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Neogenix Oncology: A Good Case Study on Securities Law (Non)Compliance by a High Growth Company – Part 3: When the Genie Can’t Be Put Back in the Bottle

November 16, 2012 By 3 Comments

In my previous posts, I described the events leading up to the Chapter 11 bankruptcy and supervised asset sale of Neogenix Oncology. To recap, Neogenix’s payment of fees to unregistered “finders” to raise money in some of its earlier rounds of financing called into question the company’s compliance with federal and state securities laws. Under such laws, just about any arrangement in which someone is paid a contingent or variable fee to raise capital for a company is prohibited, unless that person is registered as a broker-dealer or is a registered representative of a broker-dealer. After the SEC commenced an investigation into Neogenix’s practices, the company’s accountants concluded that potential investor lawsuits and/or governmental enforcement actions could give rise to large contingent liabilities on the company’s balance sheet. This uncertainty led to Neogenix being unable to raise further funds, necessitating the company’s bankruptcy filing. In this post, I’ll explore the likely reason why Neogenix had to take the drastic step of filing for bankruptcy to cure its securities violations.

Indeed, it is natural to wonder why Neogenix had to file for bankruptcy. It seems surprising that there would not be a simpler way to correct for past securities law violations. Unfortunately, often there is very little a company can do once securities laws have been violated. Once this occurs, government agencies, such as the SEC or state securities commissioners, have the ability to open an investigation and seek penalties against the company for its violations. In addition, investors who purchased the company’s securities in transactions that violated securities laws often have what are called “rescission rights” — that is, they can undo the deal and require that the company (and sometimes its officers and directors) return the money that was invested plus interest. This creates significant contingent liabilities that can deter future investors from investing in the company.

One potential solution that is sometimes used is for the company to make what is called a “rescission offer” under state securities laws. Most states provide that a company can make an offer to pre-emptively buy back securities from the investors who invested in the transactions that violated securities laws at the original purchase price plus interest. These rescission offers must be done in strict compliance with each state’s requirements. If all of these requirements are complied with, and the investor fails to take advantage of the rescission offer within 30 days, most state statutes provide that any rescission actions that investors have under state securities laws would be barred.

However there are significant limitations as to what protections a rescission offer can provide. First, while a properly conducted rescission offer provides protection against rescission suits under state securities laws, they do not provide protection against suits under federal securities law.[1] Second, rescission offers provide no protection against criminal prosecution or enforcement actions by the SEC or state securities agencies. In other words, while they can protect against investor lawsuits, they cannot protect the company from governmental enforcement actions. Nonetheless, if a company does engage in a rescission offer, it is usually looked at by regulators very favorably. Hence, it would substantially reduce the probability of an enforcement action. Finally, a company can only conduct a rescission offer if it actually has the financial ability to return the funds, a rare situation for a startup looking to raise capital.

Another factor to consider with rescission offers is that the rescission offer itself is actually a securities transaction. Consequently, it is subject both to the registration requirements under federal and state securities laws and to anti-fraud rules. Chances are, if the initial transaction did not qualify for an exemption, neither would the rescission offer. If that is the case, then the rescission offer would have to be a registered offering, which is a very expensive undertaking. Furthermore, because of the anti-fraud rules, the company will be required to disclose all material information to the investors, in order to allow them to make an informed investment decision. Because of all these complications, conducting a rescission offer is actually a very expensive process for a company, often making it impossible for a startup to conduct a rescission offer in a cost-effective manner. For instance, prior to Google’s IPO, it was discovered that Google had engaged in some transactions that potentially violated securities laws. As a result, Google was required to conduct a rescission offer prior to their IPO. Since the rescission offer was made to non-accredited investors, it did not qualify for any private placement exemption. Therefore, the rescission offer itself had to be registered.[2]

Another method that can be used to “clear up” previous instances of securities violations is to transfer the assets of the company to a new entity in exchange for stock in the new entity, leaving the existing liabilities (including securities law liabilities) with the old company. The new entity then carries out further rounds of fundraising, with reduced likelihood that the new investors’ capital will be subject to risk from securities lawsuits from previous investors. That risk doesn’t just disappear however. The old entity, which has retained the liabilities will either hold stock in the new entity, in which case such stock could be used to satisfy any judgments arising from the old liabilities, or the old entity is dissolved and such stock is transferred to the owners of the old entity. Such an approach is vulnerable to attack under the theory of successor liability. Successor liability arises when one company purchases the entire operation of another company. Even though only the assets are transferred to the new company and not the liabilities, plaintiffs have sometimes been successful in arguing that such transfers should also cause certain liabilities to transfer over to the new company because such a transaction is unfair to the creditors of the old company. So while an asset transfer has the potential to be successful at mitigating against liability for past securities violations, there is always some degree of uncertainty in using it because future investors may fear a successful successor liability claim.

Avoidance of successor liability is probably what in the end motivated Neogenix to file for bankruptcy protection. Under bankruptcy law, Neogenix could obtain a judgment from the bankruptcy court which discharges the new surviving entity from liabilities of the old company, such as past securities law violations. The fresh start the bankruptcy law allows proved very valuable here, and allowed the company to raise further funds without future investors being concerned with having to pay the price for the company’s previous mistakes.

Nonetheless, this case study provides a great illustration of why it is so difficult to proverbially “put the genie back in the bottle” once a securities law violation has occurred. Drastic action is sometimes necessary to permit the company to raise further capital and to continue.

Footnotes

[1] Neither the Federal Securities Act of 1933 nor the Securities Exchange Act of 1934 provide for any protection to issuers who engage in a rescission offer. In addition, the staff of the SEC has taken the position that rescission offers do not provide any protection against suits under federal securities law. That said, a rescission offer can still be useful to a company for certain types of securities violations, such as violations of the registration requirements, because the statute of limitations for violations of the federal registration requirement is very short: one year as opposed to state statutes of limitations which can go as long as five years. For instance, if a security was sold in violation of the registration requirements of both federal and state law, once one year has passed after the sale, an action under federal law would be barred by virtue of the statute of limitations and if the company undertakes a rescission offer correctly, the state law claims would also be barred.

[2] There was also likely another reason why the Google rescission offer needed to be registered. Since Google planned to engage in an IPO, it could not engage in a private rescission offer right before the IPO because the two offers would be considered integrated, which essentially means that the pending IPO would prevent Google from being able to successfully take advantage of a private placement exemption.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , , , , ,

Neogenix Oncology: A Good Case Study on Securities Law (Non)Compliance by a High Growth Company – Part 2: What Neogenix Did

October 24, 2012 By Leave a Comment

In my previous post, I described the events leading up to the Chapter 11 bankruptcy and supervised asset sale of Neogenix Oncology. To recap, Neogenix’s use of unregistered “finders” in some of its earlier rounds of financing called into question the company’s compliance with federal and state securities laws. After the SEC commenced an investigation, Neogenix’s accountants concluded that potential investor rescission rights could give rise to large contingent liabilities on the company’s balance sheet. This uncertainty led to Neogenix being unable to raise further funds, necessitating the company’s bankruptcy filing. In this post, I’ll explore how exactly Neogenix violated securities laws and the lessons this case study provides to startups and other growth stage companies.

Under Section 15 of the Securities Exchange Act of 1934, it is unlawful for “any broker… to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security… unless such broker… is registered [with the SEC].” The term “broker” is defined in the Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Note that a person’s activities determine whether he is a broker, and not what he calls himself or how the company employing him refers to him – whether it be finder, consultant, facilitator, or the like. The SEC has taken a broad interpretation of this provision, which requires anyone who engages in capital-raising activities for compensation to be a registered broker-dealer.[1] While the SEC has provided for a “finder exemption” for those who merely introduce potential investors to a company seeking capital, this exemption is, in practice, very narrow. The SEC has taken the position that if the finder is entitled to any fees which vary depending on whether a transaction is consummated or vary based on the amount of money raised, the finder is not exempt from registering as a broker. Whether this fee is labeled a “commission,” a “success fee,” or a “consulting fee” is irrelevant. Therefore, just about all arrangements in which someone is paid to do anything more than merely introducing investors to a company for a flat non-contingent fee are illegal, unless that person is registered under the Exchange Act or is a registered representative of a broker-dealer.[2]

In addition to the fact that engaging in capital-raising activities for compensation without being registered as or associated with a registered broker-dealer is illegal for the unregistered broker, it is also a very risky arrangement for the company raising capital to pay an unregistered broker. There are a couple of reasons for this. First, Section 29 of the Exchange Act provides that “[e]very contract made in violation of any provision of [the Exchange Act], and every contract…, the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void…” If the sale of securities was obtained through the introduction of an unregistered broker, then the sale itself could be rescinded by the purchaser under Section 29. A successful rescission suit would allow the investor to get his money back from the company, and/or potentially, the company’s officers and directors. In addition, most state securities “blue sky” laws also have a similar requirement that brokers be registered and a similar provision providing for a rescission right for investors. Finally, the use of an unregistered broker could result in the loss of the company’s private placement exemption, which would mean that all securities sold in the capital raise were sold without a proper exemption from registration under federal and state securities laws.

Neogenix, in its various rounds of financing, did indeed pay commissions to unlicensed brokers. As such, its investors had the potential right to rescind their investments (in an amount of over $30 million). Uncertainty over the accounting treatment of this potential liability caused the company to be unable to file its quarterly financial reports, bringing further fundraising to a halt. As a growth stage company, Neogenix was still reliant on further infusions of capital, sending the company into bankruptcy.

Some time ago, a Nashville-based investment banker told me that in his view, more capital raises occur through unregistered so-called “finders” than through registered broker-dealers (for the record, his firm was registered). Because the use of unregistered brokers is so rampant, many people are under the mistaken impression that the “finders exemption” allows for the payment of transaction-based compensation for capital raising activities. But it doesn’t, and the SEC and state securities administrators have taken action against both the unregistered brokers and the companies that employ them.

Footnotes

[1] Registration as a broker-dealer allows someone to act as both a broker and a dealer (which is a separate type of activity in the Exchange Act). There is no separate registration for brokers and dealers; there is simply one license that covers both activities.

[2] Another myth that is often thrown around is that if someone has taken a Series 7 exam, they can collect a commission for capital raising activities. The Series 7 exam is a test administered by FINRA which allows someone to be a licensed registered representative of a broker-dealer. However, simply taking the exam is not enough. The finder must actually also be associated with a registered broker-dealer, the operation of which requires considerable capital, overhead, expenses, and compliance responsibilities. Any commissions or other fees must be paid to the broker-dealer (usually a corporation or other entity), not the individual who acted as a finder.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , , ,

When does a deal involve securities regulation? Part 4: Promissory Notes

May 19, 2012 By 2 Comments

This post is the fourth in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws, and covered when various categories of instruments constitute a security, including partnership and limited liability company interests. In this post, we’ll explore when a promissory note falls within the definition of a security under federal law.

Under the federal Securities Act, the definition of a security includes “any note.” Taken literally, this could bring within securities regulation a vast number of transactions, including personal loans, commercial loans, and mortgage transactions, which would require the borrower to comply with securities laws. Fortunately, courts have not taken the words “any note” literally, and in the case Reves v. Ernst & Young, 110 S. Ct. 945 (1990), the Supreme Court adopted the “family resemblance” test to determine whether a particular loan transaction involves securities laws.

Under the family resemblance test, there is a rebuttable presumption that a note is a security, unless it resembles a type of note that commonly is not considered a security. However, the court also recognized that most notes are, in fact, not securities. The Court listed a number of categories of transactions that do not implicate U.S. securities laws:

  • A note delivered in consumer financing.
  • A note secured by a mortgage on a home.
  • A note secured by a lien on a small business or some of its assets.
  • A note relating to a “character” loan to a bank customer.
  • A note which formalizes an open-account indebtedness incurred in the ordinary course of business.
  • Short-term notes secured by an assignment of accounts receivables.
  • Notes given in connection with loans by a commercial bank to a business for current operations.

Just because a transaction does not fit within the list above does not mean that the note is a security. For other transactions, the Court set out a four factor balancing test. The four factors are:

  1. Whether the borrower’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest. The second half of this factor is not particularly helpful, since almost all loans involve earning a profit.[1] However, the first half can often come into play. If purpose of the transaction is to raise money for general business use or to finance a substantial investment, the note is more likely to be security; conversely, if the purpose is to facilitate the purchase and sale of a minor asset or consumer good, or to correct for cash-flow difficulties, or to advance some other “commercial or consumer purpose,” the note is less likely to be a security
  2. Whether the borrower’s plan of distribution of the note resembles the plan of distribution of a security. In general, the more buyers and the less sophistication of the buyers, the more likely it is that the notes are securities. In addition, the presence of any significant negotiation over the terms of a loan (or if the lender dictates the terms of the loan) usually makes it less likely that the note would be considered a security.
  3. Whether the investing public reasonably expects that the note is a security. If the purchasers view the notes as a type of investment, they are more likely to be securities. In addition, if the notes are unsecured, they are more likely to be securities.
  4. Whether there is a regulatory scheme that protects the investor other than the securities laws. For example, if notes are regulated under Federal Deposit Insurance or ERISA, they are less likely to be a security.

Of course, with any kind of multi factor balancing test, there is a high degree of subjectivity. As a result, it is fair to say that a note is often a security when a court thinks that it should be, which makes structuring loan transactions all the more tricky. Here are some practical guidelines:

  • If you’re selling notes to multiple people, it is likely to be a security. This is even more the case if the purchasing parties are not in the business of making loans.
  • If you’re getting a loan from one party that is in the business of making loans (like a bank), then the note associated with the loan is not likely to be a security.
  • If you’re borrowing the money personally, it is less likely to be a security than if your business is borrowing it.

Beyond that, if the circumstances are ambiguous, be sure to find qualified securities counsel.

Footnotes

[1] However, a loan among family members, where the prime motive is not profit, would be a good example of a note where profit was not the motive behind making the loan.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , ,

When does a deal involve securities regulation? Part 1: Introduction

March 29, 2012 By 3 Comments

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” is a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

“[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types of transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.

Footnotes

[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: General Business Law Tagged With: , , , , , , ,

U.S. House Votes to Adopt Six Measures Loosening Securities Regulation for Smaller Companies; Provisions Include Crowdfunding and “IPO On Ramp”

March 8, 2012 By Leave a Comment

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure:

The Reopening American Capital Markets to Emerging Growth Companies Act (H.R. 3606; the rest of the bills were added to this one).  This bill is also known as the “IPO On Ramp” and it creates a new category of company called an “emerging growth company,” which is defined roughly as a public company with less than $1 Billion in revenue.  An issuer that is an emerging growth company as of the first day of a fiscal year will continue to be one until the earliest of (i) the last day of the fiscal year during which the issuer had $1 billion in annual gross revenues or more; (ii) the last day of the fiscal year following the fifth anniversary of the issuer’s IPO date; or (iii) the date in which the issuer is deemed to be a large accelerated filer, defined by the SEC as an issuer with more than $700 million in public float. In addition, a company would not be considered an emerging growth company if it has issued more than $1 billion in non-convertible debt over the prior three years.  An emerging growth company would enjoy more lax regulation by the SEC.  For instance, the bill would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company.  Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that carries high compliance costs. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to their IPO rather than three years. The bill also exempts emerging growth companies from new corporate governance requirements within the Dodd-Frank Act, namely the so-called “say on pay” requirement and the requirement that public companies calculate and disclose the median compensation of all employees compared to the CEO.  The bill would remove restrictions prohibiting investment banks that underwrite a company’s IPO from publishing research on emerging growth companies and would  expand the range of permissible pre-filing communications to “qualified institutional buyers” or “accredited investors.”

The Access to Capital for Job Creators Act (formerly H.R. 2940).  As discussed in a previous post, this bill essentially removes the general solicitation prohibition on offerings made under Rule 506 of Regulation D.

The Entrepreneur Access to Capital Act (formerly H. R. 2930).  This is the “crowdfunding” bill, which I’ve discussed at length in the following posts: Is action forthcoming on a crowdfunding exemption to Federal securities laws?; Bill Creating Crowdfunding Exemption from Securities Registration Passes U.S. House of Representatives; What does the future hold for crowdfunding legislation?; Implications of the Pending Startup Crowdfunding Bill.

The Small Company Formation Act (formerly H. R. 1070).  This bill would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. It would also preempt state blue sky laws with regards to such offerings if they are traded on a national exchange.   Regulation A is a little used exemption from registration that permits an exempt public offering using a type of “short form” registration.  It is rarely used for two reasons: (i) it has a limit of $5 million and (ii) there is no preemption and so the offerings are subject to blue sky laws.  This bill would eliminate both of these obstacles.

The Private Company Flexibility and Growth Act (formerly H.R. 2167).  This bill raises the number of shareholders a company can have before it is forced to go public from 500 to 1,000.  In addition, it also excludes employees from counting against this limit.  More details can be found on a previous post on this topic: Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer.

The Capital Expansion Act (formerly H.R. 4088).  This bill raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.  The issue here is that community banks are often forced to engage in expensive Exchange Act reporting because they have over 499 shareholders.  This bill would remove this expense for many of them.

The vote was lopsided and the White House has indicated that it is supportive, so the bill has a decent chance of become law.  That said, don’t let the lopsidedness of the vote fool you.  There is genuine opposition to these bills in the Senate that has been building for some time.  There are some significant concern that the legislation will increase the incidence of securities fraud, particularly for senior citizens.  Therefore, stay tuned.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Startups and Venture Capital Tagged With: , , , , , , , , , , , , ,
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