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Will FINRA Rule Changes Related to Private Placement Further Deter Broker Dealers From Placing the Securities of Small Businesses?

On August 19, 2013, FINRA published Regulatory Notice 13-26 about the updated Private Placement Form that firms must file with FINRA when acting as a placement agent for the private placement of securities.  A copy of the form is included with the regulatory notice at www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p325359.pdf.  The Form went effective on July 1, 2013.  FINRA has also updated the FAQs relating to the Private Placement Form.  The updated Private Placement Form has six new questions:

  • Is this a contingency offering?
  • Does the issuer have any independently audited financial statements for the issuer’s most recent fiscal year?
  • Is the issuer able to use offering proceeds to make or repay loans to, or purchase assets from, any officer, director or executive management of the issuer, sponsor, general partner, manager, advisor or any of the issuer’s affiliates?
  • Does the issuer have a board of directors comprised of a majority of independent directors or a general partner that is unaffiliated with the firm?
  • Has the issuer engaged, or does the member anticipate that the issuer will engage, in a general solicitation in connection with the offering or sale of the securities?
  • Has the issuer, any officer, director or executive management of the issuer, sponsor, general partner, manager, advisor, or any of the issuer’s affiliates been the subject of SEC, FINRA, or state disciplinary actions or proceedings or criminal complaints within the last 10 years?

Answering the new questions is not a precondition to acting as placement agent, and FINRA specifically notes that firms can respond “unknown” to any of the questions.  However, as with all regulated businesses, the broker dealers are motivated to demonstrate efficient compliance procedures and diligent compliance with all FINRA rules and regulations. Moreover, broker dealers are also dealing with heightened scrutiny resulting from new regulations imposed by the Dodd-Frank Act.

The changes come effective just as the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act.  On the same day, the SEC adopted amendments to Rule 506 to disqualify “felons and bad actors” from participating in Rule 506 offerings.  Each of the new rules will require heightened due diligence and increased internal procedures related to private placements.

Rules relating to general solicitation and advertising will affect broker dealers

In particular, the rules allowing general solicitation require that the Issuer, and therefore its placement agent, take reasonable steps to verify that each purchaser is accredited.  The SEC published a non-exclusive list of methods that Issuers may use to satisfy the verification requirement.  Note that the verification requirement is separate from the requirement that all investors in fact be accredited.

According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.”  Among the factors that Issuers should consider under the fact and circumstance analysis are:

a.            The nature of the purchaser and type of accredited investor they claim to be.  For instance, if the purchaser is claiming that they are accredited because they are a broker dealer registered with the SEC, verification could be a simple check on the FINRA website.  Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements.  Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that Issuers may use to satisfy the verification requirement.

b.            The amount and type of information that the Issuer has about the purchaser.  Clearly, the more information, the better.  The SEC lists the obvious (W-2; tax returns; letters from a bank or broker dealer).  Moreover, although not required, it is assumed that an Issuer should at least conduct a check of publicly available information.

c.             Nature and terms of the offering, such as type of solicitation and minimum investment requirements.  The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former.  The SEC highlights the obvious, such as that the higher the minimum investment required, the fewer steps an Issuer would need to take to verify accreditation.

Examples of the type of information that Issuers and their placement agents can review and rely upon include:

                (i)            Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages)

                (ii)           Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms

                (iii)          Third-party accredited investor verification service providers

The SEC published four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the Issuer does not have actual knowledge that the purchaser is not accredited.  Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:

                aa.          Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year.  If such forms and information are joint with a spouse, the written representation must be from both spouses.

                bb.         Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed.  For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit report from a nationwide agency.

                cc.           Obtaining a written confirmation from a registered broker dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.

                dd.         A written certification verifying accredited investor status from existing accredited investors of the Issuer that have previously invested in a 506 offering with the same Issuer.

Placement agents, under review by FINRA, will need to have properly documented files on each investor and their accreditation verification.

The disqualification of bad boys and felons require heightened diligence

On July 10, 2013, the same day the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act, the SEC adopted new rules disqualifying felons and other bad actors from participating in Rule 506 offerings as required by Section 926 of the Dodd-Frank Act.   The new rules will require due diligence by broker dealers to ensure compliance by Issuers for which they act as placement agent.

New Rule 506(d) applies to the following categories of persons (“covered persons”):

         The Issuer and any predecessor of the Issuer or affiliated Issuer;

         Any director, general partner or managing member of the Issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);

        Any beneficial owner of 20% or more of the outstanding equity securities of the Issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting);

        Investment managers of Issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering, general partners and managing members of such investment managers; and the directors and executive officers of such general partners and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);

        Any promoter connected with the Issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);

       Any person that has been or will be paid, either director or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and

       Any director, officer, general partner, or managing member of any such compensated solicitor.

New Rule 506(d) enumerates the following disqualifying events:

  • Criminal convictions (felony or misdemeanor) within the last five years in the case of Issuers, their predecessors and affiliated Issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Final orders issued by state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, and the National Credit Union Administration, that at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
  • Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203(c) or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
  • Is the subject to any order of the SEC entered within five years before such sale, that at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of the federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
  • Suspension or expulsion from membership in, or suspension or a bar from association with a member of, an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
  • Has filed (as a registrant or Issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
  • U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.

Proposed new rules affecting private placements

On July 10, 2013, the same day the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act, and adopted new rules disqualifying felons and other bad actors from participating in Rule 506 offerings as required by Section 926 of the Dodd-Frank Act, the SEC issued proposed rules further amending Regulation D, Form D and Rule 156. 

The proposed amendments will (i) require the filing of a Form D to be made before the Issuer engages in any general solicitation or advertising in a Rule 506(c) offering and require the filing of a closing amendment to the Form D at the termination of the offering; (ii) require that all written general solicitation material used in a Rule 506(c) offering include certain legends and disclosures; (iii) require that all written material used in general solicitation and advertising be submitted to the SEC; (iv) disqualify an Issuer from relying on Rule 506 for one year for future offerings if the Issuer, or any predecessor or affiliate of the Issuer, failed to comply with the Form D filing requirements for a Rule 506 offering in the last five years; (v) amend the Form D to include additional information about offerings; and (vi) amend Rule 156 to extend the antifraud guidance in the rule to include sales literature of private funds (hedge funds).   In addition, as part of the proposed rule release, the SEC is seeking comments from the public on the definition of “Accredited Investor.”

With respect to Form D, the SEC is proposing to:

        Amend Rule 503 to require: (1) 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; (2) the filing of an amended Form D within 15 days of the first sale of securities under the offering; and (3) the filing of  a closing amended Form D within 30 calendar days of the termination of the offering (in the case where an Issuer does not use general solicitation and advertising until 15 days or more after the first sale, (1) and (2) would be accomplished in a single filing);

         Amend Form D to require additional information regarding offerings;

         Amend Rule 507 to disqualify an Issuer from relying on Rule 506, for one year, if the Issuer or any predecessor or affiliate of the Issuer failed to comply with the Form D filing requirements within the last five (5) years.

An in-depth discussion of the proposed new rules is not included in this blog, but previous blogs have provided detailed discussion and are available on www.securities-law-blog.com.

All of the proposed rules will affect broker dealers.  It is likely that the broker dealer placement agent will be responsible for uploading general solicitation to the SEC website and monitoring its Issuer clients to ensure compliance with the filing requirements, all at increased expense and effort.

Increased Dodd-Frank statutory liability

The Dodd-Frank Act has potentially increased liability for secondary participants through two provisions. These two provisions, which added new Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934, dramatically change the liability exposure of intermediaries in the sale of securities, such as broker dealers.

Section 9(a)(4) of the 1934 Act makes it unlawful for any broker, dealer or other person selling or offering to sell (or purchasing or offering to purchase) any security other than a government security, “to make. . . for the purpose of inducing the purchase or sale of such security, . . . any statement which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which that person knew or had reasonable ground to believe was so false or misleading.” Previously, Section 9 of the 1934 Act applied only to securities traded on an exchange. Now it applies to any securities, excluding government securities—another change that was part of the Dodd-Frank Act.  In other words, a broker dealer can be liable for untrue statements or omissions in offering documents including private placements, and very soon, advertisements.

Dodd-Frank also added Section 9(f) to the 1934 Act, which says that anyone who “willingly participates” in an act or transaction in violation of Section 9(a) above is liable to the person who bought the security.


Broker dealers have more potential liability than ever before when acting as placement agents for transactions, and their fees are limited vis-à-vis the amount of the transaction.  The rule changes have required and will continue to require increased procedures and back office support with the concurrent increased overhead.  Moreover, the due diligence process and review and administrative back office expenses are generally fixed costs with only a small variance due to the size of the offering.  Accordingly, broker dealers will be less motivated to place private transactions for small businesses as the potential fees will be proportionately less.

Small businesses that hope to attract broker dealer placement agents need to be more organized and prepared than ever.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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