Brought before Congress since late 2008 have been proposals of huge B and not-so-huge B scope. (For example, the proposals would add more supervision and regulation of bank holding companies, the asset-backed securitization process, OTC derivative products and markets, private fund investment advisers and securities rating agencies, among many other functions.)  Most have since been adopted in bills passed separately by the Senate and the House of Representatives, and await review by joint conference committees. It is likely that most will be adopted in some form, after joint conference action, and signed into law. They will significantly affect the conduct of business in this country, and therefore how attorneys must advise their clients.

These include a proposal to bring back aiding and abetting liability, subjecting to liability persons who knowingly or recklessly provide substantial assistance to other persons in violating Rule 10b-5. Adoption will impact, for example, attorneys preparing registration statements, accountants giving audit opinions in such statements and managing underwriters in public offerings. More than just those involved in public offerings, however, will be at the increased risk created by this legislation, including all persons assisting issuers or even individual security holders in selling or purchasing securities.

Similarly, the SEC has, during and following a period of intense negative scrutiny of that agency since the 2008 economic meltdown, brought many more enforcement cases in a number of areas, the main one of which is insider trading. But it is not the number of cases it has brought, rather, it is the SEC’s attempt to broaden the scope of liability under insider trading and possibly other laws, which should concern business people and their attorneys. Indeed, the broadening by the SEC of its definition of what disclosures and use of information are prohibited, together with the largely unregulated and rapidly growing (and often unthinking) use of social media, may bring about a “perfect storm” of what the SEC may consider violations of the insider trading laws.

And the Supreme Court in its recent ruling in Merck & Co., Inc., et al. vs. Reynolds, et al, No. 08-905, 559 U.S., 2010 WL 1655827 (2010) (decided shortly after the above article was published) also has expanded enforcement of the securities laws by loosening the restrictions on private securities fraud litigation. (The article describes the arguments and options for decision presented to the Court.)

In its April 27, 2010, ruling the Supreme Court adopted an interpretation of the period of limitations on bringing securities fraud actions in court which is significantly less restrictive of plaintiffs than many cases in the lower courts have been. Because private lawsuits under Rule 10b-5 for securities fraud act as private enforcement devices, the result will undoubtedly be greater enforcement of the securities laws.

The full article is available from the author or from Thomson-Reuters. Thomson Reuters Inside the Minds series provides legal and business intelligence from lawyers and C-Level executives (CEO,CFO, CTO, CMO, Partner).

Social Media – Linked In, Facebook, Twitter, etc. have become a major method of communicating not only personal information, but also business information. And with so many possible clients utilizing it, small broker-dealers must consider using it in their business in order to just keep up with their competition.

But the characteristics of social media which are so positive – quickness and freedom of the user and of responses of third parties – cause difficulty in this industry, which requires control and supervision of all communications with the public. The Financial Industry Regulatory Authority (“FINRA”), in its January 2010 Regulatory Notice 10-06, guides – and restricts – broker-dealers in their use of social media.

I have asked a “guest writer” to advise on these issues: Cliff Campeau, a Partner with Evolutionize, LLC. Cliff’s statements and opinions in this piece are his, and are not necessarily mine or those of Danna McKitrick, P.C.

The “Business Memo” part of this newsletter continues the discussion of theories of, and avoidance of, liability of broker-dealers (“BDs”) and registered representatives (“RRs”). This time we analyze “unauthorized trading.”

If you would like copies of past issues or have any questions arising from the contents of this or past issues, please call or e-mail me, Joe Soraghan, at (314) 726-1000 or jsoraghan@dmfirm.com at no charge.

A Social Media Perspective for Financial Advisors

Deferred Variable Annuities: The New Requirements and Some Problems, Solutions and Considerations

By: Cliff Campeau (cliffc@evolutionizemypractice.com)

Is your practice currently enjoying double-digit annual revenue increases? Are you profitably expanding your client base? Have you reduced the time required to convert prospects to clients? If you answered “yes” to any of these questions, read no further.

On the other hand, if you’re wrestling with how you are going to grow your practice, increasing assets under management and boosting profit margins, consider “Social Media Marketing.” But be aware of its risks.

Social media is here to stay. Consider that consumer activity on social media and blogging sites comprised 17% of all time on the internet in August, 2009, up from 6% the prior year, according to Nielsen.

Take a look at usage levels and you can begin to sense the impact social networking can have on extending your firm’s reach:

• 30 million LinkedIn users in the U.S. source: LinkedIn, February, 2010)
• 400 million Facebook users globally, with the average user spending 55 minutes per day (source: Facebook, January, 2010)
• 50 million Tweets per day (source: Twitter, February, 2010)

Perhaps at this point we can agree that leveraging the power of social media has the potential to dramatically impact your business development efforts. . . with minimal investment of time and money.

So what are you waiting for? Perhaps it is the fact that your compliance partner has not provided a clear path forward for incorporating social media into your firm’s marketing efforts. Clearly, there are guidelines that we must follow and grey areas that we must navigate as we manage our businesses on a daily basis. The same is true for social networking.

FINRA to the Rescue

The good news is that in January, 2010 FINRA issued Regulatory Notice 10-06, providing guidance on the use of blogs and social networking sites. Their guidance provides welcome clarity around the compliant use of social media.

Framework for Social Media Success

It is our goal to provide you with basic advice for advancing your consideration of social media to enhance communications with your investors, increase the number of leads you generate and convert more prospects into clients.

All communication on social networks and blog sites should be treated the same as personal or written communications. Therefore, the following rules apply:

• E-mail messages sent to 25 or more prospects is considered to be “sales literature.” E-mail to fewer than 25 prospects or customers should be considered “correspondence.”
• Publicly available websites, such as Twitter or YouTube are considered “advertisements,” while password protected sites such as LinkedIn, Facebook or MySpace are considered “sales literature.”
• Chat room discussions and/or posts on LinkedIn, Facebook for example, are considered “public appearances.”

With these guidelines established by FINRA, your compliance partner will be able to guide you on the need for pre-approval or not to allow your firm to remain compliant with FINRA’s Communications Rule 13. in conjunction with your compliance partner, it is recommended that you develop policies and procedures that suit your risk profile and ability to pre-approve or post-review your firm=s social media activity.

What we would like to focus on for this article are the following operational considerations for implementing a compliant social media program:

1. Record Keeping
2. 3rd Party Posts
3. Recommendations and Testimonials

Record Keeping

FINRA requires that advertisements and sales literature be retained for a period of three years. This includes advisor e-mails, posts or instant messaging activity related to the firm’s business, whether sent from the office, home or elsewhere. Status updates, Tweets and comparable social networking activity would fall under the advertisement and or sales literature guidelines. Sending an e-mail or instant message via a social network would be considered correspondence. Both of these scenarios, in conjunction with any network profile updates, must be captured and maintained.

Therefore, your firm will need to implement a social networking monitoring and archiving service. There are a range of software or freeware solutions providers that serve the Broker-Dealer/RIA market, providing a range of social network access control, monitoring and archiving services.

3rd Party Posts

FINRA does not generally consider 3rd party posts by customers as the firm’s communication, unless the firm was involved in producing, approving or endorsing the content. Hence, 3rd party posts can become attributable to the firm if they are republished or re-Tweeted. Commenting on a LinkedIn post or “Favoriting” a post on Twitter, for example, may be considered an endorsement and therefore attributable to the firm. This area is best addressed by 1) Limiting the advisers in the firm who are authorized to participate in the development of content and/or to post, comment or re-Tweet; 2) Training the firm’s advisers on the appropriate guidelines established by the firm related to this area; and 3) Working with your compliance partner to identify pre/post review parameters for posts and re-Tweets.

Recommendations & Testimonials

FINRA Notice 10-06 recognizes that it is beyond the reach of your firm to control or monitor all communication on the various social networks, and as a result acknowledges the fact that the 3rd party posts are generally not attributable to your firm’s communications. We do, however, want to address one particular social network. . .LinkedIn. LinkedIn provides its members the opportunity to solicit and approve endorsements from one’s contact network. FINRA has consistently advised against any form of direct or indirect testimonial “of any kind” concerning the adviser, their advice, analysis, reports or service proffered. Hence we would counsel your firm to develop a policy that prohibits advisers from soliciting or exhibiting any testimonials of any kind on LinkedIn or any of its social networks.

Conclusion

According to the Financial Planning Association, 43% of advisors surveyed are now using networking or social media sites.  Further, 60% of those advisors indicate that they have generated at least 16 leads per year form their activity on these sites.

Converting one lead to a client can offset the time and money invested in formulation, implementing, and monitoring a compliant social media marketing program.

Business Memo– Other Claims Against You: Unauthorized Trading

by Joseph R. Soraghan (jsoraghan@dmfirm.com)

I continue here the theme of the past few issues studying the claims most frequently brought against BDs and RRs in courts and arbitration. In past issues we have discussed common law fraud, negligence and breach of fiduciary duty. Yet to be discussed are Respondeat Superior, Unauthorized Trading and Failure to Supervise. In this issue I will discuss unauthorized trading.

Notwithstanding the offense and the concept of “unauthorized trading” are so important and commonplace, it is not defined in any statute or in any regulation of the Financial Industry Regulatory Authority (FINRA) or any other securities enforcement body. Rather, the Securities and Exchange Commission has simply declared that “unauthorized trading” (without defining it) constitutes a violation of the FINRA and NYSE Rules requiring members to “observe high standards of commercial honor and just and equitable principles of trade” (the “Fair Dealing Rule”). And FINRA then interpreted its Fair Dealing Rule in IM-23-2(4)(A)(iii) to include “causing the execution of transactions which are unauthorized by customers or the sending of confirmations in order to cause customers to accept transactions not actually agreed upon.”

The Easy Cases. There are scenarios in which the fact of a transaction being unauthorized is clear. In these are situations the client/customer alleges that no communication concerning the contested transaction occurred between himself and his broker. Typical evidence of this is telephone records showing

No telephone calls between them on or near the date of the trade, the customer being out of town and out of reach, etc.

But it is More Complicated Than That: Unauthorized Trading When There IS Communication. But unauthorized trading does occur (and customers can recover for it) even when it is clear that communications concerning the contested transactions DID occur. This can occur when (i) it is not clear whether an order was actually placed, or (ii) an order was placed but the customer did not understand the recommended transaction.

Most frequently, in a telephone conference the RR discusses a recommendation with the client, the client says yes to the trade, and the RR hangs up and executes the trade. Another but less frequent scenario is a meeting between the RR and customer in which the RR makes his recommendation. Industry rules do not require written authorization from the customer. And most clients, because they trust their broker and they are often in a hurry, prefer this to spending time “with the paperwork.”

Unclear Orders

But suppose the RR makes his recommendation and the customer simply says, “That’s a good idea.” Is that an order? Successful claims against brokers have occurred even in scenarios with more definiteness than this. The RR should be trained to require the customer to use clear language in ordering, and even better, to also note his or her wording briefly in writing, particularly for large or unusual orders.

Trades not Fully Understood by Clients

Courts generally hold that a customer can authorize only trades which he or she understands. Of course, that means that the customer must be explained the type of trade (buy or sell, etc.), the specific security being purchased, how many shares/units are to be purchased and the price. It is probable that a court or an arbitration panel would also require that the RR be certain that the customer understands the nature of the security (e.g., a complicated derivative versus common stock), any recent news, particularly negative, about the issuer of the security, whether the broker-dealer is a market maker or a consultant to the issuer, etc.

The theory of these cases is that an order made without knowledge and an understanding of all necessary information about the trade is one made without authority. Of course, the more exotic and complicated the security or the transaction, the less likely an arbitration panel is to find the client understood and thus authorized the trade. Essentially, securities law requires that any investor, sophisticated or not, be informed of, and understand, prior to a trade all facts concerning the trade and the issuer involved which a reasonable investor would want to know in deciding whether to make the trade. If an investor, on the stand in a hearing when asked “would you have made this trade had you known this fact (e.g., that the company is in a dying industry) might answer “no,” the RR should be certain to inform the investor of that fact.

Supervision: Indications of Unauthorized Trading

The broker-dealer has available various “red flags” which should be the basis of its computer-based supervisory system. That system should monitor for the following, based on the customer’s financial status, objectives and risk profile:

• Evidence of excessive activity;
• In and out trading (buying and selling the same or similar securities in short periods of time);
• Trading beyond the customer’s resources;
• Consistent and similar trading patterns in most of the bro- ker’s accounts;
• Large and suspicious margin balances;
• One or a few account’s commissions constituting a large portion of the broker’s total production; and
• Unusual trading.

The last item, requiring a bit of explanation, is perhaps the most trustworthy indication. By “unusual trading” I mean trades which do not fall within the parameters set by the customer’s net worth, risk tolerance, objectives, and expertise, and particularly his past investment history.

Some other warning signs for the supervisor are knowledge of an RR’s past unauthorized trading violations at prior brokerage firms, the broker’s unwarranted confidence in his own recommendations, or his or her gambling or other financial problems. Acting upon these latter signs may prevent unauthorized trading before it occurs.

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The Genesis of this Newsletter

I have represented large and small St. Louis region broker-dealers, their registered representatives and investment advisors for many years. I have wondered why there is no organization of, or publications dedicated to, the community of small broker-dealers and small banks with securities activities in that region. It also seems to me, based upon that experience, that questions arise of particular interest to that community, coverage of which benefits both that community and its clients.

Therefore, I publish this informal letter to that community, on an occasional and not necessarily periodic basis, noting and discussing (1) questions and events of interest to the small broker-dealer community as they arise; and (2) business memos on topics of on-going interest. Also, if you know of topics or questions which you would like presented, and which are of general interest to small broker-dealers, please let me know.

It is generally agreed among lawyers that some amount of information must be possessed by both disputing parties to a mediation, if the mediation is to result in settlement. (Of course, theories on how much information is necessary, i.e. how much discovery, if any, differ with types of case and frequently from attorney to attorney.) I’ll write more about that in future memos.

However, in one of my recent mediations, an interesting related situation arose. Prior the mediation, I discussed with counsel whether each of their pre-mediation briefs should be disclosed to the other party and his counsel prior to or at the mediation. One attorney agreed to disclose, but only if the other did. The other counsel refused to disclose it, apparently for strategic reasons, so the pre-mediation briefs were not disclosed to opposing parties.

No case had been filed so no discovery had been taken. The case did not settle during the mediation session, because both parties concluded they needed more information before settlement was possible. But we continued the mediation by separate telephone conferences between me and counsel.

After the mediation session and during the ensuing telephone conferences, after further information had been exchanged, the party originally refusing to disclose his pre-mediation memorandum agreed to do so. Settlement quickly followed.

The point is this: as much information as possible should be exchanged between the parties if the probability of settlement is to be maximized. Perhaps the most important such information is the information in each party’s pre-mediation brief.

Although accepted mediation practice is that parties have the option whether to exchange pre-mediation briefs, it is those briefs more than all other types of information, which ought to be disclosed to opposing parties to increase the likelihood of settlement. This of course if logical. A main purpose for preparing a pre-mediation memoranda is to convince the mediator of the probability of a party’s success. Obviously, it is even more important in a mediation to convince the other party and his counsel of the probability of one’s success. And if that is one of the purposes of a pre-mediation brief, it only makes sense that the other party have the opportunity to review it.

It is not uncommon for counsel to hesitate to exchange the pre-mediation brief because there is some short portion of it- perhaps an important fact or legal argument-that counsel does not want to disclose yet. In that event I suggest that counsel delete that portion from the brief, and put it in a separate document to the mediator, perhaps in a cover letter or some similar document, but retain all other evidence and legal arguments in the brief, and agree to exchange it with the other party.

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As now implemented, the cause of action for “unsuitability” in arbitration has become a sort of “malpractice” action against broker-dealers and registered representatives, similar to negligence and recklessness malpractice actions against lawyers and doctors. That development arose out of the recent movement of disputes out of courts and into arbitration over the past, say, thirty years. The roots of the unsuitability” action, even when resolved in arbitration, are actually in the court action of securities fraud. The action was created in state and federal statutes and rules (e.g., Rule 10b-5) and cases beginning early in the last century. And the roots of its period of limitations, not surprisingly, are in that same action of securities fraud.

Those roots are twisted indeed, with complications that only lawyers care about. But we need not analyze the complications. Suffice it to say that it is not possible to predict reliably how a panel will rule on a period of limitations argument.

Arbitrators deciding period of limitations questions must answer two primary sub-questions: (1) how long is it? and (2) when does it start?

How long is it? In practice, arbitrators appear to disagree, but it is pretty clear that it is either two or six years. A long line of federal and state statutes and cases culminated in the Sarbanes-Oxley Act in 2002, which states that, at least in court, an “action (for) . . . a claim of fraud, deceit, manipulation, or contrivance in contravention of . . . the securities laws . . . may be brought not later than the earlier of (1) 2 years after the discovery of the facts constituting the violation [the period of limitation], or (2) 5 years after such violation [the period of 'repose'].” (Because the discovery of the facts could occur a long time after the violation, the period of “repose” is intended to set an “outer limit”, as it were, to assure the matter is finally closed at some reasonable time.)

Rule 12206(a) of the National Association of Securities (NASD, now the Financial Regulatory Authority, FINRA) rules concerning arbitration of disputes between customers and broker-dealers states that “no claim shall be eligible for submission to arbitration . . . where six years have elapsed from the occurrence or event giving rise to the claim.” However, under the heading “Effect of Rule on Time Limits for Filing Claim in Court”, Rule 12206(d) states that “the rule does not extend applicable statutes of limitations.”

At first blush, it may appear that paragraph (d) in effect adopts the much shorter court litigation period of limitation of (usually) two years. And this is frequently argued by broker-dealers in arbitrations. But in fact, the more frequently accepted argument is that, although technically the six-year “eligibility” period is not a period of “limitation”, it in fact acts as one, and prevails over the two-year litigation period. Most courts hold that the six-year period mentioned in paragraph (a) limits the time within which an arbitration may be started, and paragraph (d) only says that state and federal periods limiting when a contractual arbitration clause may be enforced will not be extended. They hold paragraph (d) does not apply litigation securities law fraud limitation periods to “securities fraud” claims (i.e., unsuitability, churning, unauthorized transactions, etc.) in FINRA arbitrations. And it appears most arbitration panels deciding limitation questions agree. They do not generally give opinions explaining their decisions, but there appear to be few arbitrations dismissed on grounds of the period of limitations.

When does the period begin to run? FINRA Rule 12206(d) states that the “eligibility” period in FINRA arbitrations runs “from the occurrence or event giving rise to the claim”. That means, for “unsuitability” claims, the arbitration period of “eligibility” begins to run on the date of the purchase(s) claimed to be unsuitable (assuming the recommendation(s) and the purchase(s) were essentially simultaneous.) (Notice: it begins to run, and it expires, regardless of when or if the customer “realizes” that a recommendation was unsuitable.)

When the court litigation period of limitation begins is more complicated. The Sarbanes Oxley provision states that it begins “after discovery of the facts constituting the violation…”

This language would seem to indicate that the claimant has to actually discover the unsuitability for the period to begin running. But the courts have not been so kind to claimants. Rather, they hold that the period begins running at the earlier of when the claimant discovered, or, in the exercise of due diligence, should have discovered, the unsuitability (or other type of “fraud”, e.g., churning). This latter concept is sometimes called “constructive notice” and refers to the moment when, if the claimant had been sufficiently diligent, he or she would have noticed or should have suspected a recommendation was unsuitable. This concept is most often applied by the courts harshly against claimants, often starting the period of limitations when the claimant received a monthly or other statement from the broker indicating that the recommended security had dropped in value.

Small (and large) broker-dealers should take steps to take advantage of whichever period of limitations is applied by the arbitrators or a court. This should be done by assuring that evidence in writing exists of events which will cause the period to begin running. Of course, industry rules require records be kept of the date of purchase. If, however, the broker makes a recommendation well before a purchase is made, it is best to document the date of the recommendation so that if a claim is later made, the broker can claim and prove the earlier start date. And for purposes of later facing a claim, brokers should inform customers of negative news (not just positive news) about past investments made, and record the fact of giving the information, in order to be able to claim and prove that the customer had evidence of a recommendation’s negative aspects, and thus its “unsuitability”, if the arbitrators believe it was unsuitable.

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Reasons for Expanding Rule 144 Business.

As discussed below, the amendments to Rules 144 and 145, on balance, significantly reduce requirements for sellers and broker-dealers in processing sales of “control” and “restricted” securities in Rule 144 transactions. As amended, the Rule 144 restrictions no longer apply to the sale of debt securities. Prior to amendment, the primary task for the broker-dealer was preparation (for the customer) of Form 144 both in transactions for affiliates and for non-affiliates. After amendment, the requirement to file Form 144 for non-affiliates has been eliminated. Also, prior to amendment, the broker-dealer had to assure that sales, even by non-affiliates, met the limitations (discussed below) on volume of securities sold and manner of sale. As amended, however, those limitations no longer apply to non-affiliate sales. The amendments should make the process of sale of control and restricted securities easier and less fraught with danger for the small broker-dealer processing the transaction.

Just the elimination of manner of sale limitations on non-affiliates, by itself, may increase the ability of a broker-dealer to generate revenues. That is, prior to amendment, sales for non-affiliates could be made only in “brokers transactions,” i.e., agency transactions. As amended, sales for non-affiliates may be made in riskless principal transactions and in transactions directly with market makers, possibly allowing increased revenues for the broker-dealer. And since the non-affiliate customers’ holding periods have been significantly reduced, it is likely that a greater number of clients will seek to use Rule 144, thus also increasing the possibility for greater revenues from increased business. Small broker-dealers with contacts with (i) unregistered companies with a significant number of security holders, or with (ii) control persons of registered companies may want to consider offering Rule 144 services to those companies and security holders, or possibly even making a market in their securities, while of course maintaining a legal compliance program.

A Bit of Background

Federal and state securities laws make it illegal to sell securities in transactions which are not registered with the Securities and Exchange Commission (“SEC”), unless an exemption for the sale can be found. Any “seller”, including a broker-dealer acting for the owner of the securities, is liable to any suing purchaser to repay the purchase price to the purchaser, if the seller cannot prove an exemption is applicable. Such unregistered securities are generally called “restricted.” Other terms sometimes used are “legended” and “lettered.”

Although technically not labeled “restricted”, but similarly not freely tradeable and needing an exemption from registration are securities of publicly held companies, even though they have been registered, which are or have been owned by an “affiliate,” i.e., a control person, of the issuing company, usually an officer or director. They are also sometimes called “control” securities. To qualify as a non-affiliate, a person may not have been an affiliate during the prior three months.

The SEC adopted Rule 144 to allow purchases and sales through broker-dealers of such securities under specified and restricted conditions. Over the years since its adoption, broker-dealers have developed processes to implement Rule 144. The February 15, 2008 amendments will require broker-dealers to change those processes, but as changed, the broker-dealers’ efforts are simplified and reduced.

Rule 144 allowed holders of restricted and control securities to sell them only after holding them for certain periods of time (holding periods), only in restricted amounts (volume limitations), only in certain types of transactions (manner of sale limitations), only if certain information about the issuer was available to the public (publicly available information), and only if a Form 144 was filed with the SEC. These limitations continue after the recent amendments, but are altered and generally reduced in severity by the amendments. The amendments therefore will make it easier for clients and probably will bring about more requests for small broker-dealers to process Rule 144 transactions. In preparation therefore, small broker-dealers should be aware of the effects on them of such amendments and of changes they should consider in their operations.

For the below discussion, a “reporting company,” is one which is required to file and has filed all required periodic reports (excluding Forms 8-K) during the 12 month period preceding the sale of the restricted securities.

The below discussion will cover the Rules’ amendments, with at least a brief mention of the pre-amendment requirements for comparison purposes. This discussion will cover only federal requirements for exemptions for resales of control and restricted securities. The laws of Missouri and other states must also be complied with and should be checked.

The Amended Rule 144 Requirements.

Form 144. The amended Rule requires the filing of Form 144 in some cases, but significantly less frequently than before amendment. The Form 144 is signed and (in a legal sense) filed by the selling holder of the securities, but the assisting broker-dealer usually prepares the Form 144 and explains it and Rule 144 to the seller. That broker-dealer will now need to prepare and assist in filing the Form 144 less frequently because the threshold size of the sale, below which the Form need not be filed, has been increased. As amended, the Form 144 need be filed only for sales in excess of 5,000 shares or $50,000.00. Prior to the amendment, these thresholds were 500 shares or $10,000.00. Also, the requirement for filing Form 144 at all has been eliminated for sales by non-affiliates.

Volume Limitations. Rule 144 continues to set limits upon the amount of securities which may be sold by affiliates under Rule 144 in any three month period, but the amendment eliminates the volume limitations on non-affiliates. As thus applied to affiliates, both before and after amendment, volume limits never expire.

The volume limits restrict sale by affiliates within a three month period to the greatest of (i) one percent of the outstanding shares of the relevant class of the issuer, or (ii) the average weekly trading volume in such securities during the four calendar weeks preceding the filing of Form 144 or, if no such filing is required, the date of execution of the transaction, or (iii) the average weekly trading volume in such securities reported pursuant to an “effective transaction reporting plan”.

The February amendment provides also, however, that if the securities sold are debt securities, the limitation is the greater of the above-stated limits or, together with all sales by the seller of such class of debt securities within the preceding three months, ten percent of the principal amount of such class outstanding or tranche of such securities for the issuer.

Manner of Sale Requirements. Prior to the February amendments, Rule 144 transactions could be made only in “brokers’ transactions,” i.e., transactions in which the broker could only execute the order as agent for the seller, receiving no more than the usual and customary agency commission, and could neither solicit nor arrange for the solicitation of customers’ orders. The amendments reduce this restriction significantly. First, there are now no such restrictions on the sale of debt securities. Second, the Rule now adds to permitted methods of sale of non-debt securities (i) “riskless principal transactions”, where the offsetting trades are executed at the same price (exclusive of an explicitly disclosed fee) and the transaction is permitted to be reported as riskless under the rules of a self-regulatory organization, and (ii) transactions directly with a market maker of the securities.

Current Public Information Requirement. In sales by affiliates, “current public information” must be available concerning the issuer of the securities to be sold. Availability of “current public information” for a reporting issuer requires that such issuer have filed all required 1934 Act reports, except Forms 8-K, during the twelve months preceding the proposed sale. For the sale of securities of non-reporting issuers, there must be publicly available (usually meaning having been promulgated by the issuer to broker-dealers proposing to process transactions in the issuer’s securities) information describing the company, its business and management and its financial statements. Interestingly, this is the type of information generally found in private placement memoranda.

The nature of the current public information required was not changed in the February 2008 amendments. The current public information requirement, under the amended Rule applies always to sales by affiliates, and to sales by non-affiliates until the expiration of a one year holding period (amended from two years by the amendments).

Rule 145 – New Restrictions on Shell Company Securities.

Rule 145 concerns sales of securities obtained in “business combinations” such as mergers, stock for stock acquisitions and stock for assets acquisitions. Prior to amendment, Rule 145 imposed a “presumed underwriter” status on affiliates of both the acquired companies and the acquiring companies in such combinations. That underwriter status prevented such affiliates from selling their securities (“control securities”), even when such securities were registered under the 1933 Act in a registered public offering. Rule 145 also, however, allowed such affiliates to resell such securities under the limitations and restrictions of Rule 144.

Rule 145 was amended simultaneously with Rule 144 to eliminate this “presumed underwriter” status as to affiliates of the acquired company who received 1933 Act-registered securities of the acquiring company in a business combination registered under the 1933 Act. Such affiliates of acquired companies are now able to resell their control securities immediately upon obtaining them instead of after the one year holding period as previously required. Affiliates of the acquiring company, however, and those who become its affiliates, remain subject to all the Rule 144 resale conditions, including the holding periods discussed above. (If a business combination and its resultant securities issuances were not registered under the 1933 Act, and thus are in effect exempt private placements, the various restrictions applicable to restricted securities continue to apply.)

However, if either entity in the combination was a shell company, the presumption of underwriter status, together with its resale restrictions on affiliates, continue to apply to affiliates of both the acquirer and the acquired companies. And, importantly, Rule 144 is unavailable for the sale of securities of a company which was a shell when it issued the securities or at the time of the proposed resale.

Considerations for Small Broker-Dealers.

Small broker-dealers who process Rule 144 sales should take actions based upon the above changes. Some small broker-dealers who do not presently process Rule 144 sales may, in light of the easing of restrictions on such sales, and in some cases the reduction in possible liability of sellers and their assisting broker-dealers, want to consider making such sales a part of their business.

Amending Documents as Necessary. Sales under Rule 144 are frequently complicated and require the seller and the assisting broker-dealer to prepare and execute numerous documents. Normally, the broker-dealer requires the selling security holder to execute a representation letter setting forth the facts concerning his ownership (period held, relationship to the issuing company, etc.). The broker-dealer typically also requires the seller or the issuer to provide an opinion of the attorney of either the seller or the issuer, stating that, in light of the facts set forth in the representation letter, and possibly other facts, sale under Rule 144 by the broker-dealer is legal. And broker-dealers customarily furnish the issuer’s attorney with a letter establishing they have made the sales in conformance with Rule 144. Virtually all of these forms will require amendment to accommodate the changes to Rules 144 and 145. Also, though not mentioned in most articles about Rule 144, the broker-dealers should also require assurances of the attorney that the requested transaction will comply with relevant state securities laws.

Also, broker-dealers’ compliance manuals should have sections instructing their personnel concerning the requirements for Rule 144 sales. It is also possible that some sections of Rule 10b5-1 plans of holders of control securities may have provisions concerning Rules 144 and 145 sales. The text of these sections should also be amended to accommodate the Rule 144 and 145 changes.

A Possible Trap. One trap for the unwary broker-dealer is the new prohibition on the use of Rule 144 for the sale of securities of shell companies. Amended Rule 144(i)(1)(i)(B)(ii) prohibits the use of Rule 144 for the sale of the securities of a company that was ever a shell company. And even if the issuing company itself was never a shell company, it is conceivable that it was the acquiring company in a transaction involving a shell company, thus restricting (but not prohibiting) the use of Rule 144 for sale of its securities. Obviously, the forms above-mentioned should be amended to require the selling customer to indicate whether the issuer was ever a shell company, or was a party to a combination involving a shell company. However, some customers may not even know their company was a shell company, or involved with a shell company, in the past, the broker-dealer should also require the issuing company and the attorney giving the opinion to state that the issuing company was never a shell company.

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Any sale of a security to a Missouri resident must either be registered with the U.S. Securities and Exchange Commission (“SEC”) and the Missouri Securities Commission, or have at least one specific provable exemption from each of those two requirements.

In 1953, the U.S. Supreme Court ruled that the “private offering” exemption of §4(2) of the Securities Act of 1933 (the “1933 Act”) required that the issuer prove that all “offerees” (not only purchasers) had sufficient investment sophistication and financial well-being (hereinafter “investment suitability”) to establish that they did not “need the protection of registration” under the 1933 Act. SEC v. Ralston Purina, 346 U.S. 119 (1953) But because of the illusory definition of “offerees” as including possibly every person who learned of an offering (not just those receiving an “offer” in the contract sense), the availability and thus the usefulness of the private offering exemption of Section 4(2), was thereafter seriously curtailed.

More Recent History: Viable Exemptions Federal Regulation D

In 1982, the SEC adopted Regulation D, under which, for federal exemption purposes, the federal restriction to investment-sophisticated persons and to only a small number of such persons were intended to apply only to purchasers. 17 C.F.R. §230.501, et seq. This switch of the applicability of these restrictions from “offerees” to “purchasers” caused a sea-change increase in the availability of §4(2)’s federal “private offering” exemption.

Missouri’s First Apparently Viable Exemptions

In 1956, Missouri adopted the Uniform Securities Act and replaced it in 2003 with the Revised Uniform Securities Act. Both include an exemption for a specific limited number of purchasers per year. (Mo.Rev.Stats. §409.402(b)(10)(1966)(fifteen per year) and §409.202-2(14) (2003)(25 per year), respectively.) These allowed issuers selling to Missouri residents to focus on purchasers rather than “offerees” under Missouri law as well as under federal law. This exemption is commonly called the state “limited offering” (and below sometimes called the “25 per year” exemption.

Federal and State Cooperation: The Regulation D Coordinating and Accredited Investor Exemptions

And more recently, the SEC and the North American Securities Administrators Association (“NASAA”) have developed a joint federal and state exemption for use by adopting states to grant exemptions from state registration requirements to issuers who comply with Rules 505 and 506 of Regulation D (hereinafter called the “Reg D Coordinating Exemption”). Missouri’s version is set forth in 15 CSR §30-54.210. Also, the SEC, NASAA and most states have cooperated in the adoption of an “Accredited Investor Exemption.” The Accredited Investor Exemption defines “accredited investors” as certain institutions and as persons with net worths of at least one million dollars or incomes singly of $200,000 or jointly with spouse of $300,000 in the prior two years and the present year. The Missouri Commission adopted the NASAA Accredited Investor Exemption in 2003, replacing a similar exemption it had adopted in 1989. The terms of all of Missouri’s 25 per year exemption, its Reg D Coordinating Exemption and its Accredited Investor Exemption require investment suitability of purchasers only. Also, under the terms of the Accredited Investor Exemption, there is no limit on the number of purchasers. All but the Accredited Investor Exemption prohibit use of “general solicitation” in selling efforts, discussed below.

The Method of Use of These Viable Exemptions

With the adoption of these “purchaser focused” exemptions, securities attorneys around the country developed a fairly consistent method of structuring offerings to meet these requirements. They generally advise their issuer clients to prepare a private placement memorandum, subscription agreement and suitability questionnaire (the latter of which seeks information about the financial status and investment sophistication of persons to be contacted). They then forward these documents to 30-50 (or so) persons (and more when using the Accredited Investors Exemption), together with a letter asking such persons, if they are interested, to review the private placement memorandum, and complete and return the subscription agreement and suitability questionnaire. The issuer may also have small meetings of issuer personnel with 10-12 persons contacted to discuss the investment and to give them the memorandum, subscription agreement and suitability questionnaire.

Then, only after a review of the completed suitability questionnaires, and upon determining that they established that the interested persons held the necessary net worth, income and possibly investment sophistication to be “suitable,” the issuer would accept the subscription of those persons who met the qualifications, and reject those who did not.

The Apparent Destruction of Viable Exemptions in Missouri

But a recent civil prosecution and order by the then-Missouri Securities Commissioner, Douglas Ommen, upheld on appeal by the Court of Appeals for the Western District of Missouri, appears to invalidate this method, and again requires that issuers have reasonable grounds to believe that, prior to contacting any persons, all persons contacted meet the requirements for investment sophistication, net worth and/or accreditation. (This writer was counsel for the unsuccessful respondent/appellant in this case.)

The Moses Case in a Nutshell

In his August 2004 Order, In the Matter of John Robert Moses, et al, Case No. CD-03-16, at page 21, Securities Commissioner Ommen ruled that, prior to preliminarily discussing a possible investment with six persons, the issuer must first determine that all such persons are accredited or otherwise qualified. The Commissioner considered all contacts to be “offers” and stated that “before an entrepreneur makes an offer under this [Missouri Accredited Investor] exemption, the law requires that he know the qualifications of the person . . . “ contacted, and that discussing the investment with six persons whose qualifications were not previously known constituted unregistered offers, causing the issuer to lose all of the above Missouri exemptions for those offers. (No sales had been made.)

On appeal of Commissioner Ommen’s Order, without addressing the wording of Regulation D or its purposes, or the wording or purposes of the Missouri Accredited Investor Exemption, the Reg D Coordinating Exemption or the “25 per year” exemption, the Court of Appeals simply quoted the Commissioner with approval. Moses, et al v. Carnahan, et al, 186 SW3d 889, 908 (Mo.Ct.App. W.D. 2006). And, without citing to the Moses case, the new Commissioner in a more recent Order (In the Matter of Caobo Company, et al, Case No. AP-06-32 (August 29, 2006) paragraph 12), appeared to require that in similar circumstances, the issuer, prior to solicitation, must have a prior contact or business relationship with the 157 Missouri residents who were solicited and a “reasonable basis. . . for believing that the individuals solicited met the accredited investor definition.”

The effect of the Commissioner’s and the Court’s holdings is to nullify the intended effect of all of these three most useful Missouri exemptions to avoid requiring that all “offerees” be known and believed before initial contact to be suitable as investors.

A main rationale for Commissioner Ommen’s holding was his concern that requiring “vetting” only of purchasers “would permit unlimited offers to any number of persons, so long as the promoter intends to rely on the accredited investor exemption at the time of sale.” (Order, p.20, Conclusion of Law 50). This, of course, is true. But that is how the exemption is intended to work. And arguably inappropriate persons are prevented from investing because only accredited or otherwise suitable persons are allowed to invest. But the Commissioner argued that he needs to be able to enjoin mass solicitations (“offers” in Commissioner Ommen’s view) into Missouri well before any sales are made. This writer, upon exhaustive research, has not found similar reasoning in any other case or authority.

A Deeper Analysis of Moses

The Commissioner’s opinion mixes the two concepts of “offer” and “general solicitation” to arrive at this result. Regulation D, and thus Missouri’s exemption coordinating with it, both explicitly prohibit general solicitation. (Regulation D, Rule 502(c).) And Missouri’s “25/year” limited offering exemption also prohibits general solicitation. (Mo.Rev.Stats. §409.2-202(14)(B) (2003).) Regulation D defines “general solicitation” as “including, but not limited to . . . any advertisement . . . in any . . . media.” Virtually all authorities discussing it assume general solicitation requires solicitation in mass numbers using media such as radio, newspaper, mass mailing lists, telemarketing, etc. But in his opinion in In re Moses, et al, Commissioner Ommen held that a meeting of six persons, ho were invited by one-on-one telephone and face-to-face communications, constituted “general solicitation” and an “offer” because the issuer’s president, by

. . . distributing the Note and advising interested persons to come to the [issuer’s] office to invest was in public (i.e., “general”) solicitation. Moses was not acquainted with any of those people who were in attendance. The Commissioner finds that Moses’ comments were made in a presentation format, not in the one-on-one informal manner described by Moses in his testimony . . . . While the number of participants [six] may be relevant as to whether the solicitation is public, it is not dispositive.

(Order at p. 18, Conclusion of Law 43. Emphasis added.)

This analysis, or mis-analysis, thankfully did not appear in the Court of Appeals opinion. However, such language may be used again by the Commission (e.g., see In the Matter of Caobo Co., et al, above) or by private plaintiff litigants to establish the presence of “general solicitation” in similar private circumstances.

None of these three Missouri exemptions, by their terms, requires the issuer to have any pre-existing knowledge of persons solicited for interest in investing. Of course, they do require the issuer to fully determine the status and suitability of every purchaser. But Commissioner Ommen’s opinion requires the issuer to determine the financial and investment sophistication status of every “offeree,” and by mixing the “offer” and “general solicitation” concepts, defines an “offeree” to include every person who is contacted by the issuer, directly or indirectly, concerning the sale of securities. If this interpretation is correct, it virtually precludes Missouri (and only Missouri) entrepreneurs from the single greatest advance in tended by the SEC and the Commissioners on Uniform State Laws in adopting Regulation D, the “25 per year” exemption and the Reg D Coordinating Exemption, respectively.

And the damage done by the Commissioner’s opinion in Moses does not stop with those exemptions. An even greater advance in raising entrepreneurial capital was the collaboration between the North American Securities Administrators Association (NASAA) and the SEC in creating the Accredited Investor Exemption (adopted by the vast majority of states, and finally adopted in the NASAA format by Missouri in 2003). By its language, this exemption deletes the prohibition on general solicitation if sales are made only to accredited purchasers. The reasoning of then-Commissioner Ommen is tortuous, but it appears to say: “well . . . the language of the exemption just can’t mean what it says.” And the Court of Appeals deferred to and accepted this conclusion. (186 SW3d 889,908)

The Severe Harm to Missouri Entrepreneurs

The three exemptions most available (at least, prior to Moses) to, and the most relied on by, Missouri attorneys for their entrepreneur clients in raising funds from non-institutional investors (i.e., “angels”) are the Missouri Accredited Investor exemption, the Regulation D Coordinating Exemption and the 25 per year limited offering exemption. The Accredited Investor Exemption is undoubtedly the most used. The availability of all these exemptions for sales to Missouri residents by Missouri companies, particularly in comparison to the availability of the virtually identical exemptions in the vast majority of other states, appears to be greatly reduced by Moses.

If the Commissioner and the courts in civil cases continue to accept Commissioner Ommen’s reasoning, Missouri entrepreneurs will be placed at a significant competitive disadvantage with those of the vast majority of other states.

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Every offer and sale of a “security” must be registered or the issuing company must bear the burden of proving an exemption from the registration requirement is available under the federal Securities Act of 1933, §5, 15 U.S.C. §77(e), and under the Missouri Securities Act, Mo. Rev. State. §409.3-301. Prima facie case for plaintiff: that he was sold a security in a transaction which was not registered.

II. What is a Security?

A. STATUTORY DEFINITION – §2(1) of the Securities Act of 1933 defines a “security” as: Any note, stock, treasurer stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . .investment contract, …fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege or any security, …or, in general, any interest or instrument, commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Missouri definition virtually identical. Mo. Rev. Stat. §409.1-102(28).

B. STOCK – Traditional corporate stock is always plainly within the statutory definition. Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).

C. INVESTMENT CONTRACT – An interest is an “investment contract”, and thus a security, if the following elements are present: (I) an investment, (2) a common venture, (3) a reasonable expectation of profit and (4) profits are derived primarily from the entrepreneurial or managerial efforts of others. SEC v. W.J. Howey, 328 U.S. 293, 301 (1946). The following, as examples, have been held to be “investment contracts”:

1. Leasehold rights on subdivided parts of land coupled with lessor’s promise to drill test wells on the property.
2. Sale of citrus grove interests together with a contract whereby seller would cultivate the grove, market the produce and remit the buyer’s share of profits.
3. Certain multi-level distributorships and other business opportunities offered through pyramid sales.
4. A vacation condominium offered with a rental management contract.

D. INTERESTS IN LIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES.

Are “securities”. E.g., Mo.Rev.Stats. §409.1-102(28)(E).

III. FEDERAL EXEMPTIONS

The General Scheme1933 Act, §3(b): authorized SEC to adopt rules/regulations exempting “small” offerings, i.e., not exceeding $5,000,000. The most important are the “safe harbor” exemptions under Rule 504 and 505 of Regulation D. Less important, exemption under Regulation A.

1933 Act, §4(2): exempts “transactions not involving a public offering”, i.e., “private offerings.” Regulation D, Rule 506, is a “safe harbor” version of this exemption.

Note similarity of a “small” and “private”. Regulation D attempts to rationally combine the concepts.

IV. REGULATION D:

A. REGULATION D: The Exemptions themselves

1. Rule 504 – Offerings the proceeds of which within 12 month period do not exceed $1,000,000.

• No requirements for issuer to establish the offerees’ or purchasers’ “suitability”, i.e., investment sophistication and net worth.
• No limit on number of purchasers (but the state exemptions used will generally set limits).
• No requirement for a disclosure document for this federal exemption (though the state(s) concerned may require one).

2. Rule 505 – Offering not Exceeding $5,000,000 in a 12-month period.

• Limit of 35 purchasers, excluding “accredited investors.”
• “Bad-boy” provisions: Rule 505 unavailable to issuers which are, or have principals who are, or have been, involved in certain fraud or securities law violations.
• No requirements for “suitability” (but Missouri coordinating exemption has suitability standards – see below).
• Disclosure document must be provided to purchasers prior to sale (See Rule 502, below).

3. Rule 506 – Offerings without regard to dollar amount.

• Limit of 35 non-accredited purchasers, but unlimited number of “accredited investors.”
• Suitability: Issuer must reasonably believe any non-accredited investor or his purchaser representative has such knowledge and experience that he is capable of evaluating risks of investment.
• Disclosure document required. (See Rule 502, below)

B. REGULATION D: General Provisions

1. Rule 501 – Definitions – “Accredited Investor”:

• specific institutions
• any director, executive officer, or general partner of this issuer
• natural persons, and married couples, with net worth exceeding $1,000,000
• natural persons with annual income of $200,000, and married couples with annual incomes of $300,000 for the year of sale and the two prior years
• certain trusts with assets exceeding $5,000,000.

2. Rule 502 – General Conditions

(a) Integration – i.e., combining offerings when calculating number of purchasers and dollar amount of offering.

Not integrated: offers and sales more than 6 months before beginning of or 6 months after last sale in the offering, if no “similar” offers or sales occur during those 6 month periods.

“Similar” – consider whether prior or later offers or sales are part of same plan of financing, at about same time, of similar class of security, as in the offering being examined.

(b) Disclosure Requirements

No “specified” disclosure required for Rule 504 offerings, or offerings under Rules 505 and 506 only to “accredited” investors. (But under Rules 505 and 506, must give opportunity to ask questions of and receive answers from the issuer.) And under Rules 505 and 506 must make below disclosures if offer made to any “non-accredited” investors.

(i) Disclosures required of “SEC reporting companies” (i.e., report under §13 or §15(d) – must furnish copies of recent SEC filings.

(ii) Disclosure required of non-reporting companies:

(A) In offerings up to $1,000,000: Rule 504 No specific disclosure required (but state exemption used may require certain disclosures).

(B) In all other offerings, the non-financial information (re issuer’s business, management compensation, etc.) required in part II (offering circular) of Form I-A under Regulation A, plus the following financial information:

(I) In offerings up to $2,000,000: The financial statements required in Item 310 of Re g u l a t i o n S -B (the SEC form f o r registration of small businesses)), except that only balance sheet must be audited, and need only be dated within 120 days of start of offering.

(II) In offerings up to $7,500,000: Rules 505 and 506 – The financial statements required in SEC Form SB-2, with certain exceptions.

(III) In offerings exceeding $7,500,000 (generally Rule 506) – Information as required in full registration statement, generally Form S- I, requiring 3 years of audited financials, unless not available without “unreasonable effort and expense.”

(c) Other General Conditions

No general advertising or solicitation may be used. (Seminars, newspaper articles, etc.) SEC position: preexisting relationship between issuer and each offeree must exist to establish this (causes problems). Note: the definition and application of “general solicitation” is particularly confused by the Missouri Securities Commission and Missouri case law. See In the Matter of John Robert Moses, Case No. CD-03-16; Moses v. Carnahan, 186 SW3d 889 (Mo. App. W.D. 2006). Restrictions on further resale (implemented by legends on certificates, investment letters, etc.)

3. Rule 503 – Requires filing of Form D no later than 15 days after first sale. Presently filed by US Mail. SEC presently considering electronic filing.

4. Rule 507 – Issuer subject to an order or decree for failing to file Form D is disqualified from future use of Regulation D.

5. Rule 508 – Good Faith Compliance Attempt – Except as to certain specific requirements, exemption is available despite failure to comply with a requirement, if requirement was not intended to protect specifically the complainant, the failure is insignificant to whole offering, and there has been a good faith attempt to comply with all requirements.

NOTE: In a May 23, 2007 press release, the SEC indicated it is considering proposing numerous amendments to Regulation D, which would (i) add an exemption for “qualified investors”, (ii) permit issuers to engage in limited advertising, (iii) expand the definition of “accredited investors” to include types of investments owned to the current total assets and net worth standards, and (iv) shorten the integration safe harbors from six months to 90 days.

V. SECTION 4(2) “PRIVATE OFFERINGS”

Another exemption is available if (1) offers are made only to small number of persons, (2) all offerees (not just purchasers) possess investment sophistication, (3) all offerees have “access” to all information which a registration statement would provide (which may require “insider” status), (4) no general solicitation, and (5) all purchasers have “investment intent.” The concept is that investors who can be shown to be able to “fend for themselves” in obtaining material information do not need the protections of registration. SEC vs. Ralston Purina Co., 349 US 119 (1953). “Offers” interpreted broadly. Implication is that only face-to-face negotiations are private. Securities purchased are “restricted”.

VI. COMPARISON OF REGULATION D AND SECTION 4(2)

Regulation D, Rule 506, is a “safe-harbor” version of Section 4(2) which establishes more provable criteria for the existence of the exemption.

VII. SECTION 4(6) ACCREDITED INVESTOR EXEMPTION

Section 4(6) of the 1933 Act exempts transactions involving offers or sales by an issuer of not in excess of $5,000,000 in securities provided that (I) the securities are sold only to one or more “accredited investors”, (2) there is no advertising or public solicitation in regard to the offering, and (3) the issuer files Form D with the SEC. Infrequently used.

VIII. THE INTRA-STATE EXEMPTION OF SECTION 3(a)(11) AND RULE 147

Exempts offerings of issuers where securities are offered and sold and “come to rest” within the state of incorporation and where issuer is doing most of its business, and has most of its assets. Eighty percent tests. All offerees must be residents of the state.

Rule 147 “Safe harbor”: (1) “comes to rest” means held in state for 9 months, (2) requires legends on certificates and stop transfer orders on ledgers, disclosure on certificates, and written representations of residence by purchasers.

IX. REGULATION A: “MINI-REGISTRATION”

• “Safe harbor” version of 1933 Act §3(b) “small offering” exemption. Used infrequently after adoption of Regulation D, Rules 504 and 505
• Available for sales up to $1,500,000 during 12 month period. Must file Form 1-A with SEC, including special Regulation A offering circular.
• Securities in Regulation A offerings not subject to secondary trading prohibitions (i.e., they are not “restricted”) (securities sold under other exemptions are generally restricted – i.e., may be sold only under limited circumstances).

X. MISSOURI EXEMPTIONS: STATUTORY – §§409.2-201 and 202, Missouri Uniform Securities Act

• §409.2-202(13)(A) – sales to institutions. See 15 CSR 30-54.125.
• §409.2-202(14) – “limited offering” exemption for sales to not more than 25 purchasers per twelve month period in Missouri.
• §409.2-202(15) exempts offers to existing security holders (commissions prohibited unless waived by Commissioner). See 15 CSR 30-54.160.
• §409.2-202(20) – reorganizations to which the issuer is a party.

XI. MISSOURI EXEMPTIONS: ADOPTED BY THE SECURITIES COMMISSIONER

A. REGULATION D COORDINATING EXEMPTION (UNIFORM LIMITED OFFERING EXEMPTION – “ULOE” – adopted in numerous states) 15 CSR 30-54.210 – Exempts Missouri offerings complying with federal Regulation D Rules 505 or 506 (not available to Rule 504 offerings).

• Issuer must (1) file Form D and fee with Missouri Commission no later than 15 days after first sale and (2) reasonably believe investment is “suitable” for investors.
• No prohibition on commissions.
• Separate state “suitability” requirements for non-accredited investors.
• Suitability presumed if investment is not more than 20% of investor’s net worth.
• Not available if issuer or principals involved in certain securities law or fraud violations (“bad boy”provision).
• Commissioner may waive restrictions.

A. MISSOURI ACCREDITED INVESTOR EXEMPTION – 15 CSR 30-54.215. Exempts offerings if sales are made only to persons who are, or the issuer reasonably believes are, “accredited” and are purchasing for “investment”.

• Not available if issuer or principals involved in certain securities or fraud violations (“bad boy”provisions).
• Exemption not restricted by prohibition on “general solicitation”, in that a “general announcement” of the offering may be made containing information specified in 15 CSR 30-54.215(7) and (8). Telephone solicitations may be made only to persons that issuer reasonably believes are “accredited”.
• Issuer files with Commissioner a notice of Form AI, consent to service and filing fee within 15 days of first sale in Missouri.

XII. COORDINATION OF FEDERAL AND MISSOURI EXEMPTIONS

For offerings under $1,000,000 simultaneous use of Rule 504 for federal exemption and RSMo. §§409.402(b)(9) and 409.402(b)(10) (first 25 and 15 per year exemptions) is most frequent. Could also use Rule 147 (intra-state) for federal exemption.)

For larger offerings, could use Rules 505 and/or 506 federally and the Missouri Uniform Limited Offering Exemption in Missouri.

XI . LIABILITIES FOR FAILURE TO COMPLY

Generally, under both federal and state law, the purchaser is given a “put”– back to the issuer and to all individual “sellers” of the securities — if the issuer cannot prove an exemption for its unregistered offering. This is a rescissionary remedy which would require the liable persons to return the amount of consideration paid for the securities, plus interest and attorney’s fees, less the amount of income received on the security. Persons liable under federal and Missouri law include every partner, officer, or director of the issuer and every broker-dealer, agent or other person who materially aids in the sale of the security.

Under federal and Missouri law, there is a one year period of limitations from the date of “the violation”. 15 U.S.C. §77m(13); §409.5-508(j)(1) R.S.Mo.

X. CONCLUSION/NOTES:

A. In litigation, the issuer bears the burden of proof of availability of exemption.

B. In all sales of securities (regardless whether exempt from registration requirements), full and clear positive disclosure must be made to all investors which a reasonable investor would consider useful in making the investment decision.

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In that issue, we discussed what aspects of the RR’s recommendations could be unsuitable. In the next two issues, i.e., February, 2004 and September, 2004, we discussed what constituted “control” and what constituted a “recommendation.” In this issue we will discuss briefly the defenses available to a broker-dealer to a claim of unsuitability.

The most obvious and best defense, of course, is “suitability,” i.e., a showing by the broker-dealer that the offense alleged simply did not happen, and that all aspects of the RR’s recommendations were suitable. Other defenses which the broker should consider are lack of control, the statute of limitations (i.e., that the claimant’s eligibility to file a claim has expired), ratification, estoppel, waiver, and laches.

Ratification, Waiver, Estoppel and Laches

In this issue, we will discuss the defenses of ratification, estoppel, waiver and laches. The small broker-dealer should be aware of these defenses and should prepare its compliance systems to make such defenses in future claims.

Ratification

The theory of ratification is that the claimant-customer has ratified the actions of the broker-dealer and the RR, and thus is bound to accept them. In order to make this defense the broker-dealer must show (1) that the claimant knew all the material facts concerning the existence of his claim (i.e., knew that he had a valid claim); (2) that he had the intent to approve the actions of the broker-dealer now alleged to be unsuitable; and (3) that the customer has accepted the benefits of the broker-dealer’s actions.

Waiver

The theory of the defense of waiver is that the customer has waived the unsuitability of the broker-dealer’s conduct, or has waived his right or claim. In order to make this defense, the broker-dealer must produce evidence to show that (1) the claimant had actual or constructive knowledge that he had a valid claim; and (2) that the customer had an intention to waive his right or claim.

As can be seen, this claim is virtually identical to that of ratification.

Estoppel

The defenses of ratification and waiver essentially are based on a theory that the claimant has made a choice, and having done so must live by it. The defenses of estoppel and laches are based more on the theory that the claimant by his conduct has lured the broker-dealer into taking action which would be unfair and to the detriment of the broker-dealer if the claim was granted.

To make the defense of estoppel, the broker-dealer must show that (1) the claimant knew all the material facts giving rise to his claim; (2) that the claimant intended, or took actions leading the broker-dealer to believe he intended, that the broker-dealer act to his detriment based upon the customer’s inaction; (3) that the broker-dealer in fact did act to his detriment; (4) in reliance on claimants’ action or inaction.

Laches

The theory of the defense of laches is that the claimant has unreasonably delayed in asserting in his claim, to the prejudice of  he broker-dealer. Making the defense of laches requires that the broker-dealer show (1) knowledge by the claimant-customer that he has a claim against the broker-dealer; (2) unreasonable delay by the claimant in bringing his claim; and (3) prejudice or injury to the broker-dealer caused by such delay.

Analysis
The claims of ratification and waiver are virtually identical to one another, and the defenses of estoppel and laches are very similar to one another. All four of these defenses require a difficult showing that the claimant knew, or should have known, that he had a claim. Because it is virtually impossible to show actual knowledge, the hotly contested issue on which the parties produce evidence, and which the arbitrators must decide, is whether the claimant had sufficient information, and sufficient sophistication, to know that the actions of the broker-dealer or his RR were so unsuitable as to give the claimant a right to recover.

Some courts and arbitrators have ruled that once the customer has received account statements and confirmations, etc., even though he does not understand from them the unsuitability of the RR’s recommendations, the customer has a duty to be sufficiently suspicious to either know, or seek expert assistance about, whether the broker-dealer’s and RR’s actions were improper. Other courts and arbitration panels have ruled that account statements and confirmations, although they inform the customer that transactions have taken place, do not inform the customer that such recommendations and transactions were unsuitable, and therefore the customer does not have sufficient knowledge of his claim to have ratified or waived or for estoppel or laches to apply, simply because he received account documents.

Last, three of these defenses require a showing of intent on the part of the claimant. That is, for ratification or waiver, an intent to waive the unsuitability of the broker-dealers’ actions, and in estoppel, an intent to lure the broker into taking some action to the broker’s injury. Obviously, proving such an intent would be very difficult for the broker. And, to make a defense of estoppel and laches, the broker-dealer must show that he has been lured into prejudicial action or inaction by the claimants’ action or inaction. This is also a very difficult showing for a broker to make.

Also, these are “affirmative” defenses. That is, the burden  of proof of showing that the defense exists is on the broker and the RR. Theoretically at least, the burden is not placed upon the claimant of showing that these defenses do not exist.

These Defenses are Rarely Successful in Themselves
Courts, and probably arbitration panels, are generally reluctant to apply these defenses, particularly when the claimant is an unsophisticated investor. This is perhaps not surprising when it is remembered that in order for these defenses to even come into the play, the arbitrators must have decided that the actions of the broker and his RR were unsuitable.

Therefore, in establishing its supervisory and record keeping systems, the broker-dealer should realize that the actual best “defense”, in the event of a claim being made for unsuitability, is to be able to defeat the claimants’ allegations of unsuitability and lack of supervision in the first place. This will be discussed in a later issue of The St. Louis Broker-Dealer.

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Although the provisions for customer-member disputes were almost totally rewritten in the new rules, there are surprisingly few substantive changes in them. I have, somewhat arbitrarily, broken the more important substantive changes into categories.

Control of the Process. Two of the more important new rules give more control of the arbitration process to the attorneys and parties, and one takes some away, giving it to the Director of Arbitration and the arbitrators.

New Rule 12207 allows the parties by agreement to extend or modify important deadlines, including the deadlines for serving answers, responding to arbitrator selection requirements and motions by opposing parties, and exchanging documents and witness lists in the course of discovery. Under the prior rule, only the Director of Arbitration and/or the arbitrator panel had the authority to extend such deadlines. And new Rule 12601 allows the parties by agreement to require that the hearing be postponed. (If such postponement occurs just prior to the hearing, the parties may be required to pay a significant postponement fee.)

This writer believes that these amendments will benefit claimants (customers) and respondents (broker-dealers and registered representatives) equally, and the process generally, because the parties and their counsel know better what their needs are than do the arbitrators and the Director.

To paraphrase a famous quote, “the SEC and the NASD giveth and the  SEC and NASD taketh away.” New Rule 12512 reduces the control given the parties and their counsel, allowing only arbitrators to issue subpoenas for the production of documents and the appearance of witnesses. Prior to this rule, attorneys for the parties also had the power to issue subpoenas. Undoubtedly this rule change resulted from perceived abuses by attorneys for both sides, though probably most of such abuse was by claimants’ counsel. (An example of such abuse would be subpoenaing executives from the broker-dealer, requiring their attendance, when there is no clear need for their testimony.)

This writer believes that this rule change will hurt customers more than brokers, because claimants have a more frequent need to subpoena otherwise unwilling witnesses. This new rule will also significantly hinder the processing of the cases of both counsel validly needing a subpoena.  More often than not, counsel (for both parties) know which persons to subpoena only relatively shortly prior to the hearing. Under the new rule, subpoenas must be issued sufficiently prior to the hearing

(i) for the subpoena to be forwarded to the NASD and other parties; (ii) for the NASD to process it; and forward it to the arbitrators; (iii) for the arbitrators to set a time to meet about whether to issue the subpoena, and then (iv) to actually meet and decide it and to inform the NASD of heir decision; and (v) for the NASD to then notify the parties of the decision. This could require as much as, say, three or four weeks time, causing a serious hindrance to the party validly seeking the subpoena.

Quality and Effectiveness of the Arbitration Process. A number of the recent amendments are intended to raise the quality and effectiveness of the arbitration system. But they will simultaneously increase the complication and cost of that process.

Perhaps the major such change concerns selection and qualification of the chairpersons of arbitration panels. The chairperson has enormous impact on the hearing. New rule 12400(c) now requires that all chairpersons be attorneys who have served as arbitrators in at least two hearings leading to awards or, if not attorneys, have served as arbitrators through awards in at least three arbitrations.

Theoretically, this new rule allows non-attorneys to become chairpersons after they complete three arbitrations as non-chairpersons. However, because attorneys undoubtedly constitute the most frequent occupation of non-chairperson arbitrators presently, and because to qualify as chair, attorneys need only two, rather than three, completed arbitration hearings, it is clearly most likely that within a short period of time all but a minor proportion of chair-qualified arbitrators will be attorneys.

Not surprisingly, perhaps because I am an attorney, I believe that this amendment will increase the quality of the hearing process, as concerns rulings on the admission of evidence, the order of the hearings, and other process issues. It may also, however, cause technicalities of the court-trial process (e.g., the rules of evidence) to creep back into the arbitration process, notwithstanding it was originally intended that arbitration preclude such technical rules. Clearly this amendment also increases the need for each side to be represented by counsel, and will probably benefit broker-dealers and RRs more than claimants, at least to the extent that it is more frequent for claimants to be unrepresented than brokers and RRs.

Another improvement in the arbitration process is intended, and is likely, from new Rule 12214(c) This new rule provides payment of $200.00 to arbitrators for deciding discovery-related motions without hearing sessions. Prior thereto there was no such payment, which for some arbitrators was likely a significant disincentive to spending sufficient effort on such motions. (Indeed, even the $200.00 honorarium is much less than the average hourly pay for most attorneys, who typically are the deciders of such motions). Again, of course, this will at least slightly increase the cost of the process.

It is arguable that claimants are the more frequent violators of the discovery process, refusing to produce documents, and filing claims which lack sufficient detail, requiring broker-dealer and RR respondents to file more discovery motions. If that is true, it is the brokerage community which will benefit most from this new rule.

Stronger Enforcement of Discovery. And in two other new rules, the NASD seeks to put more “teeth” into the discovery process in arbitration. Prior to these new rules, in its “Discovery Guide” set forth in Notice to Members 99-90, the NASD set forth specific documents, specific types of documents and specific types of information which were expected to be produced to the opposing parties by customers, broker-dealers and RRs, as they prepared their cases for hearing. However, NTM 99-90, was a guide only, and was frequently ignored.

In its new rules 12505-12511, the NASD makes mandatory the discovery procedures set forth in the Discovery Guide. And Rule 12509, specifies that parties may make motions to require other parties to produce documents or information if the non-moving party has failed to comply with the requirements therefor. Further, new Rule 12511 provides serious sanctions when parties fail to respond or frivolously object to producing required documents or information.

It is difficult to speculate whether these changes in discovery rules will benefit customers or broker-dealers more. It can be argued that, because typically broker-dealers have more documents and information, and customers need more documents and information, these tougher requirements of discovery will impact broker-dealers more negatively.

Sanctions for Failure to Comply. New Rule 12212 provides that arbitrators may sanction a party for failure to comply with any provision of the arbitration code or with any order of the Panel. The sanctions allowed are serious: monetary penalties, precluding a party from presenting evidence (probably causing that party to lose), making an adverse inference against the violator, and assessing postponement, forum or attorneys fees against the violator.

The sanctions provided can be very damaging to a violator. It is doubtful to this writer, however, that they will be fully utilized by arbitrators, except for particularly egregious, repetitive violations. It will also be interesting to see whether they will be applied to parties who are not represented by attorneys.

Although it is pure speculation, this writer believes this new rule will, on balance, benefit broker-dealers more than customers.

Authority of Arbitrators to Dismiss Without Hearings. Another new rule clarifies and strengthens the authority of the arbitrators to dismiss a claim or a defense prior to, and without, a hearing on the evidence. New Rule 12700 makes it clear that the arbitrators have the authority to dismiss cases and defenses for egregious refusals to comply with discovery requirements or other orders of the Panel, or for failure of a claimant to file his claim within the six year period of eligibility (which acts as a “statute of limitations”).

This writer believes this rule will benefit broker-dealers significantly more than complaining customers.

Interestingly, the new rules do not address whether the arbitrators may dismiss a customer claim if it fails to state facts sufficient to give the customer a right to some relief (“failure to state a cause of action,” in legalese.). This non-addressing the right will undoubtedly cause claimants to argue that arbitrators may not dismiss such complaints.

CONCLUSION

The new customer dispute arbitration rules will generally improve the logic and organization of the arbitration process, while increasing its cost. This will also benefit those parties whose cases are thoroughly prepared. Because the defenses by broker-dealers are usually more thoroughly prepared-if only because their attorneys are paid by the hour, and customers’ attorneys are more often paid only contingent fees – it is likely the new rules will be of greater benefit to broker-dealers.

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So, you might ask, do these not simply assure that B-Ds and their RR know how to carry out their business and report their financial well-being, thereby protecting the investing public? What is the problem?

But what about those persons assisting, or who desire to assist, new and entrepreneurial companies seeking to raise start-up and seed stage capital from angel investors. If they are to be paid for this assistance, they are “engaged in the business of effecting transactions in securities…”, so they fit the definition of a B-D. Should they be subject to the testing and regulation required of full-service RR and brokers noted above, notwithstanding their subject matter are largely irrelevant to the actual activities of such persons.

The Problem

The ability of such entrepreneurs to raise capital to grow their businesses is crucial to the U.S. economy. Typically successful entrepreneurial companies outgrow their ability to finance their own expansion but are not yet large and mature enough to attract financing from venture capitalists or other institutions. This occurs typically when they need to raise between $250,000 and $5,000,000. In this range, historically funding has best been provided by “angels”, i.e., wealthy, investment-sophisticated individual investors. But “angels” typically do not advertise their status as such, and thus are difficult to find. Expertise is needed to find and educate angels about the value of the entrepreneur’s business. Such expertise is typically provided by unregistered intermediaries whose role is similar to that of investment banking departments of large brokerage firms putting together registered public offerings – similar, but requiring very different skills and market knowledge from that of those departments.

(Similarly, there are [unregistered] persons whose business is the introduction and assistance in consummation of merger and acquisition (“M&A”) transactions. That is, they help business owners seeking to sell their businesses and persons seeking to buy businesses to find and acquire them. When such a transaction involves the buyer acquiring the stock of the purchased company (as opposed to its assets), the intermediaries also fit the definition of “B-Ds”).

These private offering and M&S intermediaries have recently come to be known as private placement  broker-dealers ( hereafter called “PPBDs”).

The market segments in which PPBDs operate — (i) of transactions between $250,000 and $5,000,000, (ii) with securities of entrepreneurial firms in the “pre-earnings” stage in (iii) the seemingly high legal risk area of “private offerings” – are seldom of interest to full service B-Ds registered under present regulations with the NASD and state securities commissions. And the skills, knowledge and contacts held by those PPBDs (1) are seldom possessed by such registered B-Ds, and (2) are not those required to pass the present NASD testing regime for RR and B-D principals.

And, other requirements for registration and status as a B-D under present law – e.g., net capital requirements – are not meaningful when applied to, and cannot be met by, private offering and M&A intermediaries.

The Position of the Regulators

The SEC has rarely, if ever, brought enforcement actions against PPBDs based solely on their being unregistered. However, in response to requests for “no-action letters” (i.e., interpretive letters) the SEC has held that most activities conducted by such intermediaries constitute B-D activities requiring registration as such. State securities commissions have taken essentially the same position. Further, in enforcement actions brought primarily in response to evidence of fraud, such enforcing regulators typically include charges and findings of unregistered B-D activity and seek enforcement sanctions (such as injunctions) against such activity, as well as against the fraudulent activity which was the cause for the regulators’ enforcement action, in the first place.

Efforts to Resolve the Problem

The organized bar, through the American Bar Association, and the Alliance of Merger and Acquisition Advisors, an organization comprised primarily of M&A intermediaries, have thus far led efforts to resolve the problem.

Lawyers representing small businesses and entrepreneurs and M&A consultants over the years saw these issues, particularly as entrepreneurism flourished in the late 1990s. Recently the Business Law Committee of the American Bar Association established its Task Force on Private Place Broker-Dealers in response to “a widely held perception by many members of the Committee . . . that there exists a major disconnect between the various laws and regulations applicable to securities brokerage activities, and the methods and practices actually in daily use by which the vast majority of capital is raised to fund early stage businesses in the United States.” The objectives of the Task Force were (i) to survey the issues, (ii) to propose a regime of regulation more applicable to the actual activities of legitimate intermediaries and the needs of their customers.

The ABA Task Force, in its Report and Recommendations of October 12, 2006, recommended that a simplified system of registration of PPBDs be created by the SEC, the NASD and state securities administrators. The Task Force also presented a working draft of regulations to implement that system. These suggested regulations would allow PPBDs to introduce buyers and sellers in connection with sales of businesses effected as sales of securities, to structure transactions and negotiate between buyers and sellers of securities; to introduce buyers and sellers in securities transactions exempt under the 1933 Act if the buyers are accredited or otherwise qualified, and to provide advice on the use of and introduction to fully registered B-Ds. Also, the requirements for NASD membership, record keeping, reporting, net capital, testing and continuing education would be modified to be appropriate to the actual activities of PPBDs.

The proposed system would also significantly limit the activities of PPBDs; under it, PPBDs could not:

• participate in SEC – registered public offerings;
• make offerings to persons other than accredited and otherwise qualified investors, and could make them only on a best efforts basis;
• handle or take possession of funds or securities;
• engage in secondary market or trading activity.

The Regulators’ Unenthusiastic Response to Such Efforts

The Securities and Exchange Commission (“SEC”). In an exposure draft of its “recommendations” in response to an early report on these issues, the SEC Advisory Committee’s Forum on Small Business Capital Formation on February 28, 2006 “supported the concept” of development of a more appropriate system of regulation of PPBDs. And in November, 2005, the staff of the SEC Division of Market Regulation, in discussions with the PPBD Task Force, indicated they plan to issue a new interpretative release, potentially modifying some of the SEC’s restrictive positions. Perhaps more importantly, the SEC staff was also receptive to streamlining the application process and regulatory requirements for PPBDs, including a possible exemption from the net capital rule. The staff’s chief counsel suggested the ABA Task Force prepare new rules and/or amendments. As noted above, it did so last October. The SEC has not yet responded to the October 12, 2006 ABA report and recommendations.

The NASD. The NASD staff, on the other hand, was blunt in its disinterest. In a meeting with the Chairperson of the ABA Task Force, the NASD staff noted (1) its concern that (1) PPBDs are smaller than most present NASD members, and their membership fees would probably be insufficient to support their own regulation, requiring subsidization by larger members; (2) creating a regime accommodating what the NASD staff members called a “special class” of B-Ds might cause other “niche businesses” to ask for similar treatment, and (3) adopting a simple notice filing requirement for PPBDs might, if a “notice filer” PPBD got into trouble, cause the press and the SEC to be critical of the NASD for not “knowing what is going on”

State Regulators. A Draft Report of the ABA Task Force was “well received” when presented in July, 2005 by its chairperson to a training seminar of the North American Securities Administrators’ Association, the major organization of state securities regulators. But no action was taken then or since by NASAA, although the New Jersey Securities Commission is working on a draft of PPBD rules for that state.

Conclusion

The reaction of the NASD, indefinite as it is thus far, appears negative. The state regulators as a group have indicated no reaction. The SEC has appeared positive but has taken no discernible action to amend the present regulatory scheme, which is untenable. In the opinion of the undersigned, some action by Congress, either by legislation, or at least by hearings followed by directions to the SEC to take action, will be required if the problem is to be treated within a reasonable time.

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