Private Placements

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By most recent estimates, the medical marijuana business is generating at least $4.5 billion a year in revenue. Naturally, many people want to cultivate their own opportunities in this ever growing business.

Now that Pennsylvania has become the latest state to authorize medical marijuana, many people will look to invest in this industry. Some businesses in this industry may try to raise capital by having a Reg. D offering. Before investing in such an opportunity, it is important to read the “fine print” in any statutory or regulatory scheme on the subject. money and calculator

Pennsylvania, for example, will require a criminal history record check (through the State Police and FBI) “of the principals [and] financial backers . . . .” The stated purpose of such a check is to determine the “fitness and suitability” of the principals and financial backers to serve in those capacities. The criminal background check does not apply, however, to an owner of securities of a publicly traded company as long as the owner of securities is not “substantially involved” in the operations of the business.

So what does this all mean? For those of you looking for investors, you should do your own legwork on all potential investors in your venture. For those of you looking to invest in this smoldering industry, you need not apply if you have a criminal background, especially one involving the sale of controlled substances.

There are many opportunities in this industry. But ownership or financial backing of such a business in Pennsylvania comes at a price. Before you buy in, make sure you are willing to pay the price.

FINRA recently censured and fined a broker-dealer $175,000.00 for failing to perform appropriate due diligence and supervision regarding private placements that the firm and its registered representatives offered. This penalty should serve as a wake-up call that FINRA is taking a sharp look at the due diligence that firms perform before and after offering a private placement to its clients.

The firm had a number of missteps regarding a handful of private placements that FINRA discovered during a routine examination, which included the following:

  1. The firm approved an offering even though the firm highlighted shortcomings in the offering such as a failure to describe the company’s business; FINRA found the firm providing additional disclosures did not satisfy Rule 2111.
  2. The firm distributed a private placement memorandum to potential investors even though it did not include certain material facts and relied on flawed methodology for projecting ROI.pointing.jpg
  3. The firm sold an offering in which one of its associated persons was affiliated without adequate supervision of that person.
  4. The firm failed to confirm that certain offering documents were filed with FINRA.
  5. Another associated person participated in an offering away from the company without supervision.
  6. The firm allowed associated persons to send consolidated reports to its customers, but failed to adequately supervise these reports.

This conduct implicates a number of FINRA Rules (i.e., 2010, 3010, 3040 and 5122), and demonstrates that FINRA is looking at many different kinds of conduct when it comes to private placements. Although these types of investments offer firms diverse investment options for their clients, firms must take a step back before taking three forward.

FINRA’s sanction highlights that firms must fully review offerings before approving them and then properly supervise the sale of the offerings and those persons selling the offerings. Otherwise, you will likely get stung for not doing so in your next examination.

* photo from freedigitalphotos.net

FINRA is beginning investigations into private placements.  New FINRA Rule 5123 requires member firms involved in a private stock offerings to provide investors with detailed information on the transaction prior to the sale, and to file that information with FIRNA within 15 days after the first sale. The rule went into effect in December 2012.

FINRA is now reviewing the materials submitted by member firms.  In particular, FINRA has found issues regarding the private offerings.  Many of the enterprises had little or no cash flow raising specific concerns at FINRA.

Accordingly, broker-dealers, who sell private placements, will most likely be subject to new scrutiny.

The dog-days of summer certainly did not apply to FINRA when it initiated eight disciplinary proceedings against member firms and registered representatives over private placements.  This heightened interest should serve as a warning to all broker-dealers to ensure that their house is in order before permitting private placements through the firm. 

Unfortunately, the regulatory scheme involving private placements only suggests that FINRA will likely bring more and more cases considering that you must provide your offering documents to FINRA within fifteen days of your first sale.  In other words, FINRA will be able to take an earlier look at your private placement to determine if something is amiss. 

These disciplinary proceedings can lead to suspension or bars of those involved in the offering, as well as those who were supposed to be supervising the registered representatives engaged in the offering.  FINRA is also looking for red flags such as private placements in highly hyped fields, a sudden surge in a brokerage’s business, or a brokerage established to promote a certain company’s offerings.   buyholdsell.jpg

So what is a firm to do in this time of enhanced scrutiny?  The most important thing for all brokerages is Regulation D, also known as a safe harbor for private placements.  Firms must be certain that it and its representatives follow the strictures of Regulation D and, if you do not know what you need to do, consult with a lawyer or compliance person who does.  Although complying with Regulation D does not guarantee protection from FINRA, it will certainly put the odds in your favor.

* photo from freedigitalfotos.net

With the recently adopted FINRA Rule 5123, broker-dealers selling private placements will have to file a copy of any private placement memorandum, term sheet, or other offering document with FINRA.  Further, if there are any material amendments, those amended versions of the documents will also have to be filed.  These filings must be made electronically within 15 calendar days from the date of sale for sales on or after December 3, 2012, or FINRA must be informed that no such offering documents existed.  See FINRA Rule 5123. 

Exemptions for sales made to certain accounts/investors and for specific offerings do exist for these filing requirements.  For example, sales to institutional accounts, investment companies, RIAs, banks, insurance companies, among others, are exempt from these filings.  Further, if the offering involves, among other things, exempted securities offerings, Securities Act of 1933 Rule 144A or Regulation S offerings, and exempt securities with short term maturities are not required to have filings.  It has been suggested that, since there are so many exemptions, FINRA Rule 5123 will only apply to the sale of private placements to non-accredited investors.  See FINRA Regulatory Notice 12-40.  In any event, such filings are supposed to provide FINRA with current information on these offerings to better monitor the market.

We shall see if this new Rule will be successful.

“Big Boy Letters” are usually used to identify that the buyer in a transaction has made its own independent assessment of certain risks involved and that certain information has not been disclosed to the buyer by the seller.  In particular, this means that a party is not relying upon certain representations or the lack of representations.

The critical step in these letters is considering the application of these non-reliance provisions are received by the courts and the SEC.  In particular, the SEC has taken the position that such a letter will not foreclose an insider trading liability case under a misappropriation theory  However, courts and private litigants could effectively eliminate or at least limit the potential liability from these letters.

Essentially, the use of these letters is somewhat uncertain depending upon the context.  Nonetheless, these letters are certainly not a complete “get out of jail free” card, and will depend upon the facts and circumstances of each situation.