TECHNIC AL
accepted a nine-month suspension from acting in a supervisory capacity in the securities industry. The potential for severe consequences resulting from the use of unregistered broker-dealers is also illustrated by the 2012 Chapter 11 filing of Neogenix Oncology Inc. In 2011, an SEC inquiry revealed that Neogenix had been making sales through unregistered third-party broker-dealers in violation of the Exchange Act. Consequently the firm had significant potential rescission liability for the securities sold in connection with the unregistered marketers. This potential liability caused uncertainty in their financial statements and due to the uncertainty, the Neogenix auditors were unable to sign-off on those statements. Without third-party auditor sign-off, Neogenix could not properly file quarterly and annual financial statements with the SEC and struggled to raise additional capital that was essential for the development stage company. Neogenix subsequently filed for bankruptcy in July of 2012.
Disclosing registration requirement violations Once a fund uses an unregistered broker-dealer, the fund must satisfy certain disclosure requirements. Both federal and state securities laws require that a fund disclose if it has compensated any person to sell such securities. Failing to disclose such compensation can expose an issuer to potential liability for fraud under Section 10b-5 of the Securities Act. “Even if rescission is not demanded by prior investors, the use of an unregistered broker-dealer in a prior transaction will create disclosure requirements in subsequent financings, acquisitions, or offerings.” The risk of private suit, illegality or rescission, arising from finder non- registration, is a material fact that, if omitted, constitutes a 10b-5 violation. Note, however, that such failure to disclose is only fraudulent if the issuer knows the finder is not registered, but should be. Therefore, once a fund is successfully sued for employing an unregistered broker, they must disclose this information in future offerings and sales.
General solicitation and broker registration One other factor that is increasing the SEC’s attention to marketing by private investment funds and broker-dealer registration is the recent enactment of the Jumpstart Our Business Startups Act (the JOBS Act), particularly Title II, Access to Capital for Job Creators. On 10 July, 2013, the SEC approved final rules under the JOBS Act to allow general solicitation and advertising in Rule 506 and Rule 144A offerings conditional on all purchasers being accredited investors. Although the JOBS Act was intended to encourage the funding of small businesses and start-ups, Title II opens the door for general solicitation by private investment funds.
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Some funds have already begun to take advantage of the recent changes with direct marketing efforts, despite not registering as broker-dealers. However, the increased risk of fraud and predatory targeting of unsophisticated investors that general solicitation creates may be expected to be exacerbated even further by the use of unregistered finders in those solicitation efforts. In light of the SEC’s general animus against unregistered finders which it views as presenting greater potential for abuse, the SEC is likely to increase its regulatory focus and scrutiny on the marketing activities of private funds that engage in general solicitation.
Conclusion Given the SEC’s recent increased interest in the proper registration of marketers, fund managers should already be on notice that individuals, whether in-house or third-party, who engage in marketing securities will likely be required to register as broker-dealers. Without significant change to the compensation structure and job description of these marketers, it is unlikely that any of the current exemptions to registration will apply. As is evident from the experiences of Ranieri Partners and Neogenix, disclosure that a finder was in fact an unregistered broker-dealer can be the beginning of a long and arduous process for the issuer. Litigating these cases can be expensive and both the issuer and finder risk reputational damage regardless of the actual outcome of the case. Once the matter is disclosed to the public, both the issuer and the finder may be open to rescission liability, consequent monetary penalties and other liabilities. Therefore, issuers would be wise to heed David Blass’ warning and ensure their marketers are properly registered. THFJ
A fully referenced version of this article is available online at
www.thehedgefundjournal.com
ABOUT THE AUTHORS
Liam O’Brien is a managing partner at McCormick & O’Brien LLP. He received his J.D. in 1991 from the University of Fordham School of Law.
C. Mark Laskay is a partner at McCormick & O’Brien LLP. He has an LL.M. in International Business from the University of London, and a J.D. from the University of Texas School of Law.
Lauren Parra is a J.D. Candidate 2015, at the University of Fordham School of Law .
John Keating is a J.D. Candidate 2015, at the University of Fordham School of Law.
“In light of the SEC’s general animus against unregistered finders which it views as presenting greater potential for abuse, the SEC is likely to increase its regulatory focus and scrutiny on the marketing activities of private funds that engage in general solicitation.”
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