Securities Law: “Safe Harbors” aren’t Nearly as Safe as you Think
Lawrence Hartman is the author of GUILTY TILL PROVEN INNOCENT: A Shocking Inside View Into America’s Failing Justice System (now available online at Amazon) and may be contacted by email at Lawrence@ComplianceMitigation.com to discuss your legal mitigation needs.Safe Harbor Rules are an area built into the Securities Laws intend
ed to make lawyers, traders and businessmen feel more comfortable about completing transactions, in order to help grease the world of commerce. These rules basically assert that if you do x, y and z, following the rules, then you cannot be criminally or civilly charge for those actions. Those xs, ys and zs, however, are rarely crystal clear and, moreover, even when you carefully follow them, many prosecutors still feel free to bring charges of fraud regardless. You’re then left trying to defend your position with legal minutiae, as your life’s completely turned upside down.
A professional extension of the Safe Harbor Rule is often supplied by legal and tax professionals via means commonly referred to as “loopholes.” These are legal strategies employed to take advantage of certain deficiencies in the writing of law, enabling individuals or companies to avoid paying taxes or derive some other legal benefit, typically with a financial incentive of some kind. While not always specifically codified, clients and advisors alike take comfort as more and more people employ the same tactic, a greater number of professionals begin to offer the same advice and a history of non-action by the government builds, therefore increasing confidence in the solidity of the loophole. The problem is, they also only work until they don’t, because some US Attorney decides that he or she is the one to take it down.
I was helping companies obtain funding in the mid-2000s using a Safe Harbor rule known as Regulation S. This rule basically says that public US companies can sell Restricted shares to any non-US citizen without the need of registration. The companies being funded, in this instance, were then known as Blank Check Companies (now commonly referred to as SPACS, with such companies as DraftKings and Nikola recently taken public that way). SPACS, essentially, are companies with no specific operations and only a general assurance that the operator of the company will find a merger partner worthy of the money raised into the company, and that the operator will negotiate suitable terms for making the investment worthwhile. And, at the end of the day, each SPAC I helped start and fund found an operating merger partner as required. My problems arose because only one of the companies I founded turned into a success, making investors back up to ten times their money. The rest were unfortunately undone either by the Great Recession or the freezing of their ticker symbols the moment the AUSA brought charges against my partners and me.
The prosecutors alleged my use of the SPAC and Regulation S Safe Harbors was nothing more than selling “virtually worthless shares.” I honestly couldn’t believe it, ‘but I used a Safe Harbor,’ I thought. The prosecution couldn’t have cared less. So, there I was, left with the choice of trying to explain the details of Safe Harbors to a jury, as the prosecutors explained how I made money and the investors didn’t, or plead out. By now, one of my co-defendants had gone to trial and received a sentence of 25 years, so I wasn’t exactly crazy about my chances. Plus, another co-defendant testified at that trial and was sure to testify against me as well. So much for Safe Harbor protections.
And the things is, even the powerful are not necessarily safe. Principals in the renowned international accounting firm Arthur Andersen, for example, were convicted in connection with the Enron fraud case for allegedly approving the shredding documents in its normal course of business. The jury was reportedly told “even if petitioner honestly and sincerely believed its conduct was lawful, the jury could convict.” The Supreme Court overruled this outrageous conclusion in an incredible 9–0 decision, emphasizing that the statute they were being charged under used the language “knowingly … corruptly persuade.” So, while Arthur Andersen managers did instruct their employees to delete Enron-related files, those actions were within their normal document retention policy. They were essentially put out of business for following their normal protocol designed to keep certain information private. Arthur Andersen wasn’t corruptly persuading their employees to keep information private; they were merely looking out for their clients’ privacy concerns. The Supreme Court decision, while eventually exonerating for the defendants, still cost five executives over a year of prison time as the appeal wound its way through the courts. It was also of little solace to the thousands of employees who lost their jobs as the firm was destroyed. Victories like that, moreover, are few and far in between since few individuals have the resources and political clout to take on the government, and most appeals languish in the courts for years before they’re even heard.
So, the next time you casually make use of some Safe Harbor or loophole without giving it a second thought, please bear these examples in mind. Things may not always be exactly as they seem. Legal liability abounds in the seemingly safest of places just waiting to jump out and catch some unsuspecting prey.