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Avoiding Rescission Exposure in a Private Placement

Private placements can be a great vehicle for raising money to infuse a business with much needed capital while avoiding the formalities of a public offering. Many businesses that lack the contacts to secure sufficient attention and investment from a venture capital firm will use an intermediary, such as an investment banker. However, because they earn a fee proportional to the amount of money raised, large investment banks are typically only interested in transactions seeking tens of millions of dollars or more. As a result, companies seeking to raise less than that often turn to private placement agents or finders to raise capital.

Before engaging the services of any private placement agent, a company should carefully vet the agent, the agent’s relationship with the issuing company, and the proposed compensation structure. Failure to do so could expose the fundraising company to great risk, up to and including rescission in favor of the investors. The Securities Exchange Act of 1934 (the Act), requires any person effecting securities transactions on behalf of another to be registered with the Securities and Exchange Commission (SEC). The Act deems such persons to be brokers if they engage in any number of a broad set of activities that includes giving advice about the value of securities, participating in negotiation of securities transaction, and assisting in the structuring of such transactions.

Many private placement agents, including those who call themselves consultants, are not registered with the SEC. Because the Act makes it illegal for unregistered persons to participate in the purchase or sale of any security, use of an unregistered placement agent poses significant risks for an issuing company. Section 29(b) of the Act states that contracts made in violation of the requirements of the Act are void;that gives investors a legal right to rescind the transaction if the security they purchased was from an offering with an unregistered finder.

The compensation structure with the private placement agent is another area worth scrutinizing. The SEC has repeatedly stated that transaction-based compensation is one of the primary factors it uses to determine whether a person is acting as a broker. As such, regardless of how the agent characterizes the nature of the services being provided, if the agent is compensated with a percentage of funds raised, that can give rise to a finding that the agent was acting as a broker.

There are ways to reduce the risk that an unregistered agent will be deemed an unlicensed broker. Ideally, the risks should be addressed both contractually and through limitation of the finder’s involvement in the transaction. The engagement letter with the agent should contain representations and covenants from the agent that it is aware of applicable SEC rules, including registration requirements, and that it will not make any offers that would preclude the issuing company from relying on the private offering exemption. A similar letter should be produced by the agent at closing, confirming compliance with all federal and state securities laws, and indemnifying the issuing company in the event of litigation for breach of applicable securities laws. Additionally, the issuing company should restrict the agent’s involvement to introducing prospective investors to the company, with no involvement by the agent in the negotiation process. A final safeguard, although challenging from a business perspective, is to create a consulting contract between the agent and issuing company that measures the compensation by something other than the funds raised and without any contingency that the offering is successful.

For a consultation regarding your individual business issues, please contact San Diego Corporate Law today!

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