Rescission Rights of Investors in Private Placements

Summary

Investors in private placements are protected by robust rescission rights under federal and state law. These rights ensure that investors can recover their investments if the offering was conducted in violation of securities laws, providing an important safeguard in private capital markets. Issuers must remain vigilant in their compliance efforts to avoid triggering these rights and the associated financial and legal consequences.

Private placements are a common method for companies to raise capital from select investors without the extensive regulatory requirements of public offerings. However, these transactions are not immune to legal risk, especially concerning the rights of investors to rescind or cancel their investments if certain legal standards are not met.

Several years ago, the CEO of a biotech company contacted me with questions about his 1099 form. I asked him a fundamental question: Who issued the 1099? The biotech company he worked for. Why did he receive a 1099, considering he was an employee? His response, “We decided it was too much work to do payroll. We decided to issue 1099s to everyone. After all, the taxes end up being the same.” The short answer is no, it isn’t the same. For almost 14 years, this company didn’t execute payroll. The decision was willful, knowing, and intentional. In other words, criminal.

This one decision put the entire company at risk. Failure to collect and remit payroll taxes is a big deal. It is also the start of intense financial, legal, and other issues that impact every aspect of your business, including retirement plans, intellectual property agreements, employment agreements, tax laws, security regulations, and more. It ultimately led to investors exercising their right to rescind.

What Are Rescission Rights?

Rescission rights allow investors to demand a full refund of their investment if the offering or sale of securities violates applicable securities laws. This right is grounded in both federal and state law, and it can be triggered by various forms of noncompliance, such as failing to register the securities when required, misrepresenting material facts (like the payroll tax issue), or using unregistered brokers.

Legal Basis for Rescission Rights

Under the Securities Act of 1933, Section 12(a)(1) provides investors with a private right of action to rescind a transaction if the seller violated the registration requirements of Section 5. Investors generally have one year from the date of purchase to bring such a claim. Additionally, Section 29(b) of the Securities Exchange Act of 1934 renders contracts made in violation of the Act void, thereby reinforcing investors’ ability to rescind transactions involving unregistered brokers or other violations.

State securities laws (often called “blue sky laws”) may also grant investors rescission rights and impose additional requirements or remedies. State regulators can require companies to make rescission offers to affected investors, offering to return their investment plus interest.

Common Triggers for Rescission

Unregistered Securities: If a company fails to register securities when required or fails to qualify for an exemption, investors may have the right to rescind.
Material Misrepresentations or Omissions: Investors can rescind if the offering documents contain material misstatements or omit important facts.
Use of Unregistered Brokers: Transactions involving unregistered placement agents or finders may be void, and investors may be entitled to rescind their investments.
Material Changes in Offering Documents: If there is a material change in the offering terms that is not properly disclosed, investors may be entitled to rescission rights.

The Process of Rescission

When a violation is identified, issuers may voluntarily offer rescission to affected investors, or regulators may require them to do so. A rescission offer typically includes a return of the original investment plus interest, and the offer itself must comply with securities laws. If an investor accepts the offer, they generally waive further claims under federal law related to the rescission. However, if an investor rejects the offer, their rights to pursue additional claims may depend on the specifics of the case and applicable law.

Implications for Issuers

For companies, rescission rights are a significant risk. Noncompliance with securities laws can result in demands for refunds, regulatory action, and reputational damage. Issuers must carefully structure private placements to ensure compliance with all relevant laws and to minimize exposure to rescission claims.

Conclusion

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