REGISTER AND DISCLOSE: LESSONS FROM SEC COMPLAINT AGAINST TEXAS AG KEN PAXTON

Texas Attorney General Ken Paxton became the object of an SEC civil complaint this past week. While it is early in the process and the facts are far from certain, the complaint against Paxton is a reminder to anyone soliciting investments: being paid a commission means you almost always must be registered as a broker and you must disclose your compensation to potential investors. If the alleged facts are true, Paxton may learn these lessons the hard way.

The SEC complains of Paxton’s solicitations on behalf of Servergy, Inc., which raised roughly $26 million from investors to develop a new server to compete with IBM, Dell, HP, and others. The SEC claims that in July 2011 Servergy offered Paxton a 10% commission for any investors he recruited, and Paxton said he would “get to work.” Over a two-week period that month, Paxton convinced five investors to invest a total of $840,000. As payment, Paxton was issued a stock certificate for 100,000 shares of Synergy stock, but Paxton did not disclose this arrangement to potential investors he solicited.

Paxton was not and never has been registered as a broker (he has been registered as a financial advisor, but not in July 2011 and that is not enough in any event). Section 15(a)(1) of the Securities Exchange Act of 1934 requires all “brokers” who “induce or attempt to induce the purchase or sale of, any security” to be registered. Brokers are defined as “any person engaged in the business of effecting transactions in securities for the account of others.” While several factors inform being a broker, the SEC has long claimed that receipt of transaction-based compensation is a “hallmark” of being a broker. Here, Paxton allegedly agreed to be paid 10% of monies he raised, and Servergy issued him 100,000 shares after he raised $840,000.

Beyond failing to be registered, Paxton’s alleged failure to disclose his compensation arrangement violated §17(b) of the Securities Act of 1933. Under that provision, it is unlawful to make any communication describing a security in exchange for consideration without disclosing that consideration. By failing to inform investors he was being compensated by Servergy, Paxton allegedly violated that provision.

What can we learn? Anyone asked to solicit investors for any purpose or to otherwise tout an investment should consult legal counsel to learn whether that activity would require registration and disclosure to investors of how you will be paid. This analysis requires an understanding of what defines a security, potential exceptions to the securities laws, and knowing when the line is crossed into broker activity. The consequences for failing to register and disclose could be severe—as Texas AG Ken Paxton is presently learning.