Category: Fundraising

Lower the Wealth Standard for Investing in Private Placements

With the reduction in the number of public companies and larger companies staying private, the Securities and Exchange Commission is once again talking about loosening the “accredited investor” standard.

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get past the red velvet rope and into the VIP room to buy securities through a private placement. That VIP room is full of fraudsters and high rollers. You get to decide who is who.

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

The biggest risk is the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With that investment in Pets.com, you have the chance to sell your stock and get some money back before it goes bankrupt.

The same is would not be true for Pets.com as a private company, like with one of today’s unicorns.  With a private placement, the investor will have a limited ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

In his statement a few weeks ago, Chairman Clayton broadened his thoughts on private placement to not just the accredited investor standard, but the entire private placement regime. He lumped them all together in the “exempt offering framework.” He calls it an “elaborate patchwork.” I agree that a broad restructuring of non-public security sales should be implemented that makes it clear how companies can raise capital with a clear framework for protection and disclosure of risks to investors.

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Monster’s ICO

Before all my music was digital and playing out of bluetooth speakers, I was a big fan of Monster Cables for connecting my audio and video equipment. Now those cables just sit in a plastic bin in the basement. I hadn’t thought about Monster Cables until the SEC has published the first “bedbug” letter on EDGAR and it was aimed at Monster. The letter from the Division of Corporation Finance is in response to a proposed monster money offering by Monster Products, Inc. Rather than providing a detailed examination and issuing comments, the staff letter to Monster suggests trying again.

Public company filings are not in my area of expertise so I’m not sure what the SEC was concerned about.

What caught my attention was the crazy scheme that Monster is trying to put together. Monster wants to offer up to three hundred million of its to-be-created Monster Money Tokens (“MMNY”) for gross proceeds of $300,000,000.

Monster plans to use the Ethereum blockchain technology on its E-commerce website to create the new Monster Money Network where consumers may use either MMNY Tokens or fiat currencies to purchase Monster products and services. The company intends to utilize the blockchain technology to its marketing, accounting and audit, internal control and shipping management functions.

In the event of an “ICO Failure” investors in the tokens may convert them into Monster common stock at the rate of four tokens per share of stock. The “ICO Failure” means that i) MMNY Tokens not have been traded on a cryptocurrency exchange or a U.S. stock exchange by June 30, 2020 because either this registration statement is not declared effective by the SEC or MMNY Tokens are not approved for trading on any such exchange market; or ii) MMNY Tokens have ceased trading on or before June 30, 2020 due to legal or administrative enforcement actions by the SEC, the CFTC, or any other government authorities.

The ICO seems a Hail Mary to turn the company around. It was acquired by a blank check company earlier this year. It as unable to timely file its latest 10Q. It fired its auditor. It replaced its CFO.

Monster trying something new by basically pre-selling Monster products and services through the MMNY offering. It’s issuing gift certificates, tarted up with blockchain.

I saw this at the same time I saw the UBI Blockchain fraud. That company was originally JA Energy, but reincorporated as UBI Blockchain Internet. Its business was to encompasses the research and application of blockchain technology with a focus on the internet of things covering areas of food, drugs and healthcare. UBI had no revenues and has yet to develop any products for sale. The stock price shot up from $3.70 per share to over $87 at one point on a surge of buying just because the company had blockchain in its name. The SEC temporarily suspended trading in UBI Blockchain stock earlier this year due to concerns about the accuracy of assertions in its SEC filings and unusual and unexplained market activity.

Unlike UBI Blockchain, Monster has an operating business. It’s just not doing well. As a turnaround, it proposes to sell tarted up gift certificates for products that are mostly in bins in the basement.

What type of monster is it?

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Restructuring and Adviser Performance Track Record

The Securities and Exchange Commission has been skeptical of registered investment advisers using advertisements. The default position is always that it’s likely to be fraudulent, deceptive or manipulative and therefore a violation of Section 206 of the Investment Advisers Act. The level of skepticism has been even higher for performance advertisements and even higher for performance advertisement of a predecessor.

That has lead to the problem of an investment adviser carrying over his or her performance when joining a new firm. Since this happens often, the industry has been able to get the SEC to commit to some clear standards.

The SEC has laid out a five part test for an advertisement that includes prior performance results of accounts managed by a predecessor entity

  1. The person or persons who manage accounts at the adviser were also those primarily responsible for achieving the prior performance results
  2. The accounts managed at the predecessor entity are so similar to the accounts currently under management that the performance results would provide relevant information to prospective clients
  3. All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance,
  4. the advertisement is consistent with staff interpretations with respect to the advertisement of performance results, and
  5. the advertisement includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

The latest guidance from the SEC on this involves a restructuring of an investment adviser firm. South State Bank owned South State Advisory and Minis & Co., each of which were separately registered as investment advisers. The Bank wants to merge Minis and South State Advisory together for some operational efficiency. This triggers the performance advertisement from a predecessor entity concerns.

The Bank proposed that Minis would merge into the other advisor, but operate as a division within it. The SEC said it was okay to keep the performance track record based on the facts.

  1. the Minis Division will operate in the same manner and under the same brand name as Minis
  2. the Minis investment personnel, as well as the management, culture, and processes that helped to give rise to Minis’ track record, will continue after the merger
  3. The same management team that currently manages Minis would manage the Minis Division
  4. the Minis investment committee would continue to have responsibility for the Minis Division’s investment decisions and recommendations
  5. Minis’ performance track record by the Minis Division would be accompanied by appropriate disclosure

Minis pointed out the obvious flaw in the SEC position with the performance track record.  Personnel, management, culture and processes will evolve over time at any firm. Minis merely point out that none of those things are happening immediately as part of the restructuring.

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What is Pre-Marketing?

In establishing a new investment vehicle, a sponsor needs to find a pool of interested investors. Given the varying rules around fundraising in different jurisdictions, the sponsor may chose to look for support in one place over another. The big problem is the time and cost it takes to get a proposed investment registered in a jurisdiction may not be worth that time and money if no investor from that jurisdiction ends up being interested.

This is a particular problem with private equity funds when the terms of the fund may still be fluid in the early days of the fundraising process. The terms of a private placement are more often negotiated with prospective investors than a registered offering.

The question in many jurisdictions is what constitutes activities that amounts to marketing, triggering the registration process.

In the US the activities are fairly clear. You need to only direct the discussions to accredited investors and it can’t be so broadly distributed that it could be considered general marketing or general solicitation. Generally, for a private fund sponsor’s formation efforts, the sponsor wants to keep the number or prospective investors small to get a sense that the terms are right and that there is market for the product.

The European Union had been more difficult under the AIFMD rules. As much as the EU is trying to standardize the AIFMD rules across its member countries, the requirements still vary widely from member country to member country.

Last month the EU indicated that it’s looking at defining pre-marketing under the AIFMD rules. Currently, AIFMD regulates “marketing” to investors. It does not specifically regulated “pre-marketing”. Without any specific rule to base it on, member country to member country has been setting general framework on where the line is between marketing and pre-marketing.

The new regulatory regime could be good or bad for fund sponsors. If it’s drawn too narrowly, it will keep fund sponsors away from. It will disproportionately affect smaller sponsors who are not prepared to spend the money with uncertainty of potential investors. Larger sponsors will have more time and money to comply.

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More Political Contribution Problems

There is too much money in a politics. I understand the Securities and Exchange Commission’s desire to purge political contributions from the investment adviser business for state and local government money. But I’ve never been a fan of Rule 206(4)-5, the pay-to-play rule. It’s continuing to ensnare companies in ways that highlight problems with the rule and the very low limits in the rule.

One recent case is that of PNC Capital Advisors. One its employees in business development made a $1000 campaign contribution to John Kasich’s presidential campaign. Kasich was the governor of Ohio and able to appoint trustees to the Ohio state pension funds. That made Kasich an “Official” under the rule and firm had some Ohio state pension money under management.

As I had pointed out, only two out of the twenty-two the major candidates for the last presidential election were subject to the campaign contribution limit because they held state offices: John Kasich and Chris Christie. The rule obviously creates an unnecessary distortion in political campaigns. Adding Pence, the Governor of Indiana to the ticket caused another what do we do moment.

In PNC’s case, the employee had been listed by PNC as a “covered associate” and was in the process of being promoted when PNC discovered the campaign contribution. However, the employee was not responsible for the Ohio account. At no time had the employee been involved in soliciting the Ohio plans, and had never communicated with the Ohio plans. The Contributor had never solicited any other state or local Ohio government entity. The Contributor had never made presentations for, or met with, any representatives of the Ohio plans or with any other Ohio government entities, or supervised any person who met with any of the Ohio plans or other Ohio government entity. If promoted, the Contributor will neither meet with any Ohio government entities personally, nor supervise any person who solicits investment advisory services business from Ohio government entities.

The employee failed to disclose the contribution because he was focused the office Kasich was running for, President, and failed to realize that the rule applied to the current office as well. The PNC compliance group found the contribution in the process of running checks in connection with a promotion. A promotion that is now on hold and has been for 2017.

The SEC order prohibits the employee from soliciting government funds for several months. PNC was allowed to keep the two year worth of fees. $700,000 of fees was at risk for that $1000 contribution.

That was a $1000 contribution in a campaign in which Kasich raised over $19 million.

BlackRock had a similar problem with the Kasich campaign. One of its employees wrote a check for $2700 to the Kasich campaign. The employee was in the ETF division, but since he was on the global executive committee, he fell into the definition of “covered associate.”

Similar to PNC, that employee had never solicited government entities for investment advisory business that is covered under the Rule. To the extent the Contributor has personally solicited business from any government entities, it was exclusively for direct investments in RICs that are outside the scope of the Rule. He has never attended, or otherwise participated in, any meetings, discussions, or any other communications in which a solicitation of covered investment advisory business has taken place.

Blackrock’s compliance group found the donation while conducting a routine compliance review.

Here is a list of other exemptions granted. These were identified in the PNC application and BlackRock application.

  • Davidson Kempner Capital Management LLC, Investment Advisers Act Release Nos. IA-3693 (October 17, 2013) (notice) and IA-3715 (November 13, 2013) (order)
  • Ares Real Estate Management Holdings, LLC, Investment Advisers Act Release Nos. IA-3957 (October 22, 2014) (notice) and IA-3969 (November 18, 2014) ( order);
  • Crestview Advisors, LLC, Investment Advisers Act Release Nos. IA-3987 (December 19, 2014) (notice) and IA-3997 (January 14, 2015)(order);
  • T. Rowe Price Associates, Inc., and T. Rowe Price International Ltd., Investment Advisers Release Nos. IA-4046 (March 12, 2015) (notice) and IA-4508 (April 8, 2015)(order);
  • Crescent Capital Group, LP, Investment Advisers Release Nos. IA-4140 (July 14, 2015) (notice) and IA-4172 (August 14, 2015) (order);
  • Starwood Capital Group Management, LLC, Investment Advisers Act Release Nos. IA-4182 (August 26, 2015)(notice) and IA-4203 (September 22, 2015) (order);
  • Fidelity Management & Research Company and FMR Co., Inc., Investment Advisers Release Nos. IA-4220 (October 8, 2015) (notice) and IA-4254 (November 3, 2015) (order);
  • Brookfield Asset Management Private Institutional Capital Adviser US, LLC et. al., Investment Advisers Act Release Nos. IA-4337 (February 22, 2016) (notice) and IA-4355 (March 21, 2016) (order);
  • Angelo, Gordon & Co., LP, Investment Advisers Release Nos. IA-4418 (June 10, 2016)(notice) and IA-4444 (July 6, 2016) ( order);
  • Brown Advisory LLC, Investment Advisers Act Release Nos. IA-4605 (January 10, 2017) (notice) and IA-4642 (February 7, 2017) (order)

These all look technical violations with no evidence that there were weaknesses in policies or an intent to influence. The rule is just too broad, with dollar limits that are too low.

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Celebrity Endorsements of ICOs and other Securities

With BitCoin breaking through the $10,000 barrier and growing interest in the uses of the underlying blockchain technology, everyone is looking to cash in using virtual currency. As with an IPO, the goal of investors in an Initial Coin Offering is get in early and cheap before the market takes the price up. The Securities and Exchange Commission warned sponsors that ICOs look a lot like a securities offerings and need to comply with securities laws.

It turns out that ICO sponsors are violating SEC rules and FTC rules.

Looking forward to participating in the new @cobinhood Token! ZERO fee trading! #CryptoCurrency#BitCoin#ETH – https://t.co/1XFiosn22Spic.twitter.com/A7es0C2Rxr
— Jamie Foxx (@iamjamiefoxx) September 18, 2017

Looking forward to participating in the new @LydianCoinLtdToken! #ThisIsNotAnAd #CryptoCurrency #BitCoin #ETH #BlockChainpic.twitter.com/a8kT9eHEko
— Paris Hilton (@ParisHilton) September 3, 2017

The SEC warned that celebrity endorsements of securities need to disclose the nature, source, and amount of any compensation paid, directly or indirectly, by the company in exchange for the endorsement.  (Obviously, that is hard to do in the 140 280 characters of Twitter.) A failure to disclose this information is a violation of the anti-touting provisions of the federal securities laws. That also potentially pulls the celebrity endorser into possible anti-fraud provisions of the securities laws

There are the advertising rules from the Federal Trade Commission that also require disclosure of payment for endorsements. The FTC Guidelines make it clear that celebrities must disclose their relationships with advertisers when making endorsements outside the context of traditional ads, such as on social media.

Ms. Hilton’s endorsement of Lydian Coin was deleted after Forbes reporters uncovered the checkered legal past of the founder of Lydian Coin.

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Best Practices for Presenting Model and Hypothetical Performance

These are my notes from an ACA Compliance Webcast on this subject. I’m sure you can find a replay on the ACA website.

There were three great presenters:

  • Alicia Hyde, Partner, ACA Performance Services
  • Mike Sonnenburg, CIPM, Managing Director, ACA Performance Services
  • Kim Daly, Managing Director, ACA Compliance Group

Definitions

The first topic was what these terms mean:

Model–A list of investments and transactions for an investment strategy that are not actually held by the portfolio but can be backtested over historical periods and/or run contemporaneously. Model portfolios are typically constructed using individual securities (stocks and bonds), ETFs, pooled funds, or other investment products. Also known as a paper portfolio, a policy portfolio, or a target portfolio.

Hypothetical–Performance of a model or synthetic portfolio (i.e., non-actual performance). Hypothetical performance can be ex-post and/or ex-ante.

Backtested–Ex-post testing of an investment model to see how it would have performed historically. Backtesting attempts to demonstrate how an investment strategy, constructed with the benefit of hindsight, would have performed as if it had been implemented historically.

Simulated –Same as backtested; non-actual performance and can be ex-post or ex-ante.

Theoretical–Same as backtested; non-actual performance and can be ex-post or ex-ante.

Ex-ante–Projected future performance. Ex-ante performance is non-actual and, as such, is hypothetical.

Ex-post –Performance over historic (after the fact)periods. Ex-post may be non-actual or actual performance.

Contemporaneous (Live) Model–Performance derived from a live, or contemporaneous model, where investment decisions occur in real time. Live model performance is still considered non-actual.

Synthetic Portfolio–The ex-post combination of actual portfolio returns. For example, taking an actual equity portfolio and combining it with an actual fixed income portfolio to create a synthetic balanced portfolio. The underlying performance is that of actual portfolios, but they are synthetically combined according to a prescribed asset allocation. Synthetic performance is considered to be hypothetical performance.

The Law

The main limitation is section 206 that prohibits you from being fraudulent, deceptive or manipulative. That has been further extrapolated by the SEC in Rule 206(4)-1, the advertising rule. That rule has been further elaborated in the Clover No Action Letter.

All of this has been heightened by the F-Squared cases that failed to properly disclose that the adviser and the firms that used its services were not based on actual performance.

Presenting Model Performance

  1. Model portfolio performance must not be presented in a false or misleading manner.
  2. Model performance should not be linked to actual performance.
  3. ‘White-labeling’ third party model performance requires sufficient due diligence.
  4. Model portfolio performance must include specific, accurate, and robust disclosures.

Model Performance Disclosures

Disclosures should address these items:

  • The limitations inherent in model results,particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money
  • Any material changes to the conditions, objectives, or investment strategies of the model portfolio during the time period portrayed and, if so, the effect of any such change on the results portrayed
  • As applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model

Include the following disclosures:

  1. The results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight.
  2. The returns should not be considered indicative of the skill of the adviser
  3. The client may experience a loss.
  4. The results may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the back-tested model if the model had been used during the period to actually manage client assets.
  5. The adviser, during the period in question, was not managing money at all, or according to the strategy depicted.
  6. The back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

You can show projected returns

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Most Frequent Advertising Rule Compliance Issues

It looks like the Securities and Exchange Commission has been taking a close look at advertising by investment advisers. The Office of Compliance Inspections and Examinations issued a risk alert on The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers.

I didn’t see any surprises in the alert.

  • Advisers presented performance results without deducting advisory fees.
  • Advertisements that compared results to a benchmark but did not include disclosures about the limitations inherent in such comparisons, including instances where, for example, an advertisement did not disclose that the advertised strategy materially differed from the composition of the benchmark to which it was compared.
  • Advertisements that contained hypothetical and backtested performance results, but did not explain how these returns were derived.
  • Advertised performance results complied with a certain voluntary performance standard, when it was not clear to staff that the performance results in fact adhered to the performance standard’s guidelines. (i.e. GIPS compliance)
  • Advertisements that staff believe contain cherry-picked stock selections
  • Disclosure of past specific investment recommendations
    that may have been misleading because they included only certain, and not all, recommendations, in order to illustrate a particular investment strategy, and they did not meet the conditions set forth in Subsection (a)(2) of the Advertising Rule. In addition, they did not satisfy the representations upon which IM staff based certain no-action assurances as provided in the TCW Group and Franklin no-action letters.
  • Advertisements that referred to advisers receiving high rankings in various publications, but those publications were issued several years prior, and the rankings were no longer applicable.
  • References to professional designations that have lapsed or that did not
    explain the minimum qualifications required to attain such designations.
  • Statements of clients attesting to their services or otherwise endorsing the adviser that may be prohibited testimonials.

The only tidbit of information is that OCIE conducted a “Touting Initiative” in 2016. The focus was to examine the adequacy of disclosures that advisers provided to their clients when touting awards, promoting ranking lists, or identifying professional designations  in their marketing materials.

OCIE launched the Touting Initiative because of the “regularity with which staff encounters advisers that advertise these accolades without disclosing material facts about them.”

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Report on Access to Capital and Market Liquidity

Many people seem to think that the new commissioner of the Securities and Exchange Commission, Jay Clayton, is likely to focus more on capital formation issues than the previous commissioner. The recent report on Access to Capital and Market Liquidity from the SEC’s Division of Economic and Risk Analysis caught my attention.

From the signing of Dodd-Frank in 2010 through the end of 2016, the DERA notes $20.20 trillion in capital formation, of which $8.8 trillion was raised through registered offerings, and $11.38 trillion was raised through unregistered offerings. More money is being raised through private placements, than through public offerings. From 2012 to 2016 the amount raised was 26% greater. From 2009 through 2011 it was only 21.6% greater.

That data should be a caution to regulators who want to make changes to Regulation D and the “accredited investor” standard.

“When combined, the capital raised through Regulation D and Rule 144A offerings in a year is consistently larger than the total capital raised via registered equity and debt offerings. Most Regulation D offerings (over 66%) include equity securities; by contrast, in the Rule 144A market, the vast majority of issuers are financial institutions and over 99% of securities are debt securities.”

The report also looks at the new public private-placement offerings under 506(c). Only 3% of the capital raised under Regulation D since rule 506(c) went into effect has been through issuances claiming the 506(c) exemption. The report also noted that the average amount raised in a 506(c) offering is only half of that raised in Rule 506(b) offering, $13 million to $26 million. “Overall, it is not clear whether offerings under Rule 506(c) are indicative of new capital formation or a reallocation from other offering types.”

What is one of the reasons for a private placement over a public offering? It seems cheaper.

“Nonfinancial issuers paid on average about 6% in total fees for Regulation D offerings in 2009-2016. In comparison, a company going public pays an average gross spread of 7% to its IPO underwriters, while a reporting company raising equity through a follow-on (seasoned) equity offering pays an average gross spread of about 5.4%.”

There is a lot more detail in the report. More than I’m ready to digest (or want to digest).

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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.

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