The ANPR invites comment as to whether credit union alternative capital instruments would be considered "securities" under federal and state securities laws and, if so, what the implications are. As the ANPR points out, "Being subject to securities laws can impose requirements on the issuer [of the securities] to register with the Securities Exchange Commission, issue SEC mandated disclosures and comply with the SEC's broad anti-fraud rules."

Commenters probably should not waste time arguing that ACIs are not securities. Under SEC rules and numerous court cases, the definition of a security is so broad virtually any ACI imaginable would qualify.

Much more importantly, under federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. Fortunately, two types of exemptions generally would be available for most ACI offerings. First, ACIs would likely be exempt under Section 3(a)(5) of the Securities Act of 1933 (1933 Act), which applies to securities issued by certain financial institutions, including credit unions. Second, a "private placement" of ACIs to a limited number of persons or institutions (including those meeting certain financial sophistication, income or net worth thresholds) may be exempt pursuant to Section 506 of Regulation D under the 1933 Act.

Securities Fraud Can Be Costly

Even if securities are issued pursuant to a valid exemption from SEC registration, federal and state courts have made it abundantly clear the "SEC's broad anti-fraud rules" apply to virtually all purchases and sales of all securities. Although federal securities laws and regulations contain several anti-fraud provisions, the SEC's Rule 10b-5 usually gets the most attention. In connection with the purchase or sale of any security, Rule 10b-5 prohibits: Using any "device, scheme or artifice" to defraud; making any untrue statement of a material fact or omitting a material fact, and engaging in any fraud or deceit. Both the SEC and private citizens can bring legal action to enforce Rule 10b-5.

Here's a textbook example of Rule 10b-5 claim: The price of a security plummets soon after its initial issuance. A disgruntled investor argues the price was fraudulently inflated because the issuer knowingly provided false or misleading material information (or knowingly omitted material information). Under Rule 10b-5, among other things, the issuer could be forced to repurchase the security at the price the investor paid. In some anti-fraud cases, the plaintiff could recover treble damages. Thousands of 10b-5 actions have been filed by the SEC and private citizens in the past seven decades. Today, multi-million dollar 10b-5 class action settlements against public companies are commonplace. Other anti-fraud violations can result in fines up to $5 million ($25 million for companies) and/or imprisonment up to 20 years.

Disclosure as Both Investor Protection and a Defense

As the ANPR points out, "clear and complete disclosure is the critical factor in ensuring the anti-fraud provisions … are not breached." Put another way (no pun intended), failure to provide full disclosure of all material information gives the purchaser a free put option on the securities if their value falls.

Although SEC registration is designed to require companies to disclose important information that enables the public to make informed investment decisions, private offerings of securities are not subject to the comprehensive disclosure requirements that apply to registered offerings. In practice, however, in many private offerings issuers include much of the same information in a private placement memorandum that they would be required to include in a prospectus for a registered offering. These issuers view the SEC's mandated disclosures as a roadmap for minimizing the risk of anti-fraud litigation based on inadequate or misleading disclosure.

Although bank securities are exempt from SEC registration, the Office of Comptroller of the Currency requires national banks and federal savings associations issuing securities to register directly with the OCC and comply with OCC mandated disclosures, which are similar to the disclosures required by the SEC. Like the SEC framework, banks can take advantage of several exemptions from OCC registration and mandated disclosures. Similar to private offerings of non-bank securities, however, private placement memoranda for bank securities tend to track the OCC-mandated disclosures for registered offerings.

NCUA Registration and Disclosure

The ANPR asks whether the NCUA should require credit unions issuing ACIs to register with the NCUA and whether the NCUA should establish mandated disclosures based on the SEC's, OCC's, or on criteria unique to credit unions. The NCUA is concerned that "without mandated disclosures, credit unions may be at greater risk for anti-fraud suits, which, if successful, would impair not only the credit union but also the Share Insurance Fund's ability to use secondary or supplemental capital to cover losses."

The OCC's registration and disclosure approach is similar to the SEC's. Both require registration unless an exemption is available. The available exemptions generally turn on the size of the offering or on the sophistication and/or financial wherewithal of the offerees. When an exemption from registration is available, the issuing company or bank is not subject to the mandated disclosures, but is wise to treat the mandated disclosures as a roadmap for reducing the chances of defending anti-fraud claims. Arguably, issuers and investors have been well served by the flexibility of this approach.

However, most securities issued by companies and (to a lesser extent) by banks are not depended on for "loss absorption" purposes in the way and to the extent the NCUA would count on ACIs to protect the share insurance fund.

When companies issue securities pursuant to an exemption from SEC registration, they are free to determine for themselves the nature and extent of the disclosures they will provide. A prudent desire to minimize the likelihood and cost of defending anti-fraud lawsuits should produce sufficient incentive to provide full disclosure of all material information, but the company alone bears the risk of inadequate or misleading disclosure. This is not true for credit unions; if ACIs are impaired or extinguished, for example because of a Rule 10b-5 violation, the intended protection for the share insurance fund would be jeopardized or lost. As a result, the NCUA should – and probably will – implement a registration and disclosure framework with mandated disclosures for ACIs.

In cases where ACIs are being offered broadly to the public (including less sophisticated consumers), they should be registered with the NCUA and subject to comprehensive mandated disclosure requirements. In cases where ACIs are being offered only to sophisticated investors and those who otherwise do not need higher levels of investor protection, there might be some justification to streamline the mandated disclosures.

Those wanting a voice in how these disclosures should look should make their opinions known to the NCUA soon – the clock is ticking.

François Henriquez is a Partner at Shutts & Bowen LLP. He can be reached at 305-415-9076 or [email protected].