By Russell C. Weigel, III
Company executives, do not let your desperation for operating cash blind you to these four typical financing scams perpetrated by finance promoters: the Rule 504 offering, the debt-conversion, the “backdoor offering,” and the Section 3(a)(9) court-approved offering. Each financing scenario is legitimate in a properly conducted transaction, but each method is frequently misused at the expense of the issuer. Fueling the deception on company executives is the probability that they have heard of these financing terms or transactions and therefore assume their propriety. However, finance promoters have misused the legitimate techniques to trick issuers into participating in illegal unregistered stock distributions. In each scenario stock issuers are duped into issuing purportedly “free-trading” stock, which often enables the promoters to reap large returns from dumping cheap stock but exposing the issuers and distribution participants to SEC enforcement actions.
The Rule 504 Offering. In December 2012, the SEC took the position in litigation that “Minnesota” Rule 504 offerings conducted for the purpose of issuing free trading stock are illegal in circumstances where the stock issuance transaction is not registered in Minnesota. News of this situation is not widely known. Rule 504 for many years has provided that stock issued in accordance with its requirements may be free trading if it is registered in a state where advertising and general solicitation of the offering is permitted, or where the buyer’s state does not require registration when the stock is issued to an accredited investor in a transaction that allows advertising and general solicitation of the sale. Without any prior published guidance to my knowledge, the SEC took the position in litigation that Minnesota’s blue sky provisions did not meet the requirements of Rule 504. Therefore, the issuer had issued stock in an illegal Rule 504 transaction in violation of the federal registration requirements. Minnesota was the last state to my knowledge that arguably qualified for the Rule 504 free-trading result. Issuers should beware promoters or financiers promoting Rule 504 transactions and claiming that free-trading stock can be issued. Being on the wrong side of this scenario can result in an enforcement action against all participants in the transaction, including the issuer and its management.
The Debt-Conversion. The debt-conversion transaction is often pitched to issuers by a financier who claims to have purchased the Company’s corporate debt and now wants to exchange the debt for free trading stock. Rule 144 permits a swap of debt for equity provided that the original security has been held for at least one year. Trade debt, however, is not the investment security envisioned by Rule 144. Thus, an issuer that issues its stock in exchange for trade debt can only issue restricted stock to the trade debt-holder. Issuing unregistered stock without a qualifying transactional exemption from registration, of course, is illegal. The debt-conversion transaction is often coupled with a promise by the financier to loan the issuer some part of the proceeds from the ensuing sale of illegally issued stock as additional inducement.
The “Backdoor Offering.” The backdoor offering is a transaction typically involving a promoter, an existing company shareholder, and a public company. The shareholder is induced to sell his free trading shares, usually directly through his brokerage account, and remit the proceeds to the promoter and the public company in exchange for receipt of replacement restricted shares. This backdoor offering is deemed by the SEC to violate the spirit of the registration requirement because the selling shareholder acts as a conduit for the account of the issuer and not for his own account. It is therefore an illegal transaction that violates the registration requirement.
The Section 3(a)(9) Court-Approved Offering. Section 3(a)(9) of the Securities Act of 1933 classifies stock as exempt from registration if it is issued in a transaction approved by a court. Debt-conversion transactions in which otherwise restricted stock are properly issued in exchange for trade debt are frequently consummated with a proviso that a court must approve the transaction. The game here is to convert the restricted stock immediately into free trading stock and thereby avoiding the one-year holding requirement of Rule 144. The issuer is required to sign court-documents which may well be filed with a court for “settlement-approval.” These transactions rarely are properly conducted in accordance with applicable SEC guidelines, although courts may well authorize the transactions. Even if a court approves the transaction, an improperly conducted transaction may still subject the issuer to the risk of an enforcement action for unregistered stock sales.
Each of these four scenarios is real. Before engaging in an unsolicited financing transaction, no matter how badly your company needs working capital, consult competent securities counsel before leaping at a financing offer. The cost of a legal review is far less than the cost of hiring defense counsel to fight SEC charges, and fighting unregistered stock sale charges brought by the SEC are difficult or impossible to defend. Just be smart.
Doing business as InvestmentAttorneys, the law firm of Russell C. Weigel, III, P.A. practices corporation and securities law nationwide and specializes in taking companies public, helping public companies prepare SEC filings and stay compliant with federal and state securities laws, preparing transaction and disclosure documents for Rule 506 offerings, and defending issuers and other securities industry participants from SEC and FINRA enforcement actions and from customer arbitrations.
Russell C. Weigel, III, was a branch chief and special counsel at the U.S. Securities and Exchange Commission and served during the years 1990-2001.
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