Look inside the desk drawer of many, if not most, community bank presidents and you will find a list of the names of individuals who want to buy or sell the bank’s stock. We bank lawyers get asked about these “desk drawer” lists on occasion (often preceded by caveats like: “I’m not sure if this is a great idea but… ” or “Every small bank president has this list in a desk drawer …”).
On one hand, all bankers want to provide shareholders with value and service. On the other hand, you don’t need to understand the intricacies of securities laws to sense that a desk drawer list has the potential for abuse by unscrupulous company insiders or that the list of laws that might apply to a desk drawer system is long. So while these desk drawer lists are a common practice among community banks, they do pose a legal risk to even the most scrupulous and careful presidents who administer them.
If you want to have a desk drawer list of potential buyers or sellers, proceed carefully and follow some best practices, including:
Keep your involvement to “clerical and ministerial” functions only.
Potential buyers and sellers should contact each other directly; you should not be involved in communications between the parties.
The price for the stock should be negotiated by the parties, and you should not be involved in that process in any way. Have a board-approved policy in place for responding to the inevitable question, “What do you think my stock is worth?” Encourage potential sellers and buyers to talk to their own advisers. Refer potential buyers, sellers, and their advisers to the bank’s call reports, audit, or a board-authorized valuation by an independent third party.
You should never handle funds or be involved in payment for securities bought or sold after being matched through the desk drawer.
Directors, officers, and employees (including and especially you) should never profit from the desk drawer system or receive compensation based on connections made from the desk drawer.
Directors, officers, and employees (including and especially you) should not be involved with buying or selling stock through the desk drawer. If an insider wants to purchase or sell stock through the desk drawer, talk to counsel first.
Transactions from the desk drawer should remain occasional and isolated. If the practice becomes common, it may be time to evaluate whether a better, safer system exists, such as the over-the-counter market.
This is not meant to be a bulletproof checklist, but rather some best practices that might make the desk drawer system less likely to subject you to broker-dealer regulation and/or penalties under securities laws.
Consequences of Violating the Law
There are serious potential consequences to acting as an unregistered broker-dealer, both to you and to the bank. Individually, if you act as a broker-dealer without registering with federal and state authorities, you face fines and penalties. Additionally, you face potential liability in court from the buyers or sellers that you matched. Section 29(b) of the Securities Exchange Act of 1934 renders void any contract made in violation of that act or its rule and regulations. Arguably, this provision gives the parties to a transaction arranged by an unregistered broker-dealer a right to void the transaction agreements and unwind transactions that have previously closed. In other words, if you involve yourself too heavily in a desk drawer transaction, or worse use the desk drawer to buy/sell stock individually (or allow bank officers or directors to buy/sell stock individually), the innocent parties may have the right to unwind the transaction because the transaction was arranged by an unregistered broker-dealer.
For the bank, the use of an unregistered broker-dealer in a transaction could cause the bank to lose any exemption from the registration requirements of the Securities Act of 1933 (as well as from applicable state law qualification requirements). Accordingly, the bank may have a difficult time obtaining a legal opinion from its counsel in connection with a future stock offering. It also may subject the bank to civil and criminal penalties, including pursuant to Section 20(e) of the Exchange Act on the theory that the bank aided or abetted the unregistered broker-dealer. Finally, the SEC may bar the bank from conducting private placement offerings in the future, thereby risking its ability to raise capital.
Insiders and the Desk Drawer
Directors and officers buying or selling stock through the desk drawer raises particularly complicated issues. Any time anyone buys or sells stock in any American company (whether public or private) on the basis of material “inside” information that is not publicly known, it is a violation of Rule 10b-5. Breaking that rule is what sent Martha Stewart to jail, and it is a common cause of action in cases by disgruntled buyers/sellers on the theory that the insider-party had material information that he or she did not disclose. Because directors and officers frequently know material, non-public information about the company, insiders should always be cautious when conducting a transaction in that company’s stock. Insiders should certainly never use the desk drawer to “buy low and sell high.” Also, the desk drawer should never be used to send a good deal to a friendly insider at the expense of a non-insider. Any manipulation of the desk drawer in that way could expose the bank and the insider to liability, and perhaps even criminal penalties. In addition to Rule 10b-5 issues, there may be state and federal securities law restrictions on the sale of stock by insiders. To summarize a very complicated topic: contact counsel before insiders buy or sell stock, especially if those insiders have passed through the desk drawer.