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FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets

by Laura Anthony, Esq. on October 28, 2014 in FINRA, FINRA Compliance, OTC Market, OTCBB, OTCQB, OTCQB and OTCQX, OTCQX, Pinksheets, Uncategorized with No Comments

On October 7, 2014, the SEC published a release instituting proceedings to determine whether to approve FINRA’s request to delete the rules related to, and the operations of, the OTC Bulletin Board quotation service. On June 27, 2014, FINRA quietly filed a proposed rule change with the SEC seeking to adopt rules relating to the quotation requirements for OTC equity services and to delete the rules relating to the OTCBB and thus cease its operations. Although the rule filing was published in the Federal Register, it garnered no attention in the small cap marketplace. Only one comment letter, from OTC Market Group, Inc. (“OTC Markets”) (i.e., the entity that owns and operates the inter-dealer quotation system known by its OTC Pink, OTCQB and OTCQX quotation tiers) was submitted in response to the filing.

The OTCBB has become increasingly irrelevant in the OTC marketplace for years. In October 2010, I wrote a blog titled “Has the OTCBB been replaced by the OTCQX and OTCQB”; at the time and up until May 16, 2013, my opinion was “yes” with one caveat. Prior to May 16, 2013, the OTCBB was considered “an established market” but the OTCQB and OTCQX were not. On May 16, 2013, that caveat was removed (see the blog detailing the changes Here) In particular, on May 16, 2013, the SEC updated their Compliance and Disclosure Interpretations confirming that the OTCQB and OTCQX marketplaces are now considered public marketplaces for purposes of establishing a public market price when registering securities for resale in equity line financings.

Since that time, the OTCBB has been largely irrelevant, and worse, a cause of confusion in the OTC marketplace. The OTC market is comprised of publicly traded securities that are not listed on a national securities exchange. The trading platforms for OTC securities are referred to as “inter-dealer quotation systems.” Today there are two main inter-dealer quotation systems: (i) the OTC Markets comprised of OTCQX, OTCQB, and pinksheets (www.otcmarkets.com); and (ii) the FINRA owed OTCBB (www.otcbb.com). Many small cap participants believe that the OTC marketplace is comprised of a single marketplace, and are confused by the actual existence of two such marketplaces.

The regulatory framework related to inter-dealer quotation services and OTC securities in general is widely centered on ensuring compliance with Section 17B of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 17B of the Exchange Act is the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”). Although a complete discussion of the Penny Stock Act is beyond the scope of this blog, the goal of the Act is to ensure the widespread dissemination of reliable and accurate quotation information on penny stocks. Over time, the OTC Markets has become much more efficient in meeting the goals of the Penny Stock Act while at the same time, the OTCBB has become much less efficient at meeting those same goals.

As set forth in the SEC Release, “FINRA proposed to adopt rules: (1) governing the treatment of quotations in OTC equity securities by member inter-dealer quotation systems and addressing fair and non-discriminatory access to such systems; (2) requiring member inter-dealer quotation systems to provide FINRA with a written description of quotation-related data products offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives; (3) expanding the reporting requirements related to quotation information in OTC equity securities; and (4) deleting the Rule 6500 Series and related rules and thereby ceasing operation of the OTCBB.”

The FINRA rule release seeks to eliminate the OTCBB and impose governing regulations on the remaining inter-dealer quotation system—to wit, the OTC Markets comprised of the OTCQX, OTCQB, and pinksheets (www.otcmarkets.com).

Proposed Deletion of the OTCBB Related Rules and OTCBB Marketplace

FINRA is proposing to delete the FINRA Rule 6500 Series, which governs the operation of the OTCBB, and cease operation of the OTCBB. In its request, FINRA states that the level of transparency in OTC equity securities facilitated by the OTCBB has been declining significantly for years such that the amount of information widely available to investors relying on the OTCBB bid and offer data has become negligible. FINRA further expressed its belief that “the remaining OTCBB information being disseminated to investors is so incomplete as to be potentially misleading with respect to the current pricing in these securities.”

There are approximately 10,000 OTC equity securities quoted on the OTC Markets, of which less than 10% are duly quoted on the OTC Markets and OTCBB and fewer than twelve (yes, 12) are solely quoted on the OTCBB. Moreover, it is widely known in the industry that the technology used to facilitate quotation on the OTCBB is antiquated and unreliable such that broker-dealers are derisive of using the system. Accordingly, FINRA notes that the discontinuance of the OTCBB will not have an impact on issuers, investors or member firms. FINRA has also committed to take steps to ensure a smooth transition for those few issuers still using the OTCBB system, including by directly contacting these issuers and assisting with a transition to OTC Markets.

Finally, FINRA believes that the requirements related to the Penny Stock Act, and in particular widely disseminated information regarding penny stocks, better lay with the issuers, broker-dealers, and FINRA members (such as OTC Markets) rather than with FINRA itself, which is an SRO (self-regulatory organization). In other words, FINRA does not believe it needs to own and operate an inter-dealer quotation system. However, presumably to address the SEC concerns in this regard, if the availability of quotation information to investors significantly declines, FINRA has committed to revisit and, if necessary, file a proposed rule change to establish an SRO-operated inter-dealer quotation system (or other measure) to ensure that compliance with the Penny Stock Act is met.

In response to FINRA’s request to eliminate the OTCBB, the SEC received a single comment letter and it was from OTC Markets. Needless to say, OTC Markets strongly supports the proposal as well as the proposed amendments to Rule 6431 discussed below. OTC Markets welcomes the enhanced responsibility and regulations imposed upon it and FINRA’s oversight as a regulator, and it agreed with all aspects of FINRA’s proposals. OTC Markets stated that the discontinuation of FINRA’s OTCBB, together with FINRA’s expanded oversight of OTC Markets, would help eliminate investor and issuer confusion while promoting compliance with the Penny Stock Act.

OTC Markets points out that “FINRA’s OTCBB no longer provides broker-dealers with an effective service for pricing securities, and market participants will be better served by FINRA regulating Qualifying IQSs [inter-dealer quotation services] instead of expending resources trying to operate the OTCBB.”

The Proposed Regulatory Rule Changes Related to Inter-Dealer Quotation Systems

Pursuant to Section 15A of the Exchange Act, FINRA is tasked with adopting and implementing regulations designed “to produce fair and informative quotations, to prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations.” In that regard, FINRA has developed a regulatory framework including FINRA’s Rule 6400 series (Quoting and Trading in OTC Equity Securities) and Rule 5200 Series (Quotation and Trading Obligations and Practices) and the Rule 6500 series, governing the OTCBB. FINRA also owns and operates the OTCBB.

The current regulatory framework governs the FINRA member firm’s quotation activity and not the inter-dealer quotation service itself. That is, the current regulatory framework governs the broker-dealers/FINRA member firms’ activities in entering quotes on the inter-dealer quotation system, but does not impose rules or regulations on the inter-dealer quotation system itself.

For example, there are rules that require FINRA members to either file a Form 211 with FINRA including due diligence and disclosure on the company whose securities are being quoted, or be able to rely on another firm’s 211 filing (piggyback qualified) prior to initiating a quote; rules related to minimum bid price increments ($0.0001 for OTC equity securities priced under $1.00 and $.01 for those priced over $1.00); rules prohibiting cross-quotation; rules requiring the display of customer limit orders; and a requirement that any quoted bid or asked price represent a bona fide bid for or offer of such security (i.e., the “fictitious quotation” prohibition).

FINRA is now proposing to adopt rules that regulate the inter-dealer quotation service itself, which after elimination of the OTCBB will be comprised of the OTC Markets, including the OTCQX, OTCQB, and pinksheets.

Proposed Rule 6431 Amendment

FINRA is proposing to implement new regulations by amending Rule 6431 to require OTC Markets (or any inter-dealer quotation service) to: “(1) adopt and provide to FINRA written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities, (2) establish and provide to FINRA fair and non-discriminatory written standards for granting access to quoting and trading on its system, and (3) provide to FINRA for regulatory purposes a written description of each quotation-related data product offered by such member inter-dealer quotation system and related pricing information, including fees, rebates, discounts and cross-product pricing incentives.”

Rule 6431 (Recording of Quotation Information) was originally implemented in 2003 to provide FINRA with access to quotation information on the OTC marketplace. When implemented, FINRA member broker-dealers had the duty to independently report to FINRA when quoting on the OTC Markets, because at the time OTC Markets was not, in and of itself, a FINRA member. Since that time, OTC Markets has become a licensed ATS (Alternative Trading System) and FINRA member. The proposed Rule 6431 amendment includes an adjustment such that now OTC Markets will be required to provide the quotation information and the broker-dealer will not. In practice, OTC Markets has been submitting the information on behalf of member firms already, and the rule change will codify this practice and officially relieve the broker-dealer member firm from the obligation.

As the vast majority of securities quoted on the OTC markets are also penny stocks, the new rules will also bolster the Exchange Act requirements related to ensuring the availability and dissemination of reliable and accurate information on penny stocks.

(1) Written policies and procedures relating to the collection and dissemination of quotation information

The amended Rule 6431 would require OTC Markets (or any inter-dealer quotation service) to establish, maintain and enforce fair and reasonable written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities. Such policies and procedures must ensure that quotations received are treated fairly and consistently and include methods for prioritizing and displaying such quotations. In simple terms, if an investor enters a buy or sell order with a broker, or a market maker enters such buy or sell order for their own account, there must be systems in place to ensure that that order is treated fairly vis-a-vis competing buy and sell orders on behalf of other investors through other brokerage firms and market makers.

In that regard, under amended Rule 6431, the OTC Markets will be required to address its method for ranking quotations, including factors such as price, size, time, capacity and type of quotation and any other factors used or considered in ranking and displaying quotations. OTC Markets will also be required to provide FINRA with a copy of its written policies and procedures relating to the collection and dissemination of quotation information, and any material updates, modifications and revisions thereto, upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written policy or procedure.

(2) Written standards for granting access to quoting and trading on its system

The amended Rule 6431 would require OTC Markets to establish “fair and non-discriminatory written standards for granting access to quoting and trading on the system that do not unreasonably prohibit or limit any person in respect to access to services offered by such inter-dealer quotation system.” In addition, OTC Markets will be required to keep records of all grants of access and denials or limitations of access, including the reasons for denying or limiting access. OTC Markets must provide FINRA with a copy of these written standards upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written standards.

(3) Written description of each quotation-related data product and related pricing information

The amended Rule 6431 would require OTC Markets to prepare a written description of each quotation-related product offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives—for example, the listing requirements for the OTCQB including application and annual fees (see Here); the OTC Disclosure and News Service; and the various other products and services offered by OTC Markets. OTC Markets must provide FINRA with a copy of the written product descriptions upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such products or pricing.

SEC Proceedings Related to Approval of the Proposals

The SEC has instituted proceedings to determine whether the proposed rule changes, including elimination of the OTCBB, should be approved. The SEC is requesting comments from interested persons in support or opposition to the change. The SEC notes that in considering the proposal, it must (i) determine whether the changes are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest”; (ii) the rules include provisions governing the form and content of quotations on the OTC marketplace; and (iii) whether the rules support the Penny Stock Act.

The SEC has opened a 21-day total period to submit comments and a 35-day total comment period including time for rebuttals to submitted comments.

Brief Commentary

First, like OTC Markets, I am proponent of the rule changes all around. The discontinuation of the OTCBB is a natural and necessary progression of the reality of the marketplace.

However, neither the legal publications by FINRA or the SEC nor the comment letter from OTC Markets address some basic market realities. That is, with the elimination of the OTCBB and the implementation of listing standards and fees associated with quotation on the OTCQB, a new regime has been established for OTC market securities. Penny Stock issuers that are subject to the reporting requirements of the Exchange Act will no longer have the ability to achieve the turnkey credibility associated with not being a pinksheet.

Although pinksheets will now include a large class of entities that are subject to the Exchange Act reporting requirements, in order to achieve a level of credibility and prestige, such issuers will be required to meet the quotation standards and pay the fees associated with listing on the OTCQB or OTCQX. I wonder if issuers that do not meet the standards for the OTCQB will opt to cease being subject to the Exchange Act reporting requirements in a sort of acquiescence to the new regime – i.e., if we are going to be a pinksheet anyway, why report, resulting in an overall reduced level of disclosure in the OTC marketplace.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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Tags: FINRA, FINRA OTCBB, FINRA Trading Symbol, FINRA Wells Notice, OTC Market Attorneys, OTC markets, OTC Markets Securities, OTC Pink Sheet, OTC Securities Attorneys, OTCBB, OTCQB, OTCQX, Pinksheets, Regulations of the OTC Market, Rule 6431

SEC Issues Advertising Guidance Related to State-Specific Crowdfunding

by Laura Anthony, Esq. on October 21, 2014 in Crowdfunding, Intrastate Offering, JOBS ACT, JOBS ACT and Crowdfunding, Rule 147, Section 3(a)(11), Section 4(a)(6), Section 5, Uncategorized with No Comments

As required by Title III of the JOBS Act, on October 23, 2013, the SEC published proposed crowdfunding rules. The SEC has dubbed the new rules “Regulation Crowdfunding.” The entire 584-page text of the rule release is available on the SEC website. As of today, it is unclear when final rules will be released and passed into law and what changes those final rules will have from the proposed rules. Moreover, upon passage of the final rules, there will be a period of ramping-up time in which crowdfunding portals complete the process of registering with the SEC, becoming members of FINRA and completing the necessary steps to ensure that their portal operates in compliance with those final rules. Federal crowdfunding is coming, but it is a slow process.

In the meantime, several states have either enacted or introduced state-specific crowdfunding legislation.

Federal Authority for State Crowdfunding Legislation

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption. Rule 147 promulgated under Section 3(a)(11) provides for further details on the application of the Intrastate Exemption.

On the federal level, issuers relying on state crowdfunding statutes rely upon the Intrastate Exemption together with Rule 147 promulgated thereunder. The Intrastate Exemption is only available for bona fide local offerings. That is, the issuer must be a resident of, and doing business within, the state in which all offers and sales are made, and no part of the offering may be offered or sold to nonresidents. Because of the strict rules against any sales or offers to nonresidents, issuers conducting concurrent or consecutive offerings need to be extra careful to avoid the integration of any non-intrastate transactions with the Intrastate Exemption.

Advertising and Solicitation under State Crowdfunding

One of the main concepts behind crowdfunding is the ability to use the internet and social media to solicit the crowd for an investment. There is no prohibition in Section 3(a)(11) or Rule 147 regarding general advertising or general solicitation as long as such general advertising or solicitation complies with applicable state law and does not result in an offer or sale to nonresidents of such state. State crowdfunding legislation universally allows such advertisement and solicitations.

On April 10, 2014 and again on October 2, 2014, the SEC updated its Compliance and Disclosure Interpretations (C&DI’s) addressing the ability to advertise using the internet or social media in a state crowdfunding offering. In particular in April, the SEC stated that “[A]ny such general advertising or solicitation, however, must be conducted in a manner consistent with the requirement that offers made in reliance on Section 3(a)(11) and Rule 147 be made only to persons resident within the state or territory of which the issuer is a resident.”

In April, The SEC went further, addressing internet advertising via the use of a state-specific funding portal and said:

“Use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory. In the context of an offering conducted in accordance with state crowdfunding requirements, such measures would include, at a minimum, disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law, and limiting access to information about specific investment opportunities to persons who confirm they are residents of the relevant state (for example, by providing a representation as to residence or in-state residence information, such as a zip code or residence address). Of course, any issuer seeking to rely on Rule 147 for the offering also would have to meet all the other conditions of Rule 147.”

On October 2, 2014, the SEC issued further guidance on the question of whether an issuing company may use its website to conduct state crowdfunding offerings. In particular, the SEC stated:

“Issuers generally use their websites and social media presence to advertise their market presence in a broad and open manner so that information is widely disseminated to any member of the general public. Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances, using such established Internet presence to convey information about specific investment opportunities would likely involve offers to residents outside the particular state in which the issuer did business.

We believe, however, that issuers could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. Offers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law. Issuers must comply with all other conditions of Rule 147, including that sales may only be made to residents of the same state as the issuer.”

Other Considerations in State Crowdfunding Offering

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

In addition, Rule 147(b)(2) provides an integration safe harbor. That is, offerings made under Section 3 or Section 4(2) of the Securities Act or pursuant to a registration statement will not be integrated with an Intrastate Exemption offering if such offerings take place six months prior to the beginning or six months following the end of the Intrastate Exemption offering. To rely on this safe harbor, during the six-month periods, an issuer may not make any offers or sales of securities of the same class as those offering in the Intrastate offering. Rule 147(b)(2) is merely a safe harbor. Issuers and practitioners may still conduct their own analysis in accordance with the five-factor test enumerated above.

Determining Whether an Issuer is a “Resident” of and Doing Business in a Particular State

For purposes of the Intrastate Exemption, an issuer shall be deemed to be a resident of the state in which: (i) it is incorporation or organized if it is an entity requiring incorporation or organization; (ii) its principal office is located if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual.

For purposes of the Intrastate Exemption, an issuer shall be deemed to be doing business within a state if: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; (iii) the issuer intends to use and uses at least 80% of the net proceeds from the Intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state; and (iv) the principal office of the issuer is located within that state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

All offers, offers to sell, offers for sale and sales of securities in an Intrastate-exempted offering must be made to residents of the state in which the offering is conducted. For the purpose of determining the residence of an offeree or Purchaser: (i) a corporation, partnership, trust or other form of business organization shall be deemed to be a resident of a state if, at the time of the offer and sale, it has its principal office within such state; (ii) an individual shall be deemed to be a resident of a state if, at the time of the offer and sale, his or her principal residence is within that state; and (iii) a corporation partnership, trust or other form of business organization formed specifically to take part in an Intrastate offering will not be resident of the state unless all of its beneficial owners are resident of that state.

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the Intrastate Offering. Moreover, market makers or dealers desiring to quote such securities after the nine-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information. Moreover, Rule 147 specifically requires the placing of a legend on any securities issued in an Intrastate offering setting forth the resale restrictions. In the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence.

Basic Background on Crowdfunding

Crowdfunding generally is where an entity or individual raises funds by seeking small contributions from a large number of people. The crowdfunder sets a goal amount to be raised from the crowd, with the funds to be used for a specific business purpose. In addition, a crowdfunding campaign allows the crowd to communicate with each other, thus adding the benefit of the “wisdom of the crowd.” Small businesses can particularly benefit from crowdfunding as they are not limited by restrictions on general solicitation and advertising or purchaser qualification requirements.

Title III of the JOBS Act, called the Crowdfunding Act, amends Section 4 of the Securities Act of 1933 (the Securities Act), adding new Section 4(a)(6) to create a new exemption to the registration requirements of Section 5 of the Securities Act. The new exemption allows issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts.

The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income or net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Clearly there is a conflict in the language determining threshold amounts; an investor could fall within both categories. The conflict has been pointed out in numerous letters to the SEC and will presumably be addressed in the rule making.

Section 302 of the Crowdfunding Act requires that all crowdfunding offerings be conducted through an intermediary that is a broker-dealer or funding portal that is registered with the SEC and a member of a registered self-regulatory organization (SRO). Currently that SRO is the Financial Industry Regulatory Authority (FINRA). Although funding portals will have to register with the SEC and become a member of FINRA, they will not have to register as a broker-dealer. FINRA has already published proposed rules to regulate funding portals.

In addition, the Crowdfunding Act requires that issuers and intermediaries provide certain information to investors, potential investors and the SEC. The ability to utilize crowdfunding will be subject to bad boy restrictions and other disqualifying events. All crowdfunding issuers must be United States entities. Crowdfunding issuers cannot be subject to the reporting requirements of the Securities Exchange Act of 1934 or an investment company as defined by the Investment Company Act of 1940.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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Tags: Crowdfunding Act, Crowdfunding Portals, intrastate exemption, Intrastate Offering, Regulation Crowdfunding, rule 147, section 3(a)(11), Section 4(a)(6), Section 5

Depositing Penny Stocks with Brokers Creates Obstacles; SEC Charges E*Trade with Section 5 Violation

by Laura Anthony, Esq. on October 14, 2014 in Penny Stocks, Risk Alert, Rule 144, Section 4(a)(4), Section 5, Uncategorized with No Comments

Introduction

On October 9, 2014, the Securities and Exchange Commission (“SEC”) filed an enforcement action against E*Trade Securities and E*Trade Capital Markets for selling billions of shares of unregistered and otherwise restricted penny stocks for their customers. The SEC found that the firms processed the sales on behalf of three customers while ignoring red flags that the offerings being conducted were in violation of the federal securities laws in that the shares were neither registered nor subject to an available exemption from registration. E*Trade Securities and E*Trade Capital Markets settled the enforcement proceeding by agreeing to pay a total of $2.5 million in disgorgement and penalties.

The SEC press release on the matter quoted Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, as saying, “Broker-dealers serve an important gatekeeping function that helps prevent microcap fraud by taking measures to ensure that unregistered shares don’t reach the market if the registration rules aren’t being followed. Many billions of unregistered shares passed through gates that E*TRADE should have closed, and we will hold firms accountable when improper trading occurs on their watch.”

The securities laws generally require all offers and sales of securities to be registered with the SEC unless those offers and sales qualify for an exemption. A prima facie case for a violation of Section 5 is established upon a showing that: (1) no registration statement was filed or in effect as to the offer and sale of the securities; (2) a person, directly or indirectly, sold or offered to sell the securities; and (3) the sale or offer to sell was made through the use of interstate facilities (including the mail). Scienter or intent is not required to establish a Section 5 violation. Once a prima facie violation of Section 5 is established, the burden shifts to the person claiming an exemption from registration to establish the availability of the claimed exemption.

Section 4(a)(4) of the Securities Act of 1933 (“Securities Act”) provides an exemption for broker-dealers when executing customers’ unregistered sales of securities if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the customer would be violating the registration requirements of Section 5 of the Securities Act. Also on October 9, the SEC issued a Risk Alert and FAQ to remind broker-dealers of their obligations related to unregistered transactions under Securities Act Section 4(a)(4) on behalf of their customers, and ensuring such transactions are being conducted in accordance with securities laws.

Section 4(a)(4) is not, in and of itself, an exemption from registration. Section 4(a)(4) allows brokers to process the sale of unregistered securities where there is a valid exemption from such registration. The SEC has stated that broker-dealers “have a responsibility to be aware of the requirements necessary to establish an exemption from the registration requirements of the Securities Act and should be reasonably certain such an exemption is available.”

Section 4(a)(4) generally works in conjunction with Section 4(a)(1), which is a registration exemption for “transactions by any person other than an issuer, underwriter, or dealer.” Accordingly, a prerequisite to relying on Section 4(a)(4) is that the seller is not acting as an “underwriter.” The term “underwriter” is defined in Section 2(a)(11) of the Securities Act to include “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking.” For purposes of this definition, the term “issuer” includes the issuer’s affiliates, including persons directly or indirectly controlling or controlled by the issuer, or under direct or indirect common control with the issuer.

Most commonly, reliance on Section 4(a)(1) includes compliance with the Rule 144 safe harbor; however, Rule 144 is only a safe harbor and compliance with Section 4(a)(1) can be separately established. A future blog will provide an in-depth discussion of Section 4(a)(1). The basic premise herein, however, is that a broker may only rely on Section 4(a)(4) where a valid exemption from registration exists and it is the broker’s responsibility to satisfy itself that such exemption exists.

Risk Alert

The Risk Alert summarizes deficiencies that were discovered by the SEC’s Office of Compliance Inspections and Examinations during a targeted sweep of 22 broker-dealers that are frequently involved in the sale of microcap securities. In particular, the Staff scrutinized the broker-dealers’ liquidations of large blocks of shares of microcap issuers that were also the subject of significant promotional efforts. The SEC found 80% of the firms were deficient in their compliance procedures. The SEC specifically evaluated the firms’ compliance with obligations to (1) perform a “reasonable inquiry” in connection with the customers’ unregistered sales of securities where the firm relied on Section 4(a)(4); and (2) file suspicious activity reports (SAR) in response to red flags.

The SEC pointed out many deficiencies in the firms’ compliance procedures, including issues with firms improperly relying on the lack of restrictive legend or that the shares came into an account via DWAC or other electronic transfer. The SEC made it clear that it is not enough that the shares appear freely tradable on their face, but that a broker has its own independent responsibility to inquire and make a determination as to the shares. Brokerage firms cannot rely on transfer agents to act as a gatekeeper, but rather must be another layer of inquiry in a system of checks and balances.

Broker-dealer obligations to make reasonable inquiry under Securities Act Section 4(a)(4)

Section 5 of the Securities Act requires that ALL sales of securities must be registered unless an exemption from registration applies. Section 4(a)(4) provides a non-excusive exemption from registration for broker transactions executed on customers’ orders on an exchange or on the over-the-counter market. Section 4(a)(4) does not exempt the solicitation of customer orders, but rather just the sale transaction in accordance with such customer order. In order to rely on Section 4(a)(4), the broker must not have any reason to believe that the transaction is violating Section 5 of the Securities Act.

Both the SEC and court rulings have found that a broker-dealer may rely on Section 4(a)(4) if, after reasonable inquiry, they are not aware of circumstances indicating a violation of Section 5. Circumstances that may indicate a violation of Section 5 include evidence that the customer is acting as an underwriter in that they are making a distribution of the subject shares.

The SEC and courts both have indicated that brokers may consider Rule 144(g)(4) as part of their analysis and in particular note (ii) to such rule. Rule 144(g) addresses “broker transactions” for purposes of Rule 144 (affiliate sales under Rule 144 may only be completed in broker transactions…). Rule 144(g)(4) provides in part that a broker transaction is one in which:

(4) After reasonable inquiry [a broker] is not aware of circumstances indicating that the person for whose account the securities are sold is an underwriter with respect to the securities or that the transaction is a part of a distribution of securities of the issuer.

Note (ii) provides:

(ii) The reasonable inquiry required by paragraph (g)(3) of this section should include, but not necessarily be limited to, inquiry as to the following matters:

(a) The length of time the securities have been held by the person for whose account they are to be sold. If practicable, the inquiry should include physical inspection of the securities;

(b) The nature of the transaction in which the securities were acquired by such person;

(c) The amount of securities of the same class sold during the past 3 months by all persons whose sales are required to be taken into consideration pursuant to paragraph (e) of this section;

(d) Whether such person intends to sell additional securities of the same class through any other means;

(e) Whether such person has solicited or made any arrangement for the solicitation of buy orders in connection with the proposed sale of securities;

(f) Whether such person has made any payment to any other person in connection with the proposed sale of the securities; and

(g) The number of shares or other units of the class outstanding, or the relevant trading volume.

The FAQ discussed below provides further guidance on the “reasonable inquiry” requirement and a broker’s assessment as to whether the sales involve an unregistered distribution or underwriting. Broker-dealers may also potentially rely on the exemption provided by Section 4(a)(3) of the Securities Act, which generally exempts “transactions by a dealer,” but that exemption is unavailable for certain transactions, such as Section 4(a)(4), those involving an underwriter.

FINRA has also issued its Notice to Members 09-05 addressing these obligations and providing guidance. The Notice lists examples of red flags that brokers should consider, including:

a customer opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
a customer has a pattern of depositing physical share certificates, immediately selling the shares and then wiring out the proceeds of the resale;
a customer deposits share certificates that are recently issued or represent a large percentage of the float for the security;
share certificates reference a company or customer name that has been changed or that does not match the name on the account;
the lack of a restrictive legend on deposited shares seems inconsistent with the date the customer acquired the securities or the nature of the transaction in which the securities were acquired;
there is a sudden spike in investor demand for, coupled with a rising price in, a thinly traded or low-priced security;
the company was a shell company when it issued the shares;
a customer with limited or no other assets under management at the firm receives an electronic transfer or journal transactions of large amounts of low-priced, unlisted securities;
the issuer has been through several recent name changes, business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies; and
the issuer’s SEC filings are not current, are incomplete, or are nonexistent.

Obligation to file suspicious activity reports (SAR)

The Securities Exchange Act of 1934 (“Exchange Act”) requires broker-dealers to comply with the Bank Secrecy Act. The Bank Secrecy Act imposes an obligation on broker-dealers to file a SAR with the Financial Crimes Enforcement Network (“FinCEN”) to report any transaction (or a pattern of transactions) involving $5,000 or more, in which it “knows, suspects, or has reason to suspect” that it “(1) involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade any requirements of the Bank Secrecy Act; (3) has no business or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts; or (4) involves use of the broker-dealer to facilitate criminal activity.”

The Risk Alert points out red flags that should cause a broker to make further investigation as to whether a SAR needs to be filed, including:

Atypical trading patterns in the issuers’ securities, including trading involving sudden spikes in price and volume;
Certain patterns of trading activity being common to several customers, including, but not limited to, the sales of large quantities of the shares of multiple issuers by the customers;
Notifications received from the broker-dealers’ clearing firms that the clearing firms had identified potentially suspicious activity in the securities of certain issuers or certain of the broker-dealers’ customer accounts. Such notifications took the form of alerts, expressions of concern, or actions taken by the clearing firms to restrict trading in certain issuers’ securities and/or certain customer accounts;
The involvement of certain types of accounts, including those that provide anonymity to the beneficial owners in the liquidation of the shares of the microcap issuers (see examples below);
Requests received from FINRA for information relating to certain issuers and the broker-dealers’ customer accounts;
Certain types of issuer information, such as nominal assets and low operating revenue, and frequent changes to the type of activity in which the business was engaged, the name of the corporate entity, directors, and/or management; and
Sales through the broker-dealer by individuals known throughout the industry to be stock promoters.

The SEC Risk Alert gave examples of the types of accounts that should raise a red flag and therefore further inquiry. Those accounts include, but are not limited to:

Accounts of purported stock loan companies, which may hold the restricted securities of corporate insiders who have pledged the securities as collateral for, and then defaulted on, purported loans, after which the securities are sold on an unregistered basis;
Accounts held in the name of a corporate entity (or LLC), either for the company’s own use or as a third-party custodian on behalf of other beneficial shareholders or customers, which disguise the unregistered sales of securities owned by corporate insiders of the company and allow for those insiders to withdraw proceeds individually;
Accounts held in the names of foreign financial institutions, such as offshore banks and/or broker-dealers that sold shares of the stock on an unregistered basis on behalf of customers, who may have been stock promoters; and
Accounts using a master/sub-structure, which allows for trading anonymity with respect to the sub-accounts’ activity.

SEC Published FAQ

Also on October 9, the SEC issued a Risk Alert and FAQ to remind broker-dealers of their obligations related to unregistered transactions under Securities Act Section 4(a)(4) on behalf of their customers. The FAQ generally reiterates the information in the Risk Alert, set up in a question-and-answer format. In particular, the FAQ explains that brokers may rely on Section 4(a)(4) and lays out the brokers’ obligations related to making a reasonable inquiry of the facts and circumstances surrounding the transaction, including all parties involved, as a prerequisite to reliance on the statute.

Moreover, the FAQ drills down on the brokers’ independent obligation. Reiterating a long line of case law and SEC releases dating back to 1962, the SEC makes it clear that a broker may not solely rely on a third party, such as the DTC, a transfer agent, customer, or attorney for either, in making its determination.

Conclusion

Shareholders and investors that trade in small cap securities have seen a big shift in the procedures and process associated with depositing penny stocks into brokerage firms. The SEC Risk Alert explains the timing and impetus behind such shift and also provides insight into the brokerage firms’ duties and procedures. To be clear, the rules did not change. Brokers were required to make independent reasonable inquiry and an independent assessment of the proper free tradability of shares, before and after the SEC knocked on their doors. However, although most had written rules and procedures, the SEC found that many of these firms, or at least their personnel, were unaware of their obligations, especially where shares appeared to be freely tradable on their face.

Now more than ever, shareholders and investors need to maintain proper records and seek legal counsel to avoid unintended actual or perceived violations of the securities laws, which violations could result in the loss of an investment or worse, regulatory enforcement proceedings.

Click Here to Print- LC Depositing Penny Stocks with Brokers Creates Obstacles; SEC Charges E*Trade with Section 5 Violation

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

Tags: E*Trade, Penny Stocks, Risk Alert, Rule 144, Section 4(a)(1), Section 4(a)(4), Section 5

Insider Trading- A Case Study

by Laura Anthony, Esq. on October 07, 2014 in Insider Trading, Rule 10b5-2(b), S-1 Registration Statement, Safe Harbors, Uncategorized with No Comments

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Any and all persons that buy and sell stock may be subject to insider trading liability. This blog sets forth a particular hypothetical fact scenario and analyzes the associated insider trading implications.

Hypothetical Fact Pattern: Company X (the “Company”) sells shares to a group of 35 unaffiliated shareholders pursuant to an effective S-1 registration statement. These same 35 unaffiliated shareholders (the “Sellers”) sell their registered stock to a group of 35 unaffiliated purchasers (the Buyers”) in a private transaction (the “Transaction”). At or near the same time as the Transaction, the control block consisting of restricted shares of common stock is sold to a different purchaser (“Control Block Purchaser”) in a private transaction (collectively, the “Transactions”). The Transactions result in a complete change of control and shareholder base in the Company. The Buyers are known by the Control Block Purchaser and are introduced to the Transactions by the Control Block Purchaser. The Buyers and the Control Block Purchaser are aware of nonpublic information at the time of the Transactions. In particular, after the Transactions are completed, there will be either a reverse merger transaction with a previously identified operating business, or a complete change in direction of the Company’s current business. In addition, the Buyers are aware that a change of control transaction will occur contemporaneously with their Transaction. After the Transactions are complete, a reverse merger and/or complete change in direction of the Company’s business occurs, most likely resulting in an increase in value of the common stock of the Company.

Analysis and discussion:

Insider trading is prohibited by the general anti-fraud provisions and in particular Section 10(b) of the Securities Exchange Act of 1934, as amended and Rule 10b-5 thereunder. There are three main theories on which insider trading is based: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory.

Section 10(b) of the Exchange Act makes it unlawful for any person to, directly or indirectly, “use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Rule 10b-5, promulgated under Section 10(b), provides that “[I]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

The elements of a Section 10(b) and Rule 10b-5 claim include:

(i) Misrepresentation or Omission of a Material Fact – the key point here being “material.” A fact is material if, in light of the totality of information, it is substantially likely it would impact a reasonable person’s investment decision. The test is based on a reasonable person’s perspective, not necessarily the investor making the claim.

(ii) Scienter/State of Mind – Rule 10b-5 requires that the defendant be aware of the fraud. Awareness can be established either by actual awareness (defendant states that they have 5 contracts when there are only 3) or by showing that the defendant should have been aware with reasonable inquiry and diligence (defendant knew that the Control Block Purchaser owned and operated a separate business that he intended to bring public, but never asked if he was purchasing this particular control block for that purpose).

(iii) Reliance – An investment decision must have been made in reliance on the misinformation or lack of information. In other words, there must be a link between the alleged fraud and the investment decision. It is presumed, when material information is withheld, that there is reliance. The presumption of reliance can be rebutted by showing that the claimant’s decision to purchase or sell shares was not influenced by the alleged fraud, or that the alleged fraud did not alter or change the stock price.

(iv) Causation – the plaintiff in a 10b-5 claim must show that the fraud caused damages. Damages are a calculation of the monetary loss of the claimant or monetary gain by the defendant, and such damages must be linked to the fraud.

(v) Damages – in addition to linking the damages to the fraud, actual damages must exist.

Classical Theory

Rule description: Under the classical theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer. The “on the basis of” standard is met if the purchaser or seller is aware of the material nonpublic information at the time of the purchase or sale. Materiality is generally measured by whether there is a substantial likelihood that the material nonpublic information would have been viewed by a reasonable investor as having significantly altered the total mix of information currently available and influenced the investment decision. When forward-looking information is involved, including a potential reverse merger and/or future change in the direction of the Company’s business, a secondary layer of materiality is triggered, which is termed the probability-magnitude test. Under the probability-magnitude test, you must also weigh the likelihood that the future event will occur and the magnitude of the effect of the future event on the Company.

Nonpublic information is any information that is not generally disseminated to the investing public. A duty of trust or confidence arises when the person is a “corporate insider” or a “temporary insider.” A corporate insider is generally an officer, director, or employee of the Company. A temporary insider relationship arises when a special confidential relationship is established between the person and the Company in the conduct of business, and that person is given access to material nonpublic information solely for corporate purposes. A temporary insider is generally an accountant, attorney, underwriter, consultant, and directors or executives of another company that are engaged in merger talks with the Company. It is important to note that the insider trading rules under the classical theory require an insider to disclose or abstain from trading. This means that the insider must abstain from trading or disclose (disseminate) to the Company and the Company’s shareholders that the insider intends to trade on the material non-public information, and describe the information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the Company and the Company’s shareholders. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Under the classical theory, the Buyers would not be considered a corporate or temporary insider, since they are not affiliated with the Company at all and a special confidential relationship has not been created between any of the Buyers and the Company. Thus, even if every other element was met, an insider trading case under the classical theory would not be brought against Buyers. Under the classical theory, the previously unaffiliated Control Block Purchaser would not be considered a corporate insider until after the purchase of the control block. However, the Control Block Purchaser could be deemed a temporary insider of the Company if the Control Block Purchaser was an officer or director of the target company that was engaged in reverse merger talks with the Company before the purchase of the control block. If it could be shown that the Control Block Purchaser was a temporary insider of the Company, then there could be liability under the classical theory unless the Control Block Purchaser disclosed their intention to trade on the information. However, in our fact scenario, the Control Block Purchaser purchases restricted stock that is not eligible to trade. In the event that the same Control Block Purchaser bought or sold stock in open market transactions, such Control Block Purchaser would be subject to insider trading liability under the classical theory.

Misappropriation Theory

Rule Description: Under the misappropriation theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed to any other person who is the source of the material nonpublic information. The previous description of “on the basis of,” materiality, and nonpublic information apply under the misappropriation theory as well. Under Rule 10b5-2(b), a duty of trust or confidence owed to the source of the information generally arises when (a) a recipient agrees with the source to maintain the information in confidence (and it is implied that the person will not trade), (b) the recipient and the source have a history, pattern, or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the source expects the recipient will maintain confidentiality, or (c) when the recipient is a close family member (spouse, parents, children, siblings) of the source. It is important to note that the insider trading rules under the misappropriation theory require the recipient to disclose or abstain from trading. This means that the recipient must abstain from trading or disclose to the source that the recipient intends to trade on the material non-public information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the source. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.

Analysis: Let us assume that before the Transaction, the Control Block Purchaser gave the Buyers information regarding an upcoming reverse merger and/or complete change in direction of the Company’s business, which we will also assume is material and non-public information. Under the misappropriation theory, the Buyers may have a duty of trust or confidence that is owed to the Control Block Purchaser. However, it is highly unlikely that the Buyers would have agreed to maintain the information in confidence or that the Buyers and the Control Block Purchaser had a history, pattern, or practice of sharing confidences and confidentiality was expected. However, the Control Block Purchaser was most likely informed by the Buyers that the Buyers intended to purchase the Company’s shares based on the material nonpublic information, which would eliminate any deception. The Buyers, however, would need to refrain from re-selling the shares while in possession of the material non-public information, as any subsequent purchaser could claim a deceit. As long as the Buyers refrained from any public trading in the shares while in possession of the material non-public information, an insider trading case under the misappropriation theory would most likely fail.

The Control Block Purchaser would also have exposure for insider trading liability under this theory. If the Control Block Purchaser knew of the merger talks (confidence with the target company) and engaged in public trading of the stock, the Control Block Purchaser would have violated its duty of confidence to such target company.

Tipper / Tippee Theory

Rule Description: This theory is utilized when a tipper gives material nonpublic information to a tippee (recipient) in breach of a duty of trust or confidence that is owed by the tipper. Under the tipper/tippee theory, the tippee assumes the duty to disclose their intent to trade on material nonpublic information to the Company, and/or the Company’s shareholders, and/or the original source of the information, which is derivative of the duty of a corporate insider, temporary insider, or a person who owes a duty to the original source of the information as detailed in Rule 10b5-2(b) under the misappropriation theory. It must be established that the tipper breached a duty of trust or confidence when the tipper disclosed the material nonpublic information to the tippee. Generally, that breach is established when the tipper directly or indirectly benefited personally from the disclosure of the nonpublic material information to the tippee (the tipper received money or reputational benefit, or if the tipper disclosed the information to repay a debt to a relative or friend). It also must be established that the tippee knew or should have known (reckless in not knowing) that the tipper had breached their duty. Furthermore, the other elements of Section 10(b) and/or Rule 10b-5 must be established as well.

Analysis: In this case, the Control Block Purchaser may be a tipper if the Control Block Purchaser buys the control block before the Transaction, and is deemed to be a corporate or temporary insider of the Company or to have a duty of trust or confidence with the potential reverse merger candidate. It would have to be established that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders by disclosing material nonpublic information (reverse merger and/or complete change in direction of the Company’s business) about the Company to the Buyers. In the alternative, it would have to be established that the Control Block Purchaser breached their duty of trust or confidence to the potential reverse merger candidate, by disclosing material nonpublic information about the upcoming reverse merger. Some personal benefit that the Control Block Purchaser received by disclosing the material nonpublic information would have to be established. The Buyers could be considered tippees, and it could be alleged that the Buyers knew or should have known that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders.

Defenses

The most common defenses to an insider trading claim are that the information is not material, the information is already publicly known or disseminated among the investing public, and/or that there is no intent to deceive because the requisite public disclosure was made before trading.

In a situation where the Control Block Purchaser obtains the control block in the Company before the Buyers purchase their shares, it is recommended that disclosure be made, such as the filing of a Form 8-K, which discloses the anticipated reverse merger and/or complete change in direction of the Company’s business. This would make the information publicly known, and generally eliminate any exposure for insider trading.

As a safe harbor from insider trading liability, Rule 10b5-1 provides that a purchase or sale of securities will not be deemed to be on the basis of material nonpublic information if it is pursuant to a contract, instruction or plan that (i) was entered into before the person became aware of the information; (ii) specifies the amounts, prices, and dates for transactions under the plan (or includes a formula for determining them); and (iii) does not later allow the person to influence how, when or whether transactions will occur.

Conclusion

Both the Control Block Purchaser and the Buyers have exposure for insider trading liability, and each should be aware and cautioned not to publicly trade in the stock of the Company until such information is made public. However, as long as all parties are aware of the material non-public information, there is likely no cause for insider trading from the Transactions themselves.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

Tags: Control Block Purchaser, Effective S-1 Registration Statement, insider trading, Insider Trading Violations, Material Nonpublic Information, Misappropriation Theory, Probability-Magnitude Test, Rule 10b5-2(b), safe harbor, Section 10(b), Temporary Insider

Monthly Archives: October 2014

FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets

SEC Issues Advertising Guidance Related to State-Specific Crowdfunding

Depositing Penny Stocks with Brokers Creates Obstacles; SEC Charges E*Trade with Section 5 Violation

Insider Trading- A Case Study

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