Tag: general solicitation

Pre-existing, Substantive Relationship

Rule 506(b) of Regulation D provides a safe harbor for issuers to engage in private placements. Private placements undertaken pursuant to Rule 506(b) are limited by Rule 502(c) of Regulation D, which imposes as a condition on offers and sales under Rule 506(b)that “… neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising…”

The SEC Staff has issued various interpretive letters that have tried to clarify the regulation. One of those was the statement that a general solicitation is not present when there is a “pre-existing, substantive relationship” between an issuer, or its [agent], and the offerees.

The SEC has published some Q and A’s on the topic. 256.31 says “substantive” means you have sufficient information to determine the offeree is an accredited or sophisticated investor. Blast emails to unknown investors would not be substantive.

As to the “pre-existing” prong, question 256.30 says there is no minimum waiting period, but there is a waiting period. The Lamp Technologies No Action letter in 1997 said that 30 days is sufficiently long to be pre-existing. (See Footnote 6). So somewhere between 0 days and 30 days is pre-existing enough, as long as you know the potential investor is accredited, to send information on offering.

There is also the question of what amounts to an offering. If it’s at the early stages of a fund, before its formed, perhaps there is no actual security sell. It’s hypothetical information about an upcoming offering.

This all circles back to the IR people asking whether they can leave a copy of the pitchbook for a fund at the initial meeting with an investor. I think the answer is generally “no”, unless you can show that there is a pre-existing substantive relationship with the investor. An initial meeting is generally the 0-day period, unless there has been a series of discussions prior to that initial meeting.

Sources:

A Classic Example of a General Solicitation Failure

The SEC opinion in KCD Financial Inc. (SEC Opinion 34-80340, March 29, 2017) affirms a fine and disciplinary action against KCD for selling securities in a private placement when no exemption from registration was available under Rule 506. The KCD opinion makes clear that you can’t fix the general solicitation failure by then only selling only to people had a prior relationship with issuer.

The action is against KCD, a broker-dealer, for selling the unregistered securities of Westmount Realty Finance’s WRF Distressed Residential Fund 2011. The offering’s PPM stated that the securities were being made in reliance on an exemption from the registration requirements of the Securities Act and that interests in the Fund were being offered only to persons who were accredited investors as set forth in Regulation D. In 2011, that meant no general solicitation or advertising.

Westmount screwed up and issued a press release that ended up being published in two local newspapers. Westmount screwed up even further by linking to those newspaper articles from Westmount’s website.

As long ago as 1964, [the SEC] has held that the statutory definition of “offer to sell” included “any communication which is designed to procure orders for a security,” and that even a communication that did not on its face refer to a particular offering could nonetheless constitute an offer as long as it was “designed to awaken an interest” in the security. [Gearhart & Otis, Inc., Exchange Act Release No. 7329, 1964 SEC LEXIS 513, at *59 (June 2, 1964), aff’d on other grounds, 348 F.2d 798 (D.C. Cir. 1965)]

The articles reported that “Dallas-based Westmount Realty Finance LLC announced Tuesday that it launched a $10 million real estate fund to acquire bank-owned residential properties and nonperforming, discounted residential loans.” (Yes, the article is still visible online.) That seems to clearly be general solicitation.

The argument from KCD was that it did not generally solicit any of the actual investors in the WRF Fund. When prospective new investors called, KCD asked if they had seen the article. If yes, they were not allowed to invest.

This argument was rejected. Once you engage in a general solicitation in violation of Rule 502(c), the Rule 506 exemption is not available for any subsequent sales of the securities regardless of limiting the sales only to investors who did not see the general solicitation. SEC guidance in 1983 pointed out that soliciting people with a pre-existing relationship and had reasonably believed that the recipients had the knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment is not general solicitation. “The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.”

Some of this has gone away since the SEC changed the general solicitation rules. Most firms do not want to check the box that says they engaged in general solicitation, fearing it will create greater SEC scrutiny.

Sources:

Filing Form D and General Solicitation

soap box

One of the current issues around a fund manager or company from using advertising as part of its private placement fundraising is the proposed changes to filing requirements for Form D.

Few people I have spoken with actually want to use general solicitation like bulk emails, newspaper ads, or web ads. But they do want to be able to mention fundraising at industry events, advertise the fund manager as a brand, and talk to the media. All of those could be considered general advertising and solicitation or could come close to the line. The SEC has not created a bright line test for when an announcement becomes general and endangers a private placement.

Many people embraced the lifting of the ban on general solicitation and advertising because the fund manager or company could avoid the advertising foot fault of private placement.

The requirement that a firm take reasonable steps to determine if potential investor is accredited is one impediment. For funds with large minimum investment requirements and mostly institutional investors, it’s probably less of an impediment.

The foot-faults under the proposed rule are even greater.

For instance, the proposed rule would require filing of Form D before a general advertisement or solicitation begins. That’s a problem when it’s not clear whether an activity falls under those terms. It’s also a problem if the terms of the offering change over the course of the pre-sale marketing period. Often, a private fund’s terms are not complete during the initial marketing phase.

Even worse, the proposed rule imposes a draconian ban on the use of private placements if you failed to file the Form D before the activity that would be considered general advertising and solicitation.

I agree that not requiring the filing until 15 days after the first sale is not the best method to provide information to investors or regulators. I think the better position is to require the filing 15 days before the first sale.

The proposed rule 510T would also require filing the materials used in general solicitation and advertisements with the SEC. Again, with those terms not well defined it’s hard to know if you have violated the rule. If the materials escape and get published in the media, you’ve potentially blown the private placement and the filing requirement with no ability to cure.

According to Jim Hamilton’s World of Securities Regulation, seven Senators have urged the SEC to adopt the proposed rules to help state securities regulators. Broc Romanek in theCorporateCounsel.net notes that SEC Commissioner Aguilar has weighed in supporting the proposed rules as necessary for investor protection.

Fund managers may be intrigued by the lifting of advertising requirements, they are more likely to cause a foot-fault than staying under the existing private placement regime.

References:

 

 

 

The New Era of Public Private-Placements

half-price advertisement

The Securities and Exchange Commission’s new Rule 506(c) goes into effect today, lifting the ban on general solicitation and advertising. Fund managers, start-ups, and established companies can make public, their private placements of securities. That is both a good thing and a bad thing.

It’s good because start-ups can now pitch their products to potential consumers and for investments by investors. Demo days are no longer operating in a shadowy area that may violate the rule on private placements. Private fund managers can now advertise their brand, much as mutual fund companies can advertise. Private fund managers can speak to the press so that their coverage is no longer incorrect.

It’s bad because once you advertise, you have to take “reasonable steps to verify” that you should have a “reasonable belief” that an investor is an accredited investor. For individuals, it may mean that an issuer would ask for tax returns or certified financial statements. I think most individuals will resist that request. So a start-up that is seeking individual investors may actually handicap its ability to attract investors by engaging in general solicitation or advertising.

It’s also bad for securities regulators. If a regulator could see information on what should be a private placement, the regulator knows its a bad private placement. By the old definition of private placement, the regulator should not be able to see the information because its private. Either the company made a bad mistake or there’s fraud involved. In the new era of public private-placements, regulators will have little insight into the nature of the private offering.

At some point the regulators will have access to the Form D filing that provides a basic set of information about the public private-placement. But that does not need to be filed until 15 days after the first sale of securities.

In an attempt to fix the loss of the red flag, the SEC proposed some additional rules to help with investor protection. I, and many others, feel the proposed rules are more likely to impede private fundraising more than protect investors.

The better solution would have been to improve the poor definition of “general solicitation and advertising.” There were many things that clearly fit into the definition and many things that clearly fell outside of the definition. If the SEC had just carved out a few more items (see the “good” above), private placements would not be in their current turmoil.

But it was not up to the SEC. It was a Congressional mandate in the JOBS Act that swept aside the ban. It was Congress who imposed the investor verification requirement.

The good news is that the old private placement regime is still in place. As long as you don’t engage in general advertisement or solicitation, in other words have a private private-placement, you don’t have to engage in the messy investor verification process.

What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

Sources:

What Happens If You Violate the Ban on General Advertising and Solicitation?

compliance and advertising

I’m not planning to run late night ads for a latest security offering. But what could the Securities and Exchange Commission do about it? Keith Bishop asks: Can the SEC really create illegal actions by its own failures to comply with the law?

Last year’s JOBS Act contained an explicit mandate with an explicit time frame.

 Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.

However, 90 days was never a feasible deadline to draft a rule, make it available for comment, respond to the comments, and publish a final rule. Congress could have made the change a statutory one, leaving the SEC rule explicitly out-of-date. But instead they mandated a regulatory change.

The first question is what would the SEC do to a violator? The SEC has published a JOBS Act page full of Frequently Asked Questions. Under Title III for crowdfunding the SEC published a statement warning would be entrepreneurs that securities crowdfunding is not legal until the regulations are finalized. The FAQ for Title II turns to the Broker-Dealer exemption for advertising. I don’t take the lack of a warning to mean that the SEC won’t prosecute. But given limited resources, you would have to wonder why the SEC would bother.

Assuming the SEC did prosecute, what would the courts do? …

I think I’ve gone on long enough. At this point, your offering is tied up in expensive legal roadblocks and your burning through cash to pay your lawyers. Whatever advantage you thought you might gain from advertising is gone.

Some brave soul may step up and be willing to test the advertising waters out of principle. But it would be a test rooted in sensible economic analysis.

Crowdfunding and the Ban on General Solicitation

18 Rabbits Bars

While entrepreneurs are looking to create crowdfunding portals under Title III of the JOBS Act, small business owners looking to raise capital should keep an eye on the regulatory changes under Title II of the JOBS Act. That may do a better job of opening the spigot for capital than the avalanche of crowdfunding portals likely to appear.

Look at the case of Alison Bailey Vercruysse, a maker of granola-based foods, and her company 18 Rabbits. According to a story in yesterday’s Washington Post, her products attracted a loyal following, but she could not tap those fans for capital as she tried to grow her firm.

“People would come up to me in different places and say: ‘I’m interested in investing in your company. How can I do that?’ ” Vercruysse said. “I couldn’t say we were trying to raise money. I’d end up saying things like; ‘Buy our granola. That would help us.’ ”

Without the ban on general solicitation, the company could put a message on its packaging or its website for accredited investors interested in investing.

Currently, the Securities and Exchange Commission has a ban on the use of general advertising and solicitation for raising private capital under the most popular exemption, Rule 506. Title II of the JOBS Act requires the SEC to remove that ban for offering where all investors are accredited. The agency tried to rush the rules last summer to meet the Congressional deadline, but investor advocates demanded that the SEC slow down. The SEC is gathering public comment before finalizing the rule.

Two SEC commissioners, Dan Gallagher and Troy Paredes, were in favor of immediately lifting the ban. SEC Commissioner Luis Aguilar did not like the rule, saying it lacked adequate investor protections. The fourth SEC Commissioner, Elise Walter voted for the proposal, but expressed concerns. She has stated the SEC must consider ways to mitigate potential harm to investors. The fifth and presumably deciding Commissioner’s seat is vacant with the departure of Mary Shapiro. Looking into my crystal ball, it would seem that the rule is not going to be finalized anytime soon. At least not until the vacancy is filled.

Sources:

What Will the SEC Do About Advertising and Solicitation?

UPDATE: The SEC will wait a week. A new meeting has been scheduled for August 29.

At today’s meeting the Securities and Exchange Commission is set to consider a rule on lifting its longstanding ban on general solicitation and advertising for privately-issued securities.

Item 3: The Commission will consider rules to eliminate the prohibition against general solicitation and general advertising in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act and Rule 144A under the Securities Act, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act

Personally, I would welcome better information about what the SEC considers a general solicitation or general advertisement in connection with the private placement of securities. I don’t think lifting the ban is necessarily a good idea. The appearance of an ad for a private security has been a prominent red flag for an offering. Either it’s a fraud or the company is ignoring the advice of its legal counsel.

The bigger concern is what the SEC will do about verifying that the potential investor meets the accredited investor standard. Currently, most fund manager use a certification filled out by the investor. In addition to meeting the accredited investor standard, the questionnaire will typically include many other items of disclosure.

This process has worked well for decades. Hopefully the SEC won’t mess it up.

If you are wondering what changes the SEC could make, McGuire Woods put together an excellent Preview of New SEC Provisions Permitting Advertised Private Placements. The report tries to summarize the numerous comments submitted to the SEC.

Sources:

Comments on Advertising Restrictions for Private Funds

Section 201 of the recently passed Jumpstart Our Business Startups Act will change the advertising limits on private funds and any other company that raises capital through the private placement safe harbor in Rule 506 of Regulation D. That rule has historically prevented the use of general solicitation and advertising in selling private fund interests. Section 201 requires the SEC to lift the ban through a new rulemaking and gave the SEC 90 days (July 4) to do so.

I still find it strange that Congress did not just create revise the underlying statutes to allow solicitation and advertising in private offerings not registered with the SEC. Instead, Congress took the convoluted route of requiring the SEC to change a rule that interprets a statutory provision of the Securities Act. That injects some uncertainty into what limitations, if any, the SEC will continue to require after July 4 (or whenever the new rule goes into effect).

There are a few other points in Section 201 that concern me and make me worry about fundraising in the post JOBS Act regulatory world.

First, Section 201 limits sales only to accredited investors when using general advertising or solicitation. Currently, a Rule 506 offering can have up to 35 non-accredited investors. That would typically include friends and family investors. It would also include employees.

Second, Section 201 requires the SEC to include a requirement that the issuer take reasonable steps to determine accredited investor status using methods determined by the SEC. That could radically change the current practice and safeguards in the fundraising process.

Third, I’m concerned what the effect will be for a fund or other issuer that ends up selling to a non-accredited investor. A fund can take reasonable steps to determine if a potential investor is accredited. But the investor could be deceptive. That would leave the fund in violation even though it reasonably believed the investor was accredited.

Fourth, Section 201 purports to lift the ban across all federal securities law. In particular, I’d prefer clarification that the advertising and solicitation applies to the Section 3(c)(1) and 3(c)(7) of the Investment Company Act that permits most private funds to avoid regulation under that law.

In looking through the comments letters to Section 201, I see that I am not alone in these concerns.

The American Bar Association’s Federal Regulation of Securities Committee does a a great job of focusing on my fourth concern and asks for a clear statement that “an offering of fund shares pursuant to Rule 506 or Rule 144A utilizing general solicitation or general advertising will not be a ‘public offering’ for the purposes of Section 3(c)(1) or 3(c)(7) of the Investment Company Act.”

The letter also requests clarification of the reasonable belief standard in the Rule 501 definition of accredited investor.

“any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person…”

The letter falls short in its comments to the verification practice. It merely asks the SEC to have the rule reflect “current custom and practice” without letting the SEC what the customs and practice is. (It’s asking the investor to fill out a questionnaire.)

In it’s comment letter, the Managed Fund Association focuses on reasonable steps for the verification process.

In general, each potential hedge fund investor must complete a subscription document provided by the fund’s manager that provides a detailed description of, among other things, the qualification standards that a purchaser must meet under the federal securities laws. In completing the subscription materials, each investor must identify which applicable qualification standard it meets. In addition to these procedures, many hedge funds managed by MFA members obtain further assurance of the qualification of their investors by virtue of minimum investment thresholds that meet or exceed the net worth requirement in the definition of accredited investor.

The Managed Fund Association also asks that the knowledgeable employee exemption be extended to Rule 506. With private funds, investors prefer (demand?) that senior management have a significant investment in the fund. This aligns interests among the investors and management. When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employee when it’s unlikely that your key employees will have the $5 million in investments needed to qualify as  a Qualified Purchaser. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. The Managed Fund Association recommends

that as part of the implementation of Section 201, the SEC amend the definition of “accredited investor” to include those individuals who meet the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act.

The New York City Bar splits the verification process by asking for a principle-based approach with a non-exclusive safe harbor. Their comment letter points out the body of existing practice and asks the SEC to build on it, rather than replace it.

The clock is ticking and the SEC has very little time to produce a proposed rule for comment. I wouldn’t be surprised to see the SEC miss the deadline given all of the other rule making piled up in front of them. That means the advertising may have to wait that much longer.

Sources – Comment letter from:

How Do State Regulators Really Feel About the JOBS Act?

The House of Representatives recently voted to pass The Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), a collection of several bills focused on barriers to capital formation. I’m focused on the bill because of mostly because of the Access to Capital for Job Creators section that would override the ban on general solicitation and advertising under Regulation D.

I welcome some sensible changes to Regulation D because I find the ban a bit vague as part of the fundraising process. Private fund managers could use guidance from the SEC on what is allowed and what is prohibited by the ban.

On the other hand, knowing the general ban exists makes it easy to dismiss scams and spam spinning tales of possible investment opportunities. That unsolicited message is either a straight-up scam or a naive entrepreneur who thinks they can operate without competent advice. Either way you can easily dismiss the opportunity.

Another provision of the JOBS Act that I found interesting is the Private Company Flexibility and Growth Act. The main purpose is to raise the thresholds under Section 12(g)(1)(A) of the Exchange Act. Currently under that provision, private companies with more than 500 shareholders and a big stream of revenue effectively have to become public companies. That shareholder limit forced Google into going public and most recently is forcing Facebook to go public.

The centerpiece of the JOBS Act is the new crowdfunding platform. Currently, platforms like Kickstarter are prohibited from offering equity. Project sponsors have to ask for donations, offer schwag, or pre-sell products. All of which seems to work very well.

Commentators like William Carleton think the concept of crowdfunding will be great for entrepreneurs. The Wall Street Journal has a point-counterpoint this morning on crowdfunding:

Like most stuff coming out of Congress, even if the concept is good I think Congress is likely to screw up the drafting of the law.

That is my view of the JOBS Act. Most of the concepts are good, but the execution is poor. I think Congress is missing the balance between investor protection and access to capital. That opinion is shared by the North American Securities Administrators Association. Here is a snippet from an editorial by Jack E. Herstein, president of NASAA:

The most jobs this cleverly named bill may create are jobs for fraudsters, like the Nigerian scammers, penny-stock pitchers and Ponzi schemers already lurking behind the Internet to cloak their schemes.

The Senate is mulling over their version of these bills where it seems to have bi-partisan support. President Obama has also thrown his support to some of the concepts in the JOBS Act. It seem likely that something will pass. According to Talking Points Memo it looks like Senate Majority Leader Harry Reid is willing to trade support for the JOBS Act for approval of some judicial nominees.

Sources: