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Do it right the first time: Defective securities offerings and crowdfunding

Do it right the first time: Defective securities offerings and crowdfunding

For those who are not interested in reading a long, complicated, legal-centric analysis of the impact of defective securities offerings and crowdfunding, here is the summary:

Securities offerings that aren’t done properly have to be undone; fixing them is a process  that is expensive, time consuming, difficult to do correctly under state law, and exposes a company to fraud liability.  You can avoid having to undo an offering by doing your crowdfunding offering (or any offering) correctly in the first place.

Ok, now let me explain.

As CrowdCheck regularly emphasizes to anyone who will listen to us, selling securities is serious business.  Not only do you have to comply with federal securities laws, you also need to comply with state securities laws and state corporate laws.  In fact, complying with state corporate laws must come before any efforts to sell securities in a company.

Every state requires that a company satisfy certain conditions prior to selling securities.  The conditions for each state vary, but Delaware’s rules are typical.  In order to issue stock in a company incorporated in the state of Delaware, that company must:

1. State the number authorized shares that company is allowed to issue in its certificate of incorporation.  The company may not issue more shares than authorized by the certificate.

2. Obtain board of director and shareholder approval to amend the certificate of incorporation if additional stock, or stock with different terms, need to be authorized.

3. Obtain board of director approval and authorization for all grants and issuances of stock.

If these conditions are not met, then the stock sold to investors may be defective and the stock issued may be void.  This can have a cascading effect on future actions of the company if an early sale of securities was done incorrectly.  Let's look at an example.  A company sells preferred stock that grants the preferred stock holders one seat on the board of directors.  The board of directors (including the preferred stock director) then authorizes the sale of additional stock.  However, let's say that the board of directors did not formally approve the original preferred stock offering.  Now we have preferred stock issued in a defective offering that is void, so the preferred stock investors did not have the right to appoint a director.  Board actions approved by that director may be invalid, and the company's current offering of stock may be defective as well.  The same goes for any other action that requires director approval.

As you can see, when securities offerings are not  correctly authorized, it puts the company into trouble.  Mistakes in the corporate governance are not the only cause of defective securities offerings.  Some offerings are made in reliance on securities laws that impose specific conditions on the offering.  If those conditions are not met, that could make the offering defective as well. 

When an offering is not made correctly, the investors in that offering have rights against the company. Investors and regulators may also find additional ways to hold companies accountable for defective offerings under the anti-fraud rules under state and federal securities laws.  In a securities offering, the company will likely have made a representation that the company has taken the necessary steps to offer the securities and that the securities are duly authorized and validly issued.  If those two statements are not true, then the company has misstated a material fact and could be liable for securities fraud.

To rectify the situation, the company may need to “rescind” the transaction in which the securities were issued in the defective offer.  Investors may force the company to rescind the transaction.  In a rescission, the company must return the proceeds of the investment to the investor and pay interest.  That means the company owes each investor everything the company received in its securities offering, plus additional cash.  For an early-stage company, this is a significant hit that may lead to the failure of the company. 

An alternative scenario may involve the company rescinding the prior transaction and reoffering new securities that are not the product of a defective offer. This rescission offer constitutes  both an offer to buy and offer to sell securities that must be registered with the SEC or exempt from registration.  The mechanics of a rescission offer are complicated and will require compliance with both federal and state securities law. 

After reading the last sentence you may have said, "but wait, I thought federal law for crowdfunding securities under Section 4(a)(6) preempts state law.  Why do I have to worry about state law?"  Good question, and the answer is that a rescission offer is not a crowdfunding offer.  While the defective offering may have originally relied on Section 4(a)(6), rescinding and reoffering to those same investors is not covered under Section 4(a)(6).  Instead, the offering must rely on some other means to issue securities, which will likely require compliance with federal and state law. (Similar rules apply where the original defective offer was made under Regulation D.)

Conceivably, a company that issued securities under Section 4(a)(6) in a defective offer could rescind the original transaction by returning all of the investor funds, plus interest, in accordance with state law, and then undertake an entirely new crowdfunding offer.  This strategy is likely not viable if the company has already spent part of the proceeds of the capital raise, and raises questions as to how much the company has sought in the prior 12 months and which financial disclosure standard the company would be required to meet.

As in many situations, the solution to this problem is to not create the problem in the first place.  Companies must be aware of the conditions that exist under federal and state law in regards to the offering of securities.  CrowdCheck can also help by identifying whether or not you have evidence that the current offering and past issuances of securities have been done correctly.

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