November 16, 2011

New Restrictions on Reverse Mergers

Thinking of listing your company on Nasdaq or the NYSE through a reverse merger?  The SEC is making it a bit harder.

The SEC has approved new, more stringent exchange listing requirements for companies that go public through reverse merger rather than traditional registration/IPO. 

The SEC final rulemaking releases for each major national exchange are available here: 
The SEC's press release is available here:

Based on my prior experience with this very issue, I view this response as over-broad.  (Even the SEC acknowledged that the issues giving rise to the new rule arose in the context of foreign issuers.) This is yet another set of new regulations that, along with many others, could have the cumulative effect of stifling economic growth when our country badly needs it.   

Nonbank Mortgage Lenders, Prepare for FinCEN!

Nonbank mortgage lenders will soon be "deputized" by the federal government to help fight financial crime in the same way banks currently are.

Almost a year ago, the Financial Crimes Enforcement Network (FinCEN) proposed new regulations to require non-depository residential mortgage lenders (and mortgage loan originators) to establish programs to detect and report financial crimes, including by filing Suspicious Activity Reports (SARs).  (That proposal is available here.)  After receiving 13 comment letters from concerned parties, Director James Freis, Jr. reports his agency has nearly finished preparing the final regulations.

FinCEN's explanation for expanding the requirements to non-depository mortgage lenders is as follows:

"There has been a regulatory gap between the [Bank Secrecy Act's] coverage of depository institutions and residential mortgage lenders and originators in that the latter are currently not subject to BSA requirements, the Suspicious Activity Report (‘‘SAR’’) foremost among them. Imposing a SAR requirement would address this regulatory gap. Moreover, a SAR requirement would potentially expand the kinds of activities being reported to FinCEN’s BSA database, thereby giving our regulatory and law enforcement partners a more complete picture, both on a systemic and case-specific level, of mortgage-related financial crimes."

November 13, 2011

Borrowers Have Private Right of Action to Recover Damages for Violations of the North Carolina Mortgage Lending Act

Borrowers Have Private Right of Action to Recover Damages for Violations of the North Carolina Mortgage Lending Act
By Matthew A. Cordell
(First published October 2009)

During 2001, the North Carolina Mortgage Lending Act ("Act") was enacted as part of the state's continuing effort to address perceived abuses in the mortgage loan industry.  The Act applies primarily to mortgage brokers and lenders other than banks.  However, portions of the Act do apply to banks, including:
  • Section 53-243.11, which prohibits various abusive activities by lenders in connection with a mortgage loan transaction; and,
  • Section 53-243.15, which requires exempt lenders (including banks) to file a notice with the Commissioner of Banks if they engage in mortgage brokerage or lending activities.
On August 18, 2009, the North Carolina Court of Appeals issued an opinion in the case of Guyton v. FM Lending Services, Inc., which, for the first time, recognized a borrower's private right of action for damages against a lender for a violation of the Act.  Although the defendant in the case was not a bank, the Court's decision was based on § 53243.11 (referenced above) which applies to banks.  Therefore, the decision would seem to apply equally to banks and non-bank brokers and lenders.  Also, rather than being limited to traditional long-term residential mortgage loans, the Act defines "mortgage loan" to include any loan "made to a natural person…primarily for personal, family, or household use, primarily secured by either a mortgage or a deed of trust on residential real property located in North Carolina."  Therefore, the case may well serve as precedent supporting suits by borrowers against banks in connection with any of the various types of consumer loans made by banks that are secured by residential real property, including HELOCs.

In Guyton, the borrower applied for a loan to purchase residential real property.  While processing the loan application, the lender, as it was required to do by the National Flood Insurance Act ("NFIA"), obtained a flood determination that the property was in a FEMA-designated special flood hazard area.  However, the borrower alleged that the lender neither informed the borrower of that fact, as it was required to do by the NFIA, nor provided the borrower with a copy of the report.  The borrower alleged that only after the borrower had closed the loan did the lender inform the borrower of the flood hazard and the borrower's obligation to obtain flood insurance for the life of the loan.

The borrower sued the lender and raised, among others, claims for fraud and unfair and deceptive practices.  The lender argued that:
  • It had no duty under the Act to provide the borrower with property-related information; and,
  • Even if it did, the borrower did not have a right to recover monetary damages because the Act did not provide borrowers with a private right of action against lenders for violations.
The trial court agreed with the lender but, on appeal, the North Carolina Court of Appeals reversed the trial court, holding that, if the borrower's allegations were true, the lender had a duty under the Act to disclose information known to it which could affect the borrower's decision as to whether to close the loan.  In support of its reasoning, the Court cited the following provisions of § 53-243.11 of the Act:

[It] shall be unlawful for any person in the course of any mortgage loan transaction:

(1) To misrepresent or conceal the material facts or make false promises likely to influence, persuade, or induce an applicant for a mortgage loan or a mortgagor to take a mortgage loan, or to pursue a course of misrepresentation through agents or otherwise [or]

(8) To engage in any transaction, practice, or course of business that is not in good faith or fair dealing or that constitutes a fraud upon any person, in connection with the brokering or making of, or purchase or sale of, any mortgage loan.

The Court of Appeals acknowledged the case law regarding the NFIA cited by the lender, but nevertheless held that the Act creates a duty of disclosure under North Carolina law which supported the borrower's claims for common law fraud and unfair and deceptive practices.  This had the effect of making civil damages available to the borrower for a violation under the Act even though a private right of action for damages was not available to the borrower for the identical violation of the NFIA.

The Court's opinion did not clearly explain whether the lender could be found liable because it failed to disclose a material fact relating to a term of the loan (i.e., the requirement that the borrower obtain flood insurance), or a material fact relating to the property itself (i.e., the fact that the property was in a flood hazard area).  However, because of the broad language in the opinion, courts relying on Guyton in the future could find a private right of action for a failure to disclose facts about the real property rather than about the terms of the loan.  Therefore, it is possible – although not certain – that a lender subject to the Act could be held liable to borrowers for failure to disclose other facts about mortgaged property which are known to the lender and which could reasonably be expected to be material to a borrower, such as zoning restrictions, easements, conditions revealed in home or environmental inspections, and the like.

Because § 53-243.11 is one of the two parts of the Act that apply to banks and their subsidiaries, it appears that banks may well be held liable to borrowers for violations of that provision.  In light of this newly-inferred private right of action for violations of the Act, banks and other mortgage lenders should review their loan disclosure and compliance policies and procedures with an eye toward the requirements and prohibitions of the Act in order to lessen the risk of unexpected civil liability to borrowers.

The lender argued that even if it had failed to notify the borrower of the special flood hazard information, that was only a violation of the NFIA, and numerous cases have held that no such claims can be brought by borrowers under the NFIA because there is no express or implied private right of action for such a violation.  The lender pointed out that the Act, like the NFIA, expressly provides for criminal penalties and civil fines, which are paid to the government, for violations, and contains no express provision for private claims for damages by borrowers.  Thus, the lender argued, a similar interpretation should be given to the Act.

Warning: Lenders in NC Have a Duty to Disclose Information to Sureties & Co-Borrowers about a Primary Borrower's Financial Condition

North Carolina Court of Appeals Rules Lender Has a Duty to Disclose Information to Surety about Borrower's Financial Condition
By Matthew A. Cordell
(First published July 2010)

In May 2010, the North Carolina Court of Appeals ruled that a surety, including a co-borrower signing as a mere "accommodation party," can avoid liability on a promissory note if the lender knew, or should have known, that there was a material risk that the primary borrower would be unable to fulfill its obligations under the note and the lender did not inform the surety of that risk.

The case, Whisnant v. Carolina Farm Credit, ACA, involved loans by Carolina Farm Credit, ACA ("CFC") to the Wilsons to consolidate and renew outstanding debts of a commercial greenhouse business.  Mrs. Wilson's brother and sister-in-law, the Whisnants, signed the notes as co-makers, but had no interest in the greenhouse business and received none of the loan proceeds.  The notes were secured with a deed of trust on the Whisnants' farm, which also was their residence.  The greenhouse business failed, the Wilsons could not pay the notes, and CFC commenced foreclosure proceedings on the Whisnants' farm.

The Whisnants sued CFC to invalidate their obligations on the notes.  They based their arguments on four legal theories:  (i) fraud in the inducement, (ii) actual fraud, (iii) negligence, and (iv) unfair and deceptive trade practices.  They alleged that CFC knew, or should have known, that the greenhouse business would not generate the revenues necessary to repay the loans, but either (a) affirmatively represented that it would or (b) at least failed to disclose to them the known risks that it would not.  The Whisnants specifically alleged that, as they were signing the notes, they questioned the loan officer about the greenhouse's viability and were told "everything looks to be running okay."  The trial court granted summary judgment in favor of CFC.

On appeal, the Whisnants relied upon the law of suretyship, asserting that CFC's misrepresentations about the greenhouse business, or its failure to tell them of the risks, precluded CFC from enforcing their obligation to pay the notes.  CFC responded that since the Whisnants signed the notes as co-makers and, therefore, were primary obligors, suretyship principles were irrelevant.  The Court of Appeals sided with the Whisnants, ruling that summary judgment in favor of CFC was improper.  The Court stated that, regardless of the titles assigned by the loan documents, the Whisnants were in fact "accommodation makers" and the law relevant to suretyships applied.  The Court emphasized that the Whisnants had not received any loan proceeds and had no economic interest in the greenhouse business.  Therefore, the Whisnant decision demonstrates that the role assigned to parties by the loan documents may not control.  A party may be treated as a surety even where the party signs a note as a co-borrower, if the circumstances tend to indicate that the party is not receiving a direct benefit from the loan.

Treating the Whisnants as sureties, the Court held that when a lender "knows or has good grounds for believing that [a] surety is being deceived or misled, or that he was induced to enter into the contract in ignorance of the facts materially increasing the risk," the lender has an affirmative duty to so inform the surety and, if the lender fails to do so, the surety can avoid its obligation.

The Court further ruled that the Whisnants' allegations – that they "were induced to enter into the contract in ignorance of facts materially increasing the risk, of which [CFC] had knowledge…and opportunity…to inform [them]" – were sufficient to support claims under each of the four legal theories set out above, the last of which, unfair and deceptive trade practices, presents the possible liability of the lender for treble damages.

Whisnant raises at least three distinct concerns for banks and other lenders:

Lenders must exercise due diligence in underwriting loans in order to determine who is, and the possible risks to, an "accommodation party," including the collection and analysis of all material information regarding the intended use of loan proceeds and the primary borrower's ability to repay.  The Whisnant Court indicated that ignorance of the material facts may not save the lender.

Lenders must not misrepresent or mischaracterize the primary borrower's ability to repay, or the adequacy of other security for the loan, to a surety, guarantor, or accommodation maker.  As shown by the Whisnant decision, even relatively vague assurances such as "everything looks to be running okay" can amount to a material misrepresentation.

Unless it is clear that a surety or accommodation maker is aware of the repayment risks, lenders may be required to affirmatively disclose those risks.  The Whisnant Court indicated that such a duty exists.  Silence, according to the Court, may be fraudulent.

This third obligation may present complications for regulated lenders (such as banks) because of the numerous state and federal restrictions and internal policies forbidding or limiting the disclosure of customer information.  The Court did not address the possible tension between the duty created by its decision and existing privacy laws and policies.

In response to the Whisnant decision, lenders should remind their loan officers to make no assurances regarding repayment to co-borrowers, sureties, or guarantors.  Appropriate disclaimers and warnings should be included in loan documents.  Lenders should review their policies and procedures and adjust them, where necessary, in response to Whisnant, which may include creating or revising policies to allow, to the extent permitted by law, the disclosure of financial information to relevant loan parties.

From "Friend Request" to Discovery Request: Issues Raised by Business Use of Social Media

From "Friend Request" to Discovery Request: Issues Raised by Business Use of Social Media 
By Matthew A. Cordell and Barry P. Harris, IV
(first published March 2011)   

Your marketing team has been pushing for a presence on the "social web."  The potential, they've explained, is tremendous.  A Nielsen Report released in August 2010 reveals that two-thirds of internet users are active on social media websites.  Businesses are catching on:  a reported 65% of Fortune Global 100 companies have active Twitter accounts, 54% have Facebook pages, 50% have YouTube channels, and 33% have a weblog ("blog") of some kind.  "Social media" may indeed be the next frontier in marketing, customer relations, investor relations, recruiting, and even vendor relations.  While these emerging communication platforms create new opportunities, they also create corresponding risks and obligations.  This article briefly highlights a few of the most salient information management and litigation issues raised by a business's use of social media.

Warning – Social Media Content is Discoverable 

Discovery is a process whereby a party to litigation accesses information of the other parties that is relevant to the claims and defenses.  A primary tool used in discovery is "Requests for Production of Documents and Things" whereby one party demands access to documents and categories of data from another party.  State and federal laws and court rules govern the discovery process.  The Federal Rules of Civil Procedure (applicable to litigation in the federal courts) were amended in 2006 to expressly include electronically stored information ("ESI") in discovery.  The Advisory Committee drafting the amendment explained that the term ESI was "intended to be read expansively to include all current and future electronic storage mediums."  Accordingly, courts have ruled that the content of social media is generally discoverable.  Objections based on privacy, even by individuals, are usually unsuccessful.

One of the key factors in the discoverability of ESI is whether a party has custody or control of the data.  If a party to litigation is found to possess or control requested ESI, it is likely the party will be required to preserve and produce it.  Third-party social media providers who are not parties to the litigation may not be required to turn over content in response to a subpoena.  While still unsettled, some courts have ruled that social media providers may be able to withhold private messages that are akin to email under the Stored Communications Act.  Parties to litigation may be required, however, to request their data from the third-party provider and to produce what the provider delivers.

A Duty to Preserve Social Media Content 

Under state and federal court rules, parties must preserve relevant and potentially relevant information within their custody or control once litigation is pending or claims are reasonably anticipated.  In fulfilling these duties, parties employ "litigation holds" halting the destruction of potentially relevant documents.  For the party filing the suit (the plaintiff), the litigation hold is triggered before the complaint is filed; for the party being sued (the defendant), the hold is triggered when it becomes aware of a potential suit or claim.  The duty to preserve may include requesting third-party providers, such as social media providers, to segregate and save relevant data.  These duties are in addition to the recordkeeping requirements imposed on some regulated businesses.

A study published in the Duke Law Journal in 2010 found that failure to preserve electronic data has resulted in severe sanctions against offending parties, including adverse jury instructions; monetary awards which, in some cases, have exceeded $5 million; and even dismissals of claims and entire cases. 

ESI generally presents more challenges in discovery and litigation holds than information kept in hard copy, and the use of social media only increases those challenges.  For example: 
  • Social media is usually stored outside the user's firewall, either with the social media company or a third party (in the "cloud").  This lack of custody makes it more difficult to identify and preserve information.
  • Social media websites are generally dynamic rather than static, making it difficult to capture and preserve content.  What appears on a social media webpage one day may be gone, or changed, the next. 
  • The decentralized, collaborative nature of social media can make it difficult to monitor and enforce compliance with social media policies.
  • Resources available to manage and manipulate social media data have been scarce.  While several vendors now offer tools to manage off-site data issues with solutions ranging from capturing regular images of identified pages (a static record) to more sophisticated approaches capturing dynamic content, they are relatively new to the market.

Every Business with a Social Media Presence Should Have a Social Media Policy

The increasing role of social media in business and business litigation emphasizes the importance for a business to have, and regularly review and update, a comprehensive social media policy.  The policy should address, among other topics, the following:
  • Which officers and employees are authorized to control and/or use the business's social media accounts and represent the business?  Authorized personnel should be well trained in the business's other policies and applicable laws and should have access to counsel in the event questions arise.
  • What limits will be placed on the topics to be addressed through the business's social media accounts? 
  • Will review by compliance personnel or legal counsel be required prior to the communication of certain categories of information?  Examples include mergers, acquisitions, and stock offerings; changes in personnel; representations regarding new products; and comparisons to competitors.
  • Will employees be permitted to refer to the business or business's issues when using their personal social media accounts?
  • Will employees' personal accounts be monitored for compliance with the policies and, if so, how?
  • How will the business's existing document retention policy be applied to, or modified because of, the use of social media?
  • How will litigation holds and other recordkeeping requirements be satisfied?
  • In creating social media policies, businesses must understand what can be implemented and enforced; the policies will form a baseline in an opponent's or court's analysis of what can or should be produced in discovery.

Social media can open new doors, but it also presents new challenges.  All businesses participating in social media should adopt and implement policies governing its use by employees, and must be prepared to preserve relevant social media data as soon as it becomes reasonably apparent that litigation or an investigation is on the horizon. 

The Basics of State Securities ("Blue Sky") Regulations

State Securities Regulations: Selling the Blue Sky
By Matthew A. Cordell
Originally published on in September 2008 

The "Other" Securities Regulators

The U.S. Securities and Exchange Commission ("SEC") is not the only regulator keeping tabs on securities. Almost every state (and territory) has an agency or division dedicated to enforcing that state's securities laws, commonly referred to as "blue sky laws." That colorful term is attributed to a United States Supreme Court decision which explained that state securities laws were designed to protect investors from "speculative schemes which have no more basis than so many feet of blue sky." This article discusses the effects of state securities laws and regulations in the context of a nonpublic offering and the most common exemptions from state securities registration requirements.

When Do Blue Sky Laws Apply?

Blue sky laws usually apply to both the offer and the sale of securities. This means that blue sky laws must be reviewed before securities can even be offered for sale. It also means that a company issuing securities cannot avoid registration in certain states by making a widespread offer of securities and then simply declining to sell to investors in states where exemptions from registration are unavailable or where state regulators have not approved the security. Prudent issuers will consider the blue sky laws at the beginning of the process and tailor their efforts to both the federal and the state securities laws.

How Are States Involved In Securities Regulation?

State securities laws often apply in addition to, rather than instead of, federal securities laws, creating dual layers of regulation. As a result, companies issuing securities may be required to undergo state registration processes resembling the federal securities registration process. Although there is some overlap between the two regulatory systems, they are not identical. Therefore, situations exist in which an exemption from federal registration is available but in which registration is required in some states. Further, some state regulators have the authority to deny registration if they believe the price is unfair or the security is too speculative. Although it is rare, a securities offering could be exempt or approved by the SEC but rejected by a state regulator.

While most state securities statutes reflect common themes, the statutes of a few states differ dramatically from the typical state statutes. For example, while most state statutes regulate the securities being offered, New York's securities laws focus exclusively on the participants in the securities offering. Furthermore, even where state statutes resemble one another, the state securities regulators, who usually have the authority to create regulations implementing the statutes, may interpret similar or even identical statutory language differently from state to state. As a consequence, every securities offering requires a careful review of the statutes, agency regulations, and interpreting opinions of each and every state in which the securities will be offered.

There Are Exceptions to the Rules, Right?

Just as there are exemptions from the registration requirements of the federal securities laws, several types of securities and transactions are exempt from the registration requirements of most states. The following are some common registration exemptions under blue sky laws:

Exemption for Regulation D Securities

Three distinct exemptions from securities registration under the federal securities laws are collected in SEC Regulation D: Rule 504, 505, and 506 offerings. SEC Rule 506 offerings involve a number of requirements regarding advertising of the offering, qualifications for purchasers, and the ability of purchasers to resell the securities. Under Rule 506, an unlimited amount of securities may be sold to an unlimited number of high income or high net worth investors and up to 35 other "sophisticated" investors without federal registration. Under federal law, states are not permitted to require SEC Rule 506 securities to be registered at the state level. States remain free, however, to insist that they be "notified" of the offering and to impose a notification fee. If your offering conforms to the requirements of SEC Rule 506, state registration will not be necessary, but notification and payment of a fee to the relevant states may be required.

There is no similar prohibition against state registration when it comes to SEC Rule 504 and SEC Rule 505 offerings. Most states, however, have adopted exemptions that will be available for many Rule 504 and Rule 505 offerings.

A model state securities statute, the Uniform Securities Act of 1956 ("1956 Act"), has been adopted (with modification) by 28 states, and permits offers or sales to fewer than ten investors - regardless of their level of sophistication or resources - without registration. Therefore, you can raise capital from up to nine investors without registering within a state whose statutes are based on the 1956 Act.

In 2002, a revised model statute was created, the Uniform Securities Act of 2002 ("2002 Act"), and it has been adopted in some form by 14 states. The 2002 Act exempts sales to 25 or fewer investors in a 12-month period. To be eligible to use this exemption, you are not permitted to publicly advertise the offering or pay commissions based on the sales, and you may sell only to persons you reasonably believe are buying with an intent to hold the securities as an investment. The 2002 Act also exempts offers and sales to institutional investors. Therefore, in a state that has adopted the 2002 Act, you may be able to raise an unlimited amount of capital from institutional investors or from 25 or fewer non-institutional investors without registering the securities.

Existing Security Holders

Most state blue sky laws do not require registration for offers and sales to existing security holders because those security holders are presumed to already have sufficient information about the issuer. If your existing shareholders are willing to invest additional funds, you can issue securities to them without registration in most states.

Exchange-Listed Securities

There is a nationwide exemption from state registration for any security listed on the New York Stock Exchange, the American Stock Exchange, or NASDAQ, as well as for any security issued by a company that already has listed securities, so long as the offered security is of equal or higher rank than the listed security. This exemption extends to such things as warrants and options for listed securities, and means that once your stock is listed on an exchange, certain subsequent offerings may be exempt from state securities registration.

Other Blue Sky Requirements

Even when an exemption from state registration applies, some states require that issuers of securities notify the state securities regulator of the offering or sale, and pay a notification fee. Additionally, some states do not require certain securities to be registered, but still may require certain individuals dealing in the securities, including sometimes officers and employees of the company, to register. Finally, states almost always retain the authority to bring enforcement actions for fraud in connection with all offerings, including exempt offerings. In sum, even if your securities are not required to be registered, other blue sky laws still may apply, so a careful check of the laws of every state in which you plan to offer or sell securities is a necessity.

For further information regarding the issues described above, please contact Matthew A. Cordell.