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Archive for June, 2009

A recent Colorado case emphasizes the risks of using unregistered and unlicensed “finders” to sell securities in private placements.  A “finder” is a person who is not registered with the Securities Exchange Commission or any other regulatory authority, but who nevertheless assists in the sale of securities.  Use of “finders” to sell securities in a private placement is always risky, because it is difficult to monitor and control their activities. 

The facts in Black Diamond Fund LLLP v. Joseph provide a what-not-to-do checklist for every entrepreneur or business owner trying to raise money through a private placement.  Black Diamond Fund (“BDF”) was an investment vehicle managed by Wealth Strategy Partners and Harvey Altholtz of Sarasota, Florida.  BDF offered $10 million in unregistered partnership interests in reliance on the private placement exemptions from registration provided by federal securities law.  Mr. Altholtz testified that BDF offered the limited partnership interests through a network of at least 50 “finders” nationwide, 5 of whom were in Colorado.  BDF paid a 5% finders fee to each finder upon completion of a sale.

The Private Placement Rules

It is illegal to sell securities in the United States without registering the securities with the SEC and state securities commissions, unless the sale is within an applicable exemption from registration – commonly known as a private placement exemption.  However, a “private placement exemption” is not found in one simple rule.  Rather, a variety of rules, regulations and SEC guidance must be followed to successfully conduct a private placement.  For example,

  1. the securities must be sold privately (hence, “private placement”), and
  2. the persons selling the securities must be either
    1. registered and licensed as broker-dealers or investment advisers, or
    2. exempt from registration. 

Failure to meet any one requirement can mean the loss of the private placement exemption for the entire offering.  Loss of the exemption gives all of the investors the right to rescind the investment and get their money back (often with attorneys’ fees), and leaves the issuer and its directors and officers vulnerable to legal action from federal and state securities commissions.  Moreover, securities liability is usually personal liability to the individuals involved; which brings us back to BDF and Mr. Altholtz.

Facts of the Black Diamond Case

One of BDF’s Colorado “finders” was William Gay.  Altholtz testified that he knew Mr. Gay had some trouble with the SEC (a wildly waving red flag Mr. Altholtz ignored), but he did not know that Gay was permanently barred from associating with any registered broker-dealer, that the Colorado Securities Commission had revoked his investment advisor license, and that the Denver District Court had issued a permanent injunction prohibiting Gay from associating in any capacity with any person or company involved in selling securities in Colorado.

Mr. Gay’s modus operandi was the proverbial “free lunch”, and an occasional free dinner.  Gay invited people to “investment seminars” where he would feed them both food, and investment advice that pointed to investments in BDF.  The invitations were sent to Colorado residents by mail. Gay had no preexisting relationship with many of the people he invited to the lunch and dinner “seminars”, and the invitations urged the recipients to “feel free to invite a friend”. The seminars were presented by both Gay and Altholtz.

For a placement to be private it cannot be offered to the public – it can only be offered to people the offeror already knows.  If the securities are marketed to the public, it is not a private placement, and the private placement exemption is lost.  Obviously, mass mailing invitations to potential investors is public advertising – not a private offering.

If the public solicitations were not enough, Gay also took an active part in selling the partnership interests.  He discussed the BDF opportunity with investors, obtained signed subscription agreements, and collected payment, which he sent on to Altholtz, who paid Gay a 5% commission.  If a finder is actively involved in an offer or sale, and is not a registered broker-dealer or investment adviser, then the securities were sold by an unregistered and non-exempt person and the private placement exemption is lost.

Finally, the court held that the fact that Gay was barred and enjoined from selling securities or associating with those who do was a material fact that should have been disclosed to investors, and since Altholtz knew or should have known that fact and failed to disclose it, Altholtz was liable for securities fraud.

In the end, Altholtz and BDF were liable for selling unregistered securities without an exemption, using an unregistered broker-dealer, and for securities fraud.

No Free Lunch

There is no free lunch when issuers allow finders to help them sell securities.  The use of even one unlicensed and unregistered finder is risky, and the issuer and its officers and directors can be liable for the finder’s acts.  Before agreeing to pay anyone who is not a registered broker-dealer or investment adviser to assist in a private placement, issuers should consult with experienced securities counsel to fully understand the risks and limitations.

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On May 14, 2009 Governor Ritter signed changes to the Colorado General and Limited Partnership Acts allowing for “partners” in Colorado partnerships who do not have an economic interest or investment .  House Bill 1248 added language to both the Colorado Limited Partnership Act and the Colorado General Partnership Act expressly authorizing the admittance of partners who do not make an investment, and who do not share in the profits, losses or distributions of the partnership.  This new class of “non-economic partner” will allow such “partners” to have all the rights, duties and liabilities of a partner in a partnership, while being paid solely as an employee.  For example, a professional partnership could have two levels of partners (1) traditional partners (2) and non-economic partners who are paid a salary, do not receive allocation of profits, losses and distributions, but are nevertheless partners in the firm. 

This new class of partner is different form a “profits interest” partner.  A “profits interest” partner becomes a partner without making any quantifiable contribution to the partnership – in other words, he or she does not buy the partnership interest, nor contribute anything of measurable value such as property or assets in exchange for the partnership interest, but after the date of admission receives an allocated share of profits, losses and distributions.  Under partnership tax accounting rules, each partner is assigned or allocated a capital account, with a capital account balance reflecting the investment or contribution the partner made to the partnership.  The capital account balance is adjusted over time to reflect profits, losses, distributions and additional contributions.  A “profits interest” partner receives an initial capital account balance of $0.00.  A “non-economic” partner under this new law would not have a capital account, does not receive a future share of profits, losses and distributions, and would not be a partner for purposes of federal tax accounting rules and regulations.

General Partnerships and Limited Partnerships

Non-economic partners will be allowed in a general partnership so long as the partnership has at least two economic interest partners.  The new law also clarifies that a non-economic partner may be a partner in a limited partnership, so long as there is at least one partner with an economic interest.   This will allow limited partnerships where the general partner does not have to make an investment and has no economic interest, but may be paid fees or a salary, and will also allow the formation of a limited partnerships where only the general partner makes an initial investment, and limited partners may be admitted later as they invest funds.  Limited partnerships are often used as venture capital funds, hedge funds or private equity funds.  Fund managers, who are the general partners, will now be able to (1) manage funds as general partners and receive fees, without having to make an equity investment, and (2) form limited partnerships with only the manager as a member, and admit the limited partners at a later date as they invest in the limited partnership.

Non-Economic Partners Beware

Each partner in a general partnership, and each general partner in a limited partnership, is liable for the debts and obligations of the partnership.  A thriving business enterprise operated as a partnership can take-on substantial debt, such as office and equipment leases, loans and trade credit.  If the business suffers a down-turn, the general partners are liable for those obligations.  The incentive to accept such risk comes from the benefits of ownership – a say in the business and a share in profits and distributions.  However, a “non-economic” partner would have all the potential liability of a partner without the economic benefits and voting rights that normally offset the risks.

Non-economic partnership interests should not be granted or accepted before the parties have a complete understanding of the risks and rewards, and have considered options to reduce the risks, such as using a limited liability partnership, funded indemnity protection, and use of a limited liability entity to hold the non-economic partnership interest.

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