Andrew Abramowitz

I blogged recently about an SEC crackdown on failure to make required filings under Sections 13 and 16 of the Exchange Act, and continuing with that theme, the SEC recently announced a enforcement program against several public companies for failure to disclose unregistered offerings of securities.

First, some background:  Any sale of securities by a company must either be registered under the Securities Act, or it must be sold under some exemption, such as a Regulation D private placement under Section 4(2) of the Securities Act.  The SEC’s concern is that all sales of any kind be effectively disclosed to the public, so investors are aware of dilution that may have recently occurred when making their investment decisions.  The public is aware of registered sales because the registration statement and prospectus filings are made via Edgar.  When the sales are unregistered, public companies are required to make a filing on a Form 8-K if the sale exceeds a certain threshold (5% of the outstanding common stock for smaller public companies), and otherwise on the next Form 10-Q or 10-K.

In the cases brought by the SEC, ten companies failed to report transactions on Form 8-K as required by these rules, and three of them also had faulty disclosure when they disclosed the transactions in a later report.  None of these companies is a household name.  The issue of disclosure of unregistered offerings is more likely to come up in the context of smaller public companies, since larger ones tend to have more flexibility to conduct registered offerings (takedowns from shelf registration statements, etc.), while their smaller counterparts rely on PIPEs and similar transactions, which trigger the disclosure requirement.  Often, these microcap public companies don’t rely on experienced or competent securities counsel in preparing their filings.  (Yes, that is a not-so-subtle pitch for my services.)

The broader point is that the SEC is well aware that certain of its disclosure requirements are not complied with religiously, and while the agency doesn’t have the budget to police each failure individually, it is attempting to send a message with these coordinated multi-company enforcement efforts that the rules shouldn’t be ignored.

Last month, the SEC issued a user-friendly guide for potential investors in avoiding fraudulent unregistered offerings.  I highly recommend the advice given here, but I have a few specific clarifications:

• In point 1, the SEC identifies promises of high returns with little risk as a red flag.  This is of course true, but one shouldn’t necessarily be concerned if a PPM contains projections of future financial results that look rosy, as long as there is appropriate risk disclosure included.  Particularly if the company is a startup without meaningful historical financials to disclose, you’re likely to see projections in the PPM, and even the most scrupulous and honest companies are not going to have projections that make the investment opportunity look like a sure-bad thing.
• Point 4 implies that you should be concerned if the offering doesn’t have a PPM, but as I’ve noted before, it’s not uncommon for private placements to go without a PPM for all-accredited investor offerings.  The other point made here about sloppy documentation is well-taken.
• Point 5 notes correctly that many exempt transactions rely on the accredited investor definition.  In such cases, as noted, it would be a red flag if the documentation did not ask about the investor’s accredited investor status.  However, the heading of this point could be interpreted to mean that you can’t participate in these offerings without the requisite net worth or income, but of course several of the exemptions permit a certain amount of non-accredited investors.
• Point 8 says it’s a red flag if the entity isn’t in good standing in its state of incorporation/organization.  It’s pretty common for smaller companies to be delinquent in franchise tax payments and therefore not in good standing pending the payment, and in the great majority of these cases, it’s probably more about inattention to detail than a scam.  A reasonable investor could deem such sloppiness to be a red flag, but not necessarily as an indicator that the promoter will abscond with the investor’s funds.