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Presenting a live 90-minute webinar with interactive Q&A
Structuring Private Placement Memorandum
for the Private Offering and Sale of Securities Determining Materiality, Assessing Risk Factors and Conducting Due Diligence
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
THURSDAY, JUNE 29, 2017
Yelena M. Barychev, Partner, Blank Rome, Philadelphia
Brett G. Evans, Partner, Evans & Kob, Santa Ana, Calif.
Brett A. Cenkus, Cenkus Law, Austin, Texas
Karolyn Ann Knaack, MBA, JD, Member, Karolyn A. Knaack, P.C., Austin, Texas
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Structuring Private Placement
Memorandums for the Private
Offering and Sale of Securities
June 29, 2017
By: Yelena Barychev, Brett Cenkus, Brett Evans and Karolyn Knaack
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6
Brett Cenkus
Brett Evans
Karolyn Knaack
Yelena Barychev
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What We’ll
Cover Overview of regulatory framework
Essential elements of a PPM
Determining materiality for disclosure
Assessing relevant risk factors
Due diligence
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Overview of Regulatory
Framework: 4(a)(2) and Regulation D
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Presented by
Brett Cenkus & Brett Evans
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Private Placements Generally
Under Section 5 of the Securities Act, any offering of securities must be registered
with the SEC or be exempt from registration. A private placement is a securities
offering that is exempt from registration.
Benefits of private placements:
▫ Less expensive and quicker than SEC registration
▫ Reduced disclosure requirements
▫ Direct negotiation with investors = easy to tailor to fit the needs of specific
investors
▫ Avoiding certain liabilities (e.g., Section 11 of the Securities Act)
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Section 4(a)(2) of the Securities Act
▫ First adopted by Congress as a part of the Securities Act in 1933
▫ Rationale: in an offering with a limited number of offerees capable of protecting
themselves, the compliance burden of a public offering is not necessary
▫ Provides a statutory exemption for “transactions by an issuer not involving any
public offering”
Source of the Primary Exemption
“Public offering” is not defined by the statute. Standards have been developed by
courts and the SEC. BE CAREFUL OF PLACING TOO MUCH EMPHASIS ON
THE PLAIN MEANING OF THE WORD, “PUBLIC.”
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Whether a purchaser can fend for itself is based on factors such as:
▫ The purchaser’s access to the same kind of information that would be included in
an SEC registration statement; and
▫ The purchaser’s sophistication and ability to bear the economic risks of the
investment.
What constitutes a “public offering”?
SEC v. Ralston Purina (1953)
The Supreme Court established the general principle that the exemption under 4(a)(2) is
available only for an offer and sale made privately to persons able to fend for
themselves.
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What constitutes a “public offering”? (cont’d)
Other factors used in determining availability of the private offering exemption
(developed since Ralston Purina) include:
▫ The number of offerees and their relationship to each other and to the issuer
▫ The number/amount of securities offered - size of the offering
▫ The manner of the offering (e.g., general solicitation)
▫ The sophistication and experience of the offerees
▫ The nature and kind of information provided to the offerees or to which the offerees
have ready access
▫ The actions taken by the issuer to prevent the resale of securities
Each factor is flexible and highly fact-dependent.
No single factor alone is determinative. 12
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Regulation D
In 1982, the SEC adopted Regulation D to provide greater certainty regarding
which transactions are exempt from registration.
Funds Raised via Reg. D vs SEC Registered Offerings in 2014
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Regulation D
Regulation D is a series of nine rules, Rules 500-508, establishing three
transaction exemptions from the registration requirements of the Securities Act
▫ Rule 500 lays out general rules around using Regulation D
▫ Rule 501 sets out certain definitions
▫ Rule 502 sets out four general conditions to be met under the Regulation D
▫ Rule 503 establishes the requirement to file a Form D
▫ Rules 504 and 506 establish the exemptions, each with particular qualifications and
limitations (former Rule 505 is gone and 506 now has two rules - 506(b) and 506(c))
▫ Rule 507 disqualifies an issuer from relying on Regulation D in certain situations
▫ Rule 508 provides that an insignificant failure to comply (when considered in connection
with the offering as a whole) will not disqualify an offering from the exemption.
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Miscellaneous Private Offering Terms
Accredited investor
General solicitation
Any advertisement, article, notice or other communication published in any
newspaper, magazine or similar media or broadcast over television or radio or any
seminar or meeting whose attendees have been invited by general solicitation.
Includes internet activity.
▫ Salary test ($200K/300K last two years and current)
▫ Net worth test ($1MM+ without equity of primary residence)
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Rule 502 – General Conditions for use of Reg D
Integration
Several private placements offered within a short period of time, each relying on
separate offering exemptions, may be integrated and, when taken together, may
constitute a single plan of financing for which the private placement exemption is not
available.
The SEC wants to ensure Regulation D is not used as part of a scheme or plan to avoid
Section 5 registration requirements
Information Requirements
If an issuer is selling securities to non-accredited investors, the issuer must comply with
the information requirements set forth in Rule 502. The required information must be
furnished a reasonable time prior to sale.
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Rule 502 – General Conditions for use of Reg D
Manner of Offering
Until the recent changes pursuant to the JOBS Act, Rule 502 prohibited the issuer or any
person acting on its behalf to offer or sell securities by any form of general solicitation or
general advertising, including:
▫ any advertisement, article or other published or broadcast communication; or
▫ any seminar or meeting whose attendees have been invited by general solicitation
or advertising
Limitations on Resale
Regulation D is available only to issuers and applies only to a particular transaction. Rule
502(d) provides that securities acquired in a Regulation D private placement are “restricted
securities” and cannot be resold by the purchaser without registration under the Securities Act
or compliance with an available registration exemption.
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Main Regulation D Exemptions
Rule 504
▫ No more than $5MM (recently raised) in any consecutive 12-month period.
▫ No restriction on the number of investors
▫ No restriction on the manner of the offering or resale
▫ Securities may be sold to any type of investor (including unaccredited)
▫ Doesn’t prescribe specific disclosure requirements
Rule 506(b) (a safe harbor)
▫ No general solicitation
▫ Accredited investors and up to 35 non-accredited investors who meet sophistication
requirements (Accredited investor status often confirmed through self-certification)
▫ No specific disclosure requirements for accredited investors, but significant disclosure for
unaccredited investors
▫ Historically, 99% of the Regulation D activity
Rule 506(c) ▫ Removed the prohibition in Regulation D on general solicitation and general advertising in
offerings and sales under Rule 506, provided that all purchasers of the securities sold in these
offerings are accredited investors
▫ Require issuers to take reasonable steps to verify that purchasers are accredited investors,
using methods determined by the SEC
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Essential Elements
of a PPM 2
Presented by
Brett Cenkus Founding Partner, Cenkus Law
(512) 888.9860
[email protected]
www.cenkuslaw.com
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SEC Industry Guides
High-Level Considerations
PPMs serve a dual purpose – compliance and marketing
The contents of a PPM will (should) vary depending on the deal structure, industry, target
audience and specific exemption on which the issuer is relying
❖ Hedge funds
❖ EB5 Visa Deal
❖ Bank holding companies
❖ Real Estate LPs
❖ Unpaid claim adjustment
❖ Mining operations
❖ Oil and gas deals (industry guides)
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Drafting Tips
✓ Draft in plain English as much as possible
✓ Tailor the length and content to the deal,
but never soften the tone -- PPMs should
strongly communicate risk.
✓ Add the issuer’s logo and a bit of design
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10 Main Sections of a PPM
1. Notices to Investors
2. Executive Summary
3. Company’s Purpose and Overview
4. Terms of the Offering and Securities
5. Risk Factors
6. Use of Proceeds
7. Financial Information
8. Management
9. Legal and tax matters
10.Exhibits
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Notices
❖ No registration; reliance on exemption
❖ No public market
❖ High degree of risk
❖ Restrictions on transfer
❖ No one authorized to make representations outside the offering materials
❖ Descriptions and summaries in the PPM qualified by actual documents
❖ No legal, business or tax advice
❖ Right to modify or withdraw the offering
❖ Opportunity to ask questions and receive information
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Executive Summary
❖ 1-3 page overview of the opportunity
❖ Meant to facilitate quick understanding of the
transaction
❖ Current capitalization of the issuer
❖ Include material terms of the offering and securities
❖ Reference to risk factors
❖ List of documents investors will sign
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Company Overview
❖ Description of main operations of the business. Be clear about what is currently
being done and what is planned for the future
❖ Target customers
❖ Describe the industry – how companies compete, fragmented vs. concentrated
(include relative size of the issuer), how regulated the industry is
❖ For planned operations, list milestones and challenges to execution (e.g., stages
of product development)
❖ Description of the business processes – how does the company manufacture,
produce, sell, fulfill whatever it does
❖ Overview of marketing plan
❖ Explanation of sales cycle
❖ Identify supply chain risks, seasonality of revenue
❖ Number of employees
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Terms of the Offering and Securities
❖ Type of the offered securities
❖ Price of the offered securities
❖ Material terms of the offered securities – voting rights, information rights,
liquidation rights, preemptive rights, ownership percentage, mandatory capital
calls, convertibility, call and put rights, if the securities are collateralized
❖ Who may invest
➢ Accredited vs. Non-Accredited
➢ Minimum Investment
➢ Maximum Investment (absolute dollars vs. percentage of net worth)
➢ Risk Tolerance
❖ Plan of Distribution (type of solicitation, finders)
❖ Documentation investors must sign to invest
❖ Possible future dilution
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Risk Factors
❖ Most important section of the PPM from a risk management
perspective
❖ Always the source of robust conversation with clients
❖ Group into general categories (e.g., risks of the offering and
securities, risks of the company; risks of the industry)
❖ List in order of priority (most significant risks first in each
category)
❖ State each risk in a simple, bold type sentence
❖ Don’t be repetitive (cross-reference as needed)
❖ Avoid generic, boilerplate risk factors
❖ Don’t use risk mitigating language in risk factors
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Estimated Use of Proceeds
❖ Include at least 4-5 categories and up to 12 (one
should be transaction expenses)
❖ Add footnotes as appropriate
❖ Be sure one category is compensation to related
parties (e.g., salaries, bonuses, etc.), especially if
that money is coming out at or near closing
❖ Display in tabular form
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Financial Information
❖ Company capitalization
❖ Historical financials
❖ Pro forma financials (include forward-looking
statement language)
❖Management discussion of financial
➢ Timeline to achieve profitability
➢ Specific financial risks
➢ Discussion around declining metrics
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Management
❖ Biographies
➢ All officers, directors or other important
related parties
➢ Past experience going back at least 5 and
possibly 10+ years
➢ Talk about successes and failures
❖ Compensation
❖ Conflicts of Interest
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Legal and Tax Matters
❖Litigation
❖Tax Matters
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Exhibits
❖ Instructions for Investing
❖Subscription/Purchase Agreement
❖Governing documents
❖ Investor questionnaire
❖W-9
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Determining Materiality for
Disclosure 3
Presented by
Karolyn Knaack Karolyn A. Knaack, P.C.
512-879-7217
[email protected]
www.knaacklaw.com
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Core Concepts of Full and Fair
Disclosure
▫ “Is it material?”
▫ Lack of bright line rules or bright line
guidance from the courts and the SEC
▫ Flexible and adaptable to any factual
situation
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Federal Courts
There is no rigid formula
Materiality determination is a delicate assessment that is inherently
fact and context specific
TSC Industries v. Northway, Inc., 426 US 438 (1976) – omitted facts in a proxy statement
Basic, Inc. v. Levinson, 485 US 224 (1988) – materiality of contingent or speculative events
Current standard are 2 Supreme Court cases:
Information is material if a substantial likelihood exists that a reasonable
investor would consider the information important in making a buy, sell or
hold investment decision or voting decision
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Total Mix of Information Available
▫ There must be a substantial likelihood that a fact would be viewed by a reasonable
investor as significantly altering the "total mix" of information made available.
▫ Does not require that a misstated or omitted fact would result in a reasonable investor
changing an investment or voting decision
▫ Merely requires that proper disclosure of the misstated or omitted fact would have
assumed actual significance in the deliberations of a reasonable investor
The decision in TSC Industries recognized the need to balance the importance of full and fair disclosure against the pitfalls
of an unnecessarily low materiality standard. A low materiality standard would likely subject a company and its management
to much higher liability for insignificant misstatements and omissions. This could lead to a legitimate fear by management of
overexposure to liability resulting in an “avalanche of trivial information” that could cloud, not aid, the decision-making
process.
For these reasons, the Supreme Court in TSC Industries expressly rejected adopting a materiality standard that focused on
what a reasonable investor “might” consider important.
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Contingent of Speculative Events
Basic added to the TSC Industries standard a discussion of contingent or
speculative events.
A central issue in Basic revolved around the materiality of preliminary merger discussions, asking specifically
what significance a reasonable investor would place on these discussions given the real possibility that
contemplated transaction discussions can easily never come to fruition.
For contingent or speculative events, materiality determinations must balance both
the:
▫ Probability that the event will occur.
▫ Significance of the event to the company.
As with all materiality determinations, this balancing becomes fact specific. An event that is highly likely to
occur and would be material if it did occur, but is relatively insignificant, may not be considered material
and necessary to disclose until the probability of occurrence becomes higher. Similarly, if an event is
improbable but its significance is so high that it would lead to a major impact on the company, it may be
material and ripe for disclosure.
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Application of Materiality Standard
Statistical Significance
The Supreme Court has specifically held that adverse events do not necessarily need to be statistically significant to be material (see
Matrixx Initiatives Inc. v. Siracusano, 131 S. Ct. 1309 (2011)). In that case, it was found that a drug company’s failure to make public
reports of adverse drug reactions can constitute securities fraud, even if the number of adverse reactions is not statistically significant.
The Supreme Court did note that something beyond a mere adverse reaction is required in a materiality determination but that
something need not be statistical significance.
Market Reaction
Some courts test materiality by looking at the market’s reaction to a misstatement or omission (see, for example, Oran v. Stafford, 226
F.3d 275, 284 (3d Cir. 2000)). The theory is that in a developed and efficient securities market, a company’s stock price reflects all
available information about the company, its business and its industry. Therefore, information significant to reasonable investors in an
efficient market is immediately incorporated into the stock price. The SEC staff appears to agree with this reasoning.
Statements of Optimism, Opinion and Puffery
Courts often find general statements of optimism and puffery to be immaterial because a reasonable investor would not believe them to
be reliable predictions of expected performance.
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▫ The adopting release for Regulation FD (SEC Release No. 33-7881 (Aug. 15, 2000)).
▫ SEC Staff Accounting Bulletin: No. 99 - Materiality (SEC Release No. SAB 99 (Aug. 12, 1999)) (SAB 99).
SEC Guidance on Materiality
Relatively little SEC guidance on materiality
▫ SEC Rule 405 under the Securities Act
▫ Rule 12b-2 under the Exchange Act
To those matters where “there is a substantial likelihood that a reasonable investor would attach importance in determining
whether to” buy or sell the subject securities. The definition was derived from the materiality standard first set out and later
expanded in TSC Industries and Basic. The key sources for additional SEC staff guidance available in this area are:
SEC staff guidance universally accepts and adopts the materiality standard of TSC Industries and Basic. Also like the
courts, the staff recognizes the difficulty and sometimes vagueness that can arise in making materiality determinations but
has stopped short of implementing a bright-line rule or test or an exclusive list of items that are per se material. The staff
instead keeps the materiality standard flexible enough to fit the circumstances of each situation.
While most of SAB 99 discusses materiality in the accounting and auditing context, the staff guidance in the release is
indicative of the SEC staff’s view and applicable to materiality determinations generally. Furthermore, many materiality
determinations require at least considering the impact on results of operations and financial statements.
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Heightened Scrutiny
While the SEC staff does not provide an
exhaustive list of items that are per se
material, it has provided a non-
exhaustive list of items or events that
should be reviewed carefully to
determine whether they are material:
▫ Earnings information.
▫ Mergers, acquisitions, tender offers, joint ventures, or
changes in assets.
▫ New products or discoveries or developments
regarding customers or suppliers (for example, the
acquisition or loss of a contract).
▫ Changes in control or in management.
▫ Change in auditors or auditor notification that the issuer
may no longer rely on an auditor’s audit report.
▫ Events regarding the issuer’s securities, such as:
▫ defaults on senior securities;
▫ calls of securities for redemption;
▫ repurchase plans;
▫ stock splits;
▫ changes in dividends;
▫ changes to the rights of security holders; or
▫ public or private sales of additional securities.
▫ Bankruptcies or receiverships.
The staff makes it clear that even items on this list
require a fact-specific materiality determination. For
example, some new product launches and
developments with suppliers are material and others
are not.
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Numerical Cutoffs or Thresholds
Statistical Significance
It is common for issuers, their auditors, underwriters and other parties conducting due diligence on issuers or preparing
disclosure to develop rules of thumb that set numerical cutoffs or thresholds to guide when an item may be material.
Common rules of thumb that may be encountered in these situations are:
▫ That misstatements or omissions of an item that fall below a threshold of 5% or 10% of net revenue or total assets
are not material unless there is also evidence that management misconduct is involved.
▫ Another example is if a misstatement or omission of an item would create a deviation in financial statements of less
than 5%, it is not material.
The SEC staff strongly cautions against exclusive reliance on any numerical cutoff or threshold as determinative of
materiality. A numerical cutoff or threshold may be acceptable to aid in financial statement preparation, due diligence
and disclosure, but only as a preliminary assumption that, before considering all relevant circumstances, an item is likely or
unlikely to be material. Therefore, the staff cautions against using numerical rules of thumb beyond the initial step in
determining materiality.
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Quantitative and Qualitative Factors
Even if a materiality assessment begins with a numerical threshold assessment, a materiality
determination, especially in the context of the effect of financial statements, requires experienced human
judgment of the total mix of information.
This judgment includes:
▫ The size in numerical terms of the misstatement (quantitative factors),
▫ but also of the full factual context in which an evaluator of the effect of the material misstatement or
omission on the company and its financial statements would view the item (qualitative factors).
Qualitative factors can cause small quantitative misstatements to be material. The simplest example of this
is where financial statements are incorrect in one area and only by a small amount, but the misstatement is
caused by management misconduct. Depending on the seniority level of management involved, the
smallest of misstatement could be material.
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Quantitative and Qualitative Factors (Cont’d)
In this area the SEC staff has provided a non-exhaustive list of qualitative considerations that can cause a
quantitatively small misstatement to be material. These considerations are whether the misstatement:
▫ Arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision
inherent in the estimate.
▫ Masks a change in earnings or other trends or results from attempts to manage earnings.
▫ Hides a failure to meet analysts’ consensus expectations.
▫ Changes a loss into income or vice versa.
▫ Concerns a segment or other portion of the business that has been identified as playing a significant role in operations or
profitability.
▫ Affects compliance with regulatory requirements.
▫ Affects compliance with loan covenants or other contractual requirements.
▫ Has the effect of increasing management’s compensation, for example, by satisfying requirements for the award of bonuses or
other forms of incentive compensation.
▫ Involves concealment of an unlawful transaction.
A full analysis of quantitative and qualitative factors will likely result in small quantitative misstatements being deemed
qualitatively material far more often than large quantitative misstatements being deemed immaterial because the qualitative
significance is too low. However, with the total mix materiality standard, this situation is certainly possible and should be
considered when making materiality decisions.
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▫ The significance of the items to the
particular company.
▫ The effect on the financial statements
taken as a whole.
Accounting and Auditing Materiality
Standards
There are some special
considerations that should be
kept in mind that are unique to
materiality determinations in the
accounting and auditing context.
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▫ Total Mix of Information Available
▫ Contingent or Speculative Events
▫ Numerical Cutoffs or Thresholds
▫ Quantitative and Qualitative Considerations
▫ Accounting and Auditing Context
▫ Heightened Scrutiny
▫ General Examples of Materiality Hotspots
Materiality
Checklist
�
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Total Mix of Information Available
▫ Is there is a substantial likelihood that a reasonable investor would consider the information in
question to be important in making a buy, sell or hold investment decision or a voting decision?
▫ Is there a substantial likelihood that this information would be viewed by a reasonable investor as
significantly altering the “total mix” of information made available?
▫ Irrespective of whether it would change an investment decision, is there a substantial likelihood that
proper disclosure of the misstated or omitted fact would have assumed actual significance in the
deliberations of a reasonable investor?
▫ Would the significance of the information go beyond what a reasonable investor simply “might”
consider important and actually function as an important factor in the investment decision?
These fundamental questions must be asked in any materiality determination:
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▫ Is the event contingent on something else happening?
▫ Is it possible or likely that the event will not come to fruition or not occur as
expected?
▫ If yes, how does the probability of it occurring balance against the significance
of the event to the company? Is the event:
▫ highly likely to occur with moderate significance to the company; or
▫ moderately probable but with extremely high significance to the company
if it occurs?
Contingent or Speculative Events
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▫ The SEC staff strongly cautions against reliance on any numerical cutoff or threshold
beyond a preliminary assumption that, before considering all relevant circumstances, an
item is likely or unlikely to be material.
▫ Some examples of preliminary numerical questions that might require further analysis
include:
▫ does the item account for more than 5% of net revenue;
▫ does the item account for more than 10% of total assets; and
▫ does the misstatement or omission create a deviation in the financial statements of
more than 2%?
Numerical Cutoffs or Thresholds
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Quantitative and Qualitative Factors
Materiality determinations require
experienced human judgment of
the size in numerical terms of the
misstatement (quantitative
factors) but also of the full factual
context of the effect on the
company (qualitative factors).
Because qualitative factors can
often cause small quantitative
misstatements to be material,
questions to ask include:
▫ Are there qualitative considerations that can cause a quantitatively small
misstatement to be material? For example, does the misstatement or omission:
▫ mask a change in earnings or other trends;
▫ result from attempts to manage earnings;
▫ change a loss into income or vice versa;
▫ concern a segment or other portion of the business that has been identified as
playing a significant role in operations or profitability;
▫ affect compliance with regulatory requirements;
▫ affect compliance with loan covenants or other contractual requirements;
▫ have the effect of increasing management’s compensation, for example, by
satisfying requirements for the award of bonuses or other forms of incentive
compensation; or
▫ involve concealment of an unlawful transaction?
▫ Is there a single or isolated event or problem with a product or business line that
can have a significant impact on the company despite the fact that the problem is
not widespread or statistically significant?
▫ Is there a quantitatively small misstatement or omission that is the result of
employee or management misconduct?
▫ Even if the misstatement or omission is extremely insignificant, is it the result of
misconduct by senior level management?
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▫ Even if there are misstatements that are individually immaterial, could the
multiple misstatements, when aggregated, render financial statements
materially misleading as a whole?
▫ Have materially misstated amounts in the financial statements been netted
with other misstatements with the intent of diminishing materiality?
Accounting and Auditing Context
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Heightened Scrutiny
▫ Earnings information.
▫ New products or discoveries or developments regarding customers or
suppliers (for example, the acquisition or loss of a contract).
▫ Changes in control or in management.
The SEC staff has provided a non-exhaustive list of items or events that should be
reviewed carefully to determine whether they are material. Any review should look
at:
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General Examples of Materiality Hotspots
▫ Pending or threatened litigation that can be large in dollar value or impede an issuer’s ability to do
business (for example, intellectual property challenges).
▫ Pending or threatened governmental investigations.
▫ Engaging in prohibited activities with nations on which the US has imposed sanctions, such as Iran and
Syria.
▫ Regulatory approvals or changes in law.
▫ Executive compensation matters (say on pay results, employment agreements, incentive plans).
▫ Labor disputes.
▫ Significant developments with suppliers and customers.
▫ Inventory shortages and manufacturing difficulties.
▫ Product defects or recalls.
▫ Significant developments or adverse side effects in clinical trials.
▫ Impact of natural disasters.
▫ Cybersecurity breaches.
▫ Stock repurchases.
▫ Restatements.
▫ Findings of significant deficiencies or material weaknesses in internal controls over financial reporting.
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Assessing Relevant
Risk Factors 4
Presented by
Yelena Barychev Partner, Blank Rome LLP
215-569-5737
[email protected]
www.securitiesnewswatch.com
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Assessing Relevant Risk Factors
▫Why do we need risk factors (RFs)?
▫Does the SEC require RFs in the PPM?
▫What are best practices in RF disclosures?
▫What RFs are usually included in the PPM?
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Why Do We Need Risk Factors?
SEC’s position:
▫ To provide important context for assessing
the company’s financial potential (you may
lose all or part of your investment)
Issuer’s position:
▫ To provide protection in case of investors’
claims
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Does the SEC Require RFs in the PPM?
No…
▫ if the issuer is selling securities to an accredited investor,
▫ but the issuer should still including risk factors in the PPM to:
▫ provide management’s perspective on factors that may adversely
impact the company and its securities
▫ provide information that is material to an understanding of the
issuer, its business and the securities being offered
▫ Regulation S-K: Item 503(c)
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What Are Best Practices in RF Disclosures?
✓ Focus on the most significant or principal RFs that make the
company’s offering of securities speculative or risky
✓ RF disclosures must be concise and organized logically (most
significant risks should go first)
✓ Avoid “boilerplate” RFs:
▫ do not present risks that could apply to any issuer or any offering
▫ explain how the risk affects the issuer or the securities being
offered
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Best Practices in RF Disclosures (cont.)
✓ Use “plain English”
✓ Set forth each risk factor under a caption that adequately describes
the risk
✓ The risk factor discussion must be at the beginning of the PPM
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What RFs Are Usually Included in the PPM?
Item 503(c) principles-based disclosure:
Risk factors may include, among other things, the following:
▫the company’s lack of an operating history
▫the company’s lack of profitable operations in recent periods
▫the company’s financial position
▫the company’s business or proposed business
▫the lack of a market for the company’s common equity securities
or securities convertible into or exercisable for common equity
securities
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What RFs Are Usually Included in the PPM?
Business risk factors: company and industry RFs – look for sample industry RFs
▫Challenges posed by competition
▫Reliance on current management
▫Effect of general economic conditions
▫Regulatory requirements
▫Seasonality
▫Reliance on a limited number of customers
▫Reliance on a few suppliers
▫Price fluctuations
Risk factors related to investment in the company’s securities
▫ Concentration of stock ownership – lack of ability to
influence key decisions
▫ Risk of dilution from future rounds of financing or
conversion of convertible debt or exercise of
options/warrants
▫ No liquidity
▫ Anti-takeover provisions in the charter or bylaws
Risk factors related to the terms of the offering
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Performing
Due Diligence 5
Presented by
Brett G. Evans Partner, Evans & Kob, PC
657-210-2114
[email protected]
www.eklawpc.com
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What is Due Diligence?
"Due diligence":
Procedures and investigative steps by all of the parties involved,
including counsel and the independent public accountants, to
avoid liability under the complex provisions applicable to
securities offerings.
The conduct of, and procedures utilized by a reasonable
person to confirm or verify the accuracy and completeness of
material statements
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What is Due Diligence?
Why?
❖ Find Material (or Background) Info to Understand and
Complete Offering Documents – Disclosure in PPM
❖ Mitigate Potential Liability under State and Federal
Securities Fraud
❖ Other Reasons: Reputation, E&O, etc.
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What is Due Diligence? Practical
Principal Focus of Due Diligence:
❖ Compensation
❖ Self-dealing
❖ Background of Management (insiders)
❖ Litigation history or potential litigation
❖ Risks (including potential risks faced by the issuer) and accurate discussion of
the nature of the business
❖ Financial Position and prospects
FINRA Regulatory Notice 10-22 –Reasonable Investigation of:
❖ The issuer and its management
❖ The business prospects of the issuer
❖ The assets held by or to be acquired by the issuer
❖ The claims being made, and
❖ The intended use of proceeds of the offering
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Historical, Statutory and Regulatory Background
Public Offerings
❖ Section 11 of the Securities Act (and Section 15)
❖ Section 12 of the Securities Act (and Section 15)
❖ Section 10(b) of the Exchange Act (and Section 20)
Private Offerings
❖ Section 12 of the Securities Act?
❖ Section 10(b) of the Exchange Act (and Section 20)
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Historical, Statutory and Regulatory Background
Reasonableness Standard
❖ Reasonable Investigation and Reasonable Ground for Belief
❖ FINRA Regulatory Notice 10-22
Materiality
❖ Misstatement or omission of material fact
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Historical, Statutory and Regulatory Background: Case Law
Escott v. BarChris Construction Corp. (Section 11)
❖ Severe financial difficulties at closing of public offering of debentures
❖ Underwriter relied heavily on its law firm, which assigned the work to a junior associate
– inadequate review
❖ Failed to Verify Information (minutes, key contracts, lender relationship)
❖ Rejected defense of good faith reliance on counsel
SEC Rule 176 (codified principles)
Feit v. Leasco Data Processing Equip. Corp.
❖ High degree of care in their investigation, and make independent verification of the
company's representations
In re Worldcom, Inc. Securities Litigation
❖ An underwriter conducting a due diligence investigation must look deeper and question
more where confronted by red flags
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Historical, Statutory and Regulatory Background: Case Law
Phillips v. Kidder, Peabody & Co.
❖ Extensive underwriter due diligence included reviewing the issuer's financial
statements, forecasts, budgets, and accounting controls (no scienter)
General Points:
1. Independent investigation of the facts.
2. Non-reliance on management representations. Independent verification.
3. The adequacy of a due diligence investigation has historically been evaluated by
courts based on the particular facts and circumstances, each due diligence
investigation should be tailored to the particular issuer and offering.
4. The presence of and response to "red flags."
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Attorney Liability
❖ Post-Central Bank, Stoneridge and Janus
❖ Document Preparers
❖ Opinion Givers
➢ Tax or other legal opinions
❖ Other Roles
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Due Diligence – General Guidelines: Preparation
Initial Meeting with Issuer
❖ Budget, Scope and Deadlines
❖ Threshold Issues to Complete Offering
Initial Review
❖ Read and Review all Relevant and Available Materials on Issuer
Identification of Parties/Team/Experts
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Investigation Based on Particular Facts and Circumstances
No Standardized Checklist
❖ Sample Checklists may still helpful to craft of list of questions and issues
Mold Inquiry to Specific Offering
❖ Investigation appropriate to circumstances, incl. prior relationship to issuer
❖ “Reasonable Investigation and Reasonable Ground for Belief”
Due Diligence – General Guidelines: Custom Investigation
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Due Diligence – General Guidelines
Outside Auditors = Resource
Integrity of Management
❖ Balance loyalty to client with knowledge that some clients will distort facts
(healthy skepticism)
Hidden Risks
❖ What economic conditions or market forces needed to support business
venture?
❖ Ex: Real estate development pre-1986 Tax Reform Act
Independent Verification (Purpose of DD)
Identify and Follow Up on Red Flags
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Due Diligence – General Guidelines
Identify and Follow Up on Red Flags
❖ Fact dependent that indicates problems underlying material info and financial
statements
❖ Ex: lack of board minutes, records of transactions, certain info can’t be found
Update, Ongoing Process
Kick the tires
❖ Review physical property, not just issuer’s business, management, and financial
statements
Records Retention
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Practical Due Diligence
Flexible process, adapted to observations and initial review
Background Inquiry on the Issuer
❖ Organizational documents, financial statements, product advertising, governmental
filings, business plan, management questionnaires, and litigation
❖ Background and credit check, “Bad Actor”
SEC Filings Review, an Internet search, Lexis Nexis, or Westlaw
Financial Statement Analysis
❖ examination of revenues and expenses
❖ Footnotes as guideposts to areas of inquiry
Private Placement Compliance – Systems and Procedures
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NASD’s (FINRA) Special Report
❖ Nature of the offering
❖ Size of the issuer
❖ Availability of public information about the company
❖ Issuer's operating and business history
❖ Legal structure of the issuer
❖ Type of security being offered
❖ Potential problems relating to particular issuer and industry
❖ Competency of management and inside counsel
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