Whereas it is essential for Companies to possess a substantial operational history in order to launch an effective IPO, going public by reverse merger is designed to accommodate start-ups and high-growth Companies  with minimal previous operations and earnings.

2. Reverse Mergers are Fast

A private Company going public by reverse merger with a public shell can do so in a matter of weeks as long as they are organized, properly advised, and have access to a clean public shell.

3. Potentially Less Expensive

Depending on the cost of the public shell required for the reverse merger, the out-of-pocket expense for the private Company going public can be less than initiating an IPO.

4. Dilution is Reduced

In an IPO there is a greater possibility that the Company’s shares will experience dilution. This detriment is greatly reduced in a reverse merger.

5. Underwriter Requirements are Reduced

The participation of an underwriter is not essential to the reverse merger process. In an IPO it is generally necessary to have the backing of an investment bank to act as lead underwriter. This factor is eliminated when conducting a reverse merger with a public shell Company.

Such services generally will include assistance in the preparation and dissemination of press releases and stockholder communications. Services may also include, without limitation, consulting with the company’s management concerning marketing surveys, investor accreditation, availability to expand investor base, investor support, strategic business planning, broker relations, attendance at conventions and trade shows, review and assistance in updating a business plan, production of a corporate profile and fact sheets, personal consultant services, financial analyst and newsletter campaigns, conferences, seminars, printed media advertising design, newsletter production, electronic public relations campaigns, direct mail campaigns, placement in investment publications and press releases.

Provided that an IR firm restricts its services to those described above, it should be able to avoid registering as a Broker-Dealer or Investment Adviser. Nevertheless, IR firms must avoid violating other SEC rules and regulations; namely, Section 17 of the Securities Act of 1933 (the “Securities Act”) and Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder.

Broker-Dealer Registration

A Broker is defined in Section 3(a)(4)(A) of the Exchange Act as any person engaged in the business of effecting transactions in securities for the account of others and, as such, is required to register pursuant to Section 15(a) of the Exchange Act.

The SEC’s Guide to Broker-Dealer Registration (the “Guide”) dated April 2008 lists the following examples of activities and factors where broker registration may be required:

• “finders,” “business brokers,” and other individuals or entities that engage in the following activities:
• Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
• Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
• Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
• Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved).
• investment advisers and financial consultants;
• foreign broker-dealers that cannot rely on Rule 15a-6 under the Act (discussed below);
• persons that operate or control electronic or other platforms to trade securities;
• persons that market real-estate investment interests, such as limited partnership interests, that are securities;
• persons that act as “placement agents” for private placements of securities;
• persons that market or effect transactions in insurance products that are securities, such as variable annuities, or other investment products that are securities;
• persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members;
• persons that provide support services to registered broker-dealers; and
• persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer.

In order to determine whether any of these individuals (or any other person or business) is a broker, the SEC looks at the activities that the person or business actually performs. Some critical inquires include:

Does the company participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction?

Does the company’s compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal?

Is the company otherwise engaged in the business of effecting or facilitating securities transactions?

Furthermore, many companies turn to outside sources, such as finders, to identify financing. A finder’s role can be varied, from assisting companies in identifying potential investors to providing consulting services to promoting the sale of a new issuance of securities. Essentially a “finder” is a person who assists a securities issuer in locating investors but is not registered as a broker-dealer under the Exchange Act. The problem lies in the status of finders as unregistered broker-dealers.

The following four factors weigh heavily in the SEC’s analysis of whether a finder is acting as an unregistered broker dealer:

• Commissions/Transaction-based compensation
• Making buy/sell recommendations & providing investment details
• History of selling securities
• Active in negotiations between the investor and the issuer

Agreements between an IR firm and a client company should detail the IR firm’s role; prohibit the IR firm’s involvement in presentations to investors, negotiation and structuring of the investment terms, analysis of the investor’s portfolio, or any other action that would likely fall within the broker-dealer scope; and avoid performance-based or transaction-based commissions, instead opting for a flat fee approach not based on performance.

Investment Adviser

The Investment Advisors Act of 1940 defines an Investment Advisor as follows:

Section 202(a)(11) “Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities; but does not include (A) a bank. . .;(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation. . .”

The underlying policy for the exemption for bona fide newspapers and publications rests in the First Amendment right to free speech. Many publications rely upon this exemption from registration. However, many of the publications that rely upon the exemption only publish reports by independent third party licensed investment advisors. It should be noted that large established publications, such as www.thestreet.com, are generally registered as investment advisors.

In addition, Section 17(b) of the Securities Act prohibits any person from publishing, giving publicity to, or circulating any notice, circular, advertisement, newspaper, article, letter, investment service or communication which describes a security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.

The provisions of Section 17(b) as well as the anti-fraud provisions of the Investment Advisors Act are applicable, regardless of the availability of an exemption to registration.

The IR FIRM can avoid registering as an Investment Adviser if it: (a) publishes a bona fide newspaper, news magazine or business or financial publication of general and regular circulation, and (2) satisfies the following requirements:

• the publication does not offer individualized advice attuned to any specific portfolio or to any investor’s particular needs;
• the publication is bona fide in that the publisher may not engage in trading activity in any securities that were the subject of advice or comment for a reasonable period of time before or after the publication;
• the publication is bona fide in that the publication may not contain information which is false or materially misleading;
• the publication is bona fide in that it must disclose any and all compensation received or any interest in the securities which are the subject of advice or comment;
• the publication is of general and regular circulation in that it is not timed to specific market activity or to events affecting or having the ability to affect the securities industry.

Nevertheless, IR Firms are still subject to the anti fraud provisions of the Exchange Act and all federal and state securities laws.

Section 17 of the Securities Act

Section 17 of the Securities Act, Fraudulent Interstate Transactions, provides:

a. It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly÷

• to employ any device, scheme, or artifice to defraud, or
• to obtain money or property by means of any untrue statement of a material factor any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
• to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

b. It shall be unlawful for any person, by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.

A material fact, as referenced in Section 17(a)(2), exists when there is a substantial likelihood that a reasonable investor would consider it important to an investment decision.

Pursuant to Section 17(b), in the event that IR FIRM is paid to represent companies for which it disseminates press releases or other information, or displays such companies on its website, it must disclose the compensation arrangement with the company. Moreover, IR Firms should include the following in its disclaimer, as a minimum;

“Nothing on this web site should be construed as investment advice. This web site is not a solicitation to buy or sell and the information contained in the web site or in our other publications does not purport to be a complete analysis of the companies mentioned. The information and statistics shown have been obtained from sources IR FIRM believes reliable, including, but not limited to, the subject company’s reports. All information contained herein should be evaluated by an independent financial analyst. You should always investigate and fully understand all risks before investing. Although IR FIRM does not knowingly publish false information, it does not guarantee the accuracy or completeness of any information represented on this web site or in its publications. Information reported here is subject to change at any time, and changes may not be posted immediately. IR FIRM, and/or its officers, directors or employees may, from time to time, have a position in the securities represented on this web site.”

Section 10(b) of the Exchange Act and Rule 10b-5

Section 10, Regulation of the Use of Manipulative and Deceptive Devices, provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange:

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Rule 10b-5, Employment of Manipulative and Deceptive Devices, provides that it shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

• To employ any device, scheme, or artifice to defraud,
• To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
• To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security

Increasingly, however, venture capitalists have displayed an interest in attracting public investors. Companies that wish to avoid the 1940 Act, yet seek venture capital dollars from the public, generally rely on either: (1) the exclusion from investment company status under Rule 3a-1 of the Act, which generally provides that a company will not be considered an investment company if no more than 45 percent of the value of its assets consists of “investment securities,” and no more than 45 percent of its after-tax net income is derived from such securities, or (2) an exemptive order from the Securities and Exchange Commission pursuant to Section 3(b)(2) of the 1940 Act declaring the applicant to be primarily engaged in a non-investment company business and therefore not subject to the Act.

Companies relying on either Rule 3a-1 or an SEC exemptive order are not subject to the provisions of the 1940 Act. However, depending on the exemption on which they rely, such companies remain subject to either the strict numerical limitations of Rule 3a-1 or the conditions upon which their exemptive orders were granted.

An alternative to relying on either Rule 3a-1 or an exemptive order is for a venture capital company that is seeking to access the public market to elect to be regulated under the 1940 Act as a business development company (a “BDC”).

The specific provisions of the 1940 Act regulating BDCs fall into two distinct categories. The first category includes those provisions that directly or indirectly promote investment in developing businesses. Examples of these provisions include lower asset coverage requirements for borrowing, mandatory investment in small businesses (as a percentage of the company’s total assets), and relaxed restrictions on affiliated transactions. The second category includes those provisions designed to compensate employees of BDCs in a manner consistent with compensation practices in the venture capital industry. Examples of such provisions include permitting the company to issue certain types of equity÷based compensation to employees and permitting the company to make loans to employees of the company to enable them to purchase the company’s securities. Collectively, these provisions were designed to achieve Congress’s goal of promoting capital investment in small businesses by encouraging venture capitalists previously unwilling to submit to 1940 Act regulation to establish public funds for private investment.

Generally, to be eligible to elect BDC status, a company must engage in the business of furnishing capital and offering significant managerial assistance to companies that do not have ready access to capital through conventional financial channels. More specifically, in order to qualify as a BDC, a company must: (a) be a domestic company; (b) have registered a class of its securities or have filed a registration statement with the SEC pursuant to Section 12 of the Exchange Act; (c) operate for the purpose of investing in the securities of certain types of eligible portfolio companies, namely less seasoned or emerging companies and businesses suffering or just recovering from financial distress; (d) offer to extend significant managerial assistance to such eligible portfolio companies; and (e) file (or, under certain circumstances, intend to file) a proper notice of election with the SEC.

The Investment Company Act also imposes, among others, the following regulations on BDC’s:

• The issuance of senior equities and debt securities by a BDC is subject to certain limitations;
• The issuance of warrants and options by a BDC is subject to certain limitations;
• A BDC may not engage in certain transactions with affiliates without obtaining exemptive relief from the SEC;
• A BDC may not change the nature of its business or fundamental investment policies without the prior approval of the stockholders;
• A BDC must carry its investments at value if a public trading market exists for its portfolio securities or fair value if one does not rather than at cost in its financial reports;

REGULATORY STRUCTURE

Election and 1934 Act Registration

A BDC is subject to Sections 54 through 65 of the 1940 Act, which relate specifically to BDCs (the “BDC provisions”). To qualify for the exemption, a closed-end investment company must elect to be treated as a BDC and file a notice on Form N-54A to that effect with the SEC. Significantly, to make the BDC election, a company must also have a class of its equity securities registered under the Securities Exchange Act of 1934 (the “1934 Act”). As a result, shares of BDCs, like those of closed-end funds, typically are listed for trading on public exchanges or on a Nasdaq market. However, unlike closed-end funds, which are not required to register under the 1934 Act, BDCs must file with the SEC periodic reports (i.e., Forms 10-Q and 10-K) and other reports (e.g., Form 8-K) like those filed by publicly traded operating companies. Management personnel also must report their trading in the company’s stock and are restricted from obtaining short swing profits from trading in such securities within a six-month period. Like other 1934 Act registrants, BDCs are also subject to the proxy solicitation requirements of Section 14 of that Act.

Required Investments

A BDC is, in effect, required by Section 55(a), to have at least 70% of its investments in eligible assets. Eligible assets, for purposes of Section 55(a), include, among other things, (i) securities of an “eligible portfolio company” that are purchased from that company in a private transaction, (ii) securities received by the BDC in connection with its ownership of securities of an “eligible portfolio company,” or (iii) cash, cash items, government securities, or high quality debt securities maturing one year or less from the time of investment.

An eligible portfolio company is defined as any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly-owned by the BDC, and (c) does not have any class of publicly-traded securities with respect to which a broker may extend credit.

Managerial Assistance

BDCs are required to make available significant managerial assistance to their portfolio companies. Significant managerial assistance refers to any arrangement whereby a BDC provides significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company. Examples of such activities include arranging financing, managing relationships with financing sources, recruiting management personnel, and evaluating acquisition and divestiture opportunities.

Capital Structure

Unlike other investment companies, BDCs are able to issue options, warrants, and rights to convert to voting securities to its officers, employees and board members.

Any issuance of derivative securities requires the approval of the company’s board of directors and authorization by the company’s shareholders. The company also may not issue derivative securities to its non-employee directors unless it first obtains an exemptive order from the SEC.

In general, the amount of voting securities that would result from the exercise of all derivative securities of a BDC at the time of issuance is not permitted to exceed 25% of the outstanding voting securities of the BDC. However, if the outstanding derivative securities issued to management personnel as a component of their compensation represents 15% of the BDC’s outstanding shares, then the total amount of derivative securities that the BDC may issue, as a percentage of its total outstanding shares, is 20%.

A BDC may operate a profit-sharing plan for its employees, subject to certain restrictions. A BDC cannot, however, maintain such a plan if it maintains a stock option plan for management, or is externally managed by a registered investment adviser.

Leverage

BDCs are less restricted than closed-end funds as to the amount of debt they can have outstanding. Generally, a BDC may not issue any class of senior security representing an indebtedness unless, immediately after such issuance or sale, it will have asset coverage of at least 200%. (Thus, for example, if a BDC has $1 million in assets, it can borrow up to $1 million, which would result in assets of $2 million and debt of $1 million.) Other investment companies must have 300% asset coverage.

Operational Considerations

As with any other company subject to the 1940 Act, a BDC must adhere to certain substantive regulatory requirements with respect to its operations.

Composition of Board of Directors. A majority of the directors of a BDC must be persons who are not “interested persons” of the BDC. The 1940 Act defines interested persons to include, among others: (i) officers, directors, and employees (however, no person is deemed to be interested solely by reason of being a member of the board of directors); (ii) a five percent or more voting shareholder of the company; (iii) a person who is a member of the immediate family of an affiliate of the company; (iv) legal counsel for the company; and (v) any natural person whom the SEC determines to have had a material business relationship in the past two completed fiscal years with the company or its chief executive officer.

Indemnification. A BDC is prohibited from protecting any director or officer against any liability to the company, or its security holders, arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office. This prohibition also applies to the company’s investment adviser, if it is externally managed.

Valuation. The board of directors of a BDC is required to value portfolio assets on a quarterly basis in connection with filing certain required periodic reports. Assets must be valued on the basis of market value, if available; in the absence of a readily ascertainable market value for an asset, the board must in good faith determine the “fair value.”

Transactions with Related Persons. Transactions involving a BDC and certain persons related to it including, among others, officers, directors, employees, members of an advisory board, the investment adviser, the principal underwriter, and persons controlling or under common control with the BDC, are generally prohibited, absent an SEC exemptive order. Transactions involving a BDC and companies that it controls (i.e., those in which it owns more than 25% of the voting securities) generally are not subject to this limitation.

Code of Ethics. Officers and directors of a BDC, and its external investment adviser (if any) are subject to general fiduciary duties with respect to the conduct of their duties as they impact the BDC. A BDC (and its investment adviser) must adopt a code of ethics and institute procedures reasonably necessary to ensure that its employees and certain affiliates adhere to the code.

Fidelity Bond. A BDC must provide and maintain a bond issued by a reputable fidelity insurance company to protect the company against larceny and embezzlement. The bond must cover each officer and employee with access to securities and funds of the company, with the required coverage tied to the amount of the company’s assets.

Taxation

A BDC may elect to be taxed either as a “C corporation” (like typical operating companies) or as a “regulated investment company” under Subchapter M of the Internal Revenue Code of 1986. As a regulated investment company (a “RIC”), a BDC can avoid taxation at the company level on that portion of income and capital gains distributed to shareholders. To qualify for RIC treatment, in general at least 90% of the BDC’s income must consist of interest, dividends, gains from sales of securities and similar types of income and gains and the BDC must distribute to its stockholders for each taxable year at least 90% of its investment company taxable income (consisting generally of net investment income from interest and dividends and net short-term capital gains). The RIC provisions also require a BDC to comply with certain requirements with respect to its portfolio diversification

We’re in the era of permanent change, and CEOs are fair game for the chopping block, as organizations everywhere constantly overhaul their operations to become more competitive.

Where corporate leaders once were afforded a degree of latitude when company performance lagged for a quarter or two, they now are increasingly being held responsible for underperformance by boards of directors. A bad six months of financials is often enough to see off the CEO. And there are a host of other reasons that company leaders get sacked, ranging from disputes with the board to personality clashes with the management team. The post-Enron era has also created a hair trigger response if a corporate boss is suspected of cooking the books; the best way to diffuse a cloud of suspicion looming over questionable financial reporting is to eject the person in charge.

The legal position of a dismissed corporate leader isn’t always clear, which makes the communications aspect even murkier. One thing that is unambiguous, however, is that bungling the firing process can turn a challenging situation into a corporate crisis.

Twenty years ago, public displays of disaffection by a terminated executive were rare, since most were afraid that a lawsuit or excessively negative commentary to the media could damage their reputation. Badmouthing your former employer raised the prospect of having difficulty landing new work – a lawsuit was considered even worse. There was also an understanding by executives that they were members of the corporate club and as such, they had to accept the hard realities of life at the top, including being unceremoniously dumped at least once in their careers.

This is no longer the case. Two trends are emerging: terminated CEOs are filing wrongful dismissal lawsuits, and the media are scrutinizing all aspects of the departure. These trends are likely to continue and involve an expanding cross-section of the C-suite, including COOs and CFOs.

All of this spells potential trouble for companies: the last thing any organization needs is a nasty fight with a former executive. And in the absence of sound communications planning, stakeholders can be left wondering about the stability of the company. The impact of a dismissed CEO on the organization can be measured in productivity, investor confidence, and strategic integrity, as well as dollars. Share price can take a beating and when stock performance falls, the remaining executives often get the blame – and the cycle of dismissal continues.

Whether or not an executive termination proceeds smoothly often depends on the degree of communications planning the company undertakes before the CEO is let go. A good public relations strategy can also mitigate the effect of a wrongful dismissal lawsuit or other negative public commentary by the outgoing leader. What follows is a seven-step guide to help make the transition easier on everyone.

• 1. Plan Ahead – Be PreparedBefore a CEO is fired, the axe-wielder should take time to develop a communications strategy for every stakeholder: employees, including the executive team, key customers, business partners, suppliers and the media. Aligning the information delivered to each audience improves the chances that the transition will run well. A good communications strategy should present a CEO departure as a business process. Poorly planned communications efforts are nothing more than attempts at damage control, usually implemented long after things have become messy.If the situation is not an urgent crisis, a good strategy to ensure an easy transition is to fire the CEO with plenty of notice before the new head honcho steps in. Giving stakeholders early warning that a transition is to take place over a period of several weeks dispels any impression that the company is a rudderless ship.
• 2. Know Your AudienceFor a publicly traded company, the first priority must be to maintain the confidence of shareholders and the financial community. A private company’s priority, on the other hand, should be its customers and employees.
  In every case, however, a major error occurs when other stakeholders are informed before the management team knows that a CEO is on the way out. Although it might be argued that senior employees don’t necessarily have a right to know about CEO transitions ahead of time, they do hold considerable power in a tight community like Bay Street or Howe Street. In fact, senior employees do have rights: the right to leave the company; the right to speak less than fondly of the company; and they have a right to not to be unfailingly loyal to the new leadership. The best policy is to keep key leaders informed, albeit on a strictly confidential basis, when a CEO transition is afoot.
• 3. Communicate InternallyCEOs who replace outgoing chiefs have their work cut out for them and have to persuade other senior executives and staff to buy into their vision of how to lead the company.
  In this situation, the big danger occurs when another senior manager becomes better at communicating an alternative vision. This is a recipe for a kind of corporate tribal warfare in which one or other of the protagonists will suffer. Devising a comprehensive internal communications plan that articulates the new CEO’s vision and business plan will significantly increase the chances of buy-in from internal stakeholders. It will also help with early identification of any managers that are unwilling to work within the new regime. Offering those people a way out before they become a problem is obviously preferable to facing internecine strife down the road.
• 4. Use Clear LanguageCommunications need to be tailored to the needs of different stakeholders, both internal and external, and focus on protecting corporate reputation. Organizations need to communicate in language that will be understood. Lawyers can counsel clients that stating the company’s legal position with respect to the ousted executive isn’t enough; in fact, legal terms may cause the impression that the company is hiding behind a legal smokescreen.
• 5. Engage the MediaBusiness journalists are frequently the primary conduit to your audiences. Being prepared with trained spokespersons, defined key messages and a well-tested media plan will go a long way to ensuring balance, fairness and accuracy in the press. By adhering to principles of openness, honesty and prompt disclosure to the media, the company will be seen as well-poised to move forward after the executive transition.
• 6. Identify your supportCEOs are high profile executives. The media will seek comment not only from the former executive and the company, but from other sources as well, particularly if the transition was involuntary. Being familiar with knowledgeable partners, industry experts and analysts that can speak about a company’s leadership is important for building credibility through third parties.
• 7. Keep your Ear to the GroundRegular monitoring of the media, canvassing employees and seeking feedback from external stakeholders will alert the company to any lingering issues concerning the new CEO. The weeks following a transition will set the tone for the new leader, and the more positive the reception from all audiences, the better that person’s chances for success.

A fired executive can disrupt a company’s operations and create significant financial exposure if the transition is allowed to get messy. The most reliable insurance against these risks is a well thought out communications plan. A company that fails to carefully map a communications strategy for the transition will eventually be haunted by that mistake. But at its best, a CEO transition should be seen and treated as a chance for an organization to create a positive impression in the minds of its internal and external publics.

David Weiner, MBA, is a senior partner with NATIONAL Public Relations in Toronto, Canada’s largest corporate communications firm. Aaron E. Boles, LL.B., is a consultant at the firm.

You’ve just received notice of a $3,000 special assessment for your condo, your wife is looking forward to that vacation in Barbados you keep promising her and MasterCard actually has hit men looking for you. The 22-year-old kid you trained is now bucking for your office and if one more prospect tells you they are only investing in real estate until the economy turns around you are going to need a prescription for Prozac. Last but not least, one of your precious new accounts reneged on a trade last month and you’re in the hole to your firm to the tune of $5,400 for a two point drop in a technology stock that you were dead sure was going to revive your book. Now you’ve gone from “dead sure” to just “dead.”

Until the $5,400 “hit” you were making tremendous strides redirecting your business since the bubble burst in the cold spring of 2000. You started doing more mutual fund business and gold funds kept you out of the poor house while a lot of your old buddies fell by the wayside. But now it’s go time; time to flex as a true professional and show your sales manager you’re the consistent producer you keep telling people you are.

Just one innocent little ticket for $100,000 into a value-based mutual fund will do the trick. After all, how can buying quality hurt anyone? There’s a 3.5% load on the fund so you hit your breakpoint, the client is further diversified and the hit men from MasterCard give you a pass for one more month.

Problem being is that you’ve already called the last of your “go to” guys and you’ve been unable to make voice contact with the one you really need to speak with. He’s on the golf course and has left specific instructions with his secretary not be disturbed. He did however, tell you to go ahead if anything ever looks good and you can’t reach him. Then again, the guy who busted the trade on the technology stock last month said the same thing.

It’s now 3:50 p.m. and the window of opportunity is about to be slammed on your fingers. You open your book, grab a trade ticket and…

Even brokers with the best of intentions and highest regard for their clients well being find themselves in this predicament. But moves like this can be costly. And in some cases brokers have even lost their licenses for doing what they’ve seen other brokers do hundreds of times, running a “UT” or unauthorized trade. In summary, there’s no sense throwing away a dollar to make a dime.

There are Ten Commandments to avoiding lawsuits when working a book as a retail broker. These rules are not absolute, but implementing even a few of them will help insulate yourself and your firm from liability that can easily be avoided.

1. Thou Shalt Not Run Unauthorized Trades – Ever

It is never, under any circumstances, permissible to run trades without specific authorization to do so from the client. Although ever broker knows this fact several common scenarios do occur that have a tendency to blur a registered rep’s fundamental common sense. In the case where your client is married but has opened a single account, do not accept authorizations from the spouse who is not on the account, even if they are easier to contact during trading hours. If it is an elderly client, it is still not acceptable to accept trades from the son or daughter who understands your recommendations more easily. Either way, the account is being directed by another party who does not have legal authority to do so. In the event losses are incurred you will face an arbitration panel and there will be no defense, or even a logical explanation, as to why the account was being traded by an unauthorized party.

The easiest way to neutralize these two common liability scenarios is to either have the client sign a limited power of attorney to the son, daughter or spouse, or simply have them complete the necessary paperwork to make the account a joint trading account. Either way, invest a little time up front as opposed to investing an inordinate amount of time later preparing your defense in arbitration, or even worse, an action from a regulatory body.

If the client is the type of guy you’ve been trading a while and has instructed you to act on his behalf if he can’t be reached, then by all means make him put his signature where his mouth is. Get a limited trading authority document through your compliance department and have the client execute it. In the event the client won’t sign it it simply means they were setting you up for a fall anyway in the event that losses were incurred by your actions.

2. Thou Shalt Keep Careful Notes

At the risk of sounding paranoid, treat every client like a potential lawsuit. Since most arbitrations occur approximately 12 months after the account is closed by the client, do not rely on the fact that your memory will provide you with the necessary facts to assemble a viable defense.

Most firms require that brokers keep thorough work notes throughout the duration of an account. Whether your firm does or does not, it is essential that you maintain a complete daily log of every transaction you execute. These log entries do not have to be exceptionally long but they do have to include enough detail to substantiate what you were buying for the client, when they authorized the trade and ideally what they were doing or where they were when they gave their authorization. Documenting this last element of your conversation with the client will prove beyond a shadow of a doubt that you did not go back and recreate your notes after the fact.

Remember, if a client files a complaint twelve months after the fact you are looking at another eight to twelve months of discovery and trial preparation before you and your counsel get to tell your side of the story to an arbitration panel (assuming the case is not settled out in the interim). This means that two or three years may elapse from the time you lose the client to the time you have to defend your credibility and your license. Details can become sketchy in weeks, no less months or years.

Although there are typically three to five causes of action in client arbitrations, careful notes can provide a sure-fire defense against allegations of unauthorized trading. As the old sales adage goes, your notes can truly be you life.

3. Thou Shalt Separate Problem Clients From The Herd

This is a prime example that alliterates the fact that ignoring a problem is not going to make it disappear. Most brokers separate their business into an “A” book and a “B” book. Larger producers even have a “C” book.

Superstar producers build their careers on clients, not accounts. Pre-screening is the cornerstone in building a successful business because even under ideal circumstances the pressure of successfully trading a retail portfolio can be nerve-racking. Add a handful of livid clients or professional complainers to the mix and you have a recipe for disaster. In this instance it is no longer a matter of if a client will sue; it becomes a matter of when.

It is imperative to search out the weeds in your garden before they grow so large that they create a stranglehold on you entire business. Typically these land mines are buried somewhere deep in your B or C book; the clients you have the thinnest relationships with. But you know who these people are already. Problem being is that you refuse to admit it because they make your equity run look just a bit fatter. It is the rare breed of broker who possesses the nerve to turn down business. It is also this same rare breed that generates few or even no complaints from clients throughout the course of their career.

Remember, the most natural reaction from brokers when they realize they are saddled with a problem client is to hand them off to a less experienced broker who needs the business and is willing to put up with the headaches. After all, getting 50% of something is better than 100% of nothing, right? Wrong!

This approach is fundamentally incorrect on two levels. You are transferring a problem account to another, usually less experienced broker, who possesses even weaker public relations skills than you do, exacerbating an already volatile situation. Secondly, out of sight out of mind does not work in this situation because in the event the client files a complaint his or her attorney will name ALL parties involved. This includes everyone from the principles of the firm, the attending sales manager or “24”, the clearing firm in some cases, the broker who opened the account and any other broker who traded the account during its duration.

If you feel a client is a potential problem it is imperative that any active trading be ceased. Encourage the client to assume a cash position and odds are they will eventually withdraw their account.

If a client is resistant to “go to cash” then forward prospectuses on several high-grade mutual funds to them and of course document this in your notes. All decisions should be made strictly by them. In the event they decide to reposition into a select basket of mutual funds they must clearly understand that this is a five-year strategy. If they are not willing to respect the time frame of this approach you should once again advise them to purchase a CD or government bond, regardless of the payout.

4. Thou Shalt Diversify Your Business

Brokers with the widest variety of business seem to generate the lowest percentage of client complaints. Let’s face it, brokers who focus strictly on trading aggressive growth equities bear the brunt of the fallout when the markets correct. They make the most when markets are rallying but inversely suffer the most dramatic swings in equity when the economy gets choppy. But expecting a top-producing stock jock to turn into a financial planner or annuity salesman overnight is more like turning coal into a diamond. It’s going to happen but it’s going to take time and there are going to be flaws.

Over the past ten years the tide has turned against brokers who handle aggressive trading clients. Even in an ideal market losses are incurred and losses invariably equate to complaints, and you’d better be sure that one of the primary causes of action in that complaint will be churning.

Securing a variable life, health and annuity license is a great way to bolster your business while managing the inherent risks of trading equities for your clients.

Forcing a round peg into a square hole is generally not recommended in any business capacity, especially in the securities industry. So an insurance license will allow you to handle lump investment sums from your clients confidently while still keeping up your production level. Variable annuities provide maximum diversification, and although they can decline in value, they are still on the opposite side of the risk spectrum from trading separate equities.

If you intend to follow the Fourth Commandment the way it is intended, then spread yourself out into bond business as well. It is shocking to see how many brokers make it through their entire career without ever buying a single bond for their clients. Bonds can provide growth as well as income and from a risk perspective they run the gamut from conservative to very aggressive. If you really want to set yourself apart from the pack then take a few weeks and secure a Bond Principle license. Once again, this will provide you with an even stronger knowledge base of the bond business while reinforcing your credibility as a financial professional.

If you desire to create hedge positions for your clients in turbulent times then take the necessary courses to understand what a Registered Options Principle (ROP) really does. While trading options outright maintains the highest end of the risk spectrum, buying options the way they are intended to be used, as part of a hedge strategy, can provide stability and income to your clients.

In summary, if 25% of your income is derived from trading equities, 25% from buying and selling bonds, 25% from insurance business and the remaining 25% from creating options positions then in all probability your chances of generating a formal client complaint should drop dramatically.

5. Thou Shalt Produce Consistently

The brokers who generates the most complaints is the usually the one with the smallest client base. Brokers with the least clients generally overtrade and percentage wise, the numbers never work out.

The last position you want to be in is trying to explain why a $125,000 account generated $115,000 in gross commissions over the course of two years. Although this situation is quite easy to create it is also quite easy to correct.

In addition to client complaints, actions from regulatory bodies have grown increasingly commonplace when it comes to the overtrading of client accounts. One factor that is viewed by the powers that be is not just how much commission a brokers generates but when he does so. If a government agency or SRO views your company’s commission runs and discovers that 50% or more of your total commission is generated on the last three days of your company’s pay period then it will appear that you were executing trades solely for your own benefit, typically to hit a production breakpoint.

Also, if it is deduced that all of your accounts possess a high ratio of equity to commissions then it will show that your business as a whole is improper. The sanctions for conducting such business can be steep fines ($5,000.00 or more), suspensions, or worst possible scenarios, revocation of your series 7 registration.

To correct this, set a routine and stick to it. Your machine for prospecting new business should run smoothly and consistently. If you are just starting out then be sure to dedicate at least 75% of your working time towards building your client base and if you are a more established broker than you should assemble a team of support staff dedicated to helping you build your book. The most successful producers are the ones who have mastered the art of “divisional” sales so that their time is freed up to service their existing client base.

A larger, more diverse client base will eliminate the temptation to overtrade a handful of clients who, although they are more than willing to follow your lead, will definitely file a complaint in the event excessive losses are incurred. Every client is your best friend until they lose money.

Secondly, gross production must be generated and measured on a daily or weekly, not monthly, basis by the broker seeking to maintain superstar status while preempting potential client complaints and regulatory actions. Under no circumstances is it permissible to generate the bulk of your monthly production on the last two or three days of the production period unless there is a legitimate reason to do so (i.e. a large transfer has just hit up or possibly certain equity positions have blossomed to their potential and must be liquidated).

Brokers who are conscientious about avoiding arbitrations must not just eliminate business impropriety; they must eliminate even the appearance of impropriety.

Produce new accounts and gross commissions consistently and your business will run smoother from a production as well as legal standpoint.

6. Thou Shalt Never Dodge Phone Calls

The drug company you’ve just built a substantial position in has stalled out in second stage clinical trials for their revolutionary new cancer drug and the news has been less than flattering to the share price of their stock. As a matter of fact, CNBC has just started using words like “debacle” and “meltdown” and your clients want answers – NOW.

Your message caddy is bursting and your secretary is now asking for combat pay. The last thing you should do right now is crawl for the womb-like safety of the space beneath your desk.

Most clients understand the fact that risk and reward are commensurate in an active trading scenario. They equally understand that they are putting big commission dollars in your pockets and for paying this price they want service.

Nothing replaces the power of sincerity. If your client calls and you are genuinely time pressed and cannot speak with them or do not posses the answers that they are looking for then tell them so. Take their call quickly and explain to them that you are researching the situation and set a time to call them back. Most importantly, if you set a time stick to it.

Resist the urge to let the call roll through to your voice mail and do not relay messages through your secretary or sales assistant. If your clients had little or no difficulty reaching you when times were good then they should be able to reach you with the same degree of ease when markets are heading south. In times of crises communication is more important then ever.

You can eliminate a large percentage of client complaints just by showing your clients you are a professional at all times.

7. Thou Shalt Not Leverage

Although tempting as it may be, it is highly unadvisable to buy anything you can’t pay for outright. After all, if buying stock on margin was such a good idea you’d be doing it for your own account, right?

In a declining market cutting losses can be an art form in itself. Attempting to salvage equity from a leveraged stock position is typically futile. Not to mention, margin costs can be substantial and also eat into client equity day in and day out. It’s like buying a million dollar mansion without thinking about how you are going to make the mortgage payments, discovering the house is on a fault line and then being informed it has termites. You’re either going to lose fast or lose slow. Either way, you’ll lose.

Clients can accept reasonable losses if you’ve made all trades with the best of intentions and done your best to cut losses and let profits run. They will not, however, accept the fact that they’ve lost 75% of their equity after you promised them a home run and told them that margin was only going to be used temporarily. Well, the losses have a way of becoming permanent and although you may have used margin temporarily the effects are lasting. A client arbitration is all but guaranteed.

If you want to double the size of your book than hit the phone and raise equity. When in doubt the basic rule of thumb is don’t do anything with client equity you wouldn’t do with your Mom or Dad’s.

Leverage your client out of the market and their attorney will crucify you and your supervisors for breach of fiduciary responsibility. Once again, eliminate this practice from your business.

8. Thou Shalt Sell Risk

Another common cause of action from a client in the average arbitration is the allegation that they did not understand, or were not informed, of the inherent risks involved in trading separate equities, particularly NASDAQ issues. Granted, the average disclosure document that is produced by the clearing firm is enough to scare anyone out of the water forever, but statistically, these documents are not read.

If indeed they are read and executed by the client they still have the right to claim that they did not understand what they were signing and that you, the attending broker, minimized or did not emphasize the risk involved. Sure, anyone can claim anything, but why give the client more ammo than they already have when filing an arbitration?

The average broker can paint a rosy picture around anything, but when reality doesn’t sync up with the idealistic scenario, the client feels like the carpetbaggers have come to town. No one likes being made to feel stupid or misled.

Clients respect and appreciate a broker who tells it like it is. People who have the money to invest are generally pretty astute. That’s how they got money to begin with. They understand that there are no free lunches and if you want to get anywhere in life you’ve got to take on risk. But risk is best conquered with eyes wide open.

Tout the risk whenever possible and refer back to the 2nd Commandment, taking careful notes of these conversations.

9. Thou Shalt Conduct Due Diligence and Assess Suitability

Picture this if you will. An elderly woman draped in a hand-woven shawl takes the stand at your first arbitration. She is in her late 80’s, has a thick bun of gray hair tucked beneath a conservative flowered hat and moves slowly and deliberately as she prepares to tell the panel how she lost nearly $300,000 trading $5 and $10 NASDAQ technology stocks.

After her attorney gets through questioning her it becomes completely apparent to all in attendance that her only previous investment experience consisted of a portfolio of bonds and dividend-producing utility stocks. She explains that after her husband died it was up to her to start making her own financial decisions and that you, the broker, lured her to her financial demise with promises of higher returns.

Regardless of the fact that she actually was referred to you by an existing client, and that she hounded you incessantly to pursue double and triple-digit returns (the kind she kept hearing about on CNBC), you have now brought a knife to a gunfight. Regardless of how thorough your defense is you are going to wind up spending the rest of your career paying off a hit so large that just thinking about it causes you to spiral into a panic attack.

The best defense in this particular scenario is to not have been there to begin with. Even though the client has met all the traditional net worth requirements and was as sharp as Louis Navalier when reviewing account statements, prospectuses, analyst reports and the like, don’t think for a minute they won’t play the age card to take a shot at getting their money back if things don’t work out.

If you decide to pursue a business relationship with a client who is over the traditional age or possibly has limited trading experience but seems to be dead set on becoming an active trader, it may be advisable to create an audio taped disclosure that can be admitted into evidence later. Obviously, coordinate the details of this procedure with your compliance department in order to adhere to all pertinent rules and regulations.

In addition to certain standard language that should always be included, let your clients know that they have three different options to choose from when entering the market: conservative, moderate or aggressive. Conservative means that their primary goal is preservation of equity. Moderate means that they are willing to accept losses when pursuing above-average gains. Aggressive means that they are willing to accept a complete loss of their investment dollars. Instruct the client to tell you which category they fall into before you begin trading the account. Best possible scenario is that they explain their personal risk tolerance in their own words as well. Of course, refer to the 2nd Commandment and document this conversation thoroughly in your notes in addition to the audiotape you’ve just created.

10. Thou Shalt Consult With an Attorney

If the first nine commandments sound time consuming consider the fact that practicing them can literally save you and your firm hundreds of thousands, if not millions, of dollars in reparations, fines and legal costs.

The last Commandment is going to cost you a few dollars up front, but is well worth the expense. Look at it in the same light as you would view spending money on a cancer screening or even on an MRI to diagnose a potential back problem. Remember, it is always cheaper to prevent a problem than to fix one.

If you handle a book in excess of ten million dollars that means that even a 20% drop in equity can start a chain reaction that can leave you owing your clients or your firm between two and four million dollars (actual losses coupled with missed reasonable profits and attorney’s costs).

Securities attorneys charge anywhere from $200 to $300 per hour and are adept at diagnosing potential liability. For the sake of argument assume that you will retain an attorney twice a year to review your business practices and advise you where to make adjustments pertaining to record keeping, suitability issues and the latest industry requirements. If your first reaction is that your compliance officer does that job already, keep in mind that it is the compliance officer’s responsibility to protect the firm, not you, in the event of any litigation.

So you have to make a serious decision; is spending $5,000 a year to have an industry professional fortify your business more desirable than potentially giving back several hundred thousand dollars should an arbitration not go your way? Savvy brokers typically have a long-term perspective on their business and would rather be safe than sorry. They realize that spending a small percentage of their hard-earned income to establish a relationship with a securities attorney is as essential as health insurance or liability coverage on the cars they drive.

In addition, having a strong, ongoing relationship with a securities attorney will also eliminate the last minute stress and aggravation of scrambling to retain counsel should a client or regulatory body name you in an action.

Never forget, fortune favors the well prepared.

Shareholders’ rights to inspection and rights to information are set forth in at least six (6) separate provisions of the Florida Corporations Act. Certain requests for inspection require an assertion of good faith and proper purpose, while other information, a Shareholder is entitled to without objection. Some requests for information only require five (5) days notice while others require thirty (30) days. Moreover, different provisions provide for the inspection of the same records at different times. That is, the assertion of Shareholders’ inspection rights, like the maintenance of the corporate formation itself, requires technical and procedural accuracy.

For organizational purposes this article is divided between unqualified inspection rights, which rights do not require the assertion of good faith or a proper purpose and which requests do not allow for objection, and contingent inspection rights. Finally, the article will discuss the scope of inspection rights in general and this writer’s opinion as to the future direction of the law.

Unqualified Inspection Rights

Though most rights to inspection are qualified or at least subject to objection by the corporation, there are some rights to inspection for which a shareholder is simply entitled, by virtue of being a shareholder. The most obvious substantive inspection provision of the Florida Corporations Act governing Shareholder inspection rights is Florida Statutes s. 607.1602, entitled “Inspection of Records.” Section 607.1602(1) provides that “[A] shareholder of a corporation is entitled to inspect and copy, during regular business hours at the corporation’s principal office, any of the records of the corporation described in s. 607.1601(5) if the shareholder gives the corporation written notice of his or her demand at least 5 business days before the date on which he or she wishes to inspect and copy.”1 No reason necessary. No objection allowed. Subsection (4) increases the written demand notice period to fifteen (15) days in the event the shareholder resides outside of Florida or the corporation is a foreign corporation authorized to transact business in Florida.2

The records described in s. 607.1601(5), which records all corporations are required to maintain, include:

• (a) Articles or restated articles of incorporation and all amendments to them currently in effect;
• (b) Bylaws or restated bylaws and all amendments to them currently in effect;
• (c) Resolutions adopted by the board of directors creating one or more classes or series of shares and fixing their relative rights, preferences and limitations, if shares issued pursuant to those resolutions are outstanding;
• (d) The minutes of all shareholders’ meetings and records of all action taken by shareholders without a meeting for the past 3 years;
• (e) A list of the names and business street addresses of its current directors and officers; and
• (g) Its most recent annual report delivered to the Department of State3.

If a shareholder requests inspection pursuant to s. 607.1602(1) or (4) and that inspection is denied, upon application by the shareholder, the circuit court in the county where the corporation’s principal office (or, if non in this state, its registered office) is located may summarily order inspection, at the corporation’s expense, to the requesting shareholder.4

The second unqualified right to information is found in s. 607.1620, which provides that a shareholder is entitled to receive annual financial statements, within one hundred and twenty (120) days of the end of each fiscal year, unless reasonably delayed for reasons outside the corporation’s control.5 Financial statements generally include a balance sheet, income statement, and statement of cash flows.6 In the event a public accountant prepares the statements, the accountant’s report must accompany them.7 However, in the event that there is no public accountant, the financial statements must be accompanied by a statement from either the President of the corporation or the person responsible for accounting records:

• (a) Stating his or her reasonable belief whether the statements were prepared on the basis of generally accepted accounting principles and, if not, describing the basis of preparation; and
• (b) Describing any respects in which the statements were not prepared on a basis of accounting consistent with the statements prepared for the preceding year.8

A shareholder may also request copies of the latest financial statements at any time by making such a request in writing.9 If a shareholder is not provided with financial statements within thirty (30) days of delivery of such request, the circuit court in the county where the corporation’s principal office is located, upon request by the shareholder, may summarily order the corporation to furnish the financial statements.10 Moreover, “if the court orders the corporation to furnish the shareholder with the financial statements demanded, it shall also order the corporation to pay the shareholder’s costs, including reasonable attorney’s fees, reasonably incurred to obtain the order.”11 (emphasis added).

The third unqualified right to inspection is the right of any shareholder or the shareholder’s agent or attorney to review and inspect shareholders’ lists at any time during a shareholders’ meeting or any adjournment thereto.12 This third unqualified right appears to be strictly limited to inspection during the course of the meeting. Section 607.0720 requires a corporation to prepare an alphabetical list of the names of all its shareholders entitled to notice of a meeting, arranged by voting group with the addresses of, and the number and class and series, if any, of the shares held by each.13 This list must be available for inspection by any shareholder or the shareholder’s agent or attorney during the meeting or any adjournment.14 Section 607.0720 also states that the list must be available for inspection for a period of 10 days prior to the meeting, however inspection during this 10 day period must be requested in writing and is subject to the good faith and proper purpose requirements set forth in s. 607.1602(3)15 and further discussed herein.

The list must be available for inspection at the corporation’s principal office, at some other location specified in the notice in the city where the meeting is being held, or at the office of the corporation’s transfer agent or registrar.16 Appearance on the list is prima facie evidence of the entitlement to inspect it.17 On the other hand, the contingent rights set forth in s. 607.1602 to inspect shareholder lists and records, are not related to a shareholder’s meeting and presumably address a request during any other time.

If a corporation does not prepare and make a shareholders list available for inspection as required in s. 607.0720, the shareholders’ meeting must be adjourned until the corporation complies, or upon application of a shareholder, until the circuit court of the county where the corporation’s principal office (or, if none in this state, its registered office) is located, orders inspection, summarily and at the corporation’s expense.18

To protect a corporation’s valuable shareholders list, s. 607.1602(7) states that “[A] shareholder may not sell or otherwise distribute any information or records inspected under this section, except to the extent that such use is for a proper purpose as defined in subsection (3). Any person who violates this provision shall be subject to a civil penalty of $5000.”19 In addition, “a corporation may deny any demand for inspection if the demand was made for an improper purpose, or if the demanding shareholder has within 2 years preceding his or her demand sold or offered for sale any list of shareholders of the corporation or any other corporation, has aided or abetted any person in procuring any list of shareholders for any such purpose, or has improperly used any information secured through any prior examination of the records of the corporation or any other corporation.”20

Finally, s. 607.1621, requires a corporation to provide shareholders with certain reports. In particular:

• (a) If a corporation indemnifies or advances expenses to any director, officer, employee or agent under s. 607.0850 (indemnification of officers, directors, employees and agents) otherwise than by court order or action by the shareholders or by an insurance carrier pursuant to insurance maintained by the corporation, the corporation shall report the indemnification or advance in writing to the shareholders with or before the notice of the next shareholder’s meeting, or prior to such meeting if the indemnification or advance occurs after the giving of such notice but prior to the time such meeting is held, which report shall include a statement specifying the persons paid, the amounts paid, and the nature and status at the time of such payment of the litigation or threatened litigation.21
• (b) If a corporation issues or authorizes the issuance of shares for promises to render services in the future, the corporation shall report in writing to the shareholders the number of shares authorized or issued, and the consideration received by the corporation, with or before the notice of the next shareholders’ meeting.22

Although neither the cases nor the statute specifies, presumably the right to receive reports pursuant to s. 607.1621, is enforceable through an action for court ordered inspection under s. 607.1604.

Contingent Inspection Rights

The inspection of most records is contingent upon the requesting shareholder making assertions as to good faith and proper purpose and otherwise not having forfeited rights as a result of prior misconduct. Again the prominent inspection provision is Florida Statutes s. 607.1602, entitled “Inspection of Records.” In particular, Section 607.1602(2) provides “[A] shareholder of a corporation is entitled to inspect and copy, during regular business hours at a reasonable location specified by the corporation, any of the following records of the corporation if the shareholder meets the requirements of subsection (3) and gives the corporation written notice of his or her demand at least 5 business days before the date on which he or she wishes to inspect and copy.”23 (emphasis added). The records to which a shareholder is entitled to inspect pursuant to s. 607.1602(2) and (3) include:

• (a) Excerpts from minutes of any meeting of the board of directors, records of any action of a committee of the board of directors while acting in place of the board of directors on behalf of the corporation, minutes of any meeting of the shareholders, and records of action taken by the shareholders or board of directors without a meeting, to the extent not already being provided pursuant to F.S. 607.1602(1);
• (b) Accounting records of the corporation,
• (c) The record of shareholders24; and
• (d) Any other books and records.25

A records request under Section 607.1602(2) is contingent upon a shareholder meeting the requirements set forth in section (3). Section 607.1602(3) provides that a shareholder may inspect and copy the records described in subsection (2) only if (emphasis added):

• a) The shareholder’s demand is made in good faith and for a proper purpose;
• (b) The shareholder describes with reasonable particularity his or her purpose and the records he or she desires to inspect; and
• (c) The records are directly connected with the shareholder’s purpose.26

Upon satisfaction of the good faith and proper purpose requirements, the right to inspect accounting records has been construed broadly in favor of the shareholder. In fact, the Florida Supreme court construed predecessor inspection statutes as requiring a corporation to provide the materials and time needed for the inspecting shareholder to perform an audit.27 In addition, the predecessor statute provided for the imposition of penalties against the corporation, and its officers and/or agents individually, for the failure to allow inspection.28

The current inspection statute, s. 607.1602 which took effect July 1, 1990, eliminated the penalty provision, but is still broadly construed in favor of the shareholder. The Third District Court has held that where a shareholder seeks to inspect records for the purpose of valuing stock, a corporation must provide the financial data underlying unaudited financial statements.29 In particular, the corporation, in that case was required to permit the inspection of insurance policies, employment agreements, agreements for nondisclosure and subcontractor agreements.30 The Third District has also ordered inspection of corporate income tax returns, the general ledger of the corporation, as well as balance sheets, profit and loss statements and the stockbook.31

The right to inspect records of shareholders contained in F.S. 607.1602(2)(c) is in addition to a shareholders right to inspection of the shareholders list for a period of ten (10) days prior to a shareholders’ meeting found in s. 607.0720.. Both provisions make the right to inspection contingent upon the shareholder satisfying the requirements in 607.1602(3) that a shareholder’s demand be made in good faith and for a proper purpose.

The “any other books and records” provision is, of course, a topic of great debate. Although each attorney must be guided by the needs of their particular client, an example list of appropriate requests under the “any other books and records” provision include:

• (a) Balance sheets and profit and loss statements (in the form maintained by the corporation); records of any loans, expense advancements, expense indemnifications or assumptions of obligations by the corporation on behalf of any director, officer, employee or agent;[xxxii]
• (b) Any correspondence by and between the Corporation and its shareholders;
• (c) Any distributions to any director, officer, employee or agent, including any bonus payments, other than regular compensation;
• (d) Any contracts or agreements, whether consummated or pending, between individuals, corporations, or any other entity, in which an affiliate of such individual, corporation or other entity, is also an affiliate of the Corporation, as defined by the Florida Corporations Act (affiliate transactions);
• (e) Any contracts for merger, acquisition or share exchange, whether the Corporation is the acquirer or target;
• (f) Any contracts with underwriters, investment bankers or other financial institutions or businesses for financings, whether public or private;
• (g) Any contracts with other entities for shareholder relations, public relations, media relations or corporate image;
• (h) Any contracts with investment bankers or other entities for analysis and exposure to the investment community;
• (i) Insurance policies[xxxiii];
• (j) Employment agreements, subcontractor agreements and nondisclosure agreements[xxxiv];

Section 607.1602(9) defines a “proper purpose” as a “purpose reasonably related to such person’s interest as a shareholder.” The Florida circuit courts define a proper purpose as:

“A proper purpose is one that is lawful in character and not contrary to the interest of the corporation. It is one wherein a stockholder seeks information bearing upon the protection of his interest (and/or that of other stockholders), and not satisfaction of curiosity or a general fishing expedition.”[xxxv]

It is not enough to allege a proper purpose, but a shareholder must set forth facts to support the allegation of a proper purpose.[xxxvi] The following are proper purposes, in light of the general purpose for being a shareholder:

• (a) Determine the fair value, market value and potential value of his/her/it shareholder interest[xxxvii];
• (b) To determine the financial condition of the corporation[xxxviii];
• (c) To determine if money is available to pay dividends[xxxix];
• (d) To determine the method in which the directors have handled the affairs of the corporation[xl];
• (e) To determine the validity of corporate expenditures[xli];
• (f) Determine the percent ownership of his/her/it shareholder interest;
• (g) Determine the policies and conduct of management and the board of directors in the management and control of the corporation in which he/she/it is an owner;
• (h) Determine if actions have taken place in which he/she/it would be entitled to notice under Florida law and for which he/she/it has not received notice and to determine the impact on him/her/it as a shareholder therefrom;
• (i) To determine the scope and extent of affiliated transactions;
• (j) To determine the scope and extent of director, officer, employee or agent indemnifications and expense reimbursements and to determine the impact of these transactions or agreements on the value of his/her/it interest and the general well-being of the corporation as a whole;
• (k) To follow up on public statements made by the Corporation regarding future plans, goals and the like;
• (l) To determine the past history and future prospects of the Corporation and thus the viability of his/her/its interest and continued ownership;
• (m) To determine the results of a particular transaction and the impact of such transaction on his/her/its interest[xlii];
• (n) To determine if the share certificate in his/her/its possession properly represents his/her/its actual share ownership;
• (o) To determine any restrictions on the transferability of his/her/its shares and to evaluate the market value in the case of such transfer;
• (p) To assist in determining how to vote on any issue put to the shareholders for vote;
• (q) To seek out shareholders to purchase additional stock[xliii];

The fact that the request is being made by a stockholder or member who disagrees with the policies of the management of the corporation, or even has filed suit against the corporation, is not sufficient to defeat the request.[xliv]

In addition to the obvious concerns of having competitors learn of financial information, a corporation has the legitimate concern that a shareholder will use his/her/its right to inspection to gain shareholder information to be used in proxy wars. Accordingly, s. 607.1602(6) provides:

“[A] corporation may deny any demand for inspection made pursuant to subsection (2) if the demand was made for an improper purpose, or if the demanding shareholder has within 2 years preceding his or her demand sold or offered for sale any list of shareholders of the corporation or any other corporation, has aided or abetted any person in procuring any list of shareholders for any such purpose, or has improperly used any information secured through any prior examination of the records of the corporation or any other corporation.”[xlv]

The confidentiality of the requested records and information is a serious and valid concern to corporations. In the event of court ordered inspection, the court has the power to impose reasonable restrictions on the use or distribution of the records by the demanding shareholder.[xlvi] As an indication of good faith, I recommend that a shareholder consider voluntarily offering to enter into a confidentiality agreement as to the use and dissemination of the requested corporate records at the time of making the request for inspection.

In the event that a requesting shareholder properly abides by sections 607.1602(2) and (3) and their request is nevertheless denied or not responded to, upon application by the shareholder, the circuit court in the county where the corporation’s principal office (or, if none in this state, its registered office) is located may order inspection on an “expedited basis”.[xlvii]

If the court orders inspection or copying of the records demanded, it shall also order the corporation to pay the shareholder’s costs, including reasonable attorney’s fees, incurred to obtain the order and enforce its rights unless the corporation, or the officer, director, or agent, as the case may be, proves that it/she/he refused inspection in good faith because it/she/he had a reasonable basis for doubt about the right of the shareholder to inspect or copy the records demanded.[xlviii]

Section 607.1602(5) provides that “This section does not affect: (a) the right of a shareholder to inspect and copy records under s. 607.0720[xlix] or, if the shareholder is in litigation with the corporation, to the same extent as any other litigant; (b) the power of a court, independently of this act, to compel the production of corporate records for examination.[l]

Scope of Inspection Rights

A shareholder’s agent or attorney has the same inspection and copying rights as the shareholder he or she represents.[li] Obviously, all inspection rights are limited to actual shareholders and accordingly a corporation can validly deny inspection when a good faith dispute exists as to whether the requesting party is indeed a shareholder.[lii] However, shareholder rights extend to beneficial owners and not just record or legal title holders.[liii]

The shareholder or shareholder’s agent can request copies of records[liv], however, they do so at their own expense.[lv] Although the Company is limited to collecting a “reasonable charge”[lvi], this charge may include the costs of labor and material, and any costs associated with conversion of the records into written form.[lvii] A shareholder has no rights to receive copies of records other than in written form.[lviii] Presumably, a shareholder could not request copies of records on disk or cd, even though such production may be infinitely cheaper, and could be protected from alteration and/or copy.

[i] Fla. Stat. s 607.1602(1).
[ii] Fla. Stat. s. 607.1602(4).
[iii] Fla. Stat. s. 607.1601(5).
[iv] Fla. Stat. s. 607.1604(1).
[v] Fla. Stat. 607.1620(1).
[vi] Fla. Stat. 607.0620(1).
[vii] Fla. Stat. 607.0620(2).
[viii] Fla. Stat. 607.0620(2).
[ix] Fla. Stat. 607.0620(3).
[x] Fla. Stat. 607.0620(4).
[xi] Fla. Stat. 607.0620(4).
[xii] Fla. Stat. s. 607.0720(3).
[xiii] Fla. Stat. s. 607.0720(1). Section 607.1601(3) also requires that a corporation maintain shareholder records in such a matter as to permit preparation of the required lists.
[xiv] Fla. Stat. s. 607.0720(3).
[xv] Fla. Stat. s. 607.0720(2).
[xvi] Fla. Stat. s. 607.0720(2).
[xvii] Fla. Stat. s. 607.0720(4).
[xviii] Fla. Stat. s. 607.0720(5).
[xix] Fla. Stat. s. 607.1602(7).
[xx] Fla. Stat. s. 607.1602(6).
[xxi] Fla. Stat. s. 607.1621(1).
[xxii] Fla. Stat. s. 607.1621(2).
[xxiii] Fla. Stat. s. 607.1602(2)
[xxiv] The record of shareholders can be made available for inspection in accordance with s. 607.0720.
[xxv] Fla. Stat. s. 607.1602(2).
[xxvi] Fla. Stat. s. 607.1602(3); Collier Anesthesia, P.A. v. Worden, M.D., 726 So. 2d 342 (Fla. 2d DCA 1999).
[xxvii] Rahn v. Weir, 199 So. 584 (Fla. 1939); News-Journal Corporation v. Gore, 187 So. 271 (Fla. 1939); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xxviii] See for example Fail Safe Industries, Inc. v. Fontaine, 507 So. 2d 1215 (Fla. 4th DCA 1987).
[xxix] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3d DCA 1994).
[xxx] Id.
[xxxi]Jewelers International Showcase, Inc. v. Mandell, 529 So. 2d 1211 (Fla. 3d DCA 1988).
[xxxii] This request is also supported by F.S. 607.1603(4) and 607.0720.
[xxxiii] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3d DCA 1994).
[xxxiv] Id.
[xxxv] Delaney v. Santafe Healthcare, Inc., 741 So. 2d 595 (Fla. 1st DCA 1999); Oil Conservationists, Inc. v. Gilbert, 471 So. 2d 650, 653 (Fla. 4th DCA 1985).
[xxxvi] Oil Conservationists, Inc. v. Gilbert, 471 So. 2d 650, 653 (Fla. 4th DCA 1985).
[xxxvii] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xxxviii] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xxxix] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xl] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xli] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[xlii] Fritzv. Belcher Oil Company, 363 So. 2d 155 (Fla. 3d DCA 1978).
[xliii] Florida Telephone Corporation v. Peninsular Telephone Co., 111 So. 2d 677 (Fla. 1st DCA 1959).
[xliv] Delaney v. Santafe Healthcare, Inc., 741 So. 2d 595 (Fla. 1st DCA 1999) and cases cited therein.
[xlv] Fla. Stat. s. 607.1602(6).
[xlvi] Fla. Stat. s. 607.1604(4).
[xlvii] Fla. Stat. s. 607.1604(2).
[xlviii] Fla. Stat. s. 607.1604(3).
[xlix] Fla. Stat. s. 607.0720 requires that corporations make shareholders’ list available for a period of ten (10) days prior to a shareholders meeting and during such shareholders’ meeting.
[l] Fa. Stat. s. 607.1602(5).
[li] Fla. Stat. § 607.1603(1).
[lii] Universal Engineering Testing Company, Inc. v. Israel, 707 So. 2d 900 (Fla. 5th DCA 1998).
[liii] Fla. Stat. s. 607.01401(24); World Time Corporation of America v. Mizrachi, 702 So. 2d 284 (Fla. 4th DCA 1997).
[liv] Fla. Stat. § 607.1603(2).
[lv] Fla. Stat. § 607.1603(3).
[lvi] Id.
[lvii] Id.
[lviii] Id.

[1] Fla. Stat. s 607.1602(1).
[1] Fla. Stat. s. 607.1602(4).
[1] Fla. Stat. s. 607.1601(5).
[1] Fla. Stat. s. 607.1604(1).
[1] Fla. Stat. 607.1620(1).
[1] Fla. Stat. 607.0620(1).
[1] Fla. Stat. 607.0620(2).
[1] Fla. Stat. 607.0620(2).
[1] Fla. Stat. 607.0620(3).
[1] Fla. Stat. 607.0620(4).
[1] Fla. Stat. 607.0620(4).
[1] Fla. Stat. s. 607.0720(3).
[1] Fla. Stat. s. 607.0720(1). Section 607.1601(3) also requires that a corporation maintain shareholder records in such a matter as to permit preparation of the required lists.
[1] Fla. Stat. s. 607.0720(3).
[1] Fla. Stat. s. 607.0720(2).
[1] Fla. Stat. s. 607.0720(2).
[1] Fla. Stat. s. 607.0720(4).
[1] Fla. Stat. s. 607.0720(5).
[1] Fla. Stat. s. 607.1602(7).
[1] Fla. Stat. s. 607.1602(6).
[1] Fla. Stat. s. 607.1621(1).
[1] Fla. Stat. s. 607.1621(2).
[1] Fla. Stat. s. 607.1602(2)
[1] The record of shareholders can be made available for inspection in accordance with s. 607.0720.
[1] Fla. Stat. s. 607.1602(2).
[1] Fla. Stat. s. 607.1602(3); Collier Anesthesia, P.A. v. Worden, M.D., 726 So. 2d 342 (Fla. 2d DCA 1999).
[1] Rahn v. Weir, 199 So. 584 (Fla. 1939); News-Journal Corporation v. Gore, 187 So. 271 (Fla. 1939); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] See for example Fail Safe Industries, Inc. v. Fontaine, 507 So. 2d 1215 (Fla. 4th DCA 1987).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3d DCA 1994).
[1] Id.
[1]Jewelers International Showcase, Inc. v. Mandell, 529 So. 2d 1211 (Fla. 3d DCA 1988).
[1] This request is also supported by F.S. 607.1603(4) and 607.0720.
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3d DCA 1994).
[1] Id.
[1] Delaney v. Santafe Healthcare, Inc., 741 So. 2d 595 (Fla. 1st DCA 1999); Oil Conservationists, Inc. v. Gilbert, 471 So. 2d 650, 653 (Fla. 4th DCA 1985).
[1] Oil Conservationists, Inc. v. Gilbert, 471 So. 2d 650, 653 (Fla. 4th DCA 1985).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] Computer Solutions, Inc. v. Gnaizda, 633 So. 2d 1100 (Fla. 3rd DCA 1994); Soreno Hotel Co. v. Otis Elevator Co, 107 Fla. 195, 144 So. 339 (Fla. 1932).
[1] Fritzv. Belcher Oil Company, 363 So. 2d 155 (Fla. 3d DCA 1978).
[1] Florida Telephone Corporation v. Peninsular Telephone Co., 111 So. 2d 677 (Fla. 1st DCA 1959).
[1] Delaney v. Santafe Healthcare, Inc., 741 So. 2d 595 (Fla. 1st DCA 1999) and cases cited therein.
[1] Fla. Stat. s. 607.1602(6).
[1] Fla. Stat. s. 607.1604(4).
[1] Fla. Stat. s. 607.1604(2).
[1] Fla. Stat. s. 607.1604(3).
[1] Fla. Stat. s. 607.0720 requires that corporations make shareholders’ list available for a period of ten (10) days prior to a shareholders meeting and during such shareholders’ meeting.
[1] Fa. Stat. s. 607.1602(5).
[1] Fla. Stat. § 607.1603(1).
[1] Universal Engineering Testing Company, Inc. v. Israel, 707 So. 2d 900 (Fla. 5th DCA 1998).
[1] Fla. Stat. s. 607.01401(24); World Time Corporation of America v. Mizrachi, 702 So. 2d 284 (Fla. 4th DCA 1997).
[1] Fla. Stat. § 607.1603(2).
[1] Fla. Stat. § 607.1603(3).
[1] Id.
[1] Id.
[1] Id.

You’ve got the usual 100 or so things on your mind as you head to the mailbox after an exceptionally productive day at the office. The new trainee you’ve spent four months coaching is finally starting to earn his keep, a couple of positions are starting to work and the new secretary can actually do two things at once without having a nervous breakdown. Life is good.

You open the box and the interior is loaded with the usual bills, junk mail, your third Pottery Barn catalogue this week and one exceptionally large manila envelope. The return address reads “NASD” and your lunch rolls over in your stomach as you fumble to get your thumbnail beneath the tightly-sealed flap, incurring a nasty paper cut in the process.

You let the remainder of the mail tumble to the ground as you tear open the envelope in anxious anticipation and there, in plane black 12-point courier new type, is your name along with the names of your sales manager and the full name of your firm. After is written the word “Respondents.” You’ve just been named in your first formal client arbitration.

You want to believe it’s a mistake but it’s not. Then you hope it’s for a client who is seeking return of maybe $10,000 to $20,000 in commissions. But the document is about two inches thick and as you fan through pages of incomprehensible legal jargon you realize that you are being accused of breaking every conceivable regulatory and ethics standard known to man, and a few that you think have been made up just for good measure. The only things missing from the charges are double-parking a hovercraft in a school zone and impersonating a custom’s official. When you finally get to the third to the last page you see that the client’s attorney is seeking to recover damages in excess of $250,000.

You spend the next half hour breathing into a paper bag. The office is closed until the morning so you squander the entire evening dwelling on the situation and cursing the day you laughed at your father when he offered to turn the drywall business over to you upon his retirement. But after the shock comes denial, then the anger, and then ultimately, the acceptance. Acceptance, of course, that is punctuated by recurring bouts of shock, denial and anger, but acceptance nonetheless.

Moments before you are about to begin digging your trowel and drywall stilts out of the basement you have a moment of perfect clarity. You resolve yourself to the fact that this has happened to thousands of career brokers and you are no different. You are going to suck it up and take it like a man, and hopefully learn a thing or two about the legal process in the duration.

The fact of the matter is that lots of people in business get sued sometime during their careers and it doesn’t make them bad people. Doctors get sued, as do attorneys, mechanics, handgun manufacturers, wedding planners, gumball distributors and even drywall contractors like dear old Dad. They all live to tell the tale and some of them even walk away better, more confident professionals, having stared legal ridicule in the face and come away with their collective dignities and finances intact, more or less.

The more you understand the dynamics of the arbitration process the more effectively you can react. This strategy is four-fold and will hopefully manage some of the inherent stress, aggravation and expense of being named in a formal client complaint.

1. Assess the Situation and Select Representation

Begin by deciding who is going to represent your best interests in the firm’s defense. That’s right, the firm’s defense. First and foremost opposing counsel is going after your firm for damages because they have the deepest pockets and it was their responsibility to keep you operating on the straight and narrow. You however, must be named in the action in order for them to work their case through to its most lucrative outcome. If they filed against you solely their chances of actually recovering alleged damages would be slim to none. If you lost you would have thirty days to pay the judgment or lose your series 7 registration so you would simply relinquish your license, move onto another career and go through life with a massive judgment against you.

By naming the employing firm, and in many cases the clearing firm, opposing counsel understands fully that any judgment they are awarded must and indeed will be paid in the prescribed time frame or the employing firm, or the clearing firm, would have to shut it’s doors. In all probability Bear Stearns or Merrill Lynch is not going to board up their windows and hang up the “Gone Fishin’” sign over a $200,000 hit. They are going to pay in order to stay in business, as they have done many times before, and then seek to recoup financial damages from the next man down on the food chain, typically the registered rep, in accordance with their employment contract.

Obviously, best possible scenario is that you are still employed by the firm named in the complaint so that all named parties can work together as a cohesive unit.

It is the responsibility of the firm’s compliance officer to protect the firm first and you second in any client or regulatory action. Obviously, turning on you is not in their best interest because they ratified and authorized your activities on an ongoing basis and encouraged you to take certain positions in certain stocks at certain times by way of analysts recommendations. By implicating you in any wrongdoing the firm would be shooting themselves in the foot by opening themselves up to the actions of failure to supervise and breach of fiduciary responsibility.

Regardless, it is typically prudent to retain your own counsel, someone who answers to you and you only and who is working to make sure you prevail with as little damage as possible. After all, that’s what legal counsel does, damage control. Get the idea of a “magic wand” defense out of your head.

Legal counsel is best selected on a referral basis and always ask for client references. Find an attorney who specializes in securities matters and one you feel comfortable with. Relationship is everything because this is the person you are going to rely on to not only defend you against a myriad of allegations of impropriety, but also to make sure your reputation, career and earning potential are not compromised in the process.

Ideally this will be the basis for a long-term relationship and hopefully you will not have to shop for another attorney in the near future. Once you lay the groundwork with competent legal counsel you can save time and money in the future should another problem ever rear its ugly head. Have your team in place before trouble comes knocking again.

2. Develop Your Strategy and Plan Your Defense

You should have kept careful notes all along, but in the event you did not, sit down and begin a chronological explanation of everything that occurred throughout the life of the account. Begin with how the client was prospected and include every conceivable detail you can remember, no matter how inconsequential it may seem. You’d be surprised what type of information can be the saving grace in a legal defense situation.

Did the client ever speak about problems with other brokers before? At any point in the relationship did the client suffer from a substantial change in their financial profile that may have created a need to liquidate sooner than initially planned? Did they contact you with trades some of the time? Did they rely solely and exclusively on your advice? Did they ever decline your recommendation to cut losses, participate in a trade or diversify more extensively?

Your goal here is to show whenever appropriate that the client directed the account. You provided advice and they provided decisions. Opposing counsel will almost always attempt to substantiate that you, the broker, were in a control position and that the client was powerless. Without a thorough defense prepared you will be unable to prove otherwise.

The good news is that there are about six common causes of action in an arbitration and you’d better be sure that opposing counsel will attempt to apply all of them. Once you know what they are, you will be in a better position to demonstrate to the panel that you obeyed all pertinent rules and regulations, acted in the client’s best interest and maintained your fiduciary responsibility at all times.

Unsuitability

In the eyes of the law, suitability is a primary function of a broker’s duty. It is the responsibility of the broker to know the client’s level of comprehension or trading savvy. The broker should also understand the client’s threshold for absorbing trading losses if things do not go as planned.

In laymen’s terms this means that your client should not have been trading aggressive growth NASDAQ issues under $10 per share unless they had done so previously or had the financial cushion to gamble with. But opposing counsel can claim unsuitability even if your client stuck to the “Nifty Fifty” and the portfolio was padded with four or five different value funds as well. The definition of unsuitability typically varies. The concept however, is always the same; the client was unqualified to participate.

Opposing counsel will claim either that their client was too old, too poor or not experienced enough to be involved in whatever trading strategy the two of you agreed upon. They may further state that the money they invested was earmarked for other essential purposes or that they should have embarked on an income, not a growth or speculation, path.

The most effective way to defend against this particular allegation is going to be your notes or broker log. You must be able to recount to an arbitration panel the fact that several trading approaches were presented to the client and that in the end it was their sole and exclusive decision to embark on a program where they were willing to risk their investment capital in order to achieve higher than average returns.

Also, most account applications have sections where the client must document age, education, risk tolerance and trading experience in order to open and maintain an account. If the client claimed one thing when they opened the account and claimed something contradictory when they filed against you, then this discrepancy must be brought to light. After all, you were actually misled, not the client.

Client files should be updated annually to document any changes in the client’s financial condition or goals. Ultimately, your notes should demonstrate even more detail about your client’s trading qualifications and goals.

Additional Risk Disclosures can save the day as well, if you had one signed early on in the life of the account. The typical language in these disclosures requires the clients to sign off on the fact they understand there is substantial risk involved in what they are doing and that no matter how promising a trading opportunity appears they can lose all or part of what they invest.

Excessive Trading or Churning

This is probably the most vague of all causes of actions, and open to the widest variety of interpretation. How much trading is too much after all?

If a client opens a $100,000 trading account and it increases to $200,000 over the course of a year and they are charged $20,000 in commissions odds are no one is going to complain. But if the market then reverses and the account value drops to $50,000, they have still paid the $20,000 in gross commissions, creating the appearance of churning.

While opposing counsel focuses strictly on the dollar amount spent by the plaintiff on commissions, it is necessary for you and your attorney to show that the trades were executed in accordance with sound logic and with the strictest regard for the client’s well being. The way you traded the account must match with the way you and the client agreed to trade the account at its inception. Also, it is usually beneficial to be able to show the arbitration panel that the commission schedule was fully disclosed and agreed to before the first trade was executed.

If you bought and sold the same stocks in the client’s account repeatedly be sure you can document that the client fully intended to participate in an aggressive day-trading scenario. If you cannot it is all but guaranteed that this aspect of the relationship will come under scrutiny and be used against you by opposing counsel.

If indeed the account was vigorously traded for a period of a year or two, and commissions exceeded $50,000 it may be advisable to hire an expert witness to perform a forensic accounting. An expert or professional witness is an individual who is paid to evaluate all aspects of a particular broker/client relationship and give their informed opinion based on current industry standards and related business parallels. The opinion they render is typically thorough and they may cite other cases in order to substantiate their view.

Breach of Fiduciary Duty

The client is relying on you as a professional and you have a legal duty to live up to every aspect of that reliance. If you fail to exercise a standard of care imposed by law and owed to another (the client) then you will indeed face problems pertaining to breach of fiduciary duty.

Stockbrokers are expected to conduct due diligence, follow all industry rules and regulations pertaining to the trading of accounts and the solicitation of clients, and to know as much about their products as other stockbrokers. In addition, it is your responsibility to put the client’s interests before your own.

Did you cut losses and let profits run? Were phone calls from the client accepted or did you simply speak to them when you wanted them to trade? Did you ever discount commissions on a subsequent transaction after a losing trade? Did you receive any commission or compensation without disclosing it to the client? Did you attend due diligence meetings on new issues and partake in continuing education courses?

Think long and hard about these questions because they are the same one’s that may come up before an arbitration panel. The best answers are usually short, honest and direct.

Unauthorized Trading

Make sure that you can document the fact that every, I mean every, trade was authorized by the client before execution. There is simply no excuse for not doing so. Also be prepared to document conversations you had with clients after the fact and also times when you reviewed account statements and confirmations with your clients.

If you claim that you spoke to a client when indeed you did not, you run the risk of having opposing counsel subpoena phone records from your firm and the phone company. Get caught in one lie and the rest of your defense is automatically weakened. Also, lie to your legal counsel in the process and you will make an already tough job impossible.

Fraud & Failure to Disclose

State securities statutes demand that brokers make full and accurate representations to potential and existing clients pertaining to exactly what they are buying. Don’t tell a client they are buying an orange if they are buying a tangerine.

Never claim to have specific knowledge about a stock or its movement that is not available to the general public.

Also, if you fail to disclose a material fact that if disclosed would tend to make one or more of your statements “less true” this is fraud.

For example, you make a series of comparisons between an up-and-coming residential homebuilder, and an established homebuilder whose stock is traded on the NYSE. You inform the client that the new homebuilder possesses all the elements that the established company does and you make numerous references to the trading history of the NYSE stock. The stock of the new homebuilder’s company is trading on the NASDAQ however, and is teetering at about 2 _ per share.

You make no attempt to educate the client to the fact that NASDAQ issues are considerably riskier than NYSE issues and that if the stock falls below $2 per share for any period of time it will be moved to the small caps, further compromising the chances of success.

You must be able to demonstrate to the opposition that you gave a fair and balanced presentation before any such trades were executed. Balanced means that for every time you spoke about potential profits you spoke about potential loss.

Breach of Contract

You first reaction is probably “what contract?”

Breach of contract is an unjustified failure to perform when performance is due. By establishing a trading relationship with a client you are entering into a contract and promising to act as their professional liaison and guide them through the inherent pitfalls of the stock market.

This is not to be misconstrued that you are going to be their guarantor or that they are not going to ever lose money during the course of normal trading activity, but more so that you are going to be there for them in a professional capacity as necessary.

Make sure you are able to illustrate that your level of service was consistent throughout your business relationship with the client.

3. Remember What You Are Up Against

You have to keep opposing counsel’s motivation in the forefront of your mind at all times when preparing your defense. It is not a matter of what you did or didn’t do but more so how many of their attacks can you fend off over the procedural duration of the arbitration. The more claims they bring against you the more chance they have of something sticking, regardless of what really happened.

If they claim that you overtraded the account then you and your attorney can spend the next twelve months gathering evidence and testimony probably proving that you did not. But if they unload the entire shotgun on you, both barrels probably, you are going to have to fortify your defense on a variety of levels, and your weakest area of defense is what they are going to triangulate on.

However, deprive them of the luxury of being able to take the path of least resistance and they will understand from inception that you intend to stand your ground and fight back using every legal resource available. Attorneys handle multiple cases at any given time, and depending on their professional resources and their belief in the validity of the case and the veracity of their client they may begin to focus their efforts on another case that appears to be less work and more lucrative.

Typically, attorneys that make a career out of bringing arbitrations against brokers don’t do anything else. They run what is little more than a legal “mill” and know the process so intimately that they can draft written complaints in a matter of a few hours and hand off the remainder of the discovery process to young associates or paralegals. They will however step back into the process when it is “go time” and will have their best game on when it’s time to appear before the arbitration panel to make their allegations.

In most cases the plaintiff’s attorney is compensated through a minimal hourly fee they charge to your former client (now their client) but the real payoff comes at the end when the arbitration panel makes their decision or in the event the case is settled somewhere along the way. On the average they receive anywhere from 30% to 40% of what they recover. So just like everyone else, they are dollar-motivated.

You’ve seen the advertisements on late night television, usually around 1:30 a.m. on local access cable stations. They aggressively seek out investors and some even offer to work strictly on contingency, meaning that if they do not recoup damages they do not get paid. These are typically the most aggressive variety of plaintiff attorneys but also the easiest to deal with due to the fact that their motivation is singular.

So in theory, if you can remove the potential payoff, you eliminate opposing counsel’s motivation and the chances that case will either get dropped or settle out for a low dollar figure increases substantially.

If you have left the business and no longer need your series 7 registration, your situation is substantially better than someone who is still in the business. Typically, plaintiff’s attorneys only invest time into a case they know they can collect on. No one works for free, especially attorneys. If an action is brought against a broker who is no longer in the business then opposing counsel is going to collect from the sales manager or “24”, the employing firm, and possibly the clearing firm. Simply stated, anyone still holding a license.

If the firm is out of business, which is an increasingly common scenario these days, they are left with the option of going after the “24” who may or may not still be in the business at another firm, and the clearing firm. It is not as easy for them to prove their case against the “24” since he did not directly handle the account, and the clearing firm invariably has a staff of attorneys so large that the average plaintiff’s attorney has a better chance of holding the ocean back with a broom than they do of winning their case. Also, because the clearing firm has the “big guns” there is little chance they are going to settle out for any substantial sum.

That leaves opposing counsel with the prospect of going after a broker who has left the business, and probably has little or no assets aside from the equity in their primary residence, which is protected by Homestead laws. In order for opposing counsel to recoup damages in this scenario they must win their case, and then begin legal proceedings to perfect the judgment in the state court where the broker named in the arbitration lives. The claimant must then begin the long and laborious collection process, spending more money and more time in the process. Statistically, this doesn’t happen.

If you are in this position though, be prepared for the fact that you may indeed have a judgment on your credit history for the next ten to twenty years (terms vary from state to state) if opposing counsel decides to traverse the gamut and see the arbitration process the entire way through.

On the average the broker named in the arbitration is still employed with the original firm when the process is initiated. It is essential that your attorney works in lockstep with the firm’s compliance officer and legal counsel to make sure that everyone is on the same page. Even the slightest hint of in-fighting or inconsistency recounting the facts is going to fuel the fire and exacerbate what can possibly be a simple and painless occurrence.

You should judge the dollar amount that opposing counsel is seeking to recoup and factor that in with attorneys costs and lost production. The general rule of thumb is that if any complaint can be settled out for less then $10,000, do it. Ultimately, it is up to the parties named in the arbitration to make this decision, preferably together.

Make every possible attempt to settle the case out early on before it grows to encompass more and more of your time, since time is a valuable commodity that you can never get back. The best solution is typically to face the music and get things over with. Invariably, opposing counsel and the plaintiff will accept a smaller settlement now as opposed to rolling the dice on a larger one later. A bird in the hand is worth two in the bush, so on and so forth.

Mediation can be a simple and cost effective option for settling complaints as well.

Mediation can be formal or informal. If the formal variety is selected the NASD will provide a mediator to provide potential solutions. If the informal form of mediation is selected all concerned parties and their legal counsel will meet in open forum in an attempt to talk things out and reach a settlement.

Either form is non-binding and confidential. However, to be an effective settlement tool mediation should be taken just as seriously as an arbitration and it is still essential that you plan your legal strategy with as much attention to detail as if you were going before an arbitration panel. It is also recommended that you attend with counsel present, especially if the other side intends to.

An arbitration panel in theory is supposed to be a consortium of both industry and public professionals who can make a fair and impartial decision based on the facts of the case. They have all completed certain filing requirements and passed a test as well and are paid for their participation in the proceedings.

But you will probably not find a former producing broker amongst them. They are generally attorneys, accountants and individuals from other semi-related fields who have decided to take part in the process. Regardless of whom the panel is comprised of, do not expect a sympathetic audience. You are starting from the jumping off point that the only knowledge they have of you is what they have read in the initial client complaint and the series of responses and interrogatories that have been filed by your firm and your attorney.

You are also up against the traditional negative stereotype that the entertainment media and society as a whole has created about stockbrokers.

4. Move Forward

So the ugliness has come to a close in either one of four ways: you have been released from the proceeding somewhere throughout the process; the claim has been settled out; the panel has ruled you committed no wrongdoing; or the panel has ruled that the client is entitled to reparations.

If you have been released from the proceeding somewhere along the way it means that the panel has decided that the client may have a basis for their claim but that you had nothing to with what occurred. You can get back to business with a clear head knowing that you conducted yourself properly while plying your trade and that this came through in your defense.

In the event your firm has reached a settlement with the client you two must now come to an agreement as to what portion of the settlement you are financially responsible for. Traditionally, brokers are responsible for a portion of the settlement and are permitted to make payments back to the firm over a period of time. However, conditions for handling debts owed by the broker to the employing firm are typically spelled out in the broker’s employment contract. The manner in which this money can be repaid to the firm is infinite and typically open to negotiation. Work it out with your firm but try to make sure that it is your gross commission that goes toward paying the hit, not what you net.

If the arbitration runs its course completely and the panel rules that that the client’s assertions have no merit, once again it is business as usual for you.

If the panel concludes that you are indeed guilty of one or more of the allegations they will then decide the financial reparations that must be made to the client. Once the panel sends notification of its decision to the respondents, the respondents have 30 days to make reparations unless otherwise agreed. Once again, you must work out the details of paying your firm back.

The two things that must be kept in mind is that the decision of the arbitration panel is final and can only be appealed for very limited reasons. Also, the complaint is now a permanent part of your professional record (with certain exceptions) and is reportable on your U-4 for the rest of your career.

The exceptions being if you are about to be released from the case by the panel, if you are settling out with the client or if the panel decides you committed no wrongdoing, you have a chance of having your record expunged. Simply stated, that NASD will still have records of the fact that you were named in the action but this will not be reported on your CRD if a background search is initiated at a later date.

Whatever the outcome of the arbitration, treat the occurrence as a learning experience. If any adjustments need to be made to your business, then by all means make them. If you made mistakes then face facts, accept your share of the responsibility and don’t make the same mistakes twice. Move on, be a better broker and hold yourself to the highest professional standards.

“Knowledge is Power” Sir Francis Bacon once said. Nothing, I mean nothing, is truer than in the instance of defending one’s self in a client arbitration. Don’t just react, act. Think logically and apply your mental resources in a cohesive manner.

Most importantly, remember at all times that the arbitration process is not designed to crucify brokers for doing their job. It is intended to give the broker as well as the client the opportunity to tell their side of the story.

Like any system it is not perfect, but the system does work.

But these are modern times and brokerage firms are under more scrutiny than ever before, and not for just the way they treat clients; for the way they treat their brokers as well.

The securities industry boasts one of the highest turnover rates of personnel of any professional field. In some cases it has been calculated that as many as 97% of the people that start in “the business” never make it three years. Because of this fact, hundreds of millions of dollars of clients’ equity go up for grabs as 97 out of 100 brokers hit the door, either seeking greener pastures at a firm across the street or simply leaving the business for the sanity of a low-stress, salaried position in a slower-paced environment. Regardless, the practice of distributing house accounts is a tremendous part of the business that brokers rarely speak about and that the investment public hears about to even a lesser extent.

Most standard employment contracts issued by brokerage firms today include language specifying that the firm owns the brokers work product, including any and all client accounts. Whether the broker is termed for cause or simply resigns, these accounts then become “house accounts’ or simply stated, the property of the employing firm. Moreover, most such employment contracts contain a “non-competition” agreement preventing the broker who is leaving from soliciting their clients when and if he or she joins another firm. NASD rules and regulations also require that any disputes between a registered rep and employing firm will be settled by arbitration procedures.

Customarily, these accounts are distributed by the first in the chain of command, the sales manager, affectionately known as the “24.” In addition to nominal salaries, sales managers are customarily compensated in two ways: if they are a “producing manager” with their own “book”, they receive the pick of the litter of attrition when a broker leaves the firm. They also receive an override (anywhere from 1%-5%) on the brokers they manage. Their motivation is of course to first reallocate house accounts to top-producing agents who have the ability to generate the greatest amount of commission dollars for the firm while servicing their new-found client base. Secondly, managers will distribute accounts to their familiars or “buddies” in the firm, brokers they not only have to satisfy in a professional but social capacity as well.

This “buddy system” is truly one of the last bastions of unchecked nepotism in the industry today.

This dynamic brings us to the ‘chicken and the egg” scenario. Does a registered rep become a top producer because he inherits accounts, or does he inherit accounts because he is a top-producer? Regardless, the simple fact that this practice exists means that hundreds of millions of commission dollars are directed into the pockets of a handful of the firm’s brokers, without any formal industry or internal guidelines in place. The NASD rules do not provide any guidelines and do not require the firm’s written supervisory procedures to address this issue. The lack of industry procedures or guidelines not only permits this type of abuse and indiscretion by the firm’s principals, but actually encourages it. Branch managers may commit outright discrimination on a regular basis and this spells L-I-A-B-I-L-I-T-Y for the employing firm.

With any accepted practice that is unregulated, where millions of dollars changes hands, there is more than just a “potential” for abuse. Abuse becomes inherent in the system. More unfortunately is the reality that these abuses are so broadly prevalent and accepted that they become part of the institution itself and accepted by the participants as “just the way things are.”

Female registered representatives and minorities feel the sting of these arbitrary policies more severely than their white, male counterparts. Women and minorities have made tremendous strides in the securities industry since the early 1970’s and Muriel “Mickie” Siebert is living proof of this. Ms. Siebert is the first woman to own a seat on the New York Stock Exchange and the first to head one of its member firms — Muriel Siebert & Co.

For the most part though, women and minorities comprise less than 20% of the securities industry but receive few, if any, of the house accounts traditionally distributed to their white, male associates. In related fields discrimination suits have resulted in multi-million dollar settlements to established companies that possess an otherwise unblemished track record. Most brokerage firms are constantly on the lookout for potential lawsuits from clients and regulatory bodies when in actuality they should be more wary of the liability that is growing in their own backyards.

As is the nature of regulatory and compliance law, it is typically cheaper to avoid a problem than to fix one.

It is recommended that one or more of the following four guidelines be adhered to by employing firms when allocating these house accounts. These guidelines will not only strengthen the firm’s defense in the event of an arbitration filed by a disgruntled broker, but will also strengthen the firm’s sales force in the process. Ideally, more revenues will be generated and ultimately retained since big-ticket settlements with former brokers are eliminated.

However, since for every action there is an equal and opposite reaction, it is imperative that these guidelines be imposed on a case-to-case basis. There are no absolutes. Every brokerage firm has its own particular structure, strengths and weaknesses and every sales force possesses its own particular dynamic as well.

Suitability:

Although “gross is king” other factors must be considered when distributing house accounts. Forcing a round peg into a square hole will only achieve production in the short term. If the receiving broker inherits an account with $50,000 in client equity and redistributes it in accordance with current company recommendations, this will result in a handful of trades and most likely, a dead end as far as the client-broker relationship is concerned. By matching the right broker to the appropriate client there is the distinct possibility that the relationship will foster a greater trust and understanding of the client’s financial needs and risk tolerance. Once this is achieved the client may be diversified into a greater variety of products by funding the account to a greater extent, or even by consolidating other brokerage accounts at the new brokers firm. The added benefit is that clients holding a variety of products do not experience the same swings in account value as clients holding equities exclusively, further diminishing the chances of a client complaint. The receiving broker is satisfied due to the fact that they have not merely inherited an account, they have received a client. In summary, a long-term perspective equals greater revenues with lower inherent liability from the broker as well as the client.

Document the reasons a specific account was handed to a particular broker, emphasizing the benefit to the client, not the firm.

Record Keeping & Monitoring:

Since every top-producing broker starts out as a non-producing entity it is only basic common sense that everyone must be given a chance to excel. If indeed you are assigning an account to a broker who does not possess a stellar record of production, be sure to keep a separate log detailing what accounts were handed to whom and on what date and, as stated, for what reason. Also print the account’s daily statement for that date and attach it to your log. The broker should be informed that the accounts are distributed on a trial basis and that indeed they are property of the firm. You are merely appointing him or her as your representative to serve the client’s needs.

After sixty days review the progress of the account with the broker and give the client a quick call to gauge their overall satisfaction with the way their account is being handled. This practice of handing out accounts with a “probationary period” attached serves several purposes:

• Brokers who do not ordinarily receive house accounts will now be brought into the fold, diminishing the likelihood of female or male brokers for that matter filing a discrimination claim against their employing firm.
• In the event that the broker rises to the occasion and forges a solid, revenue producing relationship with the client, you now have birthed another confident, top-producer to strengthen your ranks.
• Although all account activities are supervised by the “24” the fact that the receiving broker understands there will be a sixty-day review on that particular account further encourages him or her to really stretch and service that account to the best of their abilities.

Should it be established that after sixty days the broker has basically “dead-ended” with the client, detail this in your records in order to insulate the firm from potential liability. The account should then be reassigned to another broker who may be a better fit for the client.

Consistency in Standards:

Consistency is tantamount in avoiding liability suits from employees. For example, if three accounts are handed to a broker with an annual production of $750,000 gross; there is absolutely no defense for not applying the same treatment to “Broker 2” who possesses the same qualifications.

The best way to avoid this conflict is to codify the firm’s policy for distributing house accounts. Qualifications for receiving house accounts should be based on the following:

• Set a minimum period of employment with the firm in order for a broker to benefit from attrition. This practice will not only solidify the firm’s standards of impartiality but also encourage registered representatives to go the distance as opposed to hitting the door during year two for a higher payout or a bigger office at a firm across town.
• Brokers with multiple licenses should receive preference over brokers who meet minimum licensing requirements. Once again, this practice creates two substantial benefits. Distribution practices become standardized and brokers are encouraged to secure additional licenses, further strengthening the effectiveness of your sales force.
• Above all else brokers who exceed a specified number of customer complaints should be removed form the rotation entirely. As we approach a zero-tolerance environment this practice should be enforced without exception. This threshold should be set as a percentage, not as a true numerical figure. In other words, a broker with 500 clients and one internal complaint should not be viewed in the same light as a broker with 100 clients and one internal complaint.
• Lastly, and most importantly, if 15% of the firm’s member brokers are female and minority, then the manager should make every possible effort to see that they receive 15% of the firm’s attrition.

Eliminate the Practice Entirely

The easiest and most cost effective way to handle this thorny conundrum is to simply eliminate the practice entirely. Create one house book and assign one or a small group of brokers to handle the equity and service the client base.

Since these brokers are not raising equity for the most part or cold-calling in order to initiate the long and laborious practice of opening accounts, it can be justified that they receive a substantially lower payout percentage-wise. Since attrition is an ongoing occurrence the house book will eventually become considerably large, so the attending representatives will be well compensated from a dollar perspective.

Once again, this book and these brokers should be closely monitored and held to the highest industry and internal standards to minimize the potential for any abuse.

The benefits to this approach are obvious. It creates the simplest, most cost-effective scenario for handling attrition while eliminating any risk that the employing firm will be sued for bias in distributing accounts.

The downside to this practice is potentially two-fold is this policy is initiated in mid-stream. In other words, if your brokers are currently receiving attrition it is essential that you continue to provide it. If the practice of reallocating house accounts to producing agents is eradicated, your sales staff may perceive that the employing firm has become greedy by hoarding accounts for its own book. This may initiate a mass exodus that will cost the firm its top producers and may make recruiting a near impossibility once the firm’s reputation has been damaged.

The second downside is that the ability to supply incentives to superstar producers has been lost in the process.

In summary, if house are to be kept by the house it is necessary that this procedure be implemented at the inception of the branch.

Discrimination suits adversely affect the bottom line of a securities firm on two specific fronts. There is potentially the short-term catastrophic expense of paying the settlement itself in addition to the long-term damage to the company’s reputation as a fair and impartial employer. Brokers have more options than ever before when seeking employment and it is of vital importance to create and sustain a balanced working environment where pre-empting discrimination quagmires is viewed with the same importance as generating gross production.

However, regardless of the size and focus of the brokerage firm it goes without saying that it is typically cheaper to avoid a problem than to fix one.

An offering document in a private offering is called a “private placement memorandum” or an “offering circular” – not a “prospectus.” A broker who brings the issuer and buyers together in a private placement is called the “placement agent” – not an underwriter. Private offerings are conducted on a “best efforts,” rather than on a “firm commitment” basis.

Under Rule 505 up to $5 million worth of securities can be sold to an unlimited number of “accredited investors” as well as 35 other investors as long as the investment is suitable for these other investors. Audited financial statements are required if non-accredited investors are included in the offering.

Under Rule 506 an unlimited amount of securities can be sold to an unlimited number of “accredited investors” and 35 sophisticated investors – audited financial statements are required if sophisticated investors are included in the offering. Federal securities laws preempt the ability of states to require registration of Rule 506 offerings. The preemption has made Rule 506 offerings more popular it was enacted by Congress in 1996.

General solicitation or advertising can be defined as any information generally available or widely distributed to promote the sale of a security. The SEC has provided guidance as to what activities a company or its placement agent can undertake in connection with an online private offering without violating the general solicitation restrictions.

An “accredited investor” is an investor with a net worth of $1 million – or income of $200K (or $300K for couples, if one spouse cannot meet the $200k threshold) in each of the last two years. Whereas a „sophisticated investor‰ is an investor whom a company reasonably believes has adequate knowledge and experience in financial and business matters.

PIPE transactions may involve the sale of common stock, convertible preferred stock, convertible debentures, warrants, or other equity or equity-like securities of an already-public company.

What are some of the advantages of a PIPE transaction?

• A PIPE transaction offers several significant advantages for an issuer, including:
• lowering transaction expenses;
• expanding institutional and accredited investor holdings;
• for fixed price transactions, reducing the incentive for investors to hedge their commitment by shorting the issuer’s stock;
• requiring disclosure of the transaction to the public only after definitive purchase commitments are received from investors;
• requiring preparation by the Issuer only of very streamlined information, including publicly filed Exchange Act reports; and
• enabling a transaction to close and fund within seven to ten days of receiving definitive purchase commitments.

How do traditional PIPE transactions differ from non-traditional PIPE transactions?

In a traditional PIPE transaction, the investor bears the price risk from the time of pricing until the time of closing. The issuer is not obligated to deliver additional securities to the PIPE investors in the event of fluctuations in stock price or otherwise. Investors enter into a definitive purchase agreement with the company in which they commit to purchase securities at a fixed purchase price. Investors do not fund at the time of entering into the purchase agreement. Instead, the company then files a resale registration statement covering the resale of those securities by the PIPE investors. The transaction closes once the SEC has indicated its preparedness to declare effective the resale registration statement. Consequently, the traditional PIPE investors have available a resale registration statement at the time of closing.

Non-traditional PIPE transactions generally are structured as private placements with follow-on (or trailing) registration rights. This means that once investors enter into a definitive purchase agreement, a closing is scheduled. Investors fund and the transaction closes. Post-closing, the company has an obligation to file a resale registration statement and use its best efforts to have it declared effective.

At the closing of a traditional PIPE transaction, purchasers receive legended securities.

What are the benefits of traditional PIPE transactions compared to non-traditional PIPE transactions?

A traditional PIPE reduces uncertainty, market risk, and illiquidity compared to a private placement PIPE.

Purchasers in a traditional PIPE are not required to close until a resale registration statement is available for subsequent sales of the shares purchased in the PIPE transaction. Traditional PIPE purchasers are able to obtain unlegended shares shortly after, or at, closing, allowing purchasers flexibility in disposing of the shares.

For most registered investment funds, securities purchased in a traditional PIPE are counted in the funds’ public basket. This broadens the scope of potential investors for traditional PIPEs and also generally justifies better pricing.

How is a price set?

The price is set through discussions between the placement agent and the issuer, as it is during the course of an underwritten (firm commitment) offering or directly between the purchaser and the issuer.

Typically, PIPEs are priced at a modest discount to the closing bid price for the stock. Often, in variable/reset transactions, the price is set based on a formula that relates to the average closing price of the stock over the several days preceding the pricing.

Who bears price risk?

In a fixed price transaction, the purchaser bears the price risk during the period from execution of the purchase agreement until the closing. In a variable/reset price transaction, the price risk is shared between the investor and the company. Usually, the investor will negotiate some price protection for itself.

What Items are subject to negotiation?

In addition to negotiating specific carve outs for representations and warranties, the placement agent, purchaser, and issuer typically negotiate the following points:

• whether issuer’s counsel will be prepared to include a 10b-5 negative assurance in it opinion;
• whether the issuer will be required to cause its independent auditor to furnish the placement agent (if any) with a comfort letter at closing;
• whether there will be a limitation on the length of black-out periods;
• whether there will be penalty payments;
• the length of time given to the issuer to have the resale registration declared effective (most often 90 days); and
• whether there will be a time limit for filing of the resale registration statement following execution of the purchase agreements.

What are an issuer’s typical considerations relating to a PIPE transaction?

• usually the issuer cannot issue more than 20% of outstanding stock in the PIPE transaction without shareholder approval and prior notification to exchanges;
• the purchaser (not the issuer) bears market risk;
• a short timetable provided there is no SEC review;
• the format is familiar to sophisticated institutional investors;
• PIPEs typically involve a modest discount to market price;
• the SEC is comfortable with the PIPE format; and
• PIPEs do not have any of the negative effects associated with a “death spiral” preferred or an equity line of credit (discussed below).

Does a PIPE transaction require any prior approvals from regulatory agencies or self-regulatory organizations?

A PIPE transaction may require prior approval from the exchange on which the issuer’s common stock is quoted if the transaction will be completed at a discount and may result in the issuance of 20% or more of the issuer’s outstanding capital stock. The company should consider not only the effect of completing the proposed PIPE transaction, but also, if it has completed other private transactions within the same six month period, the aggregate effect of such transactions, all of which may be integrated. Each of the New York Stock Exchange, the American Stock Exchange, and NASDAQ has a similar requirement requiring the company to obtain shareholder approval if the transaction meets certain criteria.

How does an issuer ensure that it has complied with Regulation FD in the context of conducting a PIPE transaction?

An issuer is owed a duty of confidence from its agents, such as its placement agent, accountants, and other similar participants in the PIPE process. Generally, an issuer does not share with potential investors any information that has not already been included in the issuer’s Exchange Act reports.

A private placement memorandum for a PIPE transaction usually contains the issuer’s Exchange Act reports, together with legal disclaimers. It is prudent to limit the information contained in the private placement memorandum unless the issuer will be receiving signed confidentiality agreements. Although the issuer is not sharing material nonpublic information about the issuer’s business with potential PIPE investors, the issuer is sharing its plans concerning a potential financing transaction. The fact that the issuer is contemplating a PIPE transaction may itself constitute material nonpublic information.

The issuer should ensure that, before the placement agent reveals the issuer’s name, the placement agent obtains an agreement from each potential purchaser it contacts that information shared will be kept confidential. An oral agreement may be documented subsequently through an acknowledgement and a covenant in the purchase agreement.

Executive officers and directors – and their spouses, minor children, trusts, and similar entities. An “executive officer” is not covered under the Sarbanes-Oxley Act. Most practitioners believe the definition encompasses the same persons identified in the Form 10-K as executive officers – who typically also are Section 16 insiders. Since “indirect” personal loans also are prohibited, loans to spouses, minor children, trusts and similar arrangements are suspect and should not be made.

2. What is a “personal loan”?

It is unclear – as the Sarbanes-Oxley Act does not define the term and there is no definition of the term in the Securities Exchange Act of 1934. The new law prohibits the extension or maintenance of credit; arranging of credit or renewal of credit. In the absence of guidance from the SEC or other regulators, many practitioners have been conservative in how to interpret this term – and there have been differences of opinion among many practitioners. Some practitioners have noted that this new law is novel and indicative of a greater attempt to federalize state corporate law.

3. Can executive officers or directors still use brokers to conduct cashless exercises of stock options?

This is unclear – and probably the most controversial aspect of this Sarbanes-Oxley Act provision due to its potential widespread impact. Many companies allow executive officers and directors to exercise their options through “broker-assisted cashless exercises.” This allows the officer to exercise an option and sell the underlying shares at approximately the same time – and use the proceeds from the sale to pay the exercise price and any withholding taxes. These companies have made agreements with brokers to provide this service for its officers and directors.

Depending on the precise facts of the agreement between the company and the broker, these cashless exercise agreements involve either a temporary financing of the officer’s exercises by the company – or an “arranging” for credit by the company with the broker on behalf of the officers or directors. Companies typically either advance shares to the broker with a value equal to the exercise price (which the broker sells to pay the exercise price) – or promise to deliver shares to the broker after the broker uses its own shares to sell to pay the exercise price.

There are other permutations of these types of arrangements in which the company arguably extends – or “arranges” – credit to the officers and directors for a short period of time (between the time of the option exercise and the time of the underlying stock sale).

Since new Section 13(k) prohibits companies from “arranging” for the extension of credit, the question is whether the company’s involvement with the broker is sufficient for these agreements to be considered “arranged” credit that is prohibited under the new law.

Practitioners differ widely in their opinions until further guidance is obtained from regulators. Some believe that the Sarbanes-Oxley Act was never intended to apply to cashless exercises as they are not susceptible to the type of abuses that led to Congress acting – this view is growing in popularity . Others recommend the suspension of cashless exercises through these programs for executive officers and directors.

Some practitioners point out that officers can make their own arrangements with brokers to exercise their options and sell the underlying stock. These entail the officer or director tendering their own shares to pay the exercise price. Under these circumstances, the officer or director should not recognize any gain for selling the underlying shares. However, these arrangements could result in adverse accounting treatment for the company.

Note that even cash exercises can be problematic – as the company may be deemed to be extending credit between the time of the exercise (and withholding taxes are paid by the company) and the time that the officer receives a paycheck reflecting the deduction for the withholding.

4. Can companies still pay advances to executive officers for upcoming credit card obligations or other expenses?

It is unclear. Although Section 13(k)(2) provides exemptions from the prohibition on personal loans for extension of credit under charge cards or under an open end credit plan – these exemptions are qualified to require that the credit be made in the “ordinary course” of the company’s consumer credit business.

Some practitioners believe this qualification is confusing and casts the availability to rely on the exemption into doubt – pending further guidance from a regulator. On the other hand, some practitioners believe that bona fide travel advances or use of company credit cards for business purposes should not be considered “personal loans” – so long as they are made in the ordinary course and promptly repaid.

If companies decide to bear the risk and make advances, some practitioners advise that there should be clear policies restricting the use of advances and credit cards for business purposes.

5. Can companies still guarantee loans to executive officers from a third-party?

No. Most practitioners believe this would be an “indirect” extension of credit from the company to an executive officer under most circumstances.

6. Can executive officers obtain loans in 401(k) and other broad-based employee loan programs?

It is uncertain. The “market terms” requirement for loans that are exempt from the prohibition on loans requires that the loans be no more favorable than what is offered to the “general public.” Since most 401(k) and other broad-based employee loan programs offer terms that are more beneficial than that offered to the public, executive officers may not be able to obtain loans under these plans.

On the other hand, it should be noted that these loans are permissible from an insured depository institution to its insiders under an exemption under the Sarbanes-Oxley Act for these types of loans.

7. Can executive officers obtain loans in connection with grants of restricted stock?

No. Some companies grant restricted stock under terms that require the grantees to receive a loan from the company for all – or a portion – of the purchase price of the stock. After a certain threshold is met (either corporate performance targets or employment until a certain date), the loan is partially or completely forgiven.

8. Can companies still use indemnification arrangements under which an executive officer’s or director’s litigation expenses are paid in advance?

It is unclear – for many of the reasons set forth above regarding advances for other expenses. On the other hand, some practitioners note that the analysis in making these arrangements does not involve any consideration of whether the insider is creditworthy. Others provide more detailed rationales for the inapplicability of Section 402 to indemnification arrangements.

Federal securities laws place significant restrictions on the types of publicity and communications that a Company may issue while it is “in registration” in connection with a public offering. Failure to comply with these restrictions could delay or prevent the public offering and result in civil and criminal penalties. According to the SEC, “in registration” refers to the entire process from the time an issuer reaches an understanding with its managing underwriter or an internal decision to file a registration statement, through a period of at least 25 days after the effective date of the document filed with the SEC to register the shares to be sold to the public (a “Registration Statement”).

At all stages of the public offering process, a Company may continue its public communications in the normal course of business. That is, a Company may continue to issue press releases with respect to factual business developments, continue to discuss products or potential products and continue shareholder communications, provided that: (i) the disclosures are consistent with prior practice; (ii) the disclosures are in customary form; and (iii) the disclosures do not contain projections, forecasts, predictions, opinions or valuations. For example, press releases concerning significant new contracts, personnel changes or the opening of a new facility are permissible. Also, general advertising of the Company’s products and services is allowed.

These communications, however, should not include opinions about the value of the Company and should not mention the proposed public offering. The risk is that publicity regarding a Company or its securities prior to or after the filing of the Registration Statement could be viewed as an attempt to raise public interest in a Company and its stock in violation of federal securities laws. For example, predictions of increased earnings, market share or expected industry growth should be strictly avoided. In addition, all interviews, speeches and contacts with the general and financial press should be carefully monitored. A news article containing the comments of a director or employee of a Company regarding the offering or a Company’s prospects could be interpreted as an attempt to prepare the market for the offering.

To ensure that all disclosures made during the public offering process are proper, any proposed press releases, advertising, news articles or public statements planned by a Company should be reviewed by legal counsel prior to release.

DETAILED ANALYSIS

A. Pre-Filing Period. The period between the time an issuer reaches an understanding with its managing underwriter or agreement internally to pursue a public offering and the time that the issuer files a Registration Statement with the SEC is referred to as the “Pre-Filing Period.” During the Pre-Filing Period, there can be no offer to sell a Company’s securities, whether made through the use of a prospectus or any other form of communication. The phrase “offer to sell” is broadly defined, and may include publicity efforts in advance of a proposed offering that have the effect of arousing public interest in a Company or conditioning the market for the sale of its securities. There is no legal requirement to make a pre-filing press release announcing plans to begin a public offering, and generally it is not done. In unusual circumstances, however, a press release strictly complying with SEC rules may be used to end inquiries and conjecture prior to filing.

Companies are not required to cease all advertising and product announcements or to fail to answer inquiries from customers or vendors unrelated to a public offering. Thus, a Company may continue to issue press releases with respect to factual business developments, continue to discuss products or potential products and continue shareholder communications, provided that: (i) the disclosures are consistent with prior practice; (ii) the disclosures are in customary form; (iii) the disclosures do not contain projections, forecasts, predictions, opinions or valuations; and (iv) the content, timing and distribution of the disclosures do not otherwise suggest that a selling effort is underway. It is this last element that presents the most difficult issues and that often causes companies to act fairly conservatively. Each statement or activity must be examined in light of the circumstances in which it was made and must not be shaded to emphasize favorable rather than adverse information. In making any announcement during the Pre-Filing Period, companies must analyze and balance the nature and content of the information, as well as the length of time between the date of the statement and the filing and distribution of the Registration Statement, all in the context of the past practice and potential presumed motives for making the statement.

In addition to the civil and potential criminal penalties for violating these rules, the SEC can and has imposed delays in the effectiveness of a Registration Statement where improper disclosure or conditioning in the market has been made. This “cooling off” period can have a significant adverse effect on a company facing an unstable market or a crowded calendar of offerings.

B. Period Between Filing and Effectiveness (the “Waiting Period”). The period beginning with the filing of a Registration Statement and ending when the SEC completes its review of such Registration Statement and clears the issuer to sell its securities pursuant to such Registration Statement is known as the “Waiting Period.” During the Waiting Period, there may be oral offers to sell and written or oral offers to buy the securities. Written offers to sell, however, may only be made by use of a preliminary prospectus which is contained in the Registration Statement. The securities laws prohibit distribution of a “prospectus” unless that document meets the requirements of the Securities Act. The term “prospectus” is defined broadly to include any written communication, or any communication by radio or television, which offers any security for sale.

The SEC rules do exclude certain written communications from the definition of “prospectus,” such as a press release announcing the filing of a Registration Statement which contains only permitted information, including the name and address of the persons from whom the Preliminary Prospectus can be obtained.

While the prohibition against oral offers no longer applies during the Waiting Period, the guidelines discussed above concerning publicity, press releases and advertising in the Pre-Filing Period still apply concerning written communications.

C. Post-Effective Period. After the Registration Statement has become effective, both the sale and delivery of the securities must be preceded or accompanied by a copy of the written prospectus which is part of the Registration Statement÷the so-called “final prospectus.” Upon delivery of the final prospectus, supplemental sales literature may be used, provided that its not false or misleading.

Under the Securities Act and SEC rules, the prospectus delivery requirements continue during the period that the securities are being “distributed.” Any material change in the disclosures will, therefore, require the provision of an updated prospectus, which could be done either by a supplement or a new amended prospectus. Under the SEC rules, the underwriters of a public offering must continue to distribute a final prospectus for 25 days after the effective date or the date the first bona fide offer for the securities is made. This imposes an additional obligation on the issuer to keep the prospectus current during these time periods. One of the most frequent causes for incurring the expense of a post-effective update is the dissemination of information that materially changes the information contained in a final prospectus. Most issuers, therefore, try to avoid material developments shortly after a public offering and do not resume issuing financially related press releases until more than 25 days after the public offering. The Company, however, may make required government filings, such as quarterly or annual financial statements.

D. Conclusion and Guidelines. The important thing to realize is that the SEC may view publicity regarding a Company or its securities prior to or after the filing of the Registration Statement as part of the process of distributing the securities and deem the publicity to represent an offer to sell, or a solicitation of an offer to buy, a Company’s securities in violation of the Securities Act.

The management of a Company particularly should be aware of the content, form and frequency of public statements. Publicity in the normal course of business should not violate the Securities Act. For instance, the type of press releases typically made by a company regarding new employees or other business developments are not prohibited. The Company also should not feel hesitant about answering questions unrelated to the public offering regarding its business asked by prospective customers, suppliers or others in the normal course of business. Questions regarding the public offering prior to the filing of the Registration Statement should be declined. After the filing of the Registration Statement, questions regarding the public offering should be referred to the public filings in the EDGAR database or declined altogether.

On the other hand, the SEC has indicated that changes in the pattern of a company’s public communications during the period preceding a public offering may be viewed as an attempt to focus people on favorable publicity rather than on the prospectus. Thus, a violation of the SEC rules could occur if a company increases the circulation or frequency of its press releases and promotional materials, or changes the nature and emphasis of its releases and public relations activities by, for example, conducting a more comprehensive advertising campaign than normal.

The management of the Company also should be particularly careful to avoid any predictions of future financial performance or any statements about its value.

Prior to filing the Registration Statement, the Company should only tell its bankers, attorneys, accountants and other professionals with whom the Company does business on a “need to know basis” that the Company is considering a public offering. They also should be asked to keep this information confidential.

Given the potential delay that could be imposed by improper publicity, we urge you to review in advance with us and the underwriters (and their counsel):

• any press releases or other advertising that the Company proposes to issue;
• any articles that are expected to be published by trade journals or other news media concerning the Company or its products; and
• any speeches or other “public” statements or appearances planned by Company personnel.