Best Efforts Contingency Offerings

Best Efforts Contingency Offerings

In February 2016 the Financial Industry Regulatory Authority (FINRA) published Regulatory Notice 16-08 reminding broker-dealers of their obligations under the Securities Exchange Act of 1934 ("SEA") Rules 10b-9 and 15c2-4 to have procedures designed to achieve compliance with these rules.

Best Efforts Contingency Offerings

There are various ways an offering could be structured. For example, in a "firm commitment" underwriting agreement the underwriter has a contract to buy the securities for a specified price and quantity. Conversely, in a "Best Efforts" underwriting agreement, the underwriter acts more as a broker and agrees to sell the securities for the issuer. In essence, the underwriter uses its "best efforts" to sell as many as the securities as possible, but makes no guarantee as to the amount sold.

Typically in a firm commitment offering there is no contingency because the underwriter is buying a specified amount of securities to begin with. However, in a Best Efforts offering, parties may agree to implement a contingency in the offering; this is known as a "Contingency Offering." In a contingency offering, the parties agree that unless and until a specified event occurs, the offering will not close, i.e., there is a condition precedent implemented into the offering that must occur before the issuer receives its funds and investors receive their securities. Accordingly, where the condition has not been satisfied in a Contingency Offering the offer is deemed incomplete.

A "best efforts contingency offering" may be structured as "all-or-none," or in the alternative "part-or-none." In an all-or-none offering, all the securities must be sold in order for the offering to be sold. In a part-or-none offering, a stipulated amount must be sold in order for the offering to be sold.

Securities Exchange Act Rules 10b-9 and 15c2-4

Where a broker-dealer is involved in a contingency offering, it is prudent to be cognizant of SEA Rules 10b-9 and 15c2-4 as they pertain to such offerings.

Under Rule 10b-9 it is presumed that an offering is deemed to be a "manipulative or deceptive device or contrivance" if the issuer makes a representation in connection with the offer or sale of the security in a "all or none" contingent offering unless "all the securities are sold at a specified price within a specified time and the total amount due to the issuer is received by a specified date."[1]

In essence, in a best efforts contingency offering a broker-dealer is obligated to protect investor funds. This obligation includes promptly refunding their funds when the contingency has not been met and apprising them of major events in relation to the offering (e.g., when an offering is modified, where the contingency has not been met, or where there are non-bona fide sales).

For example, in Banc One Capital Partners Corp v. Kneipper, the Court of Appeals found that the seller of the security cannot avoid returning investor funds by "fraudulently creating [the] impression"[2] that the condition has been met. Moreover, the court held that "in 'all or none' securities offering in which no securities would issue until commitments were made for purchase of the entire issue, seller had continuing duty to inform investors of material facts concerning securities after investors made their initial commitment to purchase securities until securities were issued…"[3]

Under Rule 15c2-4 a broker-dealer participating in a contingency offering must promptly transmit "any part of the sale price"[4] of the security being distributed to the person entitled to it. Additionally, in a "best efforts" contingency offering investor funds must promptly be deposited into a separate bank account and may only be distributed when and if the contingency occurs. If the contingency does not occur, the funds must promptly be returned to the investors.

Reasonable Investigation

A broker-dealer engaged in private placements and/or public offerings recommending a security must conduct due diligence, i.e., "reasonable investigation"[5] of the security and the representations the issuer makes regarding it.[6] For example, in Hanley v. SEC,[7] the court found that broker-dealers must make recommendations based only upon reasonable investigation due to the "special relationships"[8] they share with clients. Where a broker-dealer makes recommendations without conducting the requisite reasonable investigation they expose themselves to liability under SEA Rules 10(b) and 10b-5, FINRA Rules 2010 and 2020, and Securities Act Section 17(a).[9]

Additionally, where the security is offered as part of a contingency offering the broker-dealer must also reasonably investigate the terms of the contingency and ensure it is consistent with the offering documents. [10] Thus, where a broker-dealer is involved in a best effort contingency offering and there is an escrow agreement, a broker-dealer must review that agreement in detail to ensure it is consistent with the offering documents. Broker-dealers should take any inconsistences between the offering documents and the container as "red flags"[11] and seek appropriate guidance.

Non-bona fide sales

As established above, in a best efforts contingency offering the contingency must be satisfied in order for the offering to close. In order to satisfy conditions where sales have been inadequate, issuers have attempted to use non-bona fide sales.[12] Non-bona fide sales are "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."[13]

In essence, where an underwriter has not been able to sell enough securities to reach the threshold stipulated in the agreement (i.e., to satisfy the contingency), an insider (usually the broker-dealer and/or underwriter) purchases the securities themselves (or purchases the securities through their subsidiaries/affiliates) in order to satisfy the contingency and close the offering. Although such practice may seem appealing to the issuer, underwriter, and/or broker-dealer, it is unfair and misleading to investors and therefore is against federal securities laws.[14]

For example, in SEC v. Commonwealth Chemical Securities, Inc. the court held that "(U)nder Rule 10b-9, an offering may not be considered 'sold' for the purposes of the representation 'all-or-none' unless all the securities required to be placed are sold in Bona fide transactions and are fully paid for. It is clearly contrary to the intent and purposes of [Rule 10b-9] to declare an offering all sold, for the purposes of the 'all-or-none' conditions…on the basis of non-bona fide sales designed to create the appearance of a successful completion of the offering, such as purchases by the issuer through nominee accounts."[15]

Similarly in S.E.C v. Coven, SEC Rule 10b-9 was violated when an "all-or-none" portion of a contingency offering was closed by non-bona fide sales.[16] There, a company issued a public offering of 6 million shares at a price of $.10 per share. According to the registration statement, the underwriters were to use their "best efforts" to sell the entire offering within 60 days, subject to a possible 30 day extension upon agreement. Stipulated in the escrow agreement was a contingency that the first 3 million shares were to be sold on an "all-or-none basis, and if those 3 million shares were not sold in the required time, the investor funds must be refunded in full."[17] Consequently, if there was less than $300,000 in the account at the end of the stipulated time, the offering could not close. When the time to sell the Securities ended and the parties did not reach the $300,000 threshold they personally wrote checks and deposited them in the account to represent that the 3 million shares were sold and thus the offering could be closed. Ultimately, the court found that "the failure to comply with the terms of the escrow agreement and the closing prior to the bona fide sale of 3,000,000 shares plainly operated as a fraud on the public."[18]

Prompt Distribution or Return of Investors Funds

Pursuant to the SEA, upon receiving money or other consideration from an investor in a best efforts contingency offering a broker-dealer must "promptly"[19] transmit those funds to a bank that has agreed in writing to act as the escrow agent for the offering if:

(1) The broker-dealer has less than $250,000 in net capital;[20] or

(2) The broker-dealer is an affiliate of the issuer.[21]

However, if the broker-dealer maintains more than $250,000 in net capital and is not an affiliate of the issuer, the broker-dealer could deposit the 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 the beneficial interest therein.'"[22] Additionally, broker-dealers are not authorized to allow an investor to transmit their funds directly to the issuer; the funds must be allocated as mentioned above.[23]

Moreover, where contingent offerings involve escrow agents:

(1) The escrow agent must be unaffiliated with the broker-dealer and issuer;[24]

(2) The escrow account should be established before the broker-dealer receives investor funds;[25]

(3) The escrow account cannot be controlled by the broker-dealer, issuer, or an attorney;[26] and

(4) The escrow agent should be a "bank" as defined under SEA §3(a)(6) [27]

Assuming the contingency is met and thus the offering complete, the broker-dealer, at that point but no time sooner, may disburse the investor funds to the issuer.[28] It is inappropriate for broker-dealers improperly disbursed investor funds to issuers before the contingency was satisfied.[29]

Contrarily, assuming the contingency is not met and therefore the offering incomplete, a broker-dealer must promptly refund the investors' funds.[30] FINRA noted a number of instances where broker-dealers failed to promptly return investor funds, if at all which is a direct violation of SEA Rule 10b-9.[31] Consequently, a good rule of thumb for broker-dealers is to refund the investors by noon the day after the broker-dealer learns that the condition has not been satisfied and the offering is over. Moreover, where the contingency is changed in a contingency offering, broker-dealers must return subscriber funds.[32] Similarly, where the offering period is extended in a contingency offering, a broker-dealer must have the investors affirmatively reconfirm their investments.[33]

For example in Security Research Associates, Inc. a broker-dealer violated Rule 10b-9 and FINRA Rule 2010 when it failed to return all subscriber funds when an offering's minimums were reduced.[34] Additionally, SEA 15c2-4 was violated when escrowed subscriber funds were be in a money market mutual fund.[35] Similarly in Janco Partners, Inc., FINRA found that a broker-dealer violated SEA Rules10b-9 and 15c2-4, and FINRA Rule 2010, when they failed to establish an escrow account, deposited two customer checks intended as investments in the offering into the firm's personal bank account, and failed to return investor funds even though the minimum sales contingency was not met.[36] There the firm should have held the investor funds in a bank escrow account for which they had no control over. Instead, the firm paid itself commission's form the offering proceeds even though the minimum contingency had not been met. Moreover, when the minimum in the offering was not met by the stipulated time the firm should have returned the funds previously raised to the investors but failed to do so. FINRA found "…the firm…failed to cause investor funds received by the firm in the QE offering to be promptly deposited into a separate bank account, as agent or trustee for the investors, or a separate escrow account at a bank, until the contingency had occurred, as required by Exchange Act Rule 15c2-4. Moreover, prior to the minimum offering amount being raised, the firm utilized funds intended as investments in the offering. The representation in the [private placement memorandum] that investor funds would be returned if the contingency was not met by December 31, 2010, was rendered false when the firm failed to return or cause the return of investor funds when the contingency was not met by that date."[37]

In sum, FINRA's review of securities offering documents relating to contingency offerings has revealed instances of broker-dealer noncompliance with the contingent offering requirements of Rules 10b-9 and 15c2-4 under the SEA. Thus, it would be wise for those broker-dealers engaged in private placements and public offerings subject to a contingency to review the Regulatory Notice itself, as well as SEA Rules 10(b) and 10b-5, FINRA Rules 2010 and 2020, and Securities Act Section 17(a) to ensure compliance.

Wexler & Burkhart partner Ian J. Frimet has a substantial amount of experience in compliance with securities laws. If you are a broker or broker-dealer with questions in regards to your compliance with these rules and regulations please do not hesitate to contact Ian at (516) 222-2230

Mario Claudio Lattuga is an associate attorney concentrating in the firm's securities and complex commercial litigation practice groups. . If you are a broker or broker-dealer with questions in regards to your compliance with these rules and regulations please do not hesitate to contact Mario at (516) 222-2230

[1] 17 C.F.R. § 240.10b-9.

[2] Id.

[3] 67 F.3d 1187 (5th Cir. 1995).

[4] 17 C.F.R. § 240.15c2-4.

[5] Regulatory Notice 16-08, at 2 (Feb. 2016) (citing Regulatory Notice 10-22 (Apr. 2010)).

[6] Hanly v. SEC, 415 F.2d 589, 597 (2d Cir. 1969) (citing SEC v. Great American Industries, Inc., 407 F.2d 453 (2d Cir. 1968); see also Hanson v. Berthel Fisher & Co. Fin. Servs., No. 13-CV-2014 WL 2434000, at *10 (N.D. Iowa May 29, 2014).

[7] 415 F.2d 589, 595-96 (2d Cir. 1969).

[8] Id.

[9] Id; see SEC v. Great Lake Equities Co., 1990 U.S. Dist. LEXIS 19819 at *16-17 (E.D. Mich. 1990).

[10] Regulatory Notice 16-08, at 2 (Feb. 2016) (citing Regulatory Notice 10-22 at 3 (Apr. 2010)).

[11] Cf. S.E.C. v. Martin, 1983 WL 1365, at *1 (D.D.C. Oct. 4, 1983) (finding that the defendant acted negligently in misrepresenting material facts to investors when he was aware of suspicious facts and circumstances, i.e., where red flags were present and failed to act upon them. According to the commission, these "red flags" should have caused the defendant to require additional information and/or withdraw his participation form the offering, as well as correct his previous misrepresentations.)

[12] SEC v. Coven, 581 F.2d 1020, 1028 n.16 (2d Cir. 1978), cert denied, 434 U.S. 950 (1979).

[13] SEC Rel. No. 33-11532.

[14] SEC v. Blinder, Robinson & Co., et al., 1983 U.S. App. LEXIS 16806 (10th Cir. 1983); see also A.J. White & CO. v. SEC, 556 F.2d 619 (1st Cir. 1977).

[15] 574 F.2d at 97 (2d Cir. 1978).

[16] 581 F.2d 1020 (2d Cir. 1978).

[17] Id.

[18] Id. at 1028.

[19] See J.V. Ace & Co., Inc., 50 SEC at 465 n.13 (holding "promptly" to mean by noon the next business day); see 84-7 SEC Staff Interpretations of Rule 15c2-4 (finding "[a]bsent unusual circumstances, funds should be deposited or transmitted as soon as practicable after receipt. In contingent offerings not requiring suitability determinations by the issuer or the general partner, funds should be deposited or transmitted by noon of the next business day. In contingent offerings requiring suitability determinations by the issuer or general partner (for example, most direct participation programs) where investors' checks are made payable solely to the bank escrow agent but delivered to the broker-dealer, prompt transmittal may be accomplished by forwarding the checks to the escrow agent either by noon of the next business day or by noon of the second business day after receipt of the subscription by the issuer or general partner. If the Latter option is used, the subscription must be forwarded to the issuer or general partner by noon of the next business day after receipt of the funds.") (citing SEC Interpretive Letter issued to Lowell H. Listrom & Company, Inc. (April 27, 1983)).

[20] SEA Rule 15c3-1.

[21] 15c2-4b(1)-(2).

[22] SEA Rule 15c2-(b)(1).

[23] SEA Rule 10b-5; Section 17 of the Securities Act of 1933.

[24] Regulatory Notice 16-08, at 3 (Feb. 2016) (quoting Notice to Members 87-61 at 3 (Sept. 1987) ('Rule 15c2-4 requires that when an escrow account issued for distributions conducted on a contingency basis (e.g., best-efforts all-or-none or part-or-none offerings), the escrow agent must be a commercial bank that is unaffiliated with either the issuer or the underwriter).

[25] Regulatory Notice 16-08, at 3 (Feb. 2016).

[26] Richard Manchester, FINRA AWC NO. 2009020397101 (Aug. 29, 2013) (finding Rule 15c2-4 was violated where a broker-dealer failed to deposit investor funds into an escrow account and instead deposited them into bank accounts controlled by the issuer); See G.C. Andersen Partners Capital, LLC, FINRA AWC No. 2007007256802 (Nov. 20, 2008) (finding a violation of Rule 15c2-4 where broker-dealer deposited monies into an account in which it had control); See Grant Bettingen, NASD AWC No. E022005007302 (Mar. 7, 2007); See 84-7 SEC Staff Interpretations of Rule 15c2-4 (finding the escrow agent must be a bank that is unaffiliated with either the issuer or the broker-dealer).

[27] "The term ''bank'' means (A) a banking institution organized under the laws of the United States or a Federal savings association, as defined in section 2(5) [4] of the Home Owners' Loan Act, (B) a member bank of the Federal Reserve System, (C) any other banking institution or savings association, as defined in section 2(4) [4] of the Home Owners' Loan Act, whether incorporated or not, doing business under the laws of any State or of the United States, a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks under the authority of the Comptroller of the Currency pursuant to the first section of Public Law 87-722 (12 U.S.C. 92a), and which is supervised and examined by State or Federal authority having supervision over banks or savings associations, and which is not operated for the purpose of evading the provisions of this title, and (D) a receiver, conservator, or other liquidating agent of any institution or firm included in clauses (A), (B), or (C) of this paragraph." SEA §3(a)(6).

[28] SEA Rule 10b-9(a).

[29] SEA Rule 10b-9(a); SEA Rule 15c2-4; See Richard Manchester, FINRA AWC. No. 2009020397101 (Aug. 29, 2013).

[30] SEA Rule 10b-9(a).

[31] Regulatory Notice 16-08.

[32] FINRA AWC No. 2013036360601 (Apr. 3, 2014).

[33] FINRA AWC No. 2011025505901 (Nov. 5. 2012).

[34] FINRA AWC No. 2013036360601 (Apr. 3, 2014).

[35] Id. at 2-3.

[36] FINRA AWC No. 2011025505901 (Nov. 5. 2012).

[37] Id. at 3-4.


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