Resales of “Restricted Securities”

On February 15, 2008, the Securities and Exchange Commission’s (the “SEC”) amended Rule 144, which governs the resale of “restricted securities.” These amendments were an attempt to deal with the resale of “shell company” securities, shell company transactions and the persons who promote them.  In many instances, these amendments have resulted in lawyers rendering the types of legal opinions that were customarily rendered prior to the adoption of Rule 144 in 1972.  In our estimation, this is a step backwards.

The 2008 amendments preclude the use of Rule 144 for the resale of securities initially issued by a shell company until: (i) the issuer files “Form 10 Information”  (defined as to be the equivalent of information that would be included in a Form 10 Registration Statement) with the SEC; (ii) the passage of one (1) year from such filing; and (iii) the issuer has “current public information” available as required by Rule 144(c)(1). These requirements have in many cases made Rule 144 unavailable and required lawyers to render legal opinions under Section 4(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”).  Section 4(a)(1) (formerly known as “Section 4(1)”) exempts “routine trading transactions” from registration under the Securities Act.

Our firm renders Rule 144 legal opinions and, in cases where an issuer may have shell company issues in its history and compliance with the provisions of subparagraph (i) of Rule 144 as cited above cannot be met, Section 4(a)(1) legal opinions.  We also provide combined legal opinions under Rule 144 and Section 4(a)(1) when both exemptions from registration under the Securities Act are deemed to be available.  With increased scrutiny of current and former shell companies and the resale of all “restricted securities” and “free trading” securities by the SEC and FINRA, broker-dealers frequently require legal opinions on all stock certificates, regardless of whether there is a restriction on the front or reverse side of the stock certificate.  In many cases, broker-dealers also charge their customers a fee for having the brokers’ legal counsel review opinions obtained by their customers.

When we are engaged to render these types of legal opinions, we conduct extensive due diligence and review all documentation that may support the legal opinion.  This information is summarized in the opinion letter and the letter is forwarded to the issuer, the transfer agent and the broker-dealer that will be relying on the opinion.  Depending upon the client and the client’s current or prior relationship with the issuer, we may also prepare a proprietary Customer Resale Agreement that is formulated for the protection of the client, signed by the client and acknowledged by the client’s broker-dealer.  These agreements contain provisions ensuring that all sales under the opinion are made in “routine trading transactions” and are therefore exempt from registration under the Securities Act.  We conduct our due diligence free of charge, and clients owe us nothing if they decide not to proceed with an opinion letter following our fee quote.

We believe that our detailed analysis and due diligence, along with the terms of the Customer Resale Agreement, which are tailored to cover necessary circumstances that may arise or result from our due diligence and the factual basis for the legal opinion, provide additional legal protection to our clients; their brokers; the issuers; and the transfer agents who rely on them.  We also believe that our thorough approach to rendering Rule 144 legal opinions or Section 4(a)(1) legal opinions stands up to regulatory scrutiny and encourages prompt issuer, transfer agent and broker acceptance of our legal opinions.

A Trap for the Unwary

In today’s securities market, many micro-cap issuers choose to raise funds through “self-underwritten” offerings, in which securities are sold directly by the company’s directors and officers rather than through an outside underwriter.  Both federal and state securities laws acknowledge this method of fundraising, commonly exempting issuers from the statutory definition of “broker-dealers.”  Section 61-1-13(1)(c)(ii)(B) of the Utah Uniform Securities Act is one example.  However, self-underwritten offerings contain traps for the unwary.    Section 15(a) of the Securities Exchange Act of 1934 is a statute that can cause serious problems for directors and officers who engage in such offerings.

Section 15(a) makes it unlawful for a broker or dealer “to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security . . . unless such broker or dealer is registered” with the Securities and Exchange Commission.  The potential trap for micro-cap company management is that both Congress and the Commission define the term “broker or dealer” quite broadly.  Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others” and Section 3(a)(5) defines a “dealer” as “any person engaged in the business of selling securities . . . for such person’s own account through a broker or otherwise.”

Recent Commission enforcement actions illustrate both the Commission’s broad view of the types of activities that create broker-dealer status and the severe penalties that unregistered broker-dealers can face.  Many of these activities are the very things that many micro-cap companies do on a regular basis to keep themselves afloat financially.  These include:

  • solicitation of potential investors, including persons with no pre-existing relationship with the issuer;
  • expressing an opinion on the merits of an investment in the issuer’s securities with statements such as “it’s a great opportunity” and “investors could realize tremendous gains;”
  • the receipt of commissions or other transaction-based compensation for security sales; and
  • engaging in a high number of transactions such that the issuer or officer/director appears to be “engaged in the business of selling securities.” In one recent case, a corporate officer made an average of more than 200 securities sales per year over a four-year period, helping to support the Commission’s conclusion that he had violated Section 15(a).

Penalties for violations of Section 15(a) can also be severe.  In addition to being suspended from association with any broker-dealer in the future, violators may be ordered to pay disgorgement of hundreds of thousands, even millions, of dollars.  Such penalties can be financially crippling, both for individual violators and for violators at the corporate level.  In the Commission’s recent Ironridge enforcement action, for example, the corporate violators were ordered to pay disgorgement of $4.4 million. There is a sad irony in the fact that a micro-cap issuer’s dedicated effort to raise much-needed capital may be the very thing that causes its financial devastation.

If your company is contemplating a self-underwritten securities offering, the Burningham Law Group can help.