Rescission Offers: Five Tips For Entrepreneursby Scott Edward Walker on November 24th, 2009
In light of the Madoff affair and other significant external pressures, the Securities and Exchange Commission (the “SEC”) and State securities law commissions and departments are dramatically stepping-up enforcement of securities laws. Indeed, there is a heightened level of regulatory scrutiny that entrepreneurs need to be aware of as they struggle to raise capital during this difficult economic period. I have discussed the most common securities law violations in a relatively recent post: “Five Common Mistakes Entrepreneurs Make in Raising Capital”; and as I pointed out in “Mistake #1”, non-compliance with applicable securities laws could result in serious adverse consequences.
Our law firm in Los Angeles was recently retained by two separate issuers that received a “Cease and Desist” order from State securities law commissions in connection with alleged securities law violations. In both cases, the matters were settled pursuant to agreements that required the issuers to effect a “rescission offer” – i.e., an offer from the issuer to each of the respective stockholders to purchase their shares for an amount equal to the original purchase price, plus interest. This is a very tricky and costly process. Accordingly, in light of my firm’s recent experience, I thought it would be helpful to provide briefly five tips to entrepreneurs who are required to effect (or are contemplating) a rescission offer to investors.
1. Most States Have Statutes Addressing Rescission Offers. Rescission offers are a creature of state law. Indeed, there are no federal statutes providing for rescission offers. Accordingly, each applicable State statute must be complied with, which presumably means (i) the State in which the offer originated, (ii) the State in which the offer was delivered or received (if different) and (iii) any State in which part of the sale transaction took place. Generally, State statutes provide that any civil actions under state securities laws brought by an investor against the issuer will be barred if, before such action is commenced, the investor has received a written offer from the issuer offering to refund the consideration paid, plus interest, and the investor has accepted (or has failed to accept) such offer within 30 days following its receipt. Investors would still nevertheless have valid claims for liability under common-law fraud or misrepresentation, if applicable, and perhaps under the antifraud provisions of the State securities laws.
2. Rescission Offers Do Not Bar Enforcement Actions, Criminal Prosecution or Federal Claims. Rescission offers do not prevent the SEC or applicable State regulators from bringing an enforcement action against the issuer; nor do they prevent criminal prosecution. Moreover, Section 14 of the Securities Act of 1933, as amended (the “Securities Act”), expressly provides that: “Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title or of the rules and regulations of the Commission shall be void.” Accordingly, an investor who rescinds his investment may still have a claim against the issuer under federal securities laws – though there is some case law which supports the proposition that investors may be estopped from asserting federal securities law claims subsequent to a valid rescission offer. Despite the foregoing, it is still generally prudent for an issuer to commence a rescission offer if it has violated certain securities laws. Indeed, my experience is that regulators and prosecutors will view such a step quite favorably.
3. The Rescission Offer Must Comply with all Applicable Securities Laws. A rescission offer is not only an offer to buy/redeem securities, it is also an offer to sell the underlying securities — and thus either must (i) be registered with the SEC and registered/qualified with applicable State commissions or (ii) be exempt from registration. This is probably the most difficult issue for entrepreneurs to understand – i.e., that the rescission offer itself must comply with applicable federal and State securities laws. Accordingly, if any of the investors are not “accredited investors” (as such term is defined in Rule 501 of Regulation D), the issuer may not rely on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996. Moreover, an issuer should only offer rescission if it has sufficient funds to pay the investors; otherwise, such an offer could be deemed fraudulent under federal and/or state law.
4. Retain an Experienced Securities Lawyer to Conduct a Legal Audit. Prior to commencing a rescission offer, the issuer should take two significant steps: (i) it should refrain from making any offers or sales of its securities; and (ii) it should retain an experienced securities lawyer to conduct an internal investigation in order to determine what securities laws have been violated and when. This will require that the issuer provide to its lawyer a list of all investors, their respective residences and dates of purchase, and copies of any documentation relating to any offers and/or sales of securities. The securities lawyer can then analyze each of the transactions and determine the best course of action on a case-by-case basis (e.g., certain sales may arguably be exempt from registration under Section 4(2) of the Securities Act, despite its inherent uncertainties; and certain claims may be barred by applicable statutes of limitation).
5. It’s Not the End of the World. Rescission offers are time-consuming and costly; however, an issuer can work through this issue with competent counsel and eventually move on and prosper. Google is an excellent case in point (and is probably the most high-profile rescission offer ever handled by the SEC). In its prospectus filed with the SEC, Google offered to repurchase approximately 23 million shares of common stock and 5.6 million stock options because the issuances may have violated the Securities Act, as well as certain State securities laws. As the prospectus expressly provided:
Q: Why are we making the rescission offer?
A: Certain shares of common stock issued pursuant to certain of our stock plans during the period from September 2001 through June 2004 were not registered under federal securities laws and we did not seek to exempt these securities from the registration requirements of these laws. In addition, certain option grants and stock issuances pursuant to certain of our stock plans during this period were not qualified under state securities laws and we did not seek to exempt these securities from the qualification requirements of these laws. Consequently, these option grants and stock issuances may have violated the Securities Act of 1933 and the state securities laws of Arkansas, California, Colorado, Connecticut, the District of Columbia, Georgia, Illinois, Maryland, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Texas, Virginia and Washington. The rescission offer is intended to address these federal and state securities laws compliance issues by allowing the holders of the options and shares covered by the rescission offer to rescind the underlying securities transactions and sell those securities back to us.