Liability of Investor Relations Firms Involved in Publicity Campaigns
Like many of you, I am the recipient of numerous unwanted “junk faxes” touting the stocks of publicly traded microcap companies. On April 27, 2006, someone sent me a junk fax recommending the stock of Toronto-based Phinder Technologies, Inc. (“Phinder”), which was portrayed as having “very strong potential.” At first blush, it seems unlikely that anyone would buy stock based on an anonymous junk fax. However, the persistence of these publicity campaigns indicates that they have the desired effect of creating short-term investor interest. Apparently due to the junk faxes, about $50,000 of Phinder stock traded on April 27 alone. This is an impressive feat, considering that the company has reported operating losses, and its audit opinion has a “going concern” qualification. Besides providing a window into the OTC market, the Phinder publicity campaign illustrates the liability issues faced by investor relations firms that publicize stocks through the use of unsolicited faxes, e-mails and other aggressive means.
Undisclosed or Misrepresented Compensation
Section 17(b) of the Securities Act of 1933 (“Securities Act”) requires anyone who “publish[es], give[s] publicity to, or circulate[s] any notice, circular, advertisement, newspaper, article, letter, investment service, or communication” that “describes” a stock for a “consideration,” i.e., compensation, “received or to be received, directly or indirectly, from an issuer, underwriter, or dealer,” to “fully disclos[e] the receipt” of such consideration “and the amount thereof.” This statute broadly applies to virtually any type of publicly disseminated material that recommends purchase of a stock. The need to disclose the amount of compensation depends on its source. The term “issuer” includes the company that is being touted, and the term “underwriter” means “any person who has purchased from an issuer with a view to . . . the distribution of any security.” See Securities Act, Section 2(a)(11). This very broad definition encompasses any person or entity who starts to sell stock shortly after its receipt. The Phinder fax appears to satisfy Section 17(b) by disclosing that the touting entity “has been compensated forty thousand dollars by a non-affiliated third party shareholder for its efforts in preparing and distributing this information page.”
Investor relation firms must be extremely careful to accurately disclose all compensation received, or expected to be received. Otherwise, they may be charged with violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. In SEC v. Pope, [1] the SEC charged the defendant with falsely stating that he “received no direct compensation” in connection with his spam e-mail promotions, whereas in fact he received large amounts of stock and cash. The SEC views such misrepresentations as being material, meaning disclosure of the relevant facts would have been considered significant by a reasonable investor. See Basic v. Levinson, 485 U.S. 224 (1988).
Scalping (Undisclosed Personal Stock Sales)
The personal trading of persons paid to publicize stocks warrants careful consideration and disclosure. Cash-starved microcap companies usually pay their investor relations firms in stock, or arrange for such payment by large shareholders. The sale of such shares by investor relations firms, in apparent contradiction of their buy recommendations, can be legally problematic, because the U.S. Supreme Court has held that “purchasing shares of a security” for one’s account “shortly before recommending that security for long-term investment and then immediately selling the shares at a profit upon the rise in the market price following the recommendation” is a fraudulent practice. See Capital Gains Research Bureau, 375 U.S. 180 (1963). Accordingly, investor relations firms should always clearly disclose their intentions to sell stock that they are recommending. Silence is insufficient. The language used in the Phinder fax, namely that the touter “may make purchases or sales in such securities,” is arguably inadequate, due to its ambiguous nature. If possible, outside securities counsel should be retained to review whatever disclaimer is used.
False Press Releases
Investor relations firms typically compose promotional materials based on press releases, SEC filings and other publicly available materials. Press releases of issuers involved in promotional campaigns may contain actionable half-truths and exaggerations. For instance, the Phinder fax indicates that it provides a website service called “YellowPages.bz.” This reference could be considered misleading, if Phinder lacks any business relationship with the better-known Yellow Pages provided by well-known telecommunications companies. However, investor relations firms that disseminate an issuer’s false press releases usually are insulated from antifraud liability because they lack scienter, meaning they did not act with knowledge or recklessness. However, investor relations firm personnel may be liable for fraud if there was self-contradictory information, or other “red flags” that could form the basis for a finding that they acted recklessly. Further, the SEC can bring fraud charges against the issuers themselves, as well as their officers, on the basis of false press releases that are republished by an investor relations firm.
Stock Manipulation
Junk fax and e-mail campaigns result in foreseeable price and volume increases. If persons involved in the campaign sell their stock, the SEC may argue that the campaign constituted a fraudulent “pump and dump” market manipulation. In SEC v. Surgilight, Inc., [2] the agency argued that certain promoters ‘fraudulently drove up the stock price of Surgilight, and unloaded thousands of shares of that stock onto an unsuspecting investing public.” Such charges are usually accompanied by allegations that false information was disseminated and/or the presence of manipulative trading, e.g., the use of nominee accounts, wash sales or other means.
Securities Registration Violations
The origin of stock received by investor relations firms as compensation for their services can lead to securities registration charges. If stock used to compensate the firms originates from an issuer or an “affiliate” of the issuer, such stock is presumptively regarded as restricted, and cannot be legally sold without complying with Rule 144. See Rule 144(a)(3) (defining “restricted securities” as being acquired “directly or indirectly from the issuer, or from an affiliate of the issuer”). Since the term “affiliate” includes anyone who “controls” the issuer,” major shareholders may also be affiliates. See Rule 144(a)(1). Accordingly, notwithstanding the absence of a restrictive legend – which is not determinative of this issue – the SEC may conclude that the stock received by investor relations firms is in fact restricted. This is true notwithstanding typical disclosure language contained in junk faxes and e-mails that the compensation received came from a “non-affiliated” source. Since few investor relations firms care to hold their shares for the one-year holding period set forth in the Rule, such firms often inadvertently violate the registration provisions. See Rule 144(d).
Investor relations firms seeking to avoid securities registration charges brought under Section 5 of the Securities Act should make sure that any stock they receive does not come from, or at the direction of, the issuer or any of its officers, directors or major shareholders. It may be necessary to consult with counsel to determine whether the person providing the stock is an “affiliate.” Luckily for investor relations firms, the SEC rarely alleges violations of Section 5 in the absence of other violations, usually involving fraud. Further, although case law indicates that the SEC need not prove scienter to establish violations of the registration provisions, [3] as a matter of policy, the SEC takes the view that it must show a degree of recklessness to satisfy its burden of proof. The SEC appears to apply the standard set forth in the “broker's transaction” exemption from registration. This standard shields persons from liability if, "[a]fter reasonable inquiry,” they are “not aware of circumstances indicating that the person for whose account the securities are sold is an underwriter with respect to the securities or that the transaction is a part of a distribution of securities of the issuer." See Securities Act Section 4(4) and Rule 144(g). Accordingly, liability may be avoided by arguing that, under the circumstances, the investor relations firm reasonably believed that stock paid as compensation was unrestricted.
Conclusion
Investor relations firms must be careful to accurately disclose the amount of compensation they receive, and ensure that any stock paid as compensation was not arranged for, or provided by, the issuer or “affiliate” of the issuer. Such firms should also disclose their trading intentions, and be wary of any information tending to cast doubt on statements contained in press releases. Even then, firms that sell their stock into the inflated market created by their publicity campaign may be accused of manipulation.
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