On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[i] a review of a FINRA disciplinary action.[ii] While the opinion affirmed FINRA’s disciplinary action,[iii] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings. Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.
KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[iv] In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[v] Westmount did not plan to register the offering. Westmount instead planned to rely on a Rule 506(b) exemption from registration.[vi]
Prior to KCD selling any interest in the Fund, Westmount issued a press release describing the Fund.[vii] Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[viii] One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[ix] Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[x]
After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption. Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[xi] Under those guidelines, at least one person was refused an opportunity to purchase interests in the Fund.[xii]
During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from a Westmount-affiliated website.[xiii] Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[xiv] FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[xv] FINRA’s Hearing Panel found that KCD violated those rules.[xvi] FINRA censured KCD and imposed a fine of $73,000.[xvii] The National Adjudicatory Counsel affirmed FINRA’s decision.[xviii] KCD then requested an SEC review.[xix]
KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[xx] The SEC rejected KCD’s contention,[xxi] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[xxii] In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[xxiii]
KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[xxiv] This argument confused the notion of what is prohibited under Rule 506(b). It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[xxv] Whether a sale results directly from the general solicitation is irrelevant.[xxvi]
The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[xxvii] Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).
Those making exempt offerings in reliance on Rule 504,[xxviii] Rule 505,[xxix] and Rule 506(b)[xxx] should review their sales practices in light of the KCD opinion. In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper). Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.