Microcap Risk – Finders Fee Payment To Unregistered Broker Leads To Chapter XI

Posted by John Slater on December 2, 2012

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Entrepreneurial companies must now consider a new regulatory risk when raising money for their businesses or negotiating an M&A transaction.  Payment of finder’s fees to unregistered brokers could lead to corporate bankruptcy.  It did so recently for a small biotech firm, Neogenix Oncology, Inc.

Federal and state laws mandate that professionals who arrange/negotiate capital investment or merger and acquisition transactions for a fee based on the success of their efforts must be registered as securities professionals.  I decided when I got into the investment banking business in 1982 that, as expensive and time consuming as regulatory compliance might be, I would have to be registered.  Our firm has chosen to incorporate its own broker dealer, but there are other options open to investment banking professionals.

It’s long been an open secret that some or perhaps even many business advisors have chosen a different path and raise money or negotiate M&A deals without registration.  For many smaller intermediary firms, this has not posed a problem.  Either their activities have not been noticed by the regulators or they are too small for anyone to care.

It now appears that the SEC may be using another approach to assure compliance – turn the accountants and lawyers into its policemen.  In October 2011 Neogenix received a letter from the SEC requesting that the company “provide certain information relating to payments made to third parties (referred to as “finders’ fees”) in connection with the sales of the Company’s common stock”.  Following up on the SEC inquiry Neogenix pursued an internal investigation and reported in its 10-K filed July 12, 2012.

“….. finders’ fees were paid to individuals and entities whom the Company has not been able to confirm were registered as broker-dealers or otherwise properly licensed under applicable state law to participate in the sale of the Company’s securities on a compensated basis. Accordingly, it is possible that at least some investors who purchased shares of common stock in transactions in which finders’ fees were paid may have the right to rescind their purchases of those shares….

…..The Company has assessed the potential for rescission liability in accordance with the provisions of Accounting Standards Codification (“ASC”) 450-20, Loss Contingencies. Under ASC 450-20, the Company is required to perform a probability assessment of the potential liability for rescission rights. Based on the information currently available to the Company, management has determined that it is reasonably possible that certain shareholders may have rescission rights related to common stock purchased for which finders’ fees were paid.  Management believes the range of potential liability for rescission by investors as of July 10, 2012 is approximately $0 to $31 million. As of July 10, 2012, the Company had received communications from shareholders making requests or claims for rescission of investments in the Company’s common stock of approximately $1.4 million.”

As a result of these events, Neogenix was impeded from raising money needed to pursue its development efforts.  Ultimately it was forced to file Chapter XI and on September 24, 2012 Neogenix sold all its assets to a company newly formed by certain of its shareholders in order to move past the potential liability resulting from payment of the finder’s fees.

We’ve posted excerpts from relevant Neogenix regulatory filings as well as citations to several web articles that cover some of the issues raised in more detail on Capital Matters at this link.

The bottom line is that both public and private companies that engage unregistered finders should view this as fair warning that the practice could pose serious financial risks.  For companies that have paid such finders in the past, this could prove to be a field day for the plaintiff’s lawyers.  This could impact the market value of many microcap companies that have participated in such practices and may limit their ability to raise capital in the future.  As a result we would expect that many accounting and legal firms will require a disclosure of such risks in 2012 audited financial statements and regulatory findings.  For some this could have implications for the market value of their traded equity or even, as in the Neogenix case, their survival.

Going forward we would anticipate that transaction attorneys and CPAs will add finder’s fees to their growing list of compliance obligations.  For many years the IRS has used legal and accounting certifications as a lever to force such professionals to assure compliance with various aspects of the tax laws.  Failure to do so, or in some cases to report violations to the authorities, can result in fines or even in suspension of professional licenses.  Executives of operating companies are brought into the mix with rules that require certifications of various disclosures with civil or even criminal penalties for false statements (think Sarbanes-Oxley).  Who needs to hire a bureaucracy when you can enlist the citizenry to enforce the regulations at their own expense?

As a champion of entrepreneurial business we would be remiss if we failed to note the chilling impact of developments such as this on the ability of small businesses to raise the capital they need to fund innovation and growth.  The large multinationals have an overwhelming advantage when it comes to capital market access and they can afford to treat regulation as a cost of doing business, not an obstacle to survival.  The JOBS Act was passed to move the pendulum back a bit toward the entrepreneurs.  The Neogenix case indicates that’s far from a given.

A hat tip to FOCUS  LLC Senior Advisor, Barry Michael, who covers the Biotech Industry for FOCUS and brought this to the author’s attention.

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Categories: Bankruptcy, Distress, Entrepreneur, Investment Banking, JOBS Act, Middle Market, SEC Regulation, Small Business, Uncategorized, Venture Capital

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