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.
I have a written a few stories on the SEC’s case against Louis Schooler and his firm, Western Financial Planning Corp. The Securities and Exchange Commission brought charges against them for a real estate investment scheme. Schooler was selling general partnership interests that owned real estate using what looked like inflated valuations.
By default general partnership interests are not securities, but the judge found that a general partnership could be an investment contract (and therefore a security) if one of three factors is present.
(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;
(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or
(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
Schooler has continued to fight the decision, but has been hit with having to pay $150 million in disgorgement.
The SEC took an additional approach and sought to bar Schooler from the securities industry. That raised my eyebrow because Schooler does not think he is in the securities industry. He is claiming to be selling real estate interests. I’m not sure how much the bar would work. It’s a bit of a circular argument.
It does not seem to matter because Schooler decided to take some time off and go sailing in the South Pacific on his Hylas 42 sailboat: Entertainer. I’m sure that the many people who lost money in Schooler’s investment scheme have some bad thoughts of that image of him sailing alone in the tropical breeze.
Those investors are likely believing in karma now. Schooler did not appear for the ruling. He has gone missing in the South Pacific.
That did not stop the SEC from finalizing the industry bar. It also lead to his lawyer’s charge that the SEC’s Enforcement Division “is acting out of pure vengeance and spite, akin to not only killing a person, but kicking and mutilating the corpse.”
The SEC’s response:
“[T]here has been a report that Schooler’s yacht ran aground on a reef in or around Tahiti, no remains were recovered, and no death certificate has been issued. At present the U.S. State Department considers Schooler to be missing rather than dead.
I’m sure that there are many, like me, wondering if this is straight out of a movie. Did Schooler set up an elaborate scenario to fake his own death? Latitude 38 says some circumstances of the shipwreck are suspicious.
Neither scenario does anything to help those who lost money by investing with Schooler.
The tale of Western Financial Planning Corporation and Louis Schooler first caught my eye because the Securities and Exchange Commission brought charges against a real estate company. I stuck with the story because Western Financial tried really hard to structure the investments to avoid being considered securities. Even thought it tried really hard, a court still found that Western was selling securities. Having lost that battle, Western is staying on step ahead of the SEC charges. Western is claiming that the investments were sold through a good private placement.
Western had structured the real estate investment vehicles as general partnerships and sold those partnership interests to investors. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case. Western lost the securities argument and the court found that the interests met the Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981) three part operational test for an “investment contract” as a security.
Western would lose on the charge of selling an unregistered security unless it could find an exemption from registration. The firm argued that the sale of interests qualified for the exemption under Rule 506. Western managed to hold on a bit longer and managed to survive to continue the fight. The SEC failed to prove that the sale failed the Rule 506 tests.
The main parts of the Rule 506 exemption are:
There must be no more than 35 purchasers who are non-accredited.
The non-accredited investors must have the knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.
The interests can not be offered for sale by general solicitation or general advertising (from Rule 502).
The first stumbling block is whether there was one long continuous sale of interests or merely several separate sales. 17 C.F.R. §230.502(a) sets out a five factor test for whether the separate sales should be “integrated” into one long continuous sale:
(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.
Although Western sold 23 different properties and 86 general partnerships, the court found that they were sold close enough together to be integrated into one offering. Point to the SEC. As a result of losing that point, Western does not get up to 35 non-accredited investors for each general partnership, but only 35 against all of them.
The SEC made a mistake and had no evidence about the net worth of the investors. The SEC did not prove that there were more than 35 non-accredited investors. That leaves a dispute of material fact which means you don’t get summary judgment, but a trial instead.
The court draws an interesting distinction in general solicitation and notes the SEC’s no-action letter: E.F. Hutton&Co., No-Action Letter, 1985 SEC No- Act. LEXIS 2917 (Dec. 3,1985). A general solicitation for clients does not turn into a general solicitation for securities as long as a “sufficient time” passes between establishment of the relationship and the offer.
Western argues that its extensive use of cold calls, networking groups, and mailings by an affiliate was merely to solicit clients for the affiliate and not to sell Western’s securities. The SEC failed to provide sufficient evidence that there was insufficient time.
Largely, this is matter of pleading and the SEC failing to put together the right evidence to win on summary judgement. The court is allowing the SEC to refile the motion and fix the evidence mistakes.
This just goes to the charge of selling unregistered securities. It’s not addressing any actual fraud by Western.
The Financial Industry Regulatory Authority released Regulatory Notice 10-22 reminding registered firms about their obligations regarding suitability, disclosures and other requirements for selling private placements to customers.
A Broker-Dealer that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. This is true regardless of the type of security. The “reasonable” standard for the investigation depends on many factors including the nature of the recommendation, the role of the broker-dealer in the transaction, its knowledge of and relationship to the issuer, and the issuer itself.
NASD Rule 2310 requires a broker-dealer to have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer. That means they must have a reasonable basis to to determine that the recommendation is suitable for at least some investors. Then they have to determine that it is suitable for the specific customer.
The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. In a Regulation D offering the broker-dealer should, at a minimum, conduct a reasonable investigation concerning:
the issuer and its management;
the business prospects of the issuer;
the assets held by or to be acquired by the issuer;
the claims being made; and
the intended use of proceeds of the offering
Although the “reasonable investigation” must be tailored to each private placement, the regulatory notice provides a list of best practices gathered from member firms.
A. Issuer and Management. Reasonable investigations of the issuer and its management concerning the issuer’s
history and management’s background and qualifications to conduct the business might include:
Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.
Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.
Looking for any trends indicated by the financial statements.
Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.
Inquiring about internal audit controls of the issuer.
Contacting customers and suppliers regarding their dealing with the issuer.
Reviewing the issuer’s contracts, leases, mortgages, financing arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.
Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.
Inquiring about pending litigation of the issuer or its affiliates.
Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.
Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.
Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.
Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.
B. Issuer’s Business Prospects. Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:
Inquiring about the viability of any patent or other intellectual property rights held by the issuer.
Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.
Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.
Requesting financial models used to generate projections or targeted returns.
Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.
C. Issuer’s Assets. Reasonable investigations of the quality of the assets and facilities of the issuer might include:
Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.
Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.
Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.
“An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests,” said FINRA Chairman and CEO Rick Ketchum.
