The SEC alleged in its report that Jason Galanis, who was previously charged with accounting and stock fraud in unrelated cases, conducted the operation, claiming that Galanis wrote in an email to associates that the “primary objective” of the plan was to obtain “discretionary liquidity.”

The SEC further alleged that Galanis and his father, John Galanis, structured limited recourse bonds and persuaded a Native American tribal entity affiliated with the Oglala Sioux Nation to issue them. The SEC claims that Galanis then installed officers at two investment firms to use clients’ funds to purchase $43 million in bonds. According to the SEC, the funds were transferred to a bank account in Florida controlled by Galanis and his associates, where they were used to purchase luxury goods.

The SEC is seeking permanent injunctions and disgorgement plus penalties and interest, as well as officer-and-director bans against four of the individuals.

Federal officials recently accused Halek Energy, LLC with swindling 300 investors out of nearly $22 million in a Texas oil and gas project.  The company’s CEO, Jason Halek, settled with the Securities and Exchange Commission by agreeing to a $50,000 fine and to repay “ill-gotten gains.”  A Fifth Circuit Court of Appeals ruling recently affirmed that Halek and two of his companies, CBO Energy, Inc. and Halek Energy, should disgorge $21,452,137 in “ill-gotten profits”.

Just this month, the SEC filed charges against Chimera Energy Corp. alleging that Chimera was falsely claiming to have contracts with Pemex, the state-owned Mexican oil company.  In addition, the SEC alleges that Chimera made false claims that it had developed a revolutionary and environmentally friendly technology that would replace the controversial hydraulic fracturing method of extracting oil.  The federal Complaint charges that Chimera was involved in a classic “pump-and-dump” scheme to inflate its stock price and to cheat investors out of their money.

Attorney Richard LaGarde believes that investors can protect themselves by being skeptical.

“Many of my clients have been victims of fraud in the oil patch.  Here are some red flags I’ve seen in the past:  Fraudsters often form a limited partnership in State 1, acquire leases or drill wells in State 2, and use unsolicited high-pressure phone calls or e-mails to make offers to investors in State 3.  By doing so, they minimize the chances that an investor might drop by to inspect a well site or the company’s headquarters.  Additionally, hucksters tend to make ‘too good to be true’ promises.   Hang up if someone calls you from a ‘boiler room’ and promises that an investment in their well will be a ‘sure thing’ because the driller has never drilled a dry hole in the area, or a big oil company is about to drill a well next door.  Beware of claims that you need to act quickly because there are a limited number of working interests left in the well.  If it sounds too good to be true, it’s very likely fraudulent.”

By Richard LaGarde

A private placement is an offering of securities by a company that is not offered to the public at large and is not registered with the SEC. Many of these offerings are made pursuant to Regulation D of the Securities Act of 1933. Generally, one must be an “accredited investor” to make an investment in a private placement. Institutions such as banks and insurance companies, and organizations or trusts with assets of $5 million or more, are accredited investors. For an individual to be an accredited investor, the person must have a net worth of $1 million or more, excluding the value of the person’s primary residence, or an income of more than $200,000 in the two most recent years.

Gerri Walsh, a senior executive at FINRA, warned that private placements are often issued by companies that have no requirement to file financial reports, and this can lead to difficulty for investors trying to evaluate the financial health of the company. Because of the issues with liquidity and risk, Walsh said that investors should carefully consider their options before investing in a private placement.

While private placements are not new, FINRA recently uncovered fraud and sales practice abuses related to private placements, including offering documents that contained inaccurate statements.

FINRA said that if an investor is presented with a private placement offering document, it should be reviewed carefully. According to the investor alert, people considering investing in a private placement should find out as much as possible about the company’s business and what the options are for liquidating one’s investment. The organization also said that any such investment should be discussed with one’s broker in detail beforehand.

The Proposed Rules
As proposed, a company may raise investment capital through crowdfunding if certain conditions, including the following, are met:

• A company raises no more $1 million through crowdfunding offerings in a 12-month period;
• Over the course of a 12-month period, each of the company’s investors has invested no more than the following in all offerings relying on the crowdfunding exemption:
  • $2,000 or 5 percent of their net worth or annual income, whichever is greater, if both their net worth and annual income are less than $100,000; or
  • 10 percent of their net worth or annual income, whichever is greater, not to exceed a maximum aggregate amount $100,000 invested, if either their net worth or annual income is equal to or more than $100,000;
• The transaction is conducted exclusively through a single qualifying intermediary’s² platform; and
• The company complies with the requirements of the exemption.

Crowdfunding Intermediaries
Crowdfunding offerings must be conducted exclusively online through a platform operated by a registered broker or a funding portal.³ Under the proposed rules, these intermediaries must:

• Have a reasonable basis for believing that the company is complying with the applicable rules;
• Provide investors with educational materials;
• Ensure that the company’s disclosure is made publicly available for 21 days before securities are sold;
• Make available information about the company and the offering;
• Facilitate the offer and sale of crowdfunded securities;
• Take measures to reduce the risk of fraud;
• Provide communication channels to permit discussions about offerings on the platform; and
• Avoid offering investment advice or making recommendations.

Disclosure Requirements
The proposed rules require a company conducting a crowdfunding offering to file an offering statement with the SEC through the EDGAR filing system on a new Form C and to provide the offering statement to investors and the relevant intermediary facilitating the crowdfunding offering. Items that the company will be required to disclose in its offering documents include:

• A description of the company’s business and the use of proceeds from the offering;
• The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
• Information about the risks of the offering;
• Information about officers, directors and owners of 20 percent or more of the company;
• Certain related-party transactions; and
• A description of the financial condition of the company including for offerings that, together with all other crowdfunding offerings of the company within the preceding 12-month period, have in the aggregate, target offering amounts of:
  • $100,000 or less: (a) the income tax returns filed by the company for the most recently completed year (if any); and (b) financial statements of the company, which shall be certified by the principal executive officer of the company to be true and complete in all material respects;
  • more than $100,000, but not more than $500,000: financial statements reviewed by an independent public accountant using professional standards and procedures for such review or standards and procedures established by the SEC by rule for such purpose; and
  • more than $500,000 (or such other amount as the SEC may establish by rule): audited financial statements.

The proposed rules require the offering statement to be updated for material events over the course of the
offering prior to completion, and provide investors with the option to back out of their investment in such
an event.

A company relying on the crowdfunding exemption will also be required to file an annual report with the
SEC and post it on their website, which would include updates of many of the items included in the initial
offering statement.

Companies must also clearly disclose all compensation paid directly or indirectly to solicitors that promoted the offering through the channels of the broker-dealer or funding portal.

Ineligible Companies
Companies that are ineligible to use the crowdfunding exemption include companies that already are SEC reporting companies, foreign companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, certain investment companies, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Advertising Restrictions
Companies cannot advertise the terms of the offering, except for notices which direct investors to the funding portal or broker-dealer.

Resale Restrictions
As stipulated in Title III of the JOBS Act, securities purchased in a crowdfunding transaction cannot be resold for a period of one year.

Holder of Record
Holders of these crowdfunding securities will not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Exchange Act.

Preemption of State Securities Laws
The crowdfunding exemption preempts state securities laws by making exempt crowdfunding securities “covered securities”, although some state enforcement authority and notice filing requirements would be retained. State regulation of funding portals will also be preempted, subject to limited enforcement and examination authority.

Initial Reaction to the Proposed Rules
The financial and compliance burdens imposed on crowdfunding offerings may make it impractical and prohibitively expensive for start-up companies to benefit from them, although the SEC’s proposed rules are intended to make it easier for start-up companies to raise capital. In addition to the costs that start-up companies will incur to prepare financial statements, engage and compensate a broker-dealer or funding portal and prepare disclosure materials, these companies will be required to regularly file financial and informational reports that will be available for review by the general public, including competitors, customers and strategic partners. A company will need to weigh the benefits of raising a limited amount of capital through crowdfunding against the financial and compliance obligations associated with the proposed crowdfunding rules, especially if the company is otherwise able to raise capital from “accredited investors” under the recently relaxed general solicitation and general advertising rules under Regulation D.

The SEC is seeking public comment on the proposed rules until approximately January 21, 2014. The SEC will then review the comments and determine whether to adopt the proposed rules. Until the SEC adopts final rules, the crowdfunding exemption contemplated by Section 4(a)(6) of the 1933 Act is not available.

Please contact Mitchell C. Littman, Esq. at mlittman@littmankrooks.com or Steven D. Uslaner, Esq. at suslaner@littmankrooks.com if you have questions concerning the proposed rules.

¹Crowdfunding is the process of seeking relatively small investments from a broad group of investors via the Internet.
²An intermediary is either a broker-dealer or a funding portal registered with the SEC.
³A funding portal is defined as an intermediary for exempt crowdfunding offerings that does not: offer investment advice or recommendations; solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; compensate employees, agents, or other persons for such solicitation, or based on the sale of securities displayed or referenced on its website or portal; hold, manage, possess, or otherwise handle investor funds or securities; or engage in other activities as the SEC may determine. Funding portals are required to register with the SEC using Form Funding Portal, a modified Form BD, and to become members of the Financial Industry Regulatory Authority (“FINRA”).

A. Amendment to Rule 506

The SEC amended Rule 506 by adding subsection (c), which permits general solicitation and general advertising under the following conditions:

1. the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors; and
2. all of the purchasers of securities are accredited investors either because they fall within one of the categories of persons who are accredited investors under existing Rule 501 or the issuer reasonably believes that they do at the time of the sale of securities.

B. Verification Standards

To take advantage of the general solicitation and general advertising permitted under Rule 506(c), there is an affirmative requirement that the issuer take “reasonable steps to verify that the purchasers of the securities are accredited investors”. The specific steps required to be taken are not dictated by the new rules. Instead, the reasonableness of the steps taken turns on the objective assessment of the issuer. However, the final rules do set forth a non-exclusive and non-mandatory list of methods that are deemed to satisfy the verification requirement for purchasers who are natural persons, including:

1. documentation of net worth, such as through a review of bank and brokerage statements for assets and a credit report for liabilities;
2. documentation of income, such as through a review of the last two years’ income tax returns;
3. written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the past three months; and
4. reliance on written verification from an existing investor who previously purchased securities in the issuer’s Rule 506 private placement before the effectiveness of the new rules, where the investor continues to hold the previously purchased securities.

In addition to the foregoing, issuers may verify the accredited status of Rule 506(c) investors in any other reasonable manner that they select. The SEC discusses various other available methods, including a review of pay stubs or a review of an SEC or other governmental filing listing the investor’s annual compensation. Alternatively, if the amount of the investment is very high, such that only accredited investors would reasonably be expected to make such an investment, and the investor certifies that the investment is not being financed by a third party, this could be taken into account in determining that the investor is accredited. Conversely, merely having the investor check the “accredited investor” box on a questionnaire would not alone be a sufficient basis to demonstrate that the issuer has taken “reasonable steps” to verify the investor’s accredited status.

C. Proposed Form D Amendments

The SEC proposed amendments to Form D that would require additional information from issuers, such as the methods used to verify the accredited investor status of investors and the types of general solicitation and general advertising used. An issuer relying on new Rule 506(c) would also be required to file Form D with the SEC no later than fifteen days prior to commencing a Rule 506(c) offering and an amended Form D within thirty days following the completion of the offering. The SEC also proposed disqualifying issuers from relying on Regulation D for one year if they fail to file Form D and requiring additional legends and disclosures in all offering materials relying on Rule 506(c). Additionally, the SEC is proposing that for the first two years after the effective date of the rule an issuer relying on Rule 506(c) be required to file all general solicitation and general advertising materials with the SEC.

D. Bad Actor Disqualification

As mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), the SEC also approved final rules to disqualify securities offerings involving certain felons and other so-called “bad actors” from reliance on the exemption from Securities Act registration pursuant to Rule 506. If such “bad actors”, which now include investment managers and principals of private investment funds, are the subject to certain “disqualifying events”, then they will disqualify an issuer from relying on Rule 506. Disqualification will not arise as a result of triggering events that occurred before the effective date of the rule. However, matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

E. Retention of the Existing Rule 506 Safe Harbor

The SEC is retaining the existing ability of issuers to conduct Rule 506(b) offerings without engaging in a general solicitation or general advertising.

F. Amendment to Rule 144A

The SEC also adopted an amendment to Rule 144A to permit securities sold under Rule 144A to be offered to investors other than qualified institutional buyers (“QIBs”), including by general solicitation or advertising, so long as the securities are only sold to investors that the issuer reasonably believes to be QIBs at the time of sale.

The final rules will go into effect sixty days after their publication in the Federal Register (mid-September 2013). The proposed Form D amendments are currently open for comment for sixty days.

G. Noteworthy Considerations
Rule 506 Offerings

• An issuer can rely on traditional means of confirming that investors are accredited investors in connection with Rule 506(b) offerings.

• A press release announcing a Rule 506(c) offering does not need to comply with Rule 135c.

• An issuer conducting a Rule 506(c) offering must establish a reasonable belief that the investors in the offering are accredited investors. Thus, if an issuer relies on a third-party verification service, the issuer must conduct due diligence on the third-party service and seek to understand the process that will be used by the third-party verification service for verification of accredited investor status.

• An issuer can rely on the Section 4(a)(2) exemption in conjunction with or as an alternative to a Rule 506(b) offering because the Rule 506(b) offering does not involve general solicitation or general advertising. However, an issuer cannot rely on the Section 4(a)(2) exemption in connection with a Rule 506(c) offering because general solicitation of investors is not consistent with an exempt offering under Section 4(a)(2), which is a transaction “by an issuer not involving any public offering”.

• An issuer can likely begin a private offering as a Rule 506(b) offering and then decide to rely on Rule 506(c) for the offering. However, it is unlikely that an issuer would be able to change course from a Rule 506(c) offering to a Rule 506(b) offering given the presence of general solicitation or general advertising in connection with the Rule 506(c) offering.

• Generally, an issuer cannot conduct a contemporaneous Rule 506(b) offering and Rule 506(c) offering. If the issuer offers the same security, it would not be possible to prevent the general solicitation and general advertising used in connection with Rule 506(c) from tainting the contemporaneous Rule 506(b) offering. However, it may be possible to conduct contemporaneous offerings if the issuer offered different securities and if the investors in the two offerings were different. Rule 502(a) of Regulation D sets forth the traditional “five factor” test that issuers should consider in determining whether offers and sales should be integrated for the purposes of the exemptions under Regulation D.

• Once a Rule 506(c) offering has been completed, the issuer can conduct a Rule 506(b) offering. Given that the Rule 506(c) offering involved general solicitation and general advertising, it is judicious to let time elapse between the two offerings. Rule 502(a) of Regulation D provides a safe harbor from integration of Regulation D offerings made six months before or six months after an offering. A Rule 506(c) offering can follow a completed Rule 506(b) offering.

Secondary Market Transactions

• General solicitation and general advertising should not be used in connection with resales made in reliance on Rule 4(a)(1-1/2) because this exemption relies on the interplay of the Section 4(a)(1) and the Section 4(a)(2) exemptions and the JOBS Act did not amend Section 4(a)(2).
• The changes to Rule 506(c) do not affect resales because Rule 506 is available only to issuers.

Offerings in Close Proximity

• A private placement made pursuant to Section 4(a)(2) and/or Rule 506(b) shortly before the filing of an initial public offering (“IPO”) would not likely be viewed as “gun jumping” because such an offering does not involve general solicitation and general advertising. However, a Rule 506(c) offering conducted in close proximity to the filing of an IPO may be viewed as “gun jumping” because of the general solicitation and general advertising associated with the offering, especially if the Rule 506(c) offering involves the sale of the same security as that offered in the IPO. In the case of emerging growth companies, the JOBS Act specifically permits test-the-waters communications with institutional accredited investors and QIBs prior to or after the filing of a registration statement. However, the general solicitation and general advertising used in a Rule 506(c) offering may also raise concerns for any test-the-waters discussions.
• The SEC and its staff has clarified that an issuer that is conducting a public offering may conduct a concurrent private placement as long as, among other things, the issuer has not solicited the offerees in the private placement using the registration statement. Presumably, this analysis is made simpler now that general solicitation may be used in connection with a Rule 506(c) offering. The longstanding principle still applies that an offering that commences as a private offering must be completed as a private offering and an offering that commences as a public offering must be completed as a public offering except in the circumstances specified in Rule 155.
• It is unlikely that Rule 506(c) will be used in connection with a private investment in public equity (“PIPE”) transaction. An already public company will likely be reluctant to use general solicitation in connection with a PIPE transaction, because announcing the potential private offering may have an effect on its stock price. Also, once an announcement is made, an issuer may be more reluctant to terminate a deal if the pricing is not favorable.
• Rule 152 clarifies that a completed private offering will not be integrated with a subsequent public offering. Generally, issuers that conduct a PIPE transaction, or private offering wherein resale registration rights are offered to the private investors, rely on Rule 152 in connection with the filing of a resale registration statement. When Rule 152 was adopted, the private offering would not have involved a general solicitation. Thus, it is unclear whether Rule 152 would be available in connection with an offering in which general solicitation is permitted.

Please contact Mitchell C. Littman, Esq. at mlittman@littmankrooks.com, Steven D. Uslaner, Esq. at suslaner@littmankrooks.com or Lesley DeCasseres, Esq. at ldecasseres@littmankrooks.com if you have questions concerning the Rule.

* General solicitation and general advertising include advertisements published in newspapers and magazines, website postings, press releases, communications broadcast over television and radio, and seminars or meetings where attendees have been invited by general solicitation or general advertising.

The Securities and Exchange Commission (SEC) has issued new rules for broker-dealers requiring them to search for securities holders if they lose contact with them.  The rules require for the first time that broker-dealers attempt to find securities holders that they have lost touch with.  Broker-dealers and other participants in the securities market must also notify people who have not processed checks that were issued to them in association with their securities.

Record-keeping transfer agents, who function as intermediaries between broker-dealers and the clearing house, were already subject to a similar rule.  The SEC was required to apply the same requirement to broker-dealers under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Elisse Walter, the Chairman of the SEC, said that the new rules have a common-sense objective and would help investors receive funds that they may not realize they are owed.

Specifically, under the new rules, broker-dealers must conduct the same searches for lost securities holders that transfer agents conduct.  In addition, broker-dealers, transfer agents, and other paying agents must notify unresponsive payees in writing of unprocessed checks, unless the check is for less than $25.

The previous rules required only record-keeping transfer agents to use reasonable care to find the addresses of missing securities holders and conduct searches of databases to find them.  When a missing securities holder cannot be located, the securities, interest and dividends may be at risk of being designated as abandoned under state laws.

The new rules will go into effect 60 days after they are published in the Federal Register, and broker-dealers will have one year to achieve compliance.

FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI) conducts a surveillance program intended to detect fraud and insider trading.  In 2012, the OFDMI referred 692 matters involving potential wrongdoing to the SEC or other law enforcement agencies.  This included 260 referrals involving potential fraud and 347 referrals involving potential insider trading.

FINRA also brought several important disciplinary actions in 2012, and was sometimes the first regulator to address certain cases of ongoing fraud.  The regulator took disciplinary action in 1,541 cases in 2012, a rise of 53 from the previous year.  The actions were taken against firms and registered individuals, and included fines of over $68 million and restitution orders of $34 million to investors that were harmed.  FINRA also barred 294 people from the securities industry, expelled 30 firms and suspended 549 brokers from associating with firms regulated by FINRA.  The disciplinary actions included cases involving exchange-traded funds (ETFs), complex products, incorrect pricing and inadequate disclosure.

The regulator also conducted 1,846 routine examinations, 800 examinations of branch offices and 5,100 examinations for cause in 2012.  Examinations were conducted in response to regulatory tips, investor complaints and terminations for cause.  FINRA also began using new technology to conduct examinations more efficiently.

FINRA is a non-governmental regulatory body for securities firms operating in the United States.  For more information, visit www.finra.org.

The new rule means the value of the primary residence does not count toward the net worth. Another new wrinkle in the rules penalizes investors for being “upside down” in their primary residence. Any debt secured by the main residence that is above the value of the home in a fair market will now be treated as a liability against net worth.

The move was made in an attempt to prevent rule manipulation as some investors could artificially inflate their net worth by borrowing against their home just before an investment opportunity, according to the SEC. The SEC will have to revisit the “accredited investor” definition in 2014 and every four years after that to make sure they remain fair, according to requirements by the Dodd-Frank Act.

The SEC’s Division of Corporate Finance issued the guidance document, which is not a new regulation, to offer guidance on how existing disclosure obligations apply to cybersecurity risks. Since many companies are relying heavily on digital technology to conduct business, the guidance document could prove to play a key role in the future of disclosures.

Too many details online could create a roadmap for those who wish to do harm, but not enough disclosure and a company may not be in compliance with other required disclosures. There are no SEC disclosure requirements that specifically refer to cybersecurity.

The guidance document suggests disclosing risks of cyber incidents if they are among the factors that make investing in the company risky. If a company has a history of cybersecurity breaches and it is likely that they will continue, then an evaluation of what the company is doing to prevent those attacks would be valuable. As with all risk disclosures, an appropriate disclosure of cybersecurity risks should include an analysis of outsourced functions that put the company at risk, a list of issues and how they are addressed and resolved and a description of insurance coverage.

The document also warns against boilerplate disclosures and encourages detail. It is important to reiterate that the guidance document is only a guide and does not represent any new official requirements.

H.R. 2940 proposes allowing small private companies to solicit investors through advertising. The SEC’s ban on solicitation is said to shrink the pool of investors in small companies. H.R. 2930 would change SEC rules to allow for “crowdfunding,” where companies pool smaller investors. Two other bills propose to help grow the economy by changing SEC thresholds to allow more companies to maneuver outside of the regulatory agency’s jurisdiction.

The House also passed H.R. 1070, which makes it easier for a small company to go public. The Small Company Capital Formation Act would allow companies to have an offering threshold of $50 million without having to register with the SEC instead of the current $5 million mark. Another bill, H.R. 1965, would change regulations on small bank holding companies making it easier for them to register or deregister by raising the shareholder threshold from 500 to 2,000.

One other bill that proposes a change to a SEC threshold recently passed the Financial Services Subcommittee. H.R. 2167 would make it so that a company would need 1,000 shareholders before it had to register with the SEC instead of just 500. The committee said the lower threshold was an impediment to capitalization.

The SEC proxy access rule states that public companies need to provide shareholders with information regarding shareholder-backed candidates when board of directors are going to be voted on. The Business Roundtable and U.S. Chamber of Commerce said this rule violates the Administrative Procedure Act and had not “…adequately considered the rule’s effect upon efficiency, competition, and capital formation.”

Lately the SEC has come under fire for not analyzing their new rules with data and economic analysis that demonstrates the trade-offs and consequences of the new procedures. Some accuse the SEC of “back of the envelope” analysis or picking and choosing what makes sense to them rather than assessing the full economic repercussions of those rules. The Circuit Court decision is the first time one of the new rules has been vacated out of the 250 new requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Other rules from the Dodd-Frank Act have been challenged and the SEC must consider the far-reaching effects of their regulations. SEC Chairwoman Mary Schapiro has admittedly, “…parachuted into complex legislative matters demanding immediate specialized expertise” that warrants solid economic analysis and legal consideration before releasing as a rule.