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6 Lessons to Learn About Private Offerings from an Experienced Broker-Dealer

Post on: April 5, 2017 | Jim Raper | 1


As we wrap up our 2016 regulatory sales practice exam, I remain impressed with the exam staff’s attention to detail that the private security offerings my firm administers are required to follow. I often say around the shop, "in compliance, the best we can do is not mess up,’' meaning there's no extra credit given when it’s all done properly—it's our minimum viable product.

Private security offerings, as a class of securities, rightly garner disproportionate regulatory attention. These securities have no regulatory pre-approval before they are sold; no public market, no secondary market. Generally, there are no supporting audited financial statements to assure investors of a company’s sound financial practices. Often there isn’t a demonstrated or proven business practice, or maybe not even a proven management team. Private security regulations are intended to protect investors from fraud, fraudsters, and fraudulent offerings. Registered broker-dealers that administer these private offerings are obligated, with reputation and licenses on the line, to assure that each regulation is followed—and their consistent performance is held accountable by that comprehensively focused exam staff (with incredible attention to detail).

Often, private security issuers engage a competent securities attorney to draft their offering documents. At minimum, they put together the private placement memorandum and subscription agreement. Who drafted the documents – the issuer or his outside counsel – is an attribute of the offering that we look for when we begin our offering diligence to determine if we can, or are willing to accept an offering. Generally, when a securities attorney crafts those documents, they contain proper disclaimers and a more comprehensive list of risk disclosures than when the issuer prepares their own offering documents.

An issuer, unconcerned with regulatory constraints, may be more motivated to tell a favorable story, holding the offering and its potential outcomes in the most favorable light. Risk statements become bullet points, all mitigated by the words of a well-crafted rebuttal and their potential effect diluted. Their counsel knows better. And to be clear, so do the sophisticated investors that the issuer seeks. The best written offering documents that I have read are well-balanced, accurately presenting both the opportunity and its risks, clearly instructing on the investment procedure and effectively communicating the business plan of the entity and the structure of the offering. Some of the least well-crafted offering documents would make an infomercial huckster wince. Maybe not, but you get my point.

There are literally hundreds of ways that a private security offering can come off the rails. Viewing these offerings by their components – the issuer, the offering, the investors, the flow of funds, the regulatory form filings, and any advertising that may be used to promote the offering – can become quite expensive to ‘mess up’ for an issuer, or even for a broker-dealer more experienced with sales supervision than with an offering’s diligence and its administration. That, of course, presumes that there is cognizance that the offering or offering process is flawed. For the issuer, the cost of non-compliance can be a significant gamble; for the broker-dealer, the price of admission is accountability. 

Issuers are permitted to administer their offerings without the services of a broker-dealer. There is no requirement that a private security offering be administered and sold through a single broker-dealer or syndication of broker-dealers. In fact, most are self-administered. Many issuers forego the incremental cost, additional regulatory oversight and transactional administration that a broker-dealer might bring to their offering. There is no requirement to use an accountant to create financial records or pro-forma estimates, an attorney to draft offering documents, or a broker-dealer to administer the offering process. However, many issuers that consider using WealthForge for its services view these professionals as layers of assurance, or perhaps reassurance, that their offerings are proper.

Since everyone loves a good story, I thought I would pick a few of the more interesting things that have crossed our desk when we’ve considered an offering (and things were a little off-kilter). 

  1. Issuer – Known arms dealers may not be worthy issuers. That’s a real, but extreme example. However, more than once we have worked with a team of owners where one of them is considered a ‘bad actor,’ unbeknownst to his other partners, which makes the Reg D exemption unavailable to that issuer. That would be incredibly bad news to find out after closing. When raising private capital, the starting point is to know beyond a doubt that the control persons of the issuer do not prevent reliance on a registration exemption.

  2. Offering – We often see offering documents describing shares, both preferred and common, being offered for a Limited Liability Company. LLC’s have membership interests vs. shares. Those interests can be offered with rights and privileges that allow them to behave like common or preferred equity. Another thing that we frequently see in an offering’s documents is that the versioning of those offering documents between the PPM, pitch deck, and subscription agreement do not keep material facts in phase, which again causes confusion. Lastly, make sure that there is a corporate resolution authorizing the securities to be issued, or that they have been authorized in the company’s original formation. Again, it’s really bad form to sell securities that don’t exist. And once you have a single executed subscription document, you can really get wrapped around the axle if you want to change a material element of the offering – like a contingency or an offering end date. Be sure to have all of the details finalized before soliciting the offering.

  3. Investors – Who are they and how do you know? Are they a grantor, a trust, or an entity? It matters! If they are a trustee, what documentation do you have that demonstrates their authority to act on behalf of the entity or trust? How do you verify when two or more people are actually associated with the same social security number presented by a subscriber? We see it frequently. Just like the issuer should avoid investor confusion, he should also not have any confusion created by an investor’s identity or accreditation credentials. If the offering is a 506(c) exemption, the issuer is required to have taken reasonable steps to know that an investor is accredited. Often that is an attestation from a CPA or an attorney. Those letters have a shelf life, however, and closing on an offering using expired attestations can be a troublesome thing.

  4. Flow of Funds – No kidding, don’t mess this up. There are many rules and clarifying disciplinary actions that govern what you are allowed to do (outlined in this whitepaper), either as an issuer or an administering broker-dealer with a subscriber’s funds before an offering’s contingency is met. Can you change a contingency? When, with what disclosures and what communication to subscribers? With or without a right of rescission? To be sure, regulators are most concerned when an investor and his money are separated not in accordance with securities regulations. The foresight to craft contingency terms anticipating a potential kerfuffle at closing is hard won experience.

  5. Regulatory Form Filing – Many issuers are not aware of each state’s exercise of their state’s rights to govern unregistered securities transactions sold to residents of that state. To be certain, not every state has identical notice filing requirements, methods (paper vs online), or timing, before or after funds are received by the issuer. And, the SEC expects their due notice as well (i.e. the state of New York Blue Sky filings, see our previous post about state requirements).

  6. Advertising – This is defined as any communication about an offering: print, web, road show, billboard, teaser etc. What are you promising? Have you balanced the presentation? Language is so important—have you given your investors the opportunity to later say, "I was confused" and then provided them the exhibit to use in the future to be convincing that indeed they were confused as a court or arbiter determines whether or not to unwind their investment?  

About that, "the best you can do is not mess up" -  in compliance, delivering competence to the private capital formation process, gained from many at bats, for the benefit of the issuer or a selling broker dealer and the investor is better than not messing up. It’s not a part-time thing for us—it’s what we do.

Author's Note: I am the Chief Compliance Officer for a FINRA registered broker dealer that specializes in Reg D private placements – both flavors – 506(b) and 506(c).  In the past three years, we have evaluated over 600 of these offerings, have accepted about 400 and have had closings on about 300 of those.  We’ve helped issuers raise a little over $300M in private capital.  For the past two years, according to the data available on the SEC’s website, we have been in the top five broker dealers named on the original Form D filings for successful private security offerings.

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Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

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Jim Raper

Jim Raper is the Chief Compliance Officer at WealthForge Securities, LLC, who is among the top 5 broker-dealers as measured by the number of original Form D filings over the past two years.
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