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Thursday, June 30, 2011

If Your Company Doesn't Go Public, Are You Going To Jail?

The federal government may be using its powers of investigation and prosecution to effect economic policy -- namely, that certain types of business failure may result in your prosecution.

An interesting white-collar criminal case has been unfolding in Manhattan federal court this month. The case, against one Ross Mandell of an outfit called Sky Capital, alleges securities fraud. However, the government's case appears to most revolve around the risks of private placement investments and the prospects for going public.

Now, as someone with a background as an investor, a securities transaction lawyer who has taken small companies public, and as a lawyer investigating some complex situations, I can tell you this: The investor should care only about return on investment. (And an investor who does not care about return on investment is not investing; he has a hobby.) 

You can have a small company, a risky company, even a garbage company. But if you sell its stock for more than you bought it at, it's been a profitable investment.

Conversely, you can have a great company that is not likely to fail. But if you sell it for much less than your purchase price, you've had a losing investment. That's true, even if the fundamentals underlying your original investment were solid. In other words, even if your investment was a "smart" investment, meaning that it should have worked, you can lose money on it.

For example, there's a company whose products impact virtually every business in America. It's a computer software company and its stock is down by half since 1999.

If you thought it was Microsoft, take a bow.

The ultimate measure of an investment is the bottom line: did or did you not make money on it?

There are other troubling signs that the government might be trying to create a "crime" out of certain "failures" which, when understood properly, are quite defensible. For example, prosecutors tried to argue that not providing investors in a private placement with audited financial statements of the company whose stock was being offered was somehow nefarious -- in essence, a crime, a felony.

However, here's the truth. Under the securities laws, there is simply no requirement for a privately-held company to give audited financial statements to private placement investors if those investors are "accredited" (a standard which presumes sophistication in making investment decisions on the part of people meeting certain income or asset tests). If nonaccredited investors are involved, just like millions of regular investors in the stock market, then audited financial statements are needed. See the difference?

As for the issue of going public, there is another troubling theme in this Mandell trial: that our federal government asserts a crime has occurred if you plan to go public and don't actually go public.

One can only think of the chilling effect this will have on some entrepreneurs.  It's already tough -- and getting tougher -- to get bank financing (loans)And should you try to save your company and are unsuccessful and have to declare bankruptcy, you also risk prosecution; the same U.S. Attorney's Office in Manhattan prosecuting the Mandell case brought -- and later famously withdrew-- a criminal case against Collins & Aikman CEO David Stockman in 2007 

Again, from the investor standpoint, one should care about return on investment.  And nothing else.

Going public and having a liquid investment is nice, it sure makes it easier to sell, but its not the only way to make money.

There are many privately-held companies whose founders, employees and investors wait until the company is sold or merged into an acquiring company. They cash out, or receive the buyer's stock, or get new employment contracts, at that time. The bottom line is that they get value back, without an IPO.

Admittedly, until the "liquidity event," they don't get their investment back and retain all the risk. During the time they wait for a liquidity event (essentially, a sale), however, their investment retains value; it just is not liquid and therefore cannot readily be sold without having to sustain a significant discount on the price one can realize by trying to sell it. (This is the same phenomenon with real estate.) However, it is misleading -- and downright untrue -- for the government to suggest that there is no value in the stock of nonpublic, small companies. Their stock is merely illiquid, and retains its high risk character; indeed, one can invest privately and lose all of the investment. But that possibility is (or should be) contemplated in every private placement. In fact, agreements routinely warn investors that they must be prepared to do without the capital invested for an indefinite period of time and may lose their entire investment.

Lying to investors certainly needs to be deterred and punished. However, our government should be careful not to set precedents with the cases it chooses to prosecute and how it chooses to prosecute them which risk punishing short-term business failure, in its zeal to protect investors and preserve the integrity of our capital markets.

Finally, our Justice Department must heed its primary mission: to do justice. Its mission is not to make, or implement, economic policy through its selection of cases and methods -- its "prosecutorial discretion." The use of admitted, habitual liars in the Ross Mandell case and, over in New Jersey, in the legendary series of public corruption cases starring the notorious "serial defrauder" Solomon Dwek, is troubling and just disturbing to see.

(PS: New Jersey federal district judge Jose Linares revoked Dwek's bail and moved up his sentencing after hearing of Dwek's continued lies regarding a rental car in Baltimore, MD.)

Eric Dixon is a New York lawyer with a special interest in investigating complex matters involving the potentially wrongfully accused.  Mr. Dixon has a strong background in the securities laws, corporate governance and complex fraud cases

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