History Repeating Itself: Microcap Fraud and Tertiary Players

According to the WSJ, the SEC is looking into microcap fraud. Microcap fraud typically involves a dishonest broker (someone has to facilitate the sale of the shares) and often a dishonest company (someone has to tell the market a false story). But these sorts of fraud can't happen without tertiary players.  

Critical tertiary players include lawyers who are either part of the scheme or who don't take adequate care in connection with their legal advice. They can write opinion letters that allow for free transferability of shares before the law allows (before expiration of the six month or one year holding period set out in Rule 144). They can involve transfer agents. Transfer agents, after all, have to issue the new securities, free of the legend that restricts transferability, in order for the shares to trade.  

So its not a surprise that, from an enforcement angle, the SEC is apparently looking as some of these tertiary players. According to the article: 

  • The SEC is looking at whether some lawyers and accountants are liable for helping to enable penny-stock frauds, either by signing off on phony information or simply not asking the right questions, said people close to the agency.

Accountants may or may not play a steady role in these types of frauds. Presumably efforts to pump up a company's share prices are not typically based upon fraudulent financial statements but are related more to fabricated development such as technological breakthroughs, rich ore strikes, or major new contracts with recognized companies, but lawyers and transfer agents are regular participants.

In the 80 years the SEC has been policing this type of fraud, the central role of lawyers and transfer agents has not changed. The question then is why there isn't more concerted regulatory action to put these bad, but tertiary, actors out of business. Enforcement can catch some of them. Presumably when it does, at least the lawyers may incur a bar from practicing before the SEC. But as we have written

  • The concern over the role of lawyers is not alleviated by the Commission’s authority under Rule 102(e). Attorneys are occasionally barred or suspended from practice before the Commission as a result of an alleged role in unregistered offerings. Not all lawyers involved in registration violations are, however, subjected to proceedings under Rule 102(e). More to the point, even those sanctioned may not be prevented from writing additional opinion letters. The opinion letters are not filed with the Commission and therefore arguably fall outside of the definition of “practice before the Commission.” See Rule 102(f) (defining practice to include the preparation of any opinion “filed with the Commission.”).

What should be done? At a minimum, the bad actor provisions should be extended to include lawyers and transfer agents sanctioned for certain types of offenses (certainly offenses that would arise from participation in offerings that violate Section 5 of the 1933 Act). In doing so, this would put onus on issuers and brokers relying on the various exemptions that are subject to the bad actor provisions (Rules 505, 506 of Regulation D and Regulation A & A+) to make sure that these persons do not participate in an exempt offering.  

We've suggested reforms in this area before. See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions (asserting that bad actor provisions should be extended to Rule 504 and that  definition should be expanded to include as covered persons lawyers and transfer agents). The suggestions, however, remain unaddressed. Without a more protracted regulatory response, history, in this area, will continue to repeat.  

J Robert Brown Jr.