There are a number of issues to bear in mind when you receive a Request for Information from FINRA and prepare your response – should you choose to respond. To begin with, FINRA has very limited jurisdiction over OTCBB companies, most of which is ministerial in nature. The OTCBB is not regulated by FINRA and FINRA does not impose listing standards on any exchanges. In sum, FINRA has no formal relationship with, or direct jurisdiction over, issuers. As such, unless the Request for Information relates to an action that falls within FINRA’s limited jurisdiction as described below, any response to the information request is voluntary. Also, it should be noted that absent a court or arbitration proceeding, FINRA has no subpoena power over issuers, the way the SEC does. Issuers may refuse to respond completely to Requests for Information; however where cooperation is not unduly burdensome and does not involve disclosing confidential information it may be the better course in most circumstances.

In responding to Requests for Information, issuers should consider the following:

• Must the issuer respond to the Request for Information? As a general premise, no, since FINRA has limited jurisdiction over issuers. (FINRA’s primary jurisdiction is over market-makers/broker dealers.) An issuer can initiate a response by calling FINRA to discuss the Request and decide after that what items it is willing to respond to and which items are appropriate to answer.
• Is the disclosure of the requested information prohibited by law, or issuer policy – such as information about employees or vendors? Issuers cannot simply turn over confidential information about employees. Often employee information is protected by law, or by the issuer’s own employment or privacy policies.
• Is the requested information subject to a confidentiality agreement, whether or not the subject of a confidential treatment order from the SEC? Issuers have to be mindful of contractual relationships with their business partners. Not all information about contractual relationships is publicly disclosed. Unless disclosed in a press release or SEC-filed report, issuers should consider whether such information is subject to contractual confidentiality provisions that restrict disclosure. Information certainly should not be disclosed if it is the subject of an SEC order of confidentiality. Issuers should analyze carefully their confidentiality obligations.
• Is information about shareholders otherwise public? Issuers often do not have information regarding shareholder trading, current holdings or acquisitions of stock in the open market. Outside of issuer reporting requirements (e.g. beneficial ownership tables), or shareholder reporting requirements (e.g., Section 13 filings), issuers often do not have, and should not obtain for disclosure to FINRA, private information about shareholders.
• What can FINRA do with the information it gathers? Although FINRA may be reviewing particular trading events, FINRA does have authority to refer information it gathers to the SEC for further review. In addition, unless expressly agreed to, FINRA is not expressly bound to any confidentiality agreements and as such, any confidential information shared with FINRA may not be entirely secure from further disclosure.

The areas where FINRA has limited jurisdiction over issuers include the following:

• Form 211

When an issuer first applies to be quoted on the OTCBB, it must complete and file a Form 211 with FINRA. The burden of filing this form actually falls on the market maker who is sponsoring the issuer for quotation on the OTCBB. The purpose of the form is to ensure the market maker has performed the necessary due diligence before making a market in the issuer’s stock.

• Delisting

Under FINRA Rule 6530(e), an issuer who has been delinquent in its reporting obligations three times in a twenty-four month period will be removed from the OTCBB by FINRA. Such issuer shall not be eligible for quotation until the issuer has timely filed in a complete form all required annual and quarterly reports due in a one-year period.

• Company-Related Actions

FINRA has ministerial jurisdiction to effect the following Company-Related Actions:

• Dividends or other distributions in cash or kind;
• Stock splits or reverse stock splits;
• Rights or other subscription offerings;
• Issuance or change to a trading symbol or company name;
• Mergers, acquisitions, dissolutions or other company control transactions; and
• Bankruptcy or liquidation.

FINRA has proposed a new rule with the SEC that would give it more than just ministerial jurisdiction over Company-Related Actions. This proposal was published in the Federal Register on December 28, 2009 and will likely become effective 90 days thereafter. The new Rule 6490 would codify the authority of FINRA to conduct in-depth reviews of Company-Related Actions and allow the staff discretion not to process such actions that are incomplete or when certain indicators of potential fraud exists.

Jennifer A. Post, Esq.
Deanna Whitestone, Esq.

Ms. Post has twenty years of experience representing issuers and investors in corporate, securities and finance matters. She is counsel to numerous public companies and acts as outside general counsel for them in all their corporate, transactional and SEC matters.

Ms. Whitestone is an associate at the firm and is the leader of the firm’s broker-dealer regulation practice. She also specializes in representing issuers in connection with alternative public offerings, SEC compliance and pipe financings.

The problem with using finders, however, is that many are engaging in broker-dealer activity in violation of the registration requirements of the Securities Exchange Act of 1934 (“Exchange Act”) as well as California’s Corporate Securities Law of 1968 (“California Securities Law”). Often the finders themselves are unaware of the parameters of the “finders exemption” under federal law.

Broker-Dealer Registration

Section 15(a)(1) of the Exchange Act requires a “broker” to be registered with the SEC or, if a natural person, to be associated with a registered broker-dealer. “Broker” is defined broadly as any person engaged in the business of effecting transactions in securities for the account of others.

According to the Securities and Exchange Commission (“SEC”), a person may “effect transactions” in securities by, among other ways, assisting an issuer to structure prospective securities transactions, by helping an issuer to identify potential purchasers of securities, or by soliciting securities transactions. A person may be “engaged in the business” of effecting transactions by, among other ways, receiving transaction-related compensation or by holding itself out as a broker-dealer.

California Securities Law substantially mirrors the Exchange Act broker-dealer provisions. California Corporations Code Section 25004 defines a broker-dealer as any person engaged in the business of effecting transactions in securities in California. Under Section 25210, any person acting as a broker-dealer must be licensed by the Department of Corporations unless they are otherwise exempt.

Finders’ Exemption to Broker-Dealer Registration

The SEC has recognized a “Finders’ Exemption” to broker-dealer registration for a person who merely introduces a potential purchaser to an issuer and accepts a “finder’s fee” when a sale of securities results. However, this exemption has been narrowly applied, and it is the position of the SEC (and most state securities law administrators) that a person who accepts a finder’s fee more than once is probably “engaged in the business” of selling securities for compensation and is therefore required to register. Moreover, guidance from both the SEC and the Financial Industry Regulatory Authority (“FINRA”) suggests that very little finder activity would qualify for the Finders’ Exemption to registration, no matter how infrequently it occurs, and regardless of whether compensation is transaction-based.

In its December 2005 Guide to Broker-Dealer Registration (“SEC Guide”), the SEC stated:

Each of the following individuals and businesses may need to register as a broker, depending on a number of factors:

• Finders, business brokers,” and other individuals or entities that engage in the following activities:
  • Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investments companies or other securities intermediaries;
  • Finding investors for issuers, even in a consultant capacity;
  • Engaging in, or finding investors for, venture capital or angel financings, including private placements; and
  • Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved).

The SEC Guide further states that placement agents selling securities exempt from registration under Regulation D are not exempt from broker-dealer registration.

In Notice-to-Members 05-18, FINRA cautioned its members against paying referral fees to real estate agents in connection with the sale of tenancy-in-common interests. Citing several SEC No-Action Letters, the Notice listed the following, as the types of activities the SEC has found require broker-dealer registration:

• Receiving transaction-based compensation;
• Participating in presentations or negotiations;
• Making securities recommendations or discussing or presenting the attributes of a securities investment;
• Structuring securities transactions; and
• Recommending lawyers, underwriters, or broker-dealers for the distribution or marketing of securities in the secondary market.

Not surprisingly, receiving transaction-based compensation tops the list of activities that requires broker-dealer registration. In a 1999 No-Action Letter, the SEC stated that receiving transaction-based compensation is “one of the hallmarks of being a broker-dealer.”

Given the stance taken toward finders in the SEC Guide and SEC No-Action Letters, it appears that any Finders’ Exemption to broker-dealer registration that may still be available would be extremely limited in scope.

Consequences of Using an Unregistered Broker

The consequences to an issuer of using an unregistered broker to assist in funding a private placement can be severe. When an unregistered broker is involved, the issuer can face regulatory action by the SEC and state authorities, and may face private actions by investors for damages. In addition the transaction may be subject to rescission under both federal and California law. Further, using an unregistered broker can compromise reliance on the Regulation D private placement exemption, risking unwinding the entire transaction and jeopardizing future private placement transactions, since a common sanction by the SEC in these circumstances is to bar the issuer from conducting Regulation D offerings in the future. The contingency created through the rescission right may also cause accounting complications and require that a risk factor concerning rescission be included in offering documents and certain public filings. Finally, the issuer may have difficulties in obtaining a legal opinion to close a transaction if investors demand one.

The consequences to the unregistered broker can be equally severe. If the person acting as a finder is in fact deemed to be acting as an unregistered broker, the agreement with the issuer will be wholly unenforceable in court (leaving little or no resource to be compensated), and the finder will be susceptible to both civil and criminal penalties under both federal and state laws.

Recommendations

Proceed with caution. While the use of finders in California is prevalent, the exemption is very narrow and the risks of utilizing an unregistered broker are not mitigated by the fact that the practice is widespread. Obviously, the least risky move is to use only registered brokers in any financing deal involving securities. An issuer can easily determine the registered status of an individual or entity by consulting the list of registered broker-dealers maintained by FINRA on its website.

If an issuer does decide to use a finder, there are steps it can take to minimize risk, including:

• Researching the finder’s history of involvement in securities transactions;
• Excluding the finder from negotiating or making recommendations regarding the transaction;
• Carefully delineating the scope of the finder’s engagement in an agreement with the finder that would prohibit activities that only a registered broker can undertake;

Limiting the finder’s compensation to a flat or hourly fee that is not contingent on the success of the transaction.

Jennifer A. Post, Esq.
Deanna Whitestone, Esq.

Ms. Post has twenty years of experience representing issuers and investors in corporate, securities and finance matters. She is counsel to numerous public companies and acts as outside general counsel for them in all their corporate, transactional and SEC matters.

Ms. Whitestone is an associate at the firm and is the leader of the firm’s broker-dealer regulation practice. She also specializes in representing issuers in connection with alternative public offerings, SEC compliance and pipe financings.

Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise. If one purchases securities from a controlling person or “affiliate” of the issuer, the securities will be restricted even if they were not restricted in the affiliate’s hands.

Certain requirements need to be met in order to resell securities under Rule 144, depending on whether the holder is an affiliate or non-affiliate of the issuer of the securities, and whether the issuer of the securities is a reporting company under the Securities Exchange Act of 1934 (“Exchange Act”).

1. Holding Period. Before restricted securities can be sold in the marketplace, they must be held for a certain period of time. If the company that issued the securities is subject to the reporting requirements of the Exchange Act, then the securities must be held for at least six months. If the issuer of the securities is not subject to the reporting requirements, then the securities must be held for at least one year. The relevant holding period begins when the securities are bought and fully paid for. The holding period only applies to restricted securities. Because securities acquired in the public market are not restricted, there is no holding period for an affiliate who purchases securities of the issuer in the marketplace. But the resale of an affiliate’s shares is subject to the other conditions of the rule.
2. Adequate Current Information. There must be adequate current information about the issuer of the securities before the sale can be made. This generally means that the issuer has complied with the periodic reporting requirements of the Exchange Act.
3. Volume Restrictions. The number of equity securities an affiliate may sell during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class being sold, or if the class is listed on a stock exchange or quoted on NASDAQ, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the filing a notice of sale on Form 144. Over-the-counter stocks, including those quoted on the OTC Bulletin Board and the Pink Sheets, can only be sold using the 1% measurement.
4. Manner of Sale. The sales of affiliate-owned restricted stock must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission. Neither the seller nor the broker can solicit orders to buy the securities.
5. Filing a Notice of Proposed Sale With the SEC. Affiliates must file a notice with the SEC on Form 144 if the sale involves more than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any three-month period. The sale must take place within three months of filing the Form and, if the securities have not been sold, the affiliate must file an amended notice.

The following table provides a summary of the conditions of Rule 144.

Common Holding Period Issues under Rule 144

Some of the most frequent issues that arise under Rule 144 relate to the holding period requirement, when it commences, and whether holding periods from previous transactions can be “tacked” on to holding periods of subsequent transactions. Generally speaking, the holding period does not begin to run until the person acquiring the securities from the issuer or an affiliate of the issuer has paid the full purchase price. Tacking may occur, however, when restricted securities are purchased from non-affiliates or are gifted, and where restricted securities are exchanged solely for other restricted securities of the issuer. Some common scenarios are outlined below.

Non-affiliate restricted securities. If a non-affiliate purchases restricted securities from another non-affiliate, he can tack on that non-affiliate’s holding period to his holding period.

Gifts by affiliates to non-affiliates. A non-affiliate recipient of a gift of securities from an affiliate may tack on that affiliate’s holding period to his holding period.

Cashless exercise of options or warrants. Restricted securities received upon a cashless exercise of either an option or a warrant may tack the holding period of the derivative security to the newly acquired securities, regardless of whether the original terms of the option or warrant provided for a cashless exercise feature. Tacking is not permitted when the derivative securities are amended to allow for a cashless exercise and the holder delivered as consideration for the amendment something other than securities. Tacking is similarly not allowed when the options or warrants are not purchased for cash or property and do not create an investment risk to the holder, as is the case with employee stock options.

Conversions and exchanges. Securities surrendered solely for other securities of the same issuer may tack the holding period of the restricted securities acquired from the issuer even when the securities were not convertible or exchangeable by their original terms. Tacking is not permitted when the surrendered securities are amended to allow for cashless exchange or conversion and the holder delivered as consideration for the amendment something other than securities.

Accrued interest. In a telephone interpretation, the staff of the SEC determined that accrued interest paid with securities pursuant to a conversion can be tacked to the holding period of the surrendered securities.

Companies reorganizing into holding company structure. A holder of restricted securities is permitted to tack the holding period of the predecessor company’s securities as long as the holder received securities of the same class and rights, evidencing the same proportional interest, and immediately following the transaction, the holding company has substantially the same assets and liabilities on a consolidated basis as the predecessor company.

Services as consideration. When the consideration for the issuance of restricted securities consists of personal services, the holding period does not commence until all of the service has been rendered, unless both parties intend that the issuer be irrevocably committed to issuing restricted securities in advance of the time when the recipient’s service obligation arises, then, the holding period commences upon execution of the agreement. Where the restricted securities have been issued under the terms of a later agreement in settlement of cash amounts otherwise due for services previously rendered, the date of the later agreement would be deemed the commencement of the holding period.

Jennifer A. Post, Esq.
Deanna Whitestone, Esq.

Ms. Post has twenty years of experience representing issuers and investors in corporate, securities and finance matters. She is counsel to numerous public companies and acts as outside general counsel for them in all their corporate, transactional and SEC matters.

Ms. Whitestone is an associate at the firm and is the leader of the firm’s broker-dealer regulation practice. She also specializes in representing issuers in connection with alternative public offerings, SEC compliance and pipe financings