Posts Tagged ‘private placement’

May 15, 2015 – On April 13, 2015 Governor Hickenlooper of Colorado signed the Colorado Crowdfunding Act. The Crowdfunding Act becomes law on August 5, 2015, and on May 7, 2015 Colorado Securities Commissioner Gerald Rome said that he anticipates the regulations will be final by that date so that Colorado businesses will be able to raise money in a crowdfunded offering beginning August 5, 2015. Under the Crowdfunding Act, offers can be made solely in Colorado, under the federal intrastate offering exemption. This means that the offers may be made only to Colorado residents, and only Colorado residents may invest. In addition, the offering must comply with the federal intrastate exemption, which means, among other things, ownership of the stock must not leave Colorado for 9-months after it is purchased.

I discussed the requirements for crowdfund offerings in Part 1 of this article; this Part 2 discusses the role and requirements for “intermediaries” who provide the Internet website for offerings.

Before the JOBS Act was passed three years ago, “crowdfunding” in the U.S. comprised only donations, or pre-sale purchase of goods or services, through websites such as gofundme, KickStarter, and indiegogo, and not the sale of securities. The JOBS Act required the SEC to establish a procedure for small securities offerings to a large number of investors, and in 2013 the SEC published proposed “crowd funding” rules, but they have not yet been approved and adopted. As a result states have begun to adopt their own laws and regulations to enable businesses to raise money by offering securities to “the crowd,” and now Colorado has followed suit.

In a private placement, the issuer may, and often does, sell its securities directly to investors. However, the issuer cannot sell its securities directly to the public in a crowdfund offering, for example, through its own website. In Colorado securities can be sold in a crowdfund offering by a registered broker-dealer, a registered sales representative (stockbroker) or an online “intermediary.”

An online intermediary is a website that is not a broker-dealer or stockbroker, and does not offer securities except for crowdfund offerings. Before offering online intermediary services, the intermediary must:

  1. File a statement or form with the Colorado Division of Securities disclosing the following:
    • identity, address, contact information, and names of the officers, directors, managers, or other persons who control the company;
    • a consent to service of process; and
    • an undertaking to provide investors the offering information required by the Crowdfunding Act.
  2. Comply with reporting and filing rules of the Securities Division. The rules have not been published yet, but the Crowdfunding Act says the Securities Commissioner may require intermediaries to file financial information, make and retain specified records for 5 years, and establish written supervisory procedures to prevent and detect violations of the Crowdfunding Act and rules. I anticipate the rules will include all of these requirements
  3. Maintain records of all its offers, which must be available to the Securities Division on request and subject to division examination at any time.
  4. Not have any ownership or financial interest in, or be affiliated with, any issuer it conducts offerings for.

Intermediaries cannot charge commissions on securities sold. Under both federal and state securities laws, only registered and regulated persons such as broker-dealers and stockbrokers can be paid commissions. Since intermediaries are not registered, they cannot be paid based on the amount of securities sold. Intermediaries have two fee options, and they can use one or a combination. They may charge (1) a fixed fee for each offering, or (2) a variable amount based on the length of time the securities are offered. As a result, intermediaries will have several fee options. For example:

• a flat fee unless the offering is not sold within a number of weeks, and then an additional fee for every week the offering remains open;
• or a fee for every week the offering remains open, but not less than a fixed amount, which will guaranty the intermediary a minimum fee even for offerings that sell out very quickly.

No Advertising?

An intermediary cannot promote a crowdfund offering – the Act says: “An on-line intermediary shall not identify, promote, or otherwise refer to any individual security offering by it in any advertising for or on behalf of the on-line intermediary.”

An issuer cannot promote its crowd fund offering either, because issuers are restricted to distributing a notice that can only state the company is conducting an offering, the name of the intermediary, and a link to the intermediary’s website.

Non-securities crowdfunding offers, like the recently extremely successful effort by Alan Tudyk and Nathan Fillion to raise funding for the series Con Man on indiegogo, can use social media to publicize the opportunity. Tudyk and Fillion used their extensive Twitter and facebook followers to gain momentum and attention for the Con Man fund raise. Companies selling securities in a crowd funded offering through an intermediary will not be able to undertake any similar advertising, promotion, or sales campaigns, and will instead have to rely on investors who follow intermediaries looking for investment opportunities.

Although the Colorado Crowdfunding Act has several advantages over the proposed SEC rules, it is still a very expensive option when compared to a traditional private placement, and only time will tell if it presents a viable funding option for companies who cannot raise the needed funds through traditional private placements.


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According to the SEC, in 2012 companies raised $173 billion through direct private placements, and pooled funds raised $725 billion. These offerings were conducted without public advertising. After September 23, 2013 companies and hedge funds offering their securities in private placements can now advertise the offering to the public, so long as (1) all purchasers are “accredited investors” and (2) they take “reasonable steps” to verify that each purchaser is “accredited.” However, the new rules also increase the risk and likelihood of losing your private placement exemption, and should be used with caution.


The basic foundation of securities laws in the United States is that every offering and sale of a security must be either registered with the SEC and applicable state commissions, or qualify for an exemption from registration. The primary exemption from registration is §4(2) of the Securities Act of 1933 (“Securities Act”), which exempts “transactions by an issuer not involving any public offering.” In the decades after 1933, court rulings and SEC guidance added a confusing and formidable crazy-quilt of rules about what made a “private placement” under §4(2). To address this problem, in 1983 the SEC issued Regulation D; private placements that meet one of the three Reg D requirements are deemed exempt from registration, and thus Reg D provides issuers with a “safe harbor” so they know their private placement is exempt, instead of having to deal with the uncertainty of §4(2).

The details of Reg D offerings are beyond the scope of this article, but nearly all private placements by issuers are conducted under Rule 506 of Reg D, because there is no limit on the amount raised or the number of accredited investors (now known as Rule 506(b)). There are several specific requirements that must be met to comply with a Reg D exemption, and Form D must be filed with the SEC and the relevant state commissions – more on that later. But until now, it was a requirement of every Reg D private placement that it not involve any public offering.

That means no advertising, no Internet webpages about your offering, no hosted breakfast meetings at the retirement home about an “investment opportunity,” no facebook postings, no windshield flyers at the mall – until now.

The JOBS Act

Section 201(a) of The Jumpstart Our Business Startups Act, (the “JOBS Act”)(April 5, 2012) directed the SEC to issue rules allowing “general solicitation” in connection with a private placement. Earlier this year the SEC issued new Rule 506(c), which went into effect on September 23, 2013 and provides a new “safe harbor” exemption from registration for securities offerings marketed using general advertising if:

  • all investors are “accredited investors” at the time of investment, and
  • the issuer takes reasonable steps to verify that each purchaser is an accredited investor.

How It Works

New Rule 506(c) under Regulation D allows issuers and their agents to advertise and offer to the public their securities, without having to register the offering or the securities under the Securities Act, if (1) all investors are “accredited investors” at the time of investment, (2) the issuer takes reasonable steps to verify that each purchaser is an accredited investor, and (3) they otherwise comply with Reg D. Note that the definition of “accredited investor” under Reg D has not changed, which means that an “accredited investor” includes persons that the issuer reasonably believes to be an accredited investor. Therefore, the issuer will not lose the exemption if an unaccredited investor sneaks in, so long as the issuer reasonably believed the investor was accredited.

Securities issued under new Rule 506(c) will still be “covered securities” under federal securities laws, and therefore preempt the “Blue Sky” laws of the 50-states; state registration will not be necessary, but the issuer must still file Form D with the SEC and the states where securities are sold. Form D has been amended, and the issuer must now check-the-box to state whether the offering is conducted under new Rule 506(c), or traditional Rule 506(b) with no public offering.

One of the key compliance requirements will be taking “reasonable steps to verify each purchaser is an accredited investor.” The SEC has provided guidance. First, the traditional method of requiring investors to “self-certify” that they are accredited by checking a box on their stock purchase agreement will not be acceptable for public offerings under new Rule 506(c). Second, rather than a “bright line” test, the SEC has adopted a “principals-based approach” to whether the issuer takes reasonable steps – a “common sense” test, depending on the facts of each offering. At one end of the spectrum, if the issuer sells its shares to JP Morgan Chase, Bank of America and Goldman Sachs, very little effort will be required to establish that the purchasers are “accredited,” it is readily confirmed in the public record. On the other end of the spectrum, verifying the accredited status of natural persons will require some effort (and record-keeping).

Natural persons may be accredited based on (1) income (alone or with spouse), or (2) their net worth. The SEC provided a few safe-harbor methods for satisfying that investors are “accredited,” which are not exclusive.


An issuer will be deemed to have satisfied the verification requirement for the income of a natural person by reviewing the investor’s IRS income forms for the two most recent years, such as Form W-2, Schedule K-1, Form 1099, and Form 1040. The issuer must also get a written representation from the investor that he expects to reach the required income level again in the current year. If the income requirement is based on joint income with the investor’s spouse, the IRS forms and representation must pertain to both the investor and spouse.

Net Worth

An issuer will be deemed to have satisfied the verification requirement for the net worth of a natural person by reviewing one or more of the investor’s bank statements, brokerage statements, securities account statements, certificates of deposit, tax assessments and appraisal reports for assets, and a consumer credit report for liabilities from one of Experian, Equifax, or Trans Union. The investor’s written representations described above are required.

Third-Party Verification

An issuer will be deemed to have satisfied the verification requirement by getting a written confirmation from the investor’s registered securities broker or investment adviser, CPA or licensed attorney.

Bad-Actor Disqualifications

Concurrent with issuing the new Rule 506(c), the SEC also issued the long awaited “Bad Actor” disqualification rules, disqualifying felons and other “bad actors” from participating in Rule 506 offerings. The issuer will lose its private placement exemption and be subject to rescission (discussed below) if the issuer, a director or officer, a 20% owner, a promoter, or a finder has had a “disqualifying event” such as a criminal conviction, a securities related injunction or restraining order, a banking regulator order, or any of a number of other disqualifying events. These will be discussed in more detail in a companion article.

The Big Risk – Claims for Rescission, Damages and Enforcement Action

The penalty for violating the registration or antifraud provisions of the securities laws is that, at a minimum, investors can rescind their purchase and receive a refund of their investment.  Some states, such as Colorado, provide for attorney’s fees in these types of cases. Additionally, the state and federal regulatory agencies have enforcement rights and, in extreme and aggravated circumstances, may fine and enforce criminal penalties.

The federal antifraud provisions arise primarily from Section 10(b) and rule 10b-5 of the Securities Exchange Act of 1934 (“Exchange Act”), as well as the lesser known Section 12(2) of the Securities Act. States have similar or identical antifraud provisions in their “Blue Sky” laws. Failure to comply with these provisions can result in civil liabilities (i.e., money damages). The liability can be, and often is, personal as to corporate officers, directors, principal shareholders and promoters. These antifraud laws prohibit any person in connection with the purchase or sale of any security from misrepresenting or omitting a material fact or engaging in any act or practice that constitutes a “fraud” or deceit upon any other person. Fraud, for securities law purposes, is much broader than the average person thinks of “fraud”. It includes omissions in disclosure (sometimes even unintentional ones) rather than just deliberate misrepresentations. Therefore, regardless of whether you intend to defraud an investor, if you fail to disclose a material fact, you may be liable.

If an issuer loses its exemption, or, fails to disclose important facts or makes mistakes in disclosures, it is at risk for claims by investors seeking to get their money back, and the directors and officers who participated in the offering may be personally liable. None of the antifraud damages or rescission rights were removed by these new rules.

 Risk #1 – Lose The Exemption, No Fall-Back Exemption

Lawyers commonly help their clients design and conduct private placements so that they comply with both old Rule 506 of Reg D (now Rule 506(b)), and §4(2) of the Securities Act. Rule 506 has a number of specific requirements that, if not met, will cause you to lose the exemption. For example, it is not uncommon for an issuer to restrict its offering to accredited investors, thereby decreasing its disclosure obligations, but then decided to let in Uncle John and Aunt Jane, who are not accredited. Since it hasn’t met the disclosure obligations for non-accredited investors required by Rule 506, the issuer has lost the benefit of that exemption. However, if the placement also complied with the §4(2) requirements, and Uncle John and Aunt Jane meet the “sophisticated investor” requirements of §4(2), the issuer has not lost its private placement exemption – the offering is still exempt.

But, if the offering includes general solicitation and advertising to the public under new Rule 506(c), there is no fallback exemption. Remember, the §4(2) registration exemption applies only to offerings “not involving any public offering,” and therefore will not be available as a fallback if you fail to meet the formal requirements of new Rule 506(c). A private placement with public advertising under new Rule 506(c) is all-or-nothing – you are on the trapeze without a net.

Risk #2 – Commit Securities “Fraud”

“Oops, we forgot to mention, that one guy is suing us about that one thing!”

“Did we tell the investors about that note coming due next year?”

Generally speaking, liability for securities fraud arises when the investor makes his investment decision. While there is no specific disclosure requirement under Rule 506 for offerings made only to accredited investors, without a disclosure document like a private placement memorandum or offering circular, the issuer will be in a tough spot if an investor claims securities fraud, which will be all the more difficult if the offering was advertised. First, a disgruntled investor could claim that he decided to invest based on the public advertising that he saw, before he even saw any investment documents – a risk that did not exist before. An issuer would have little evidence to defend that claim without a robust offering disclosure document with comprehensive risk factor disclosures, and a well-controlled investment acceptance procedure.

Second, securities “fraud” includes the failure to disclose a material fact, which is a fact that a reasonable investor would consider important to an investment decision. The courts have consistently held that generic or “blanket” risk disclosures, such as “this investment is risky and you could lose all your money,” are not sufficient to protect issuers from liability for securities fraud. Fact and risk disclosures must be well considered and specific to each issuer and each offering. In the author’s opinion, public advertising of private offerings will increase the already considerable tension between an issuer’s desire to make its stock attractive, and the lawyer’s desire to disclose all “bad facts” and potential risks. Absent the regulatory scheme of SEC review and comment for public offerings, and specific and very detailed disclosure rules, issuers making public offerings of private placements under new Rule 506(c) may “sales pitch” their stock, and pay the price for inaccurate and incomplete advertisements and solicitations at a later date.

Risk #3 – Lose the Broker-Dealer Exemption

In addition to the registration exemption, a private placement must also comply with the broker-dealer registration or exemption requirements of the Exchange Act. That is, securities may not be sold in the United States except by a person registered as a broker-dealer (or their agents), unless an exemption applies – the persons selling the securities must be registered or exempt. The “issuer exemption” is most commonly used for a private placement. The issuer exemption allows the directors and officers of a company to sell its securities without registering (1) so long as they do not sell more often than once every 12 months, (2) the selling persons are officers, directors, or full-time employees who perform substantial duties for the Company other than selling these securities, and (3) the selling persons are not paid compensation for their sales efforts – they can continue to receive their normal compensation, but no commissions or bonuses for selling the stock. Issuers must be mindful that these rules still apply, even with a publicly advertised private placement. If advertising an offering generates excessive calls and inquiries to the company, the company must be very careful that the persons taking the calls understand their roles and limitations in the context of the broker-dealer exemption, and don’t cause the issuer to lose its “issuer exemption.”

Risk #4 – Hedge Funds May Get Special Attention

In addition to the registration exemption and the broker-dealer exemption, private pooled investment funds, such as hedge funds, private equity funds and venture capital must, must be registered as an investment company under the Investment Company Act of 1940, unless an exemption applies. Most private funds rely on one of two exemptions from the 1940 Act, both of which are not available if they make a public offering of their securities. Because the new rules allowing general solicitation would be of no value to private funds if advertising caused them to lose their 1940 Act registration exemption, the SEC has determined that private funds can make public offerings under Rule 506(c) without losing their 1940 Act registration exemption. Specifically, the SEC ruled that since the JOBS Act provided that offers and sales under new Rule 506(c) shall not be deemed public offerings “under the Federal securities laws,” and the 1940 Act is a “Federal securities law,” then, offerings by private funds under Rule 506(c) shall not be deemed public offerings.

However, the SEC indicated it may be paying particular attention to advertising and disclosures by private funds. Investment advisers to private funds are subject to additional rules under the Advisers Act, and in its issuing release the SEC said “we intend to employ all of the broad authority Congress provided us ….. and direct it at adviser conduct” affecting investors in private funds. The SEC provided this pointed reminder: “Recently, for example, we have brought enforcement actions against private funds advisers and others for material misrepresentations to investors and prospective investors regarding fund performance, strategy, and investment, among other things.” It is probable that the SEC will be carefully scrutinizing advertising and sales materials of private funds for potential misrepresentations.

The Early Fallout

The SEC, and particularly state securities regulators, did not support allowing “public advertising of private placements” (and yes, that is a direct contradiction in terms – a fact not lost on the SEC). However, the JOBS Act required this rule-making, and it does not come without a cost. First, the SEC finally issued the “Bad Actor” rules, prohibiting persons with a relevant bad history from participating. That will be discussed in a different article. At the same time, the SEC issued new proposed rules regarding Form D and filing requirements. Until now, Form D has been a mere formality and an information gathering tool for the SEC. Failure to timely file Form D had little or no real consequences. The SEC is proposing to add real enforcement and penalties behind the Form D filing requirement, and to require issuers making public offerings under new Rule 506(c) to file their offering materials with the SEC.  While these new Form D and reporting requirements are only proposed for comment at this time, and the final regulations remain to be seen, it is clear that the SEC intends to keep a close eye on issuers using advertising for their private placements. State securities commissions will be doing the same.

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This is the second in a series analyzing important changes to capital markets and securities laws by the Dodd-Frank Wall Street Reform and Consumer Protection Act. On July 21, 2010 President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.  While the Act is 2,319 pages long, it has very little immediate effect on the financial markets. Rather, the Dodd-Frank Act empowers a variety of financial regulators and government agencies to conduct studies, take testimony, publish reports and promulgate rules and regulations to enforce the various provisions of the Act.  Not unlike Twilight (New Moon), nothing much happens in the Dodd-Frank Act, but it lets you know there’s more to come.

The Dodd-Frank Act was primarily crafted to reduce the exposure of the U.S. banking system to a repeat of the 2008 melt-down, and end the potential for “too big to fail” government bail outs.  However, the Act goes well beyond the initial intent, addressing broad changes in securities laws, capital markets, banking and consumer finance.

47 Studies (or is it 67 Studies?)

Depending on whom you ask, and how you count parts and sub-parts, the exact number of studies commissioned by the Dodd-Frank Act varies.  The best estimate may be “scads”.  Studies will be conducted and reports published by the Financial Stability Oversight Council, the FDIC, the GAO, the FTC, the Federal Reserve, Treasury, the new Bureau of Consumer Financial Protection, and the SEC, among others.  In particular, the SEC will have one of the biggest roles in implementing Dodd-Frank.   The SEC has begun ramping-up to implement its role.  Compliance Week reports that the SEC will hire roughly 800 new employees, create five new offices, and revamp its internal reporting and technology processes in implementation of its broader reporting and enforcement role.

The following studies may be of interest to our clients:

  • Accredited Investors. The GAO will study and report on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.  As I reported recently, the Dodd-Frank Act already increased the asset value required for individual investors to be “accredited” by excluding the value of the investor’s primary residence.  This report is due in 3 years.
  • Short Selling and Swaps. The SEC must report on several studies on different aspects of short selling and swap transactions.  Particularly, reporting and regulation of certain aspects of short selling are likely to be forthcoming.  While selling stock you don’t own, gambling that the price will go down, can be an effective hedge (insurance) strategy for persons with substantial and complex stock positions, short selling for speculation often vexes public companies.  Management of public companies who watch their stock go down for no apparent reason in the face of growing short positions often believe that speculators are conducting a “short and distort” campaign – taking a short position, then spreading negative rumors or false information about the company to insure a profit from the short position, or that the existence of the short position itself causes other investors to sell their stock, driving the price down and hurting the company.
  • Information on Broker-Dealers, Investment Advisers and Registered Reps. The SEC must study and recommend ways to improve investor access to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information) about registered and previously registered investment advisers, associated persons of investment advisers, brokers and dealers and their associated persons.  This report is due by January 21, 2011.
  • Aiding and Abetting Violations of Securities Laws. The GAO must study and report on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws. This is of particular interest to securities lawyers, accounting firms, and their insurers.  At common law, aiding and abetting occurs through “knowing participation” in the illegal conduct. Although knowing participation is required, wrongful intent by the defendant is not necessary.  Nor is it necessary that the plaintiff establish that an agreement existed between the defendant and the guilty party.  There is a fine evidentiary line between participating in someone else’s conduct, and knowing the conduct was illegal. Thus, when a fraudster commits securities fraud and heads for the border with the money, the aggrieved investors look for people to sue – the lawyers who prepared the offering documents, the accountants who prepared the financial statements, the financial printer, the broker dealer who sold the securities, the investment banker who advised on the deal.

Under current law the SEC may bring action against aiders and abettors, but individuals may not. In addition, the Dodd-Frank Act provides for the SEC to impose aiding and abetting liability on persons who “recklessly” provide substantial assistance to someone who violates the Exchange Act.  Previously, the SEC was required to show that such assistance was provided “knowingly.”  Private plaintiffs have been unable to bring such claims since the Supreme Court’s Central Bank of Denver decision in 1994, and the 2008 decision in Stoneridge Investment Partners blocked plaintiffs from bringing similar “scheme” liability claims.

The Dodd-Frank Act also extends aiding and abetting liability for the first time to the Securities Act, the Investment Company Act and the Investment Advisers Act. The Act also clarifies that the SEC may pursue enforcement actions against so-called “control” persons – those found to “directly or indirectly control” a violator – unless they acted in “good faith” and did not “directly or indirectly induce” the violative conduct.  This report is due in 1 year.

  • Lessen Impact of Sarbanes-Oxley on Medium-Sized Companies. The SEC will study how the SEC could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies whose market capitalization is between $75,000,000 and $250,000,000 while maintaining investor protections for such companies, including whether any such methods of reducing the compliance burden or a complete exemption for such companies from compliance with such section would encourage companies to list on exchanges in the United States in their initial public offerings.  See Sarbanes-Oxley discussion below. This study is due in 9 months.

  • Core and Brokered Deposits.  The FDIC will conduct a one year study to evaluate:

– the definition of core deposits for the purpose of calculating the insurance premiums of banks;

– the potential impact on the Deposit Insurance Fund of revising the definitions of brokered deposits and core deposits to better distinguish between them;

– an assessment of the differences between core deposits and brokered deposits and their role in the economy and banking sector of the United States;

– the potential stimulative effect on local economies of redefining core deposits; and

– the competitive parity between large institutions and community banks that could result from redefining core deposits.

Current FDIC policy strongly discourages acceptance of brokered deposits by charging an FDIC insurance premium if brokered deposits exceed a specified percentage, and by very broadly interpreting the definition of brokered deposit.

What the Dodd-Frank Act Does Today

  • Makes it Harder to Qualify as an Accredited Investor.  As detailed in my earlier article, effective immediately, the definition of an individual accredited investor under the SEC’s Regulation D for private placements now excludes the value of the investor’s primary residence. This reduces the number of people eligible to participate in many private placements, which are often offered only to accredited investors.

  • Sarbanes-Oxley Relief. After six compliance extensions by the SEC, including a couple of “final extensions”, the matter is taken out of the SEC’s hands.  The Dodd-Frank Act provides immediate relief from the onerous Sarbanes-Oxley internal control audit provisions for approximately 5,000 smaller public companies.  Smaller public companies, (non-accelerated filers – companies with a market cap less than $75 million) are now exempt from Sarbanes-Oxley 404(b) compliance. Sarbanes-Oxley 404(a) requires a management report on internal controls, which smaller public companies must still provide – 404(b) requires external audit of internal controls. Based on a 2007 study by Financial Executives International, the average filer incurred outside audit and legal fees associated with Sarbanes-Oxley compliance of $846,000. The costs of compliance with 404(b) were clearly beyond the reasonable reach of smaller public companies.  Smaller public companies comprise approximately 50% of all public companies in the United States.

Stay tuned – the real financial reform will be published over the next few months and years.

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This is the first in a series that will analyze important changes to capital markets and corporate finance laws, enacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Most U.S. based companies seeking to raise money from investors do so through a “private placement” authorized under Regulation D of the Securities and Exchange Commission.  Reg D provides several exemptions from SEC registration of a securities offering, the most popular of which (Rule 506) allows unlimited investment and participation by “accredited investors”.  If the offering includes non-accredited investors, the issuer must meet required disclosure obligations by providing information of the same kind that would be provided in a registration statement for a public offering.  If only accredited investors participate in the offering, there are no specific disclosure requirements mandated by Reg D (although thorough disclosure is still recommended as a risk management practice).  Therefore, many issuers chose to limit their offerings only to “accredited investors”.

With the enactment of Dodd-Frank, effective July 21, 2010, and for at least the next four years, the definition of “accredited investor” has changed.  The net worth part of the accredited investor test, which specifies that a natural person is an accredited investor if his or her net worth is at least $1 million, now excludes the value of that person’s primary residence.   Before July 21, the net worth test included the investor’s primary residence.

There was no transition period or future effective date, so that issuers conducting private placements on July 21, 2010 had to amend and re-document their private placements in process to comply with the change.   Fortunately, the other portions of the accredited investor definition, including the net income tests for natural persons, remain unchanged for now.

The Comptroller General is required to study the appropriate criteria for accredited investor status and report back to Congress within three years.  On July 20, 2014 and every four years thereafter the SEC must review the definition of accredited investor as it applies to natural persons and make adjustments in the rules if appropriate.

The Race to the Bottom has a discussion of the history of the definition of accredited investor, as well as some thoughts about the SEC’s role in developing the standards in the past and the future.

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I will be presenting “Avoiding Land Mines on the Road to Success; Review of Federal & State Security Laws and legal aspects of Real Estate Investments” to the Denver Metro Commercial Association of REALTORS®. The talk will be from 8:00 a.m. to 10:00 a.m. on Thursday, May 27, 2010 at the DMCAR offices, 4300 E. Warren Ave., Denver, CO 80222. We will be discussing securities laws and private placement rules as they apply to real estate investment ventures, and I will be providing a review of some recent enforcement and fraud actions by the Colorado Securities Commissioner in real estate matters.

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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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