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Home » Treatises » Common State and Federal Securities Law Violations
Many entrepreneurs learn the hard way that failure to comply with state and federal securities laws in the creation of a business or in connection with entrepreneurial financing can cause crippling regulatory and litigation issues, which later destroy the business. To prevent such risks, entrepreneurs should involve competent securities financing counsel early in all aspects of business organization, financing, and corporate governance. While it might seem like an unnecessary, expensive cost early in the genesis of a business, funds invested in competent securities counsel at the time of business formation will save substantial attorneys’ fees, costs, liabilities, regulatory issues, uncertainty and disputes later on in the life of a company. Indeed, it is common for securities lawyers to joke that corporate transactional lawyers are expensive, but securities litigators are much more expensive, which is another way of saying that an ounce of prevention is worth a pound of cure.
Securities Registration or Exemption from Registration The sale of any ownership interest in a business generally requires that the sale of the ownership interest comply with all applicable state and federal securities laws. Typically, for example, the sale of stock or a similar ownership interest in a business must be done so that the sale is exempt from registration with federal and state regulators (for example, in a private offering), or a registration statement must be filed with state and federal regulators (i.e., a public offering).2 Exemptions from securities registration typically depend on a number of factors, including, for example, the number of persons offered the stock, and the financial net worth, income and sophistication of the purchasers of the stock.3
Securities Include Notes, Debentures and Investment Contracts Many entrepreneurs are surprised to learn that different types of ownership interests are “securities” under state and federal law, regardless of the label used or type of entity involved, and surprised to learn that the sale of ownership interests in or use of certain financing methods requires compliance with state and federal securities laws. For example, in Utah, notes, bonds, debentures, investment contracts, certificates of interest, viatical settlements, certificate of deposits for a security, and interests in a limited liability company, are “securities” subject to regulation under the securities laws. Many entrepreneurs incorrectly believe that raising money by issuing promissory notes, debentures or other debt instruments does not involve the offer and sale of securities, or that selling shares only to friends and family is always legal. Sadly, unprepared and uninformed entrepreneurs later learn the hard way that promissory notes and debentures are, in fact, securities subject to state and federal securities laws, and that if sales are done improperly, even your friends and family can and will sue when life savings are lost in a new business.
Rescission Rights for the Sale of Unregistered Securities Under state securities laws, if securities, including notes and debentures, are sold to unqualified or unaccredited investors without a valid exemption from registration or without an effective registration statement, the investors who purchased the notes, securities and/or debentures can and many times do demand rescission of the investment, and can be entitled to a full refund of their investment, along with statutory interest, attorneys’ fees and costs, regardless of the success or subsequent failure of the business.4 In other words, if an entrepreneur does not comply with state and federal securities laws in selling certain ownership interests in a business, the investor can later demand all of their money back, along with statutory interest, attorneys’ fees and costs, and the company is obligated to refund the investment, even if the company is losing money and the investment would otherwise have resulted in a net loss. Rescission claims can often later cripple a company if investors panic and demand a refund of their investments and find a securities violation.
General or Limited Solicitations of Investors Many entrepreneurs also are surprised to learn that there are specific regulations governing the manner and types of solicitations that can be done to obtain investors, including, who can be solicited to invest in a business and under what circumstances. Failure to follow general and limited solicitation regulations can result in an otherwise exempt financing transaction losing its exemption, or even result in the person involved being prosecuted for, among other things, selling unregistered securities without an appropriate securities license. Accordingly, entrepreneurs should always consult competent securities counsel before soliciting investors to purchase interests in or financing a business to make sure that manner and content of any solicitation is legal.
Many entrepreneurs who are short of funds at the inception of a company fail to hire counsel to advise them on the proper way to capitalize a company or to raise money for the business. As a result, many entrepreneurs raise initial capital or subsequent rounds of financing in ways that violate state and federal securities laws, including by raising funds from unqualified investors, raising funds from too many investors so that the offering becomes an unregistered public offering, raising funds without appropriate disclosure of risks, raising funds without a properly drafted private placement offering memorandum, raising funds through inappropriate or prohibited advertising of the investment, or diluting earlier investors in ways that violate the rights of earlier investors.
Common Securities Violations The most common regulatory violations pursued by securities regulators and at issue in private securities litigation involve the sale of unregistered securities by persons who are unlicensed to sell securities, as well as securities fraud violations involving misrepresentations and/or omissions, including those arising out of Ponzi schemes, affinity fraud or other investment schemes.
Misrepresentations Common securities violations committed by entrepreneurs generally involve intentional and even negligent misrepresentations about the investment and/or company, including, without limitation, misrepresenting the use of investor funds; the safety of the investment; the expected return on the investment; the risks of the investment; the viability or experience of the business; the market opportunities; ownership and status of intellectual property rights; and/or the experience of or liabilities associated with the officers, directors or managing members of the business. For example, it is not unusual for entrepreneurs to induce investors to put money into a company by misrepresenting that a big deal is about to close, and that the investment will dramatically increase in value when the big deal is closed when, in fact, there is no deal pending or the deal is only speculative.
Omissions Common securities violations also involve actionable omissions, including, without limitation, omissions about the capital structure of the business; the regulatory, criminal, tax lien or bankruptcy history of the officers, directors or managing members; and omissions about known risks to the viability of the business. Indeed, failing to disclose substantial risks to the business, which are known to the insiders, can subject the insiders to liability for securities fraud. For example, raising funds from investors without disclosing an imminent lawsuit, which will put ownership of the company’s patent rights at issue, can be an actionable omission. Failing to disclose that the President of the Company filed personal bankruptcy a year earlier, and that there are tax liens on the President’s house, also can be an actionable omission. Omissions generally must be material, that is something a reasonable investor would want to know in making an investment decision, and there must be a direct relationship between the parties giving rise to a duty to speak.
Affinity Fraud In Utah, it is not unusual for dishonest individuals to raise investment funds within their church, neighborhood or community, and to prey on the inherent trust that exists within the community of people that belong to their church, neighborhood or community. Regulators refer to this type of predatory fund raising or investment fraud as “affinity fraud.” Examples of affinity fraud include, for example, Bernard Madoff, who preyed on members of the Jewish community in perpetrating his securities fraud, or more locally, Val Southwick, who preyed on members of the LDS church. There was even a Greyhound bus driver in California, for example, who preyed on other Greyhound bus drivers. There are statutory criminal enhancements in Utah law for criminals who exploit members of their own churches or community groups for fraudulent financial gain.
Ponzi Schemes Much of the affinity fraud that takes place in Utah arises in the context of Ponzi schemes. A Ponzi scheme is generally an investment scheme in which returns to investors are not financed through the success of the underlying business venture, but are taken from principal sums of newly attracted investments. Typically, investors are promised large above-market returns for their investments. Initial investors are actually paid the promised returns, which attract additional investors, but not from the success of the business. Instead, they are paid with funds raised from new investors. In Utah, most Ponzi schemes tend to involve the sale of promissory notes or real property, which provide for a high, and often guaranteed, rate of return. Typically, early investors are paid with investments from new investors, and the illusory high returns paid to early investors help attract additional investors. Ponzi schemes typically thrive in vibrant economies, and collapse when there are difficult economic times and it becomes difficult to find new investors to pay old investors. When a Ponzi scheme can no longer raise sufficient funds from new investors to make payments to old investors, the Ponzi scheme collapses, and investors are left holding the bag.
Often times receivers are appointed to clean up the Ponzi scheme after it collapses, and investors who received more money back than they invested are often surprised to learn that they will be sued by the receiver and required to return the amounts they received in excess of the principal amounts they invested, which interest or false profits are then re-distributed to those investors who lost money in the Ponzi scheme. Professionals who provide services to Ponzi schemes, such as accountants, lawyers, and related investment professionals, also are surprised when the receiver sues them, arguing that they helped perpetuate the fraud, and but for their turning a blind eye, it is alleged that they could have prevented the Ponzi scheme from defrauding additional victims. It also is not uncommon in Utah for there to be a double Ponzi scheme, where the promoter of the Ponzi scheme invests in another Ponzi scheme with the hope of earning his or her way out of the hole in which the initial Ponzi scheme finds itself.
Derivative Liability Another area that surprises entrepreneurs doing business in Utah is derivative liability for the actions of other officers, directors, managing members or other control persons of a business. Under Utah law, if an officer or director of a company commits securities fraud, the other officers and directors of the company also are liable for securities fraud, unless the innocent officer or director can prove that they did not know of their co-officer’s fraud or in the exercise of due diligence, could not have learned of their colleague’s fraud.5 This derivative liability makes it
critically important for officers, directors, managing members and other control persons to carefully choose their fellow officers and directors, to make sure that they do not hire dishonest officers or directors, and to make sure that they do not turn a blind eye to any potentially suspect behavior by another officer or director, regardless of the economic benefit to the entity. It also is critically important to design and institute appropriate corporate governance procedures to ferret out and prevent any potential fraudulent conduct by other officers, directors, managing members or other control persons. Indeed, corporate governance is an area where good corporate counsel and careful structuring can guard against derivative liability for the improper actions of another officer or director.
Finders and Unregistered Broker Dealers Another area where entrepreneurs frequently run into securities law problems involves what are commonly referred to as “finders.” Under state and federal securities laws, to be paid a commission or other compensation for arranging for the purchase or sale of a security or other interest in a business, the person receiving the commission or other compensation must have a securities license. Unfortunately, there is a fairly common practice in Utah of people paying “finders” a fee, commission or a percentage of the funds raised for selling stock or raising funds for a company. Indeed, many so-called business brokers who purport to arrange for the purchase or sale of a business are paid a percentage of the sale or purchase price of the business. Business brokers and “finders”, however, who do not have a securities license cannot lawfully be paid a commission or other compensation for arranging for the sale or purchase of a business under Utah law. There has been a great deal of litigation in Utah involving the payment of finders’ fees and commissions to unlicensed individuals once it is discovered that it is illegal to pay such a fee. Payment of an illegal finders’ fee or commission also potentially could subject the person or entity paying such fee or commission to regulatory aiding and abetting liability. Entrepreneurs should not pay finders’ fees or commissions to any person or entity that is not properly licensed to engage in the purchase or sale of securities in connection with the purchase or sale of a business. Only licensed broker dealers and registered securities professionals should be paid commissions or other compensation for the purchase or sale of securities. A person also should not accept a commission or other compensation for helping find investors, unless the person has a securities license.
Class Actions, Derivative Actions and Dissenters’ Rights Apart from private and regulatory litigation involving the improper sale of unregistered securities, or investment fraud committed in the sale of securities, entrepreneurs can also face securities litigation in the form of class actions, derivative actions, dissenters’ rights actions and dissolution actions.
Securities class actions typically happen in publicly traded companies, and most commonly occur after a significant drop in the trading price of a listed security, or a major corporate change, such as a merger or going private transaction, which impacts the value of the shares of a company. In 2013, according to the Securities Class Action Clearinghouse, there were 166 securities class action lawsuits filed. A total of 97 class actions were filed against firms with stock listed on NASDAQ, and 55 with stocks listed on the NYSE. In 2013, 14.3% of securities class actions were filed against telecommunication services companies, with 8.6% being filed against information technology companies, 8.4% against consumer-oriented companies, and 5.7% against health care companies. Securities class actions are big business. Since the Securities Class Action Clearinghouse started keeping statistics, publicly traded companies have paid in excess of $84 billion in settlements; and there have been 28,024 total defendants, with 1965 settlements. In 2013, there were 375 active securities class action cases, and approximately one in three companies listed on a U.S. exchange was the subject of a class action. The U.S. Chamber Institute for Legal Reform issued a report on February 5, 2014 stating that in 2013 alone, attorneys’ fees and expenses in securities class actions totaled $1.1 billion, and that over the past decade, the amount that went to plaintiffs’ attorneys from settlements exceeded $10 billion. A recent trend in securities class actions involves public companies with overseas operations. Employees of the overseas operations engage in bribes and/or kickbacks, which are acceptable in the foreign country, but which violate the Foreign Corrupt Practices Act in the United States. Auditors or whistleblowers discover the bribes and kickbacks, exposing the company to substantial regulatory risk, and the stock market reacts by punishing the stock. A securities class action is a foreseeable and common response to such increasingly common scenarios in the world economy. Needless to say, serving as an officer or director of a publicly traded company comes with substantial risks.
Directors & Officers’ Liability Insurance Typically, officers and directors of public companies are covered by directors and officers’ liability insurance, and/or have rights to corporate indemnification by the company in the bylaws, to protect their individual assets in the event of a securities class action lawsuit. Directors and officers’ liability policies generally are self-liquidating, so that funds expended on securities class action defense counsel reduce the amount of insurance available under the policy limits. As a result, there is an economic incentive for the plaintiffs, the defendants, and the insurance company to explore settlement of securities class actions in the event that a class action cannot be resolved on a motion to dismiss or summary judgment basis, so that the D&O policy is not exhausted and unavailable for settlement purposes. If an entrepreneur is going to serve as an officer or director of a publicly traded company, it is critical that the person become well informed about the D&O insurance held by the company, the coverage afforded to them under the policy, and the indemnification rights available to the officer or director in the bylaws or articles.
Derivative Actions In contrast to a securities class action, which seeks to compensate shareholders for the damage done to the value of their shares by some action of the corporation and its officers or directors, shareholder derivative actions, which are closely related and often filed at the same time as securities class actions, seek to compensate the corporation for damages caused to the corporation by actions or inactions by the officers or directors, including, for example, by breach of fiduciary duty, self- dealing and/or corporate waste. For example, objections to excessive compensation paid to officers and directors have recently been the subject of derivative actions filed against officers and directors. Typically, in contrast to securities class actions, officers and directors are not always covered by D&O insurance for purposes of defending a derivative action. Officers and directors should carefully guard against actions which could be considered self-dealing, corporate waste, or otherwise detrimental to the company in ways that go beyond typical business judgment decision making.
Freeze Out Mergers and Dissenters’ Rights In Utah, when a company engages in a merger or other types of change of control transactions that result in a forced sale of an owner’s interests in a business entity, the owner who has been forced to sell can challenge the price paid for the forced sale within a very limited period of time, and demand an independent appraisal of the shares if the owner timely objects to the value provided to the seller. Typically, dissenters’ rights actions arise in the context of freeze out mergers, where a majority owner merges an entity into another entity for the sole purpose of cashing out one or more minority owners. During the freeze out merger, the majority owner tenders what the majority owner considers to be the fair value for the shares that the minority owner(s) was forced to give up in the merger. The minority owner(s) can then challenge the value paid for the shares, provided that the minority owner(s) acts promptly and files an appropriate appraisal proceeding. Typically, the appraisal proceeding is the exclusive remedy afforded minority owners forced to sell shares in a freeze out merger, and failure to timely challenge the share price in an appraisal proceeding has been held to be a waiver of all other rights to challenge the transaction.
Corporate Opportunity Doctrine Other potential disputes among shareholders can result in actions for dissolution of the business entity, or allegations of self-dealing, and usurpation of corporate opportunities for personal gain. With respect to the corporate opportunity doctrine, for example, Utah law requires that for an officer, director or control person of a company to pursue an independent corporate opportunity outside of a business which opportunity is in the same business market as their employer, the officer or director must (a) fully and appropriately disclose the opportunity to the company; (b) offer the corporate opportunity to the company; and
get permission from the company to pursue the opportunity outside of the company before he or she can pursue the independent corporate opportunity. Many officers and directors have been sued for pursuing a side business without disclosure and permission, which should have been used to benefit their employer, but which they pursued for their own personal gain. An officer or director who has any doubt about whether an outside opportunity is or is not an opportunity that belongs to the company should disclose the opportunity to the board, and seek permission to pursue the opportunity.
Regulatory Actions Numerous agencies enforce state and federal securities laws, including the United States Securities and Exchange Commission (the “SEC”), the United States Department of Justice (“DOJ”), the Utah Division of Securities, the Financial Industry Regulatory Authority (“FINRA”), district attorneys’ (“DAs”), county attorneys, and attorneys generals (“AG”) offices, among others. Typically, the SEC investigates matters involving public companies and large fraudulent schemes. The SEC institutes civil proceedings, both in court and in administrative proceedings before administrative law judges. The SEC also works with the DOJ on criminal prosecutions involving federal securities law violations. The Utah Division of Securities, and other state securities agencies, focus on smaller securities violations, including with licensed and unlicensed individuals and companies, and works with DAs, county attorneys, and AGs in state law violations involving criminal conduct. FINRA brings administrative actions against licensed individuals who violate FINRA’s rules and regulations, as well as oversees private arbitration proceedings involving brokerage firm customers, and/or disputes between brokerage firms and their registered representatives. Most securities violations are handled in administrative proceedings filed by the SEC, the Utah Division of Securities (or other state agencies), and/or FINRA. Criminal prosecutions by the DOJ, DAs and AGs, however, are common, and typically involve more serious securities violations where an intent to defraud or reckless conduct is present.
It is important to keep in mind that when a person or entity settles or agrees to resolve a state or federal securities violation, even without admitting any liability, in most circumstances, entry of the consented settlement decree will bar the person from ever raising funds for another business under the most common exemptions from securities registration. Federal law precludes a business relying on the most common exemptions from registration of a securities offering if it employs or has any meaningful relationship with a person who has consented to and settled a state or federal securities violation. Accordingly, it is important to hire competent securities regulatory counsel if any action is filed involving alleged violations of state or federal securities laws because even certain cease and desist orders can result in a person’s career coming to a sudden end.