Securities Lawyer 101 l Brenda Hamilton

Securities Lawyer 101 l Brenda Hamilton

Friday, August 30, 2013

SEC Rewards Three Whistleblowers l Securities Lawyer 101

Bad Actor Ban l General Solicitation Countdown

 
Companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Rule 506 of Regulation D is the most widely-used exemption from registration.
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 926 of the Dodd-Frank Act requires the SEC to adopt rules that would prohibit the use of the Rule 506 exemption for any securities offering in which certain felons and other bad actors are involved. The new provisions prohibit issuers as well as underwriters, placement agents, directors, executive officers, and certain shareholders from participating in Rule 506 offerings, if they have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.

Scope of New Rule

As amended, Rule 506 provides that Bad Actor disqualification arises from final orders finding the relevant person or entity violated a rule or regulation prohibiting “fraudulent, manipulative, or deceptive conduct.” The new rules are applicable to all Rule 506 offerings regardless of whether the issuer engages in general solicitation or advertising. However, the Bad Actor rule only applies to persons who will be disqualified in the future. In other words, a Bad Actor will only be disqualified if the triggering event that occurs after the effective date of the rule, September 23. Anyone who is a bad actor under the SEC’s new definition prior to September 23 may continue to participate in Rule 506 offerings on a going forward basis.

Rule 506 of Regulation D

According to the SEC, Rule 506 is the most widely used exemption from securities registration. Rule 506 provides an exemption from securities registration that allows an issuer to raise an unlimited amount of funds from the sale of securities from an unlimited number of accredited investors and up to 35 non-accredited investors if certain informational requirements are met. Securities sold in Rule 506 offerings are restricted securities and generally cannot be resold publicly by investors unless registered or pursuant to Rule 144’s safe harbor.
The Amendments to Rule 506
The Bad Actor disqualification provisions in Rule 506 apply to the following “covered persons”:
• the issuer and its predecessors;
• any affiliated issuer;
• any director, executive officer, other officer participating in a Rule 506 offering, or the issuer’s general partner, or managing member;
• any promoter as defined in Rule 405 of the Securities Act connected with the issuer in any capacity at the time of the sale of securities in a Rule 506 offering;
• any beneficial owner of 20 percent or more of any class of the issuer’s outstanding voting equity securities;
• any investment manager of an issuer that is a pooled investment fund;
• any person who has been or will be paid directly or indirectly compensation in any form for soliciting investors in connection with the Rule 506 offering;
• any general partner or managing member of any such investment manager participating in the Rule 506 offering; or
• any director, executive officer or other officer participating in the Rule 506 offering of any such investment manager or compensated person or general partner or managing member of such investment manager or person compensated for soliciting investors.
Disqualifying Events For Covered Persons in Rule 506 Offerings
Rule 506 identifies bad actors as persons or entities that are the subject of:
• Criminal convictions;
• Court injunctions and restraining orders;
• Final orders of federal regulators, including the U.S. Commodity Futures Trading Commission;
• Final orders of certain state regulators including securities, banking, and insurance regulators;
• SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers, and investment companies and their associated persons;
• Certain SEC cease and desist orders;
• Suspension or expulsion from membership in, or suspension or barring from association with a member of, a securities self-regulatory organization;
• SEC stop orders and orders suspending a Regulation A exemption; and
• U.S. Postal Service false representation orders.
Disclosure Of Disqualification Events Prior to Effectiveness of Rule
The rule requires that issuers provide written disclosure of matters that would have triggered disqualification, except that these actions occurred prior to the rule’s effective date. Disclosures must be provided a reasonable time prior to sale.   These disclosure requirements apply to all Rule 506 offerings regardless of whether general solicitation is used. 
Exception for Reasonable Care
Consistent with the proposed rule, the final rule contains a reasonable care exception for an issuer who can establish that it did not know and, in the exercise of reasonable care, could not have known that a disqualification event existed for a covered person.  The elimination of the prohibition of general solicitation is likely to make the Rule 506 exemption more popular.  An issuer seeking to raise capital will favor Rule 506(c) because advertisement of an offering will increase the chances of its success.  Additionally, there are no information requirements for accredited investors and no cap on the amount of capital that can be raised.
 
For more information please visit: Securities Lawyer 101

Smooth Sailing For General Solicitation Under Rule 506(c)

 
Rule 506(c) fundamentally changes how private placements will be conducted, by allowing issuers to engage in general solicitation and advertising if they comply with the Rule’s specific requirements. The advantages offered by  Rule 506(c) are significant for issuers who comply with its inflexible but adaptable requirements. In order to ensure smooth sailing and compliance with the new rule, issuers should understand certain basic requirements of the exemption.
The Checklist below sets forth the most significant items the issuer should know about Rule 506(c).
Rule 506(c) Is Not Forgiving
Rule 506(c) has stringent requirements. The Rule is not  forgiving for issuers who engage in general solicitation but fail to comply with its requirements.  An issuer’s sale to even one non-accredited investor will prevent the issuer from relying upon the exemption.
Rule 506(c) Offerings Are Not Yet Allowed Until September 23
Rule 506(c) will become effective September 23.  Until such time, general solicitation and advertising of private placment offerings remains illegal.
Issuers Can Continue to Use Existing Rule 506 After September 23
After September 23, issuers may still rely on existing Rule 506 to raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 nonaccredited investors without general solicitation and advertising.  On September 23, old Rule 506 will become Rule 506(b).
Sales May Only Be Made to Accredited Investors
If the issuer will use general solicitation or advertising in connection with the Rule 506 offering, sales of the securities may be made only to accredited investors. Offers can be made to any investor, but the issuer may only makes sales to investors who are accredited.
Simultaneous Offerings
Issuers cannot conduct simultaneous offerings under both Rule 506(b) and Rule 506(c).
Ongoing Offerings
Issuers conducting ongoing Rule 506 Offerings to non-accredited investors prior to September 23, can rely upon Rule 506(c) on September 23, and may use general solicitation and advertising to conduct their offerings so long as sales are only made to accredited investors after the effective date of the rule.
Bad Actors Not Allowed
Issuers will not be able to rely upon Rule 506 if either the issuer or its officers, directors, managing members, owners holding more than 20 percent of its equity securities, placement agents, finders have been subject to certain disqualifying events, unless the it can establish that it did not know and, “in the exercise of reasonable care, could not have known” about the bad actor disqualification.  This bad-actor disqualification applies to offerings made under Rule 506 regardless of whether the issuer engages in general solicitation and advertising.
For Bad Actors Only Applies to Bad Actors After Effective Date
If the issuer or its affiliates were subject to a disqualifying bad actor event prior to September 23, the issuer can still rely on Rule 506, but must make disclosure to investors prior to the sale of securities about the disqualifying event.
Covered Securities
Securities that are offered, sold and issued in Rule 506 offerings are considered  “covered securities” under state blue sky laws regardless of whether the issuer engages in general solicitation and advertising is used.
Verification Of Accredited Investor Status Is Required
Rule 506(c) requires that issuers take reasonable steps to verify that Rule 506(c) investors are accredited. The SEC  has indicated that accredited investor status will be an objective determination by the issuer based upon the particular facts and circumstances. The SEC provided the non-exclusive methods of satisfying this requirements set forth below:
Income Requirement - The issuer should review tax forms, including W-2s, 1099s, K-1s, and 1040s, that report the purchaser’s income for the two most recent years. The issuer should also obtain written representations from the investor that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
Net Worth Requirement Assets - The issuer should review bank, brokerage and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports that are no more than 3 months old.
Liabilities – The issuer should obtain reports from credit agencies. The reports would need to be dated within the prior three months.  The issuer should obtain written representations from the investor that all liabilities necessary to make a determination of net worth have been disclosed.
Third Party Confirmations - The issuer should request written confirmations from third parties such as broker-dealers, investment advisers, attorneys and certified public accountants, that such third party has taken reasonable steps within the prior three months to verify that the purchaser is an accredited investor.
Existing Investors – The issuer should ensure that accredited Investors who purchased prior to September 23 should certify that he or she remains an accredited investor.
Rescission
If an Issuer fails to comply with Rule 506(c)’s requirements,  investors have an automatic right of rescission.

For more information please visit: Securities Lawyer 101

Rule 506 l General Solicitation Countdown

Rule 506(c) will become effective in less than a month, on September 23, 2013.   The rule fundamentally changes how private placements will be conducted, by allowing issuers to engage in general solicitation and advertising if specific requirements are met. The SEC has confirmed that the Rule 506(c) exemption will not be forgiving for issuers who engage in general solicitation but fail to comply with its requirements.
Even one sale to a non-accredited investor will prevent the issuer from relying upon the exemption, making it a time bomb for issuers who fail to adopt proper compliance methods for their offerings.  The most significant compliance concern is that issuers make sales only to accredited investors. The advantages offered by  Rule 506(c) are significant for issuers who comply with its inflexible but adaptable requirements.
Pending SEC ProposalsIn the adopting release implementing Rule 506(c), the SEC made proposals and provided some guidance about the steps issuers should take to confirm accredited investor status. These proposals include imposing disclosure and filing requirements for offerings made under Rule 506(c), and changing Form D.   Rule 506(c) will go into effect on September 23, with or without final action on the SEC’s proposals.
Rule 506(c) GenerallyBoth public and private companies can rely upon Rule 506. The exemption is commonly used in going public transactions to raise initial capital and obtain a shareholder base. Rule 506 allows issuers to raise an unlimited amount of capital and there are no limitations on the number of non-accredited investors who can invest. Rule 506(c) allows issuers to advertise their offerings so long as sales are made to accredited investors only.
Issuers should ensure that prior securities offerings made to non-accredited investors are not integrated with a Rule 506(c) offering or the exemption will could be lost.
Simultaneous Offerings Under Rule 506Issuers can either conduct their offering under Rule 506(c) or sell to accredited investors. They cannot conduct simultaneous offerings to both accredited and non-accredited investors if general solicitation and advertising is used.  Issuers must also consider whether any prior Regulation D offerings made to non-accredited investors will be integrated with its Rule 506(c) offering making 506(c) unavailable. Rule 502 (a) of Regulation D provides a safe harbor from integration of Regulation D offerings, made six months before or six months after another offering.  If six months has not elapsed between offerings, the issuer should rely upon the 5 factors set forth in 502(a) to determine whether its prior Regulation D offering will be integrated.
Rule 502(a)’s integration factors include:
● Whether the offerings are part of a single plan of financing;
● Whether the offerings involve the same class of securities;
● Whether the offerings were made at or about the same time;
● Whether the same type of consideration was received in the offerings; and
● Whether the offerings were conducted for the same general purpose.
Once an issuer determines that no prior securities offerings are integrated with its Rule 506(c) offering it can proceed with its Rule 506(c) compliance strategy.  The first step should be to determine how it will confirm accredited investor status.
506(c) Accredited Investor RequirementsIssuers may only use general solicitation and advertising in their Rule 506(c) offerings if sales are made to accredited investors. Under the Securities Act an accredited investor must have either (i) a net worth of at least $1 million, not including the value of his or  her primary residence, or (ii) income of at least $200,000 in each year of the last two years or $300,000 together with his or her spouse if married and have the expectation to earn the same amount in the current year.
Confirming Accredited Investor Status
Rule 506(c) requires that issuers take reasonable steps to verify that Rule 506(c) investors are accredited. The SEC  has indicated that accredited investor status will be an objective determination by the issuer based upon the particular facts and circumstances. The SEC suggested the  methods below.
Income Requirement
The issuer should review tax forms, including W-2s, 1099s, K-1s, and 1040s, that report the purchaser’s income for the two most recent years. The issuer should also obtain written representations from the investor that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
Net Worth Requirement
Assets
The issuer should review bank, brokerage and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports that are no more than 3 months old.
LiabilitiesThe issuer should obtain reports from credit agencies. The reports would need to be dated within the prior three months.  The issuer should obtain written representations from the investor that all liabilities necessary to make a determination of net worth have been disclosed.
Third Party Confirmations
The issuer should request written confirmations from third parties such as broker-dealers, investment advisers, attorneys and certified public accountants, that such third party has taken reasonable steps within the prior three months to verify that the purchaser is an accredited investor.
Existing Investors
The issuer should ensure that accredited Investors who purchased prior to September 23 should certify that he or she remains an accredited investor.
The advantages offered by Rule 506(c) are significant for issuers who comply with its inflexible but adaptable rules for issuers who properly prepare for their offering by developing compliance strategies to ensure accredited investor status.
 
For more information please visit: Securities Lawyer 101

Going Public Law

Court Says Aged Debt Cannot Be Used to Issue Free Trading Shares

Thursday, August 29, 2013

Getting Current l SEC Filings l Securities Lawyer 101

Public companies with a class of securities registered under Section 12 or subject to Section 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act ), are subject to the periodic and current reporting requirements of Section 13 or 15(d) of Continue reading

http://www.securitieslawyer101.com/10-k/

etting Current l SEC Filings l Securities Lawyer 101

Confidential Submission of Draft SEC Registration Statements l Ask Securities Lawyer 101

Court Says Aged Debt Cannot Be Used to Issue Free Trading Shares

Buyers of Beware of Aged Debt l Court Finds Aged Debt Not A Security

In recent years, numerous issuers have misused aged debt to issue unrestricted securities by obtaining a legal opinion from a corrupt or incompetent securities attorney.  A recent decision makes clear that issuers cannot use aged debt as a basis for the Continue reading

http://www.securitieslawyer101.com/aged-debt/

Wednesday, August 28, 2013

SEC Obtains Judgment Against Rule 504 Offering Participant

On August 15, 2013, the SEC obtained a summary judgment against Jonathan C. Gilchrist for violation of the antifraud and registration provisions of the federal securities laws. On August 16, 2013, the court entered a final judgment imposing monetary and other Continue reading

http://www.securitieslawyer101.com/504/

SEC Obtains Judgment Against Rule 504 Offering Participant

Smooth Sailing For General Solicitation Under Rule 506(c)

The SEC's Reverse Merger Task Force

Wedding Singer Charged by the SEC

Wedding Singer Charged by the SEC

On August 27, 2013, the Securities and Exchange Commission (the SEC )  filed a securities fraud enforcment action against an Oklahoma wedding singer and former investment adviser, Larry J. Dearman, Sr. and his special friend, Marya Gray, in connection with fraudulent securities offerings that Continue reading

http://www.securitieslawyer101.com/wedding/

Reverse Merger Bootcamp l Toxic Reverse Mergers

Over the last eight years, the Securities and Exchange Commission (“SEC”) and theFinancial Industry Regulatory Authority (“FINRA”) have overhauled the rules and regulations applicable to reverse merger transactions.
Not only have the SEC and FINRA jumped on the bandwagon to eliminate them, but, as will be explained, Depository Trust Company and national securities exchanges have joined in their efforts.  Among the SEC’s efforts to stem microcap fraud is a campaign to remove public shell companies that might used in reverse merger transactions from the marketplace. Its efficacy is demonstrated by what the agency calls operation Shell Expel, which so far has resulted in trading suspensions for more than 700 dormant public companies.  In addition, the SEC has recently identified gatekeepers – securities lawyers, transfer agents, accountants- and shell purveyors as ripe targets for enforcement actions.
On July 2, 2013, the SEC announced its new task force “Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis”    whose targets, among others, would be reverse merger purveyors and securities attorneys involved in reverse merger transactions.
The rules and regulations impacting reverse mergers have  changed dramatically in recent years and reverse mergers are often misunderstood and misapplied. This is illustrated by the string of SEC cases involving reverse merger participants and their legal counsel.
Shell company purveyors praise the virtues of reverse merger transactions claiming they are easier and faster than filing a registration statement with the SEC, despite recent rule changes that eliminate many if not all of the benefits once conferred by them. Seeking to persuade clients to use their services, shell peddlers hark back to the glory days of unregulated reverse merger transactions. The reality is that those glory days are over. Anyone familiar with the rules and regulations impacting reverse merger transactions knows they can be toxic for private companies seeking to go public if not done properly.
We are frequently asked about the legal ways that reverse mergers can be completed and under what circumstances, if any, unrestricted shares can be issued. This bootcamp blog series will address changes to the rules and regulations impacting reverse mergers, the payment of finders fees  and commissions in reverse merger transactions, the use of forward stock splits in reverse merger transactions,  and the issuance of unrestricted securities in reverse merger transactions. Lastly, it will address rampant abuses of the process, including custodianship and/or receivership change of control transactions, fraudulent use of attorney escrow accounts in reverse mergers and the  improper and illegal use of convertible debt and the securities exemptions provided by Rule 504, 3(a)(9) and 3(a)(10) of the Securities Act of 1933.
Creating Inventory for Reverse Mergers l Illegal Custodianship and Receivership Actions
Custodianship and receivership fraud has become an epidemic in the OTC markets particularly with non-reporting issuers. It is by far the most abusive and blatant crime committed by reverse merger scammers.
In these custodianship and receivership actions, fraudsters locate dormant tickers and/or public companies that are inactive in their state of domicile. They then file pleadings with a state court under penalties of perjury, falsely stating, among other things, that the issuer’s board of directors was deadlocked in a vote, and so shareholders, unable to break the deadlock, are appealing to a state court judge to appoint a receiver selected by the shareholders, who are in fact the fraudsters. In reality, there was no deadlock, vote or even a meeting of the board of directors or shareholders.  Upon appointment, the receiver presents the fraudulent order to the issuer’s transfer agent and causes it to issue millions, sometimes billions and sometimes even  billions, of illegally free trading shares.  To issue the illegally free trading shares, the fraudsters solicit the assistance of incompetent or corrupt securities attorneys to render flawed opinions in reliance upon Rule 3(a) (10) or Rule 144 of the Securities Act. To conceal their illegal actions from the legitimate shareholders and board of directors, the fraudsters often change the name and domicile of the issuer and conceal material aspects of their transactions from public filings as well as from FINRA.
Once the coast is clear, the fraudsters sell the hijacked entity to unsuspecting small companies in going public transactions. Fortunately, these fraudsters’ days are numbered.  In the last year, the Justice Department has charged  numerous defendants for using similar schemes to exploit state court actions.
The Risk to Private Companies in Going Public Transactions
Any private company that purchases a custodianship or receivership shell is at risk of an SEC enforcement action even if they were an unknowing participant in certain securities violations that occurred.  Section 5 of the Securities Act does not require scienter. In other words, even if someone is an unknowing participant relying upon a legal opinion to improperly issue free trading shares to himself or others, he can be charged with violating Section 5. In addition to SEC enforcement actions, issuers purchasing custodianship shells risk SEC trading suspensions.  In the less than two years, the SEC has suspended approximately 700 dormant public companies to prevent corporate hijackings using fraudulent custodianship and receivership actions.   Additionally, issuers may be subject to civil actions by legitimate management and shareholders of the entities hijacked in the custodianship proceedings.   As stated above, most reverse mergers fail to properly disclose information material to investors. Additionally, where public vehicles are hijacked and/or taken over in custodianship proceedings, egregious accounting failures are present because the auditors employed fail to contact former management of the entity subject to the proceeding. To do so would reveal the scheme.
Any company considering going public through a reverse merger transaction should consider the decision carefully, and consult a qualified securities attorney before signing the dotted line for a reverse merger.
For for more information please visit Securities Lawyer 101

OTC Pink Sheets l Bootcamp

Getting Listed on the OTC Pink Sheets
Many companies going public for the first time are opting for the OTCMarkets OTC Pink Sheets. One way for companies seeking to list on the OTC Pinks is by engaging in a Reverse Merger (“Reverse Merger”) with a public shell company.  Securities regulators tend to look askance at Reverse Mergers, fearing they may be used as vehicles for fraud either by stock promoters or others – including securities attorneys – who manufacture or hijack them. This is no more evident than on the OTC Pink Sheets.
Over the last eight years, the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) have overhauled the rules and regulations applicable to Reverse merger Transactions.  On July 2, 2013, the SEC announced its new task force “Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis” whose targets, among others, are Reverse Merger purveyors and gatekeeper securities attorneys involved in Reverse Merger transactions.
Among the SEC’s efforts to combat microcap fraud is a campaign to remove public shell companies from securities markets to prevent their use in Reverse Merger transactions by corporate hijackers. Its efficacy is demonstrated by what the agency calls operation Shell Expel, which so far has resulted in trading suspensions for more than 700 dormant public companies to prevent  illegal custodianship and receivership corporate hijackings. A majority of the suspended issuers are listed on the OTCMarkets OTC Pink or Gray Sheets. Not only have the SEC and FINRA jumped on the bandwagon to eliminate them, but, as will be explained below, the Depository Trust Company (“DTC”) has joined in their efforts.
Despite the unfavorable climate and diminishing benefits of Reverse Mergers, shell purveyors continue to persuade clients to engage in Reverse Merger transactions. Any securities attorney familiar with the rules and regulations impacting reverse merger transactions knows they are more often than not-toxic for private companies seeking to go public.
Apart from traditional Reverse Merger risks, which include SEC investigations or violations, undisclosed liabilities, litigation and potential litigation, companies going public in Reverse Merger transactions seeking to list on the OTCMarkets now face increased compliance costs due to increasing regulations and scrutiny of these transactions. Even where issuers attempt to file a registration statement after a Reverse Merger, they are overwhelmed with SEC comments about the pre-reverse merger entity.
We are frequently asked about the legal ways that Reverse Mergers can be completed for companies listed on the OTC Pink Sheets and under what circumstances, if any, unrestricted shares can be issued. This bootcamp blog series will address changes to the rules and regulations impacting Reverse Mergers for OTC Pink Sheets issuers, the payment of finders fees and commissions, the use of forward stock splits,  and the issuance of unrestricted securities in Reverse Merger transactions. Lastly, this blog series will address how private companies can list on the OTC Pink Sheets without a Reverse Merger or registration statement filing with the SEC.
OTC Pink Sheets Myths
Reverse Mergers are Fast and Cheap 
Stock promoters often compare the price of an initial public offering (“IPO”) to the much lower cost of a Reverse Merger for an OTC Pink Sheet listing. This is misleading because in an IPO, a company pays an underwriter to sell securities to the public and develop an active market after the company becomes public; that is not cheap. Assuming it qualifies, a private company can go public on the Pink Sheets for a cost of between $10,000 and $50,000. A public shell for a Reverse Merger can cost as much as $450,000 and 5% of the Shell Company’s outstanding securities. In addition to the time it takes to perform due diligence, negotiate the Reverse Merger agreement, and close the transaction, FINRA Rule 6490 eliminates the timeliness benefit of the Reverse Merger that once existed.  The rule requires that corporate acts frequently associated with Reverse Mergers obtain FINRA approval before effectiveness. FINRA approval takes between  a month to three months.
Reverse Mergers Create Liquidity
Reverse Mergers do not create liquidity, and in fact may permanently destroy any chance of realizing it. Issuers engaging in them often undertake name changes, stock splits or similar transactions which are reviewed by both FINRA and DTC. Upon review, many Reverse Merger companies lose DTC eligibility and their securities are subjected to DTC chills and global locks. Without DTC eligibility, it is impossible for a company to establish liquidity in its securities.
Companies Can Issue Free Trading Shares in Reverse Mergers
Shell brokers continue to promote the mistaken notion that Shell Companies or former Shell Companies can issue free trading shares upon conversion of debt or convertible notes. Rule 144 was amended in February of 2008, and the amendment applies to issuers who were shells prior to that time. This issue has already been addressed by the SEC in its Compliance and Disclosure Interpretations set forth below:
Question: If an issuer had previously been a shell company but is an operating company at the time that it issues securities, is the Rule 144 safe harbor available for the resale of such securities if all of the conditions of Rule 144(i)(2) are satisfied at the time for the proposed sale?
Answer: No. Rule 144(i)(1) states that the Rule 144 safe harbor is not available for the resale of securities “initially issued” by a shell company (other than a business combination related shell company) or an issuer that has “at any time previously” been a shell company (other than a business combination related shell company). Consequently, the Rule 144 safe harbor is not available for the resale of such securities unless and until all of the conditions in Rule 144(i)(2) are satisfied at the time of the proposed sale. [Jan. 26, 2009]
Question: Does Rule 144(i) apply to securities issued before February 15, 2008, which was the effective date of the amendments to Rule 144 in which the Commission adopted Rule 144(i)?
Answer: Yes. [Jan. 26, 2009]
The SEC cannot make it any clearer.  Rule 144 prohibits shareholders of present or former Shell Companies from relying upon it safe harbor to sell their shares until certain requirements are met. There is no other resale exemption for unregistered securities. For a company to rely upon Rule 144 after a Reverse Merger it must have ceased to be a shell company and at least one year must have elapsed from the time it filed Form 10 Information with the SEC reflecting its non-shell status.
Any private company seeking to have its securities publicly traded on the OTC Pink Sheets should proceed with caution when considering whether to engage in a Reverse Merger. Private entities should ensure that the public entity has never had a period of inactivity in its corporate records and that the issuer consistently generated meaningful revenues.
For more information please visit: Securities Lawyer 101

SEC Halts Market Action Advisors Hedge Fund

On August 6, 2013, the Securities and Exchange Commission (the “SEC”)  obtained an emergency court order to halt a hedge fund investment scheme targeting mostly unsophisticated investors including friends, family members, and military personel to invest in his hedge fund. According to the SEC, the fund was controlled by a former Marine living in the Chicago area who purported to be a successful trader to defraud fellow veterans, current military, and other investors.
The SEC alleges that Clayton A. Cohn and his hedge fund management firm Market Action Advisors raised approximately $1.8 million from investors.  According to the SEC, Cohn lied to investors about his success as a trader, the performance of the hedge fund, his use of investor proceeds, and his personal stake in the hedge fund.
The SEC’s investigation revealed that Cohn invested less than half of the money raised from investors and instead used over $400,000 for personal expenses including homes, autombiles and nightclubs.
Cohn allegedly used his lavish lifestyle to portray the image of a successful investor and trader despite losing almost all of the money he had invested through the hedge fund.
In order to conceal his actions he raised funds ponzi style from more investors and he created phony hedge fund account statements reflecting 200 percent returns.
Timothy L. Warren, Acting Director of the Chicago Regional Office, stated, “Cohn lured fellow military and other investors into his hedge fund by portraying himself as a successful trader …. But Cohn’s hedge fund investors didn’t have a chance to make a profit since he never invested most of their money and promptly lost the portion he did invest.”
The SEC also learned that Cohn controled the Veterans Financial Education Network (VFEN), charity that purports to teach veterans how to understand and manage their money.
According to the SEC’s complaint, Cohn managed his hedge fund Market Action Capital Management through his investment advisory firm Market Action Advisors.  Not only did Cohn falsely claim he had major success as a personal trader, he also claimed to have invested $1.5 million of his own money in the hedge fund.
The SEC’s complaint charges Cohn and Market Action Advisors with violating the antifraud provisions of the federal securities laws.  The court granted the SEC’s request for emergency relief including a temporary restraining order and asset freeze.  The SEC action seeks permanent injunctions, disgorgement of ill-gotten gains, and financial penalties.
For more information please visit: Securities Lawyer 101

SEC Short Sale Alert l Trading to Conceal Failures to Deliver


On August 9, 2013, the SEC‘s Office of Compliance Inspections and Examinations issued a Risk Alert concerning certain trading activity being used to circumvent Regulation SHO’s close-out requirements for short sales. The SEC observed that some short sellers create the false impression of compliance with Regulation SHO’s “close-out requirement” when ”failures to deliver” occur.
In a short sale, the seller sells a security it does not have at the time of the sale. The seller profits when the price of the security declines by purchasing it at a lower price than they sold it for in a short sale.  The short seller profits even more if it engages in trading activity that creates the false appearance that their short position was closed out to avoid the cost of purchasing a security to cover.  These bogus close-outs violate Regulation SHO which requires that trades settle within the time frame allowed by the rule.
Locate and Close-out Requirements
Regulation SHO requires short sellers who fail to deliver securities after the required settlement date to close out their position immediately, unless they are a market maker.    The “locate” requirement of Regulation SHO requires broker-dealers to have  reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order. Regulation SHO’s close-out provisions apply to all equity securities including OTC Pink Sheet issuers.
FINRA Rule 4320 expands Regulation SHO’s close-out provisions to OTC Pink Sheet issuers and other non-reporting issuers. The close-out requirements of Regulation SHO require broker-dealers to close-out all failures to deliver that exist in threshold securities for thirteen consecutive settlement days by purchasing securities of like kind and quantity.
Reset Transactions
The activity that prompted the SEC’s Risk Alert generally involves hard to borrow securities in which the Put/Call Parity is imbalanced.  If a market maker does not deliver shares when he needs to, but instead engages in a second transaction to give the appearance of satisfying the close-out requirements while maintaining the original short position, he will be deemed not to have closed out the position at all.  This is called a “reset transaction.”  Reset transactions are usually accomplished through the use of a buy-write trade, but may also employ a married put, and may incorporate the use of short-term FLEX options.
The SEC’s Renewed Interest in Short Sale Transactions
The SEC’s interest in these types of Reg SHO violations is illustrated by two recent enforcement actions.  The first, from April, 2013 was brought against optionsXpress, owned by Charles Schwab.  According to the SEC, the firm had “engaged in… sham reset transactions in a number of securities, resulting in continuous failures to deliver.”
Robert Khuzami, the SEC’s head of Enforcement, said, “Feldman and optionsXpress used sham reset transactions to avoid, sometimes for months, compliance with Reg SHO’s stock delivery requirements.  In effect, they ‘kited’ shares of stock, thus depriving buyers of the benefit of their bargain – prompt delivery of their shares.”
In early June, the agency brought an administrative proceeding against the Chicago Board Options Exchange and its subsidiary C2 Options Exchange for regulatory oversight violations involving reset transactions, saying the exchanges failed to enforce the close-out rule because staff did not understand it, and its investigators had never received formal training in the rule.
In a statement, the SEC noted further that “CBOE failed to provide information to SEC staff when requested, and went so far as to assist the member firm [presumably OptionsXpress, though it was not named] by providing information for its Wells submission to the SEC. The CBOE actually edited the firm’s draft submission, and some of the information and edits provided by CBOE were inaccurate and misleading.”
The CBOE agreed to pay a $6 million fine and implement new measures designed to prevent a recurrence of the violations.
Short Sale Red Flags Identified by the SEC
The SEC’s Risk Alert identified certain red flags of illegal short sale activity.  These include:
 Trading exclusively or excessively in hard-to-borrow securities or threshold list securities, or in near-term listed options on such securities
 Large short positions in hard-to-borrow securities or threshold list securities
 Large failure to deliver positions in an account, often in multiple securities
 Continuous failure to deliver positions
 Using buy-writes, married puts, or both, particularly deep in-the-money buy-writes or married puts, to satisfy the close-out requirement
 Using buy-writes with little to no open interest aside from that trader’s activity, resulting in all or nearly all of the call options being assigned
 Trading in customizable FLEX options in hard-to-borrow securities or threshold list securities, particularly very short-term FLEX options
 Purported market makers trading in hard-to-borrow or threshold list securities claiming the exception from the locate requirement of Regulation SHO; often these traders do not make markets in these securities, but instead make trades only to take advantage of the option mispricing
 Multiple large trades with the same trader acting as a contra party in several hard-to-borrow or threshold list securities; often traders assist each other to avoid having to deliver shares
This memorandum about short sale transactions and Regulation SHO is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does ths message create an attorney-client relationship.
For more information please visit: Securities Lawyer 101

DTC Conspiracies l Custodianship And Receivership Hijackings

We continue to receive inquiries from management and shareholders of public companies about the Depository Trust Company (“DTC”). Many of these people believe that there is a larger DTC conspiracy in the works.
Frequently, companies engaging in certain types of reverse merger transactions find their securities without DTC eligibility.
A closer review of these transactions reveals that in most instances the reverse mergers involved public shells that were illegally acquired by the shell purveyor.

How Do Scammers Get Their Inventory of Public Shell Companies?

More often than not control of public shell companies is obtained through corporate hijackings involving bogus reinstatements and/or fraudulent state court custodianship and receivership actions.
In these actions, the  participants file verified pleadings that falsely state that a shareholder and/or board meetings were held. In reality, no shareholder or board meetings were held. Participants in these illegal schemes to obtain control of shell companies often misuse the exemptions from registration to issue free trading shares including Section 3(a)(10) of the Securities Act of 1933, as amended (the ”Securities Act”)  and the safe harbor provided by Rule 144.  Despite the blatant illegal nature of these actions, securities lawyers, market makers and even transfer agents continue to assist these fraudsters by serving as gatekeepers of the fraud.
The SEC and FINRA Become Proactive
Between January of 2000 and present, the Securities and Exchange Commission (the “SEC”) has suspended or halted more than 1400 publicly traded companies. Most were dormant penny stock issuers suspended to prevent corporate hijackings by custodianship or receivership proceedings. Others were penny stock issuers engaged in massive pump and dump schemes.
How DTC Fits In
DTC serves as the only stock depository in the United States. When DTC provides services as the depository for an issuer’s securities, those securities can trade electronically. Without DTC eligibility, it is almost impossible for an issuer to establish an active market in its stock. Issuers must satisfy specific criteria established by DTC to receive initial DTC eligibility after a going public transaction. When a going public transaction is complete, the issuer must comply with DTC’s criteria to remain eligible for electronic trading regardless of whether a company goes public using a registration statement or reverse merger. Applying for  DTC is the last step in the going public process and the last chance to prevent fraud before a company begins actively trading.
Even after securities become DTC eligible, DTC may limit or terminate its services. It is critical for private companies seeking public company status to consider factors that may impact DTC eligibility prior to their going public transaction if they want to establish an active market in their securities.
When DTC eligibility is denied, limited or terminated, issuers and their securities attorneys often express astonishment and scream foul play, asserting various conspiracy theories, each more ludicrous than the last. We have all read about issuers who self-righteously proclaim that their loss of eligibility was due to conniving short sellers, nefarious clearing firms and the purported “agenda” of the SEC to eliminate small broker dealers and microcap issuers. The reality is that most DTC Chills and Global Locks occur after reverse mergers, particularly when there is a suspicion of fraud such as that found in public shell companies created in state court custodianship and receivership actions.
DTC can limit its services by placing a chill (“DTC Chill”) on a security and terminate its services for a variety of reasons, but most often it is because securities lawyers have rendered flawed opinions or the issuer has engaged in illegal promotional activity. It should come as no surprise to the officers and directors of public companies that DTC reviews the issuance of free trading shares since it is the free trading shares DTC holds in its depository, under its nominee name CEDE & Co.
DTC has several options when concerned about the eligibility status of a newly eligible security, or when it detects fraudulent activity. These include limiting or suspending its services or making referrals to the enforcement divisions of FINRA or the the SEC or the Justice Department.
When DTC eligibility is lost, issuers will often tell their stockholders they have no idea what happened. Since only the company can direct its transfer agent to issue free trading shares, most often it knows exactly why DTC limited or suspended its services. Many officers and directors of microcap companies are facing the harsh reality that reliance upon a legal opinion will not provide them with an effective defense to SEC charges securities violations.
What is really going on with DTC?
DTCC’s Office of Corporate and Regulatory Compliance monitors unusually large deposits of microcap securities that are sent to DTC. it is looking for an indication that the issuer or persons associated with the issuer have violated the securities laws.
With penny stocks, this behavior typically involves the deposit of large blocks of unrestricted securities in reliance upon flawed legal opinions rendered in connection with convertible notes, reverse merger transactions or Rule 504 offerings.
Where any of the foregoing are present, the issuer should expect a review by DTC and should be prepared to provide a competent legal opinion from an independent securities attorney.
Does FINRA Rule 6490 Have Anything To Do With DTC?
DTC review is also prompted when issuers provide notice to the Financial Industry Regulatory Authority (“FINRA”),  pursuant to Rule 6490, of name changes, stock splits, dividends, reverse mergers and spin-offs. While FINRA examines the corporate action prompting the notice under 6490, DTC reviews matters related to the issuer’s shares including the tradability of the securities it holds on deposit.
DTC staff may discover (previously undetected) illegally free trading share issuances based upon bogus legal opinions rendered by banned securities lawyers or other fraudulent activity that will persuade them to limit or suspend its services. In these instances, DTC may make referrals to appropriate regulators including the SEC’s Division of Enforcement.
How will a DTC Chill or Global Lock Impact trading?
A DTC Chill restricts DTC’s services, including limiting a DTC participant’s ability to deposit or withdraw chilled securities. A DTC Chill may last a few days or for an extended period of time depending upon the problems that caused the chill and the issuer’s willingness to address them. A “Global Lock” is a termination of all of DTC’s services to an issuer. Like a DTC Chill, a Global Lock may last a few days or much longer, depending on the reason for the action. If the fundamental cause cannot be corrected, then the security will be removed from DTC’s depository, and transactions in the security subject to the Global Lock will no longer be eligible for clearing at any registered clearing agency. When this happens, clearance and settlement of open market trades is significantly delayed because trades can only occur upon physical delivery of stock certificates between the buyer and seller’s brokerage firms. In such circumstances it could take weeks for trades to clear and settle.
DTC does not always disclose the reason for a Chill or Global Lock, nor does it suggest how long it will be in effect. DTC Chills and Global Locks are publicly announced on DTC’s website.
DTC Chill Removal Specialists
Recently, quite a few websites have popped up claiming their operators can remove DTC Chills and Global Locks. The irony is that most of these service providers participate in the activities that can cause the loss of DTC’s services in the first place. Some of these quick fixes are offered by the same lawyers who render flawed tradability opinions and the same transfer agents who knowingly or blindly accept the opinions that cause DTC difficulties in the first place.
Similarly, stock promoters with pump and dump websites now tout that they can remove DTC Chills despite the fact that their own dubious services have resulted in DTC problems.
There are only two people who can help you remove a DTC Chill, a securities attorney acceptable to DTC, who can render a tradability opinion concerning the issuer’s unrestricted shares held by DTC, and a DTC Market Participant, who can ask that DTC provide its services with respect to a security. Anyone else claiming he can secure DTC eligibility or remove a DTC Chill is unqualified to do so.
Fairness Procedures
On September 24, 2009, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the Middle District of Florida alleging that International Power Group (“IPWG”) had issued shares of common stock in violation of the securities registration requirements. The SEC reviewed the actions taken by DTC, and determined that DTC must provide issuers with fairness procedures, adding further that DTC’s suspension of its services to an issuer is subject to DTC review upon request.
The SEC did not make a determination that DTC’s suspension of services to IPWG was unwarranted. It merely concluded that DTC did not follow required fairness procedures. Unfortunately, the agency failed to define adequate fairness procedures precisely. Even with a fairness hearing there can be no assurance that DTC will resume its services; it continues to have broad discretion in these matters.
Removing A Chill or Global Lock
In some circumstances, DTC obtains additional information from the issuer and its securities counsel regarding the activity in question, and may decide not to limit its services or may remove a DTC Chill with respect to the security. Accomplishing this is not an easy task. Even with the SEC’s new requirement that DTC provide a fairness hearing, from a practical perspective nothing has changed for most issuers. A fairness hearing is expensive, and may take years to obtain. In the few cases in which removal of a Chill is possible, the process requires, among other things, an opinion from securities counsel concerning the (free trading) shares held on deposit by DTC and a DTC participant- usually a market maker- for services to be resumed. DTC reserves the right to refuse to rely upon the opinion of any issuer’s securities counsel. In recent months, the SEC has brought multiple enforcement actions against attorneys in connection with tradability opinions rendered for microcap issuers. Often these actions are preceded by a loss of DTC eligibility.
The Solution
Because DTC may choose to refer securities violations it discovers to the SEC’s Division of Enforcement, issuers need to consult with a qualified securities attorney at all stages of the DTC process, particularly when information must be provided by the issuer. The selection of counsel to address DTC problems, and other potential problems, should no longer be considered a routine legal matter. The most satisfactory solution for issuers seeking DTC eligibility is for the issuer to file a registration statement under the Securities Act of 1933 for either an Initial or Direct Public Offering.
Issuers expecting to obtain DTC eligibility in their going public transaction and maintain it once their going public transaction is complete need to recognize that they may be penalized if they go public in a reverse merger with a public shell company or use the services of securities professionals, including unregistered brokers, stock promoters, shell purveyors, investor relations firms, transfer agents and even securities lawyers who have been the subject of SEC investigations and enforcement actions.
For more information please visit: Securities Lawyer 101