COMPLIANT ESCROW MANAGEMENT

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1 Compliant escrow management is not a sexy, movie-plot-worthy concept like other areas of American securities law. It was not the reason why Bud Fox was hauled off in handcuffs and tears at the end of Wall Street. Nor was it a pivotal indictment in the Enron scandal, the culmination of Written by: Barrett Enix which marked a major turning point in American securities regulation. Thus, lack of excitement for and dramatization of escrow management in securities transactions is unsurprising. Nevertheless, escrow management is an integral component of engineering a successful, seamless, and, most importantly, lawful securities transaction. Anyone brokering a private placement 1 should consult and understand the applicable escrow rules to ensure a smooth and violation-free securities transaction. The Securities Exchange Act of 1934 requires anyone who facilitates private-placement, contingency offerings to control the flow of funds via a designated escrow account or separate bank account, 2 depending on the type of offering and the broker-dealer s net capital position. 3 Failure to do so is a violation to which the Financial Industry Regulating Authority ( FINRA ) and the Securities Exchange Commission ( SEC ) are particularly sensitive. 4 Both regulating bodies have expressed a heightened desire to enforce escrow requirements in recent years, and the consequences for noncompliance can be just as devastating as any other securities violation. 5 But the rules governing escrow management for private placement offerings are convoluted and often difficult to navigate. This paper provides a concise and comprehensive breakdown of the federal escrow management rules to give the reader a solid foundation from which to structure his or her own escrow management procedure. The Rules of Compliant Escrow There are three primary rules governing escrow management for private placement offerings. First, Rule 10b-9 (the Antifraud Rule ) governs the level of accuracy and specificity of information that must be prescribed in the offering materials and escrow agreement before any investments are taken. 6 Second, Rule 15c2-4 (the Escrow Rule ) provides compliant escrow procedure to which sales@

2 participating broker-dealers must adhere. 7 Finally, Rule 15c3-1 (the Net Capital Position Rule ) segregates available escrow management options under the Escrow Rule depending on the brokerdealer s net capital position, 8 i.e. how much liquidated capital the broker-dealer keeps on hand to insure the risk of losing investor funds. 9 Taken together, these rules provide the basic framework for compliant escrow management. Rule 10b-9: The Antifraud Rule The first rule governing compliant escrow management is the Antifraud Rule. The Antifraud Rule makes it a manipulative or deception device or contrivance, i.e. illegal, to represent an offering as a contingency offering 10 unless the offering is actually sold under specific contingency terms. 11 Accordingly, the offering materials disseminated to all subscribers must clearly and accurately represent the specific contingency terms of the offering. 12 The escrow agreement must also clearly and accurately delineate the specific contingency terms of the offering so the escrow agent properly and promptly disposes of the funds upon the occurrence or failure of the enumerated contingency. 13 This is required because the escrow agent, not the issuer or the participating broker-dealer, is solely responsible for determining whether and when the listed contingency is satisfied. Additionally, broker-dealers must provide full disclosure to all subscribers in a written amendment of the offering materials with the option of a full refund if a change is made to the mandatory contingency terms after the escrow begins collecting investment funds. 14 Therefore, the offering materials and escrow agreement must designate a specified amount of securities that must be sold at a specified price within a specified time, as well as the total amount due to the issuer that must be received by a particular date. 15 There are two nuances under the Antifraud Rule worth mentioning. First, only bona fide purchases count towards the contingency. Per SEC guidance, an offering may only be considered sold if all the securities required to be placed are sold in bona fide transactions [and] fully paid for. 16 Thus, mere indications of interest by purchasers and non-bona fide sales made to create the appearance of a successful completion of the offering will not satisfy the contingency. 17 Second, purchases made by the issuer or participating brokers to satisfy the contingency will not count toward the contingency unless the details of such purchases are specifically disclosed in the offering materials disseminated to all subscribers. 18 Such purchases must also be for investment, and not for immediate resale sales@

3 by the issuer or broker-dealer making the purchase. 19 Therefore, the Antifraud Rule establishes the default rule that only non-participating investors may make bona-fide purchases toward the targeted contingency. But if the issuer or any participating broker within the syndicate wishes to also contribute to the contingency, the specific terms of those purchases must be clearly and accurately delineated in the offering materials and disseminated to all subscribers with the option of a full refund if investments have already been collected. Rule 15c2-4: The Escrow Rule The second applicable rule is the Escrow Rule. The Escrow Rule requires broker[s], dealer[s], or municipal securities dealer[s] participating in any distribution of securities, other than a firmcommitment underwriting, to control the flow of funds for any contingency offering through the use of an escrow account. 20 Whether the Escrow Rule applies and under which enumerated procedure the flow of funds must be controlled is determined by properly defining the type of offering that the broker-dealer is facilitating. The Escrow Rule applies to all best effort offerings; 21 however, the Rule specifically contemplates heightened security on the flow of funds for contingency offerings because they inherently carry more risk of loss of funds. All private placements facilitated without a contractual guarantee that any of the offered securities will be sold is a best effort offering. 22 Best effort offerings do not facially require the realization of a contingency event to successfully complete the offering. This model is sometimes referred to as raise a dollar, keep a dollar. Under the Escrow Rule, broker-dealers facilitating best effort offerings without an enumerated contingency event do not need to utilize a segregated escrow account to control the flow of funds. Rather, the broker-dealer may accept any part of the sale price of any security being distributed so long as the money or other consideration received is promptly transmitted to the persons entitled thereto. 23 Thus, if the offering is structured as a best effort offering without an enumerated contingency requirement, then the broker-dealer may accept and promptly transfer the investor funds to the issuer without the use of a segregated escrow account. But if the offering is structured as a contingency offering, then the broker-dealer must use an escrow account to control the flow of funds. The Escrow Rule defines contingency offerings as those sales@

4 made on an all-or-none basis, or on any other basis which contemplates that payment is not to be made to the person on whose behalf the distribution is being made until some further event or contingency occurs. 24 The SEC elaborated further on its definition of contingency offering in a 2013 regulatory notice, providing that a contingency offering is a private placement in which the actual closing or sale of securities in the private placement is contingent on an event, typically the receipt of orders for a minimum aggregate amount of securities by an expiration date. 25 Typical contingency offerings establish a minimum amount of the offered securities that must be sold by a specified date before investor funds are released from escrow. 26 But any best effort offering 27 that enumerates a specific non-monetary event that must be realized to complete the offering is also treated as a contingency offering for purposes of the escrow rules. Therefore, if release of escrowed funds depends on the realization of any event enumerated in the offering materials and escrow agreement, then the offering should be treated as a contingency offering for purposes the escrow rules. Typical contingency offerings come in two forms: (1) all-or-none offerings; or (2) part-or-none (otherwise called minimum-maximum ) offerings. 28 In all-or-none offerings, all offered securities must be sold within a pre-determined time period. If the entire offering is not sold before the expiration date, then all funds held in escrow must be promptly 29 refunded to the investors. 30 For instance, the private placement memorandum ( PPM ) and escrow agreement for an offering stipulates that Company A is raising capital by selling 500,000 shares of stock, valued at $1.00 per share. The offering is designated as an all-or-none offering, and will close in one year. If all 500,000 shares are sold, i.e. the escrow account collects $500,000 from various investors to purchase the available shares in Company A, before the one year term expires, then the escrow agent will promptly release the investors funds to Company A. Company A will then issue to the subscribers their purchased shares in Company A. But if escrow only collects $300,000 before the one year term expires, then the offering fails and the escrow agent must refund all $300,000 to the investors before closing the escrow account. Conversely, in a part-or-none ( minimum-maximum ) offering, the issuer designates a minimum amount of securities (less than the full amount offered) that must be sold before the expiration of sales@

5 the pre-determined time period. 31 If the designated minimum amount of securities is sold before the expiration date, then the escrow agent must promptly release the investors funds to the issuer. 32 But if the minimum amount of securities is not sold by the expiration date, then the escrow agent must promptly refund the investors money. 33 For example, the PPM and escrow agreement provide that Company A is raising capital by selling 500,000 shares of stock, valued at $1.00 per share. The offering is designated as a part-or-none offering, the minimum amount of shares that need to be sold is 300,000, and the term of the offering will close in one year. So long as escrow collects $300,000 in investor funds before the expiration of the one year term, the escrow agent will release the funds to Company A, and Company A will issue the purchased shares to the purchasing investors. But if escrow only collects $200,000 before the one year term expires, then the offering fails and all $200,000 will be refunded to the investors before the escrow account is closed. Either way, the result and consequences are the same the designated contingency is met and the funds release to the issuer, or the transaction fails and the funds are refunded in full to the investors. Application of the Escrow Rule depends on two things: (1) the existence of a contingency offering; and (2) the net capital position of the broker-dealer. 34 If the offering is not contingency based, then the Rule does not apply and the participating broker-dealer may accept any part of the sale price of any security being distributed [if]: (a) [t]he money or other consideration received is promptly transmitted to the persons entitled thereto. 35 But if the offerings is a contingency offering, then the Rule applies and participating broker-dealers must either (1) promptly deposit investors funds into a separate bank account and act as its agent or trustee, or (2) put the funds in escrow with an unaffiliated bank that agrees in writing to hold the funds in escrow and act as the escrow agent. 36 Which of the two options the broker-dealer may choose, however, depends on the broker-dealer s net capital position under the Net Capital Position Rule. Rule 15c3-1: The Net Capital Position Rule The third rule governing compliant escrow management is the Net Capital Position Rule, which makes a broker-dealer s net capital position the controlling factor in whether the broker-dealer can participate in certain actions. 37 Applying only to registered broker-dealers, 38 the purpose of the sales@

6 Rule is to ensure that registered broker-dealers maintain at all times sufficient liquid assets to (1) promptly satisfy their liabilities[;]... and (2) provide a cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks if they should be required to liquidate. 39 Accordingly, the Rule assigns a liquidity test that broker-dealers must use to determine their net capital positions, and, by extension, their available escrow options under the Escrow Rule. 40 The Net Capital Position Rule has two provisions that are particularly important for basic escrow compliance. First, broker-dealers must maintain a net capital position of at least $5,000 to facilitate any private placements. 41 This means that the broker-dealer must keep at least $5,000 in liquid capital on hand at all times to remain compliant under the Rule. Second, broker-dealers must maintain a net capital position of at least $250,000 to carry customer or broker or dealer accounts and receives or hold funds or securities for those persons. 42 Following the purpose of the Rule, broker-dealers with a net capital position of at least $250,000 have more options available to them regarding the flow of funds because they can account for higher-risk transactions and procedures. Regarding the Net Capital Position Rule s effect on the application of the Escrow Rule, a $250,000 broker-dealer (a broker-dealer with a constant net capital position of $250,000) may choose either flow of funds option under the Escrow Rule. 43 Thus, a $250,000 broker-dealer can either deposit investor funds in a segregated bank account and act as trustee or escrow agent, or deposit the investors funds in an escrow account with an unaffiliated bank, which will serve as escrow agent. But $5,000 brokerdealers (broker-dealers with the minimum, $5,000 net capital position) may only control the flow of funds for contingency offerings using an escrow in an unaffiliated bank. 44 Therefore, if the offering is designated as a contingency offering, then the broker-dealer s option under the Escrow Rule depends on its net capital position. Escrow At a Glance: Three Common Models These rules, read together, provide the basic framework for compliant escrow management. Accordingly, there are three common scenarios in which most transactions will operate. 1. If the broker-dealer has a net capital position of at least $250,000 and is facilitating a contingency offering, then it may choose either of the following: sales@

7 a. Promptly deposit investor funds into a separate bank account and act as trustee or agent b. Or, deposit the funds in escrow with an unaffiliated bank that agrees in writing to act as the escrow agent and release or refund the funds when necessary. 2. If the broker-dealer has a net capital position of less than $250,000, and is participating in a contingency offering, then the broker-dealer must deposit the investors funds in escrow with an unaffiliated bank that agrees in writing to act as escrow agent and release or refund the funds when necessary. 3. If the broker-dealer is not participating in a contingency offering, then it may accept and promptly transfer investors funds to the issuer. Conclusion Following the spirit of securities brokerage, the ultimate takeaway is that compliance is paramount. This is especially true because there is so much at stake during every private placement transaction, including the issuer s capital raise, the investors money, and the broker-dealer s FINRA membership, broker licenses, and professional reputation. Where FINRA and the SEC are increasingly vigilant in their enforcement of the escrow rules, the best and least cumbersome tactic available is to formulate a compliant escrow management procedure at the outset of every transaction. Of course, the first step to formulating a compliant escrow management procedure is to understand the laws governing the flow of funds. WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied on as legal advice. sales@

8 REFERENCES 1 The term private placement indicates a securities transaction not involving a registered public offering. 2 See Transmission or Maintenance of Payments Received in Connection With Underwritings, 17 C.F.R c2-4 (1976). Section 15c2-4 prohibits any broker, dealer, or municipal securities dealer participating in a distribution of securities, other than in a firm-commitment underwriting, from accepting investor funds in noncompliance of the terms of the rule. Anyone can broker a private placement of securities under the Rule 3a4-1 registration exemption. See Associated Persons of an Issuer Deemed Not to Be Brokers, 17 C.F.R a4-1 (1985). Thus, Rule 15c2-4 is not limited in its application to only broker-dealers. 3 See Net Capital Requirements for Brokers or Dealers, 17 C.F.R c3-1 (2014). 4 See Robert B. Robbins, Avoiding Liability in Best Efforts Offerings and Closings Under Rule 10b-9, ABA-AMI (March 2015), available at sitefiles/publications/avoidingliabilityinbesteffortsofferingsandclosingsunderrule10b9.pdf [hereinafter Robbins]; Letter from Rick Ketchum, Chairman and CEO, FINRA Chairman, 2015 Regulatory and Examination Priorities Letter (January 6, 2015), available at [hereinafter 2015 Regulatory and Examination Priorities]. 5 See, e.g., 2015 Regulatory and Examination Priorities Letter ( FINRA s review of private placement filing has also revealed a number of problems associated with contingency offerings and escrow procedures. ). 6 See Prohibited Representations in Connection With Certain Offerings, 17 C.F.R b-9 (1962). 7 See 17 C.F.R c See 17 C.F.R c OFFICE OF INTERNAL AFFAIRS, SECURITIES EXCHANGE COMM N, GAO/GGD , KEY SEC FINANCIAL RESPONSIBILITY RULES , available at about/offices/oia/oia_market/key_rules.pdf (last visited January 25, 2016) ( The primary purpose of this rule is to ensure that registered broker-dealers maintain at all times sufficient liquid assets to (1) promptly satisfy their liabilities[;]... and (2) [] provide a cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks if they should be required to liquidate. ). 10 See infra note and accompanying text (defining contingency offering ) C.F.R b-9(a); SPECIAL RULES GOVERNING ALL-OR-NONE AND MINIMUM OFFERINGS (1934 ACT RULES 10B-9 AND 15C2-4), 1-1 SECURITIES LAW TECHNIQUES 1.07 (2015) [hereinafter SPECIAL RULES] (exploring the nuances of Rule 10b-9 in terms of its effects on escrow management). 12 SPECIAL RULES, supra note 11, at SPECIAL RULES, supra note 11, at Requirements of Rules 10b-9 and 15c2-4 Under the Securities Exchange Act of 1934 Relating to Issuers, Underwriters and Broker-Dealers Engaged in an All or None Offering, Exchange Act Release No , 1975 SEC LEXIS 1229 (July 11, 1975). 17 SPECIAL RULES, supra note 11, at 1.07; see Exchange Act Release No , supra note Interpretive Release on Regulation D, Securities Act Release No , 48 Fed. Reg. 10,045 (March 3, 1983) C.F.R c2-4. The Rule reads in full as follows: It shall constitute a fraudulent, deceptive, or manipulative act or practice as used in section 15(c)(2) of the Act, for any broker, dealer or municipal securities dealer participating in any distribution of securities, other than a firm-commitment underwriting, to accept any part of the sale price of any security being distributed unless: (a) The money or other consideration received is promptly transmitted to the persons entitled thereto; or (b) If the distribution is being made on an all-or-none basis, or on any other basis which contemplates that payment is not to be made to the person on whose behalf the distribution is being made until some further event or contingency occurs, (1) the money or other consideration received is promptly deposited in a separate bank account, as agent or trustee for the persons who have the beneficial interests therein, until the appropriate event or contingency has occurred, and then the funds are promptly transmitted or returned to the persons entitled thereto, or (2) all such funds are promptly transmitted to a bank which has agreed in writing to hold all such funds in escrow for the persons who have the beneficial interests therein and to transmit or return such funds directly to the persons entitled thereto when the appropriate event or contingency has occurred. 21 FINRA Notice to Members Securities Exchange Commission Interpretation of Application of Rule 15c2-4 to Direct Participation Program Offerings [hereinafter FINRA Notice 84-64]. Best effort offerings are those where the underwriter does not contractually guarantee that any securities will be sold during the term of the offering. Robbins, supra note 4, at 2. This seems to be an area of confusion, or at least ambiguity, within guidance released by FINRA and other commentators. Many claim that the Rule applies to best effort offerings, or best effort contingency offerings, implying that the two types of offerings are one in the same. See, e.g., ( Rule 15c2-4 applies to offerings... to which payment will not be made to the issuer until a particular contingency event occurs (best effort distributions). ); Robbins, supra note 4, at 2 ( Private placement offerings usually are structured as best efforts, contingency offerings.... ). Combining the two types of offerings is not per se incorrect; however, it should be understood that they are neither mutually exclusive nor mutually inclusive. This is particularly important for purposes of escrow compliance because the rules specifically describe contingency offerings. 22 Robbins, supra note 4, at C.F.R c2-4(a) C.F.R c FINRA Regulatory Notice (August 2013) (providing also that the commanding SEC rules were 15c2-4 and 10b-9). 26 Infra notes and accompanying text. 27 Best effort offerings, on the other hand, do not establish a minimum amount of securities that must be sold before investor funds are released to the issuer. This model is sometimes referred to as raise a dollar, keep a dollar. For such offerings without an enumerated contingency event, any funds raised by the broker-dealer during the

9 REFERENCES term of the offering may be forwarded directly to the issuer. 17 C.F.R c2-4(a). 28 Robbins, supra note 4, at The SEC elaborated on the terms promptly deposited in a separate bank account and promptly transmitted within the scope of Rule 15c2-4 in a staff interpretive Letter. See FINRA, 84-7 SEC Staff Interpretations of Rule 15c2-4, in FINRA Manual (1984). With regard to both terms, the SEC provides: Absent unusual circumstance, funds should be deposited or transmitted as soon as practicable after receipt. In contingency offerings not requiring suitability determinations by the issuer or the general partner, funds should be deposited or transmitted by noon of the next business day. In contingent offerings requiring suitability determinations by the issuer or general partner (for example, most direct participation programs) where investors checks are made payable solely to the bank escrow agent but delivered to the broker-dealer, prompt transmittal may be accomplished by forwarding the checks to the escrow agent either by noon of the next business day or by noon of the second business day after receipt of the subscription by the issuer or general partner. If the latter option is used, the subscription must be forwarded to the issuer or general partner by noon of the next business day after receipt of the funds. 30 Robbins, supra note 4, at at 3 5; see 17 C.F.R c C.F.R c2-4(a). This is not an explicit carve-out. But it follows because the implication of contingency offerings is not enumerated until section 15c2-4(b). See 17 C.F.R c2-4(b) C.F.R c C.F.R c Supra note 9, at 131. Generally, the rule does not apply to the broker-dealer s holding company or unregulated subsidiaries or affiliates. But the exception to this general rule provides that if the broker-dealer guarantees or assumes the liabilities of a related unregistered entity, then the broker-dealer must consolidate the assets and liabilities of both itself and its guaranteed entity into a single computation. Consolidated Computations of Net Capital and Aggregate Indebtedness for Certain Subsidiaries and Affiliates, 17 C.F.R c3-1c (1992) (Appendix C to 17 C.F.R c3-1). 39 Supra note 9, at at See Rule 15c3-1(a)(2)(vi) ( A broker dealer that... does not engage in any of the activities described in paragraphs (a)(2)(i) through (v) of this section shall maintain net capital of not less than $5, ). 42 Rule 15c3-1(a)(2)(i) (providing further that A broker or dealer shall be deemed to receive funds, or to carry customer or broker or dealer accounts and to receive funds from those persons if, in connection with its activities as a broker or dealer, it receives checks, drafts, or other evidences of indebtedness made payable to itself or persons other than the requisite... escrow agent... ). 43 See id. 44 See 17 C.F.R. 15c2-4(b)(2).