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FINRA Issues Regulatory Notice on Best Efforts Contingency Offerings
Practical Law Legal Update w-001-4457 (Approx. 4 pages)
FINRA Issues Regulatory Notice on Best Efforts Contingency Offerings
by Practical Law Corporate & Securities
| Published on 17 Feb 2016 • USA (National/Federal) |
The Financial Industry Regulatory Authority (FINRA) issued a regulatory notice on best efforts contingency offerings.
The Financial Industry Regulatory Authority (FINRA) recently issued a regulatory notice on best efforts contingency offerings after it identified instances in which broker-dealers did not comply with the contingency offering requirements of Rules 10b-9 and 15c2-4 under the Exchange Act. The purpose of the notice is to:
- Provide guidance on the requirements of Rules 10b-9 and 15c2-4.
- Remind broker-dealers of their responsibility to have procedures reasonably designed to achieve compliance with these rules.
Best Efforts Contingency Offerings
A contingency offering is an offering where a broker-dealer does not:
- Commit to purchase any securities from the issuer.
- Guarantee that the issuer will receive any amount of money from the offering.
FINRA's regulatory notice states that the most common contingency offerings reviewed by FINRA are either "all-or-none" or "part-or-none" offerings that require all or a certain amount of the securities to be sold for the offering to close. Rule 10b-9 under the Exchange Act requires that a best efforts offering subject to either an "all-or-none" or "part-or-none" contingency must provide for the prompt return of investor funds in the event the requisite contingency fails to be met by a specific date.
Broker-Dealer Responsibilities in a Best Efforts Contingency Offering
The regulatory notice provides that a broker-dealer that participates in an offering and recommends a security must, among other requirements, conduct a reasonable investigation of the security and the issuer's representations about it. If the security is offered as part of a contingency offering, the broker-dealer's reasonable investigation must include a review of the terms of the contingency, including any agreement and disclosure by the issuer regarding the contingency.
According to the notice, FINRA has identified several instances in which:
- A broker-dealer conducting an offering failed to identify inconsistencies between the escrow agreement and the offering document relating to the requirements of the contingency. The notice states that these inconsistencies should be red flags to a broker-dealer performing a reasonable investigation.
- Broker-dealers violated Rule 10b-9 by failing to:
- return subscriber funds after the issuer changed the contingency by reducing the offering minimum; or
- take the proper steps in response to an issuer's extension of the offering period.
The notice also states that broker-dealers must be aware of any attempt by an issuer to use non-bona fide sales in order to declare an offering sold for the purposes of an "all-or-none" or "part-or-none" offering. In general, non-bona fide sales are sales of undisclosed purchases by the issuer or broker-dealer, their affiliates or associated persons, or any entities through nominee accounts, that are designed to create the appearance of a successful completion of an offering. The use of non-bona fide sales in these types of offerings could violate the antifraud provisions of the federal securities laws.
FINRA has found instances where a broker-dealer violated Rules 10b-9 and 15c2-4 under the Exchange Act, including when:
- It participated in an offering in which the issuer declared a contingency offering sold by counting non-bona fide sales made to the issuer's employees.
- An issuer used the proceeds from a loan to purchase securities in an offering in order to meet the minimum offering amount.
Requirements for the Handling of Investor Funds
Rule 15c2-4 under the Exchange Act requires that, on receiving money or other consideration from an investor in a contingency offering, a broker dealer must promptly either:
- Deposit those funds into a separate bank account for which the broker-dealer is the account holder and is designated as agent or trustee for the persons who have beneficial interests in the funds.
- Transmit those funds to a bank that has agreed in writing to act as the escrow agent for the offering.
However, under Rule 15c3-1 under the Exchange Act, only a broker-dealer that maintains at least $250,000 in net capital may carry customer accounts and receive or hold funds or securities for those persons. Therefore, a broker-dealer that maintains less than that amount and deposits investor funds into a separate bank account, rather than transmitting them to an independent escrow agent, would violate Rule 15c3-1. In addition, when a participating broker-dealer is an affiliate of the issuer, investor funds must be transmitted to an independent bank escrow agent.
Escrow Agreements
The notice states that in contingent offerings that require an escrow agent, the escrow agreement must be executed with a bank that is unaffiliated with the broker-dealer and the issuer. The escrow account:
- Should be established before the broker-dealer receives any investor funds.
- May not be controlled by the issuer, the broker-dealer, or an attorney.
Generally, the escrow agent must be a financial institution that meets the definition of "bank" under Section 3(a)(6) of the Exchange Act, although the SEC staff has provided no-action relief to permit certain other entities to act as escrow agents.
Prompt Transmittal of Funds
As discussed above, Rule 15c2-4 requires a broker-dealer to promptly transmit funds to either an escrow agent or a separate bank account. The SEC staff has interpreted "promptly" to mean by noon of the next business day. A broker-dealer that fails to promptly transmit funds to either the escrow agent or a separate bank account may face sanctions. However, in certain offerings (such as direct participation programs that require suitability determinations by the issuer), the SEC staff has provided procedural guidance under which a broker-dealer can still comply with the "promptly" requirement even if the funds are not transmitted by noon the next business day after they are received.
A broker-dealer is also required to promptly refund investors' funds if the contingency is not met. FINRA has identified a number of instances in which investors did not receive their money back in a prompt manner, if at all, when the contingency did not occur.
Disbursal to the Issuer
Broker-dealers must segregate investor funds they receive at least until the contingency is met. The notice states that FINRA has found that some broker-dealers improperly disbursed investor funds to issuers before the contingency was satisfied.
Issuer's Direct Receipt of Investor Funds
In some contingency offerings, FINRA has observed broker-dealers instructing investors to transmit their funds directly to the issuer. Since Rule 15c2-4 governs a broker-dealer's receipt of investor funds, funds that are not received by the broker-dealer are outside the scope of the rule (unless there is an affiliation between the broker-dealer and the issuer). The notice reminds broker-dealers that even if Rule 15c2-4 does not apply, the anti-fraud and anti-manipulation provisions of the securities laws, as well as FINRA Rule 2010, apply to all of their securities transactions. Broker-dealers that participate in contingency offerings in which the issuer does not escrow or otherwise segregate investor funds may still violate the securities laws even if there is no violation of Rule 15c2-4.