damages of $1,800,000 in gains it realized from its fraudulent conduct.
A federal appeals court affirmed the SEC position. It noted that the federal Securities Act prohibits “fraud and other deceptive practices” in connection with the purchase and sale of securities.
To prove securities fraud, the SEC must demonstrate that a defendant: “(1) made a material misrepresentation or a material omission as to which it had a duty to speak . . . (2) with scienter (i.e., a conscious intent to defraud); (3) in connection with the purchase or sale of securities.”
The court concluded that the SEC’s evidence “suffices to establish that [the defendant] made material misstatements and omissions with scienter in connection with the purchase and sale of securities . . . in violation of . . . the Securities Act.” It noted:
First, the SEC demonstrates that [the defendant] solicited investors through multiple, repeated, brazen misrepresentations about the offered promissory notes, including the use to which [it] would put investors’ money, the guarantee of a profit of between 10 and 25 percent, the claim that the investments were “secured,” and the assertion that prior investors had been paid back in full . . . while simultaneously omitting to disclose its deteriorating financial condition, growing debt, and inability to fully repay investors. . . .
Second, the SEC establishes that the misrepresentations and omissions were material, that is, that there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. . . . In this case, as the SEC argues, a reasonable investor would want to know that (i) his or her investments were not “secured,” (ii) the promised return was not “guaranteed,” (iii) the defendant had implemented no mechanism to track investors’ funds to ensure they were used for the stated purposes and had used investor funds to pay personal expenses, (iv) the defendant’s financial condition had been deteriorating, and (v) the defendant did not in fact repay 100 percent of prior investors. . . .
[Third] the SEC demonstrates that the defendant acted with scienter. It made repeated false representations about the safety and security of the investments at issue, including that repayment was “guaranteed,” the investments were “secured,” and all prior investors had been paid back 100 percent, while using invested funds to repay high-interest debt and other personal expenses as well as to repay prior investors and failing to disclose the defendant’s deteriorating financial condition.
What this means for churches
Laws regulating the sale of securities have been enacted by the federal government and by all 50 states. The term security is defined very broadly by such laws to include many instruments utilized in church fundraising efforts, including bonds, notes, and trust agreements.
Securities laws were enacted to protect the public against fraudulent and deceptive practices in the sale of securities and to provide full and fair disclosure to prospective investors. To achieve these purposes, most securities laws impose the following conditions on the sale of securities:
- registration of proposed securities with the federal or state government in advance of sale
- filing of sales and advertising literature with the federal or state government
- registration of agents and broker‑dealers who will be selling the securities
- prohibition of fraudulent practices
Although the federal government and most states exempt securities offered by any organization “organized and operated not for private profit but exclusively for a religious . . . purpose” from registration, it is important to note that some states do not exempt the securities of religious organizations from registration. Other states impose conditions on the exemption. Many require that an application for exemption (or “notice” of exemption) be submitted and approved before a claim of exemption will be recognized. A few states require churches and religious denominations that “issue” their own securities to register as issuers or issuer-dealers. Further, all securities laws subject churches and other religious organizations to the antifraud requirements.
Churches therefore must not assume that any securities that they may offer are automatically exempt from registration or regulation. Put another way, all churches that offer or sell securities will be subject to state and federal securities laws—the only question is to what extent.
It is important to note that the antifraud provisions of federal and state securities laws are very broad, and some churches have violated them without knowing it. For example, the following activities have been deemed to be fraudulent:
- making false or misleading statements about church securities
- failing to disclose material risks associated with securities
- manipulating the church’s financial records in order to facilitate the sale of securities
- failing to establish a debt service or sinking fund reserve out of which church securities will be retired
- making false predictions
- recommending the sale of securities to investors without regard to their financial condition
- inducing transactions that are excessive in view of an investor’s financial resources
- borrowing money from an investor
- commingling investors’ funds with the personal funds of another, such as a salesman
- deliberately failing to follow an investor’s instructions
- making unfounded guarantees
- misrepresenting to investors the true status of their funds
- representing that funds of investors are insured or “secure” when in fact they are not
- representing that investments are as safe as if they had been made in a bank, when this is not the case
- representing that securities have been approved of or recommended by the state securities commission or that the commission has passed in any way on the merits or qualifications of the securities or of any agent or salesman
Bottom line: Churches should never consider using securities to raise funds without the counsel of an experienced securities attorney. SEC v. Wall, 2020 U.S. Dist. LEXIS 56152 (D. Me. 2020).