Wolves For The Small Business Sheep

By Mark J. Astarita, Esq.

As the regulatory environment in the corporate finance area becomes less restrictive, in order to permit smaller companies to obtain access to financing that the myriad of traditional regulation makes cost prohibitive, the relaxed regulations often open doors to scams and frauds – not necessarily on the public, but on the entrepreneur for whose benefit the “cheaper and easier” access to financing these same regulations were designed to protect.

While it is certainly true that the overwhelming majority of consultants, brokers, underwriters and others in the financial industry are honest and hardworking, the small business owner, like everyone else these days, needs to be sure that she understands the varied processes that are available to her to raise capital for her business, and the common pitfalls and scams used by the unscrupulous to lure her, and her own capital, into their pockets.

The downside of being caught in the clutches of an unscrupulous “consultant” reaches far beyond the loss of potential capital, as most of these scams involve the payment of up front fees to the scammer, and an enormous waste of something equally precious as money to an entrepreneur – her time. Companies have spend months, even years, attempting to work with a scammer to raise capital, foregoing, or ignoring, other financing options, only to be out of pocket the fees paid to the scammer, the time lost in raising capital, and often in a drastically worse financial predicament than she was when she started the process.

Other parts of the Securities Law Home Page, and the Corporate Finance Center deal with the process of obtaining capital. Other sites, such as CorpFiNet, provide an excellent resource for the practical resources to obtain funding. But this article is intended to identify the scams before the entrepreneur turns from businessman to sheep, and finds herself out of money, and perhaps worse, losing her business.

Regulation S Offerings

The Securities and Exchange Commission enacted Regulation S, a regulation designed to make it easier for large companies to sell their stock to investors overseas. But, the scammers have found the regulation, and its supposed loophole, and are exploiting it, to the detriment of the small business owner.

Some financial “consultants” are offering to assist companies in Reg S offerings, with promises of large investments by overseas investors. This scam is not really a sophisticated scam, since it simply involves misrepresentations by the scammer as to the nature and extent of his potential investors, but the lure of Reg S, and its intended benefits, are offered to the small company as way to obtain financing without the usual “red tape”. The consultant receives a fee in advance, and the investors never appear. It is amazing how many bright and intelligent businessmen who would otherwise ignore this scam, simply fall prey to it because of the allure of a SEC Regulation that supposedly supports the financing efforts.

But a scam involving Reg S can also take a different, more sophisticated form. Reg S offerings often take place at deep discounts, up to 50% of the value of the stock, supposedly because of the easier and less cumbersome regulatory involvement. But what the small business owner is not told, is that the foreign investor only has a very short holding period before he can sell his stock, in the United States. The entrepreneur then finds, a few months later, that his stock is being dumped back in the market, with the foreign investor making a 100% profit, and the other price of the outstanding shares of the company becoming depressed because of the newly increased float in the US market. Though presumably legal, this back door can have a devastating effect on the price of the company’s stock. If short sellers are involved, selling before the foreign investors dump their stock, a true scenario for disaster is in the making.

The Unregistered “Consultant”

As issuers move towards the various small offering exemptions such as Reg D and Reg A and SCOR offerings, trying to avoid the cost of underwriters, they are finding another hurdle they must climb – access to investors. Most such issuers have absolutely no experience in marketing a securities offering, and do not have access to investor funds. If they did, they wouldn’t be doing a small offering.

This leaves the small issuer open, and vulnerable, to the scammer consultant, who, for an upfront fee, agrees to provide contacts to wealthy investors, or advice on how to attract investors. Some of these consultants even offer advise on how to find investors by direct marketing techniques.

While the majority of financial consultants are themselves honest businessmen, some are not, and the small business owner, finding himself in dire need of investment capital, sometimes lets his usual guard down, and becomes involved with a scammer consultant, who, for an upfront fee of anywhere from $50,000 to $150,000 agrees to provide contacts to investors, or consulting services to help the issuer find investors.

Unfortunately, what many issuers have found is that after paying the upfront money, and spending months following the advice of their “consultant” they have nothing but a fragile checkbook made even more fragile, and huge amount of wasted time – because the consultant did not, in reality, have any investors, or his advice was totally useless.

The response of the consultant? The failure of the offering, or their consulting services, is typically blamed upon the financial status of the company, so some other pretext that has nothing to do with their lack of performance.

The SCOR Scam

The Securities and Exchange Commission enacted a new procedure for financing by small corporations, known as the Small Corporate Offering Registration (SCOR). In essence, it is a procedure designed by the SEC to enable smaller companies to raise capital, by making the process easier and cheaper, by using a shortened prospectus for registering offerings of up to $1 million.

Small businessmen have been finding difficulty raising capital through the legitimate SCOR registration process, and those problems are discussed in another article titled SCOR Registration – Cheap and Easy?

While one might argue that the SCOR process has, according to those figures, enabled over 100 companies to effectively and inexpensively raise needed capital, the SCOR process has created as many, if not more, problems than it sought to solve. Aside from the time and energy that the various entrepreneurs in the unsuccessful 400 or so offerings virtually wasted in pursuit of “inexpensive and easier” corporate finance, abuses have crept into the process, as small companies move away from the use of established attorneys, accountants and underwriters, and into the world of “easier and cheap”.

With the requirement that the company itself find investors, rather than having an underwriter provide that function in a traditional offering, services have sprung up which offer to assist companies in finding those investors on their own, by non-traditional methods, such as by direct-marketing. Direct marketing to find investors in a offering of stock? Yes, incredibly so, this is sometimes the method used, despite the traditional rule of thumb for direct marketing, of expected sales of less than 2% of the mailed pieces.

Various financial publications have reported abuses in the SCOR process, by firms offering consulting services to small companies, to assist in the marketing effort of their underwriting. Sometimes it seems, the startup company winds up paying $50,000 or more in fees and expenses, not to mention an inordinate amount of time and energy, to raise what ultimately becomes a couple of hundred thousand, but no where near the $1 million that they sought. Often, companies find that the money they ultimately raised, after expenses, and a 6 month process, is nowhere near what they need, and in fact, the company is worse off than when it started the process, since it has continued to consume capital, and has forgone other financing projects, in pursuit of the “easier and cheaper” method.

The Shell Sham

Another aspect of the corporate finance environment that is subject to abuse is the reverse merger. In this scheme, which on the surface is entirely legal, a stock promoter obtains an inactive “shell” company – that is, a company with no business activities, but which is already a public company, with a listing on NASDAQ. Then the promoter approaches a legitimate small business, looking for investors and offers a “fast and inexpensive” way of going public, by a reverse merger, where the shell company merges with the startup, and takes the startup’s name and business, thereby effectively converting the startup company into a public company.

The benefits of this entirely legitimate and legal process are obvious. The cost to the startup of “going public” is vastly reduced, and once again, the underwriter and his costs have been avoided. Additionally, with a public offering taking approximately a year to complete, the few months that are required for a reverse merger with a shell is a very tempting benefit. Unfortunately, too often such reverse mergers result in disaster for the startup.

The reason is that the process, in the hands of an unscrupulous promoter, becomes a sham. The promoter manages to convince the startup to go into the shell by extolling the fast track to being public, and then to raise the needed capital by issuing more shares of stock to the public. What the unscrupulous promoter does not mention is that some of the shell companies, and in particular the one that they are going to use, is controlled by them, and is too small to be subject to all of the SEC reporting requirements. Investor interest in such companies is often non-existent, and there are very few shareholders making the securities of the startup easier to manipulate, often resulting not only in no financing for the startup, but in a situation where the startup is now a public company, with its stock trading at virtually no value, and its original owners having less equity then when they started the process, and no ability to attract any underwriters or market makers.


What can the entrepreneur do? Well, for starters, do not leave your common sense and business acumen behind when you are seeking financing. In money matters, as in most matters, if it is too good to be true, it probably isn’t.

On a more practical side, there are a few things that can be done to lessen your chances of becoming involved with a scammer:

  1. Check the consultant, promoter or finder with your State’s Securities regulator, and with the State regulator where the consultant, promoter or finder maintains his office. For a list of all of the State Securities Commissioners and their addresses, telephone numbers and internet contact points, see the SHLP Guide to State Securities Regulators
  2. Call the Securities and Exchange Commission Regional office nearest to your location, and ask for an “SV” check on the consultant, and his company. An “SV” check is a “securities violator” check, and will reveal if there are any SEC enforcement or administrative proceedings against the individual or corporation.
  3. Avoid paying any upfront fees without seeing results of the consultant’s efforts;
  4. Have an attorney read the agreements before you sign them, not after you are the victim. An hour or two of an attorney’s time before the dispute might just avoid paying for hundreds of hours of an attorney’s time trying to get your money back.

Mark J. Astarita is an attorney who represents financial professionals, small businesses and public companies in a wide variety of matters from his office in New York City. He is also the sponsor of The Securities Law Home Page, a web site devoted to the legal aspects of investments and corporate finance.

Copyright © 1996 Mark Astarita. Nothing contained herein should be construed as legal advice. Please see our disclaimer for further information.

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Mark Astarita

Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | mja@sallahlaw.com | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.