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.