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

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.

Alexander J. Davie About Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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