The Financial Industry Regulatory Authority’s (FINRA) review of securities offering documents has revealed a large number of instances in which broker-dealers have not complied with requirements of Rules 10b-9 and 15c2-4 under the Securities Exchange Act of 1934 (SEA) as they relate to contingency offerings. FINRA published Regulatory Notice 16-08 to provide guidance regarding the requirements of SEA Rules 10b-9 and 15c2-4 and to remind broker-dealers of their responsibility to have procedures reasonably designed to achieve compliance with these rules.
Ultimately, broker-dealers that participate in best efforts public and private securities offerings that are contingency offerings (i.e., an underlying condition or qualification that must take place by a specified date prior to the issuer taking possession of the offering proceeds) are required to safeguard investors’ funds they receive, until the contingency is satisfied. If the contingency is not met, broker-dealers must ensure that investors’ funds are promptly refunded. FINRA’s reviews of these offerings and subsequent investigations have revealed instances in which broker-dealers have not complied with the requirements of SEA Rules 10b-9 and 15c2-4.
Best Efforts Contingency Offerings
In a best efforts offering, a broker-dealer does not commit to purchase any securities from the issuer or guarantee that the issuer will receive any amount of money from the offering. Furthermore, a best efforts offering subject to satisfaction of an underlying condition is deemed to be a “contingency offering.” The most common contingency offerings reviewed by FINRA are either “all-or-none” or “part-or-none” offerings that require all or a certain amount of the securities to be sold for the offering to close. Under SEA Rule 10b-9, a best efforts offering subject to either an “all-or-none” or “part-or-none” contingency must provide for the prompt return of investor funds in the event the requisite contingency fails to be met by a specific date.
Broker-Dealer Responsibilities in a Best Efforts Contingency Offering.
As discussed by FINRA in Regulatory Notice 10-22, a broker-dealer that participates in an offering and recommends a security must, among other requirements, conduct a reasonable investigation of the security and the issuer’s representations about it. If the security is offered as part of a contingency offering, the broker-dealer’s reasonable investigation must also include a review of the terms of the contingency, including any agreement and disclosure by the issuer regarding the contingency. Issues noted by FINRA in this area include: (i) several offerings in which the broker-dealer conducting the offering failed to identify inconsistencies between the escrow agreement and the offering document as it relates to the requirements of the contingency.; (ii) broker-dealers violated SEA Rule 10b-9 by failing to return subscriber funds after the issuer changed the contingency by reducing the offering minimum; and (iii) broker-dealers violated SEA Rule 10b-9 by failing to take the proper steps in response to an issuer’s extension of the offering period; (iv) broker-dealers must be aware of any attempt by the issuer to use non-bona fide sales in order to declare an offering sold for the purposes of an “all-or-none” or “part-or-none” offering. In general, “non-bona fide sales” are sales of undisclosed purchases by the issuer or broker-dealer, their affiliates or associated persons, or any entities through nominee accounts that are designed to create the appearance of a successful completion of an offering. The use of non-bona fide sales in “all-or-none” and “part-or-none” contingency offerings could violate the antifraud provisions of the federal securities laws; (v) a broker-dealer violated SEA Rules 10b-9 and 15c2-4 when it participated in an offering in which the issuer declared a contingency offering sold by counting non-bona fide sales made to the issuer’s employees; and (vi) a broker-dealer was found to have violated SEA Rules 10b-9 and 15c2-4 when an issuer used the proceeds from a loan to purchase securities in the offering in order to meet the minimum offering amount.
Requirements Concerning Manner of Handling Investor Funds
SEA Rule 15c2-4 requires that upon receiving money or other consideration from an investor in contingency offerings, a broker-dealer must promptly:
- deposit those funds into “a separate bank account” for which the broker-dealer is the account holder and is designated as agent or trustee “for the persons who have the beneficial interests therein”; or
- transmit those funds to a bank that has agreed in writing to act as the escrow agent for the offering.
The manner in which a broker-dealer must handle investor funds generally will be determined by two factors. First, pursuant to SEA Rule 15c3-1, only a broker-dealer that maintains at least $250,000 in net capital is allowed to carry customer accounts and receive or hold funds or securities for those persons. Therefore, while not a requirement of SEA Rule 15c2-4, a broker-dealer that maintains less than $250,000 in net capital and deposits investors’ funds into a separate bank account rather than transmitting those funds to an independent bank escrow agent would violate SEA Rule 15c3-1.15. Second, when a participating broker-dealer is an affiliate of the issuer, investors’ funds must be transmitted to an independent bank escrow agent.
Escrow Agreements
In contingent offerings that require an escrow agent, the escrow agreement must be executed with a bank that is unaffiliated with the broker-dealer and the issuer. The escrow account should be established before the broker-dealer receives any investor funds. The escrow account may not be controlled by the issuer, the broker-dealer or an attorney. As a general matter, the escrow agent must be a financial institution that meets the definition of a “bank” under SEA Section 3(a)(6),21 although the SEC staff has provided no-action relief to permit certain other entities to act as escrow agents.
Prompt Transmittal of Funds
SEA Rule 15c2-4(b) requires that a broker-dealer promptly transmit funds to either an escrow agent or a separate bank account. SEC staff has interpreted “promptly” to mean by noon of the next business day. Failure to promptly transmit funds to either the escrow agent or a separate bank account has resulted in sanctions. However, in certain offerings, such as direct participation programs that require suitability determinations by the issuer, the SEC staff has provided procedural guidance under which a broker-dealer can still comply with the “promptly” component of SEA Rule 15c2-4 even if the funds are not transmitted by noon the next business day after they are received.
In a best efforts offering, a broker-dealer does not commit to purchase any securities from the issuer or guarantee that the issuer will receive any amount of money from the offering. Furthermore, a best efforts offering subject to satisfaction of an underlying condition is deemed to be a “contingency offering.” The most common contingency offerings reviewed by FINRA are either “all-or-none” or “part-or-none” offerings that require all or a certain amount of the securities to be sold for the offering to close. Under SEA Rule 10b-9, a best efforts offering subject to either an “all-or-none” or “part-or-none” contingency must provide for the prompt return of investor funds in the event the requisite contingency fails to be met by a specific date.
Ultimately, following the guidance provided by FINRA, formerly NASD, in the 1990’s, it’s surprising that member firms continue to be cited with the same deficiencies that have plagued private placement offerings for the last decades.