Failure To Comply With Plan Technicality Causes US Securities Law Violation

by Dechert LLP
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Dechert LLP

Section 5 of the Securities Act of 1933 prohibits the sale of a security unless a registration statement is in effect. This prohibition on the sale of unregistered securities does not apply to exempt transactions. One such exemption is found in the Bankruptcy Code — section 1145 provides that securities issued under a plan of reorganization may be exempt from the registration requirements of the Securities Act. For debtors, the recent decision of Golden v. Mentor Capital, Inc., 2017 U.S. Dist. LEXIS 153415 (D. Ut. Sept. 25, 2017) highlights the importance of complying with the requirements set forth in the plan and confirmation order, as failure to comply with even a minor plan provision could result in securities not being issued pursuant to section 1145, and thus a securities law violation.

Mentor Capital, Inc. filed for bankruptcy in 1998, and two years later, the bankruptcy court confirmed Mentor’s plan of reorganization. The plan allowed for Mentor to issue several classes of warrants to its creditors, which were exercisable for shares of Mentor’s common stock. The plan provided that the securities, including the warrants, issued thereunder were exempt from the registration requirements of the Securities Act pursuant to section 1145 of the Bankruptcy Code. The plan further provided that the “Effective Date” of the plan was the date which Mentor filed the amendment to its articles of incorporation as required under the plan. Under the plan, the amendment to the articles of incorporation were required to be filed within 120 days following confirmation. There was no evidence that Mentor filed an amendment to its articles of incorporation within the 120-day period.

In 2014, a recipient of the warrants that were issued under the plan determined that he, on behalf of himself and two others (the “Goldens”), wanted to exercise the warrants to purchase shares in Mentor. Mentor’s CEO confirmed that the shares were unrestricted and fell under the exemption from registration afforded under section 1145 of the Bankruptcy Code. After such confirmation, the recipient exercised his warrants and purchased shares for himself and on behalf of the Goldens. The Goldens then brought an action against Mentor for violating the Securities Act, arguing that Mentor was not authorized to issue the shares it sold to them. The Goldens argued that because Mentor failed to comply with the plan and confirmation order by not filing the amendments to the articles of incorporation, the plan never went effective. As a result, such shares were invalidly issued and not exempt from the Securities Act’s registration requirement.

The district court determined that the bankruptcy exemption did not apply, as the securities were not sold under the plan. Agreeing with the Goldens, the court found that Mentor was not entitled to the section 1145 exemption because the plan never became effective. Given that the plan would become effective only upon the filing of amended articles of incorporation, which Mentor failed to file during the requisite period, the plan was never effective. Absent an effective plan, the securities mentor sold were unregistered and not subject to the section 1145 exemption from registration. In reaching its holding, the district court rejected the arguments that the plan became effective upon confirmation and that substantial compliance with the terms of the plan rendered it effective.

The Golden decision highlights the importance of complying with all effective date requirements in a plan and confirmation order, as failure to comply with a minor technicality could result in securities laws violations.

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