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© 2018 Financial Industry Regulatory Authority, Inc. All rights reserved. 1 Alternative Investments and Current Issues Monday, May 21 11:15 a.m. 12:15 p.m. This session addresses the role of alternative investments in raising capital and new distribution models. The session emphasizes the importance of understanding product features, characteristics and their supervisory challenges. Moderator: Joseph Price Senior Vice President and Counsel FINRA Corporate Financing / Advertising Regulation Panelists: Gabriela Aguero Director, Public Offerings FINRA Corporate Financing Alan Berkeley Partner K&L Gates Robert McCullough Senior Vice President and Chief Financial Officer EcoVest Capital, Inc.

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Page 1: Alternative Investments and Current Issues Monday, May 21 ... · Alternative Investments and Current Issues Monday, May 21 11:15 a.m. – 12:15 p.m. This session addresses the role

© 2018 Financial Industry Regulatory Authority, Inc. All rights reserved. 1

Alternative Investments and Current Issues Monday, May 21 11:15 a.m. – 12:15 p.m. This session addresses the role of alternative investments in raising capital and new distribution models. The session emphasizes the importance of understanding product features, characteristics and their supervisory challenges. Moderator: Joseph Price Senior Vice President and Counsel FINRA Corporate Financing / Advertising Regulation Panelists: Gabriela Aguero Director, Public Offerings FINRA Corporate Financing Alan Berkeley Partner K&L Gates Robert McCullough Senior Vice President and Chief Financial Officer EcoVest Capital, Inc.

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© 2018 Financial Industry Regulatory Authority, Inc. All rights reserved. 2

Alternative Investments and Current Issues Panelist Bios: Moderator: Joseph E. Price is Senior Vice President, Corporate Financing/Advertising Regulation, at the Financial Industry Regulatory Authority. The FINRA Corporate Financing Department regulates capital-raising activities of broker/dealers; including equity, debt, REIT, closed-end fund, limited partnership offerings and private placements. The FINRA Advertising Regulation Department regulates broker/dealer sales materials, mutual fund advertisements, social media and other communications with the public. Mr. Price previously worked in various capacities at the Securities and Exchange Commission. He was an Assistant General Counsel and a Special Counsel in the Office of General Counsel and he was the Deputy Chief of the Office of Disclosure and Investment Adviser Regulation in the Division of Investment Management. Prior to working at the SEC, he was a litigator in the Bureau of Competition at the Federal Trade Commission. Mr. Price also worked as a Compliance Investigator at the Coffee, Sugar & Cocoa Exchange. He was an Adjunct Professor at Georgetown University Law Center from 1994 to 2002, where he taught “Current Issues in Securities Regulation” and “Disclosure under the Federal Securities Laws.” He graduated with distinction in economics from the University of Wisconsin and received his J.D. from Fordham University. Panelists: Gabriela Aguero is Director in FINRA’s Corporate Financing Department. In her role, she oversees the Public Offering Review (POR) program. The POR group is responsible for the review of a wide array of filings and the interpretation and application of FINRA’s rules that regulate underwriting activities and conflicts of interests in public offerings. Ms. Aguero began her career at FINRA when she joined NASD in 2000. She has an MBA from the John’s Hopkins Carey Business School in addition to an undergraduate degree in Finance as well as designation as a FINRA Certified Regulatory and Compliance Professional™ (CRCP™) Program at Wharton. Alan J. Berkeley is a corporate and securities regulatory lawyer whose practice encompasses corporate, Board and management counseling and crisis response, corporate transactions (including mergers, acquisitions, financing transactions for privately-held and public companies), regulatory and enforcement matters before the Securities and Exchange Commission and other securities regulatory bodies, and other corporate governance and compliance matters. He is a registered foreign lawyer with the Solicitors Regulation Authority in England and Wales and is registered as a foreign legal consultant in Brazil. Mr. Berkeley has more than 40 years of experience as counsel in corporate and business transactions and securities regulatory and enforcement matters. He has extensive professional association and academic activities, including many years as member of the adjunct faculty at Georgetown University and George Washington University law schools specializing in business planning and as a well-recognized speaker on professional and client education programs. Mr. Berkeley has been listed in The Best Lawyers in America in the category of Corporate Law since 2001. He has a J.D. from Georgetown University and B.S. from Cornell University. Robert (Bob) M. McCullough has a Bachelor of Arts from Vanderbilt University and a Masters of Business Administration with a concentration in Accounting from Georgia State University. In January 2014, Mr. McCullough became the Senior Vice President and Chief Financial Officer of EcoVest Capital, Inc. From 2008 to 2014 Mr. McCullough served as the Chief Financial Officer of Wells Real Estate Funds, Inc., a national real estate investment management company that has invested over $12 billion in commercial real estate for more than 300,000 investors in 18 publicly registered and 12 private investment programs. From 2002 to 2008, Mr. McCullough served in various financial and operational roles at Wells Real Estate Funds. Mr. McCullough also served as the Chief Financial Officer and Financial and Operations Principal for Wells Investment Securities, Inc., the wholly-owned broker-dealer subsidiary of Wells Real Estate Funds. From 1998 to 2002 Mr. McCullough worked for Arthur Andersen, LLP in the Atlanta, GA office.

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2018 FINRA Annual ConferenceMay 21 – 23, 2018 • Washington, DC

Alternative Investments and Current

Issues

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FINRA Annual Conference | © 2018 FINRA. All rights reserved.

Moderator

Joseph Price, Senior Vice President and Counsel, FINRA

Corporate Financing / Advertising Regulation

Panelists

Gabriela Aguero, Director, Public Offerings, FINRA Corporate

Financing

Alan Berkeley, Partner, K&L Gates

Robert McCullough, Senior Vice President and Chief Financial

Officer, EcoVest Capital, Inc.

Panelists

1

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© 2018 Financial Industry Regulatory Authority, Inc. All rights reserved. 1

Alternative Investments and Current Issues Monday, May 21 11:15 a.m. – 12:15 p.m. Resources FINRA Notices

FINRA Regulatory Notice 17-17, Updated Private Placement Filer Form, FINRA Updates Private Placement Filer Form Pursuant to FINRA Rules 5122 and 5123 (April 2017)

www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-17.pdf

FINRA Regulatory Notice 16-37, Capital Acquisition Brokers, SEC Approves FINRA’s Capital Acquisition Broker (CAB) Rules (October 2016)

www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-16-37.pdf

FINRA Regulatory Notice 16-08, Contingency Offerings, Private Placements and Public Offerings Subject to a Contingency (February 2016)

www.finra.org/sites/default/files/Regulatory-Notice-16-08.pdf

FINRA Regulatory Notice 15-32, Regulation A Offerings, FINRA Filing Requirements and Review of Regulation A Offerings (September 2015)

www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-15-32.pdf

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Some Observations about Rule 506 Private Placements By Alan J. Berkeley

1. What’s Happened with Rule 506(c)? While crowdfunding hit an anecdotal homerun, the fact is that equity crowdfunding offerings

are burdened by regulatory constraints, such as the requirement for a registered

intermediary, and mandated disclosure and filing obligations, that make compliance (and

success) problematic (and very possibly expensive). Equity crowdfunding (under Regulation

Crowdfunding) has had limited success, primarily through a limited number of broker-dealers

that have established and marketed affiliated portals.

Although Rule 506(c) is real, workable and considerably less burdened by regulatory

uncertainty and allows broad public marketing of equity securities, it has not attracted

crowdfunders, perhaps because only accredited investors are permitted to invest.

Nor has Rule 506(c) found wide acceptance among investment funds and in the established

private offering community, perhaps because of these offerors disdain for public marketing

and comfort with an established and tested process.

In many respects, amended Regulation A has turned out to be the small start-up financing

vehicle promised in the JOBS Act. And, all is well with Rule 506(b).

2. General Solicitation Concerns are Not History. With Rule 506(b) offerings still very much in vogue, the prohibition on general solicitation and

advertising remains very much alive. Only Rule 506(c) allows general solicitation and

advertising. The prohibition of general solicitation and advertising is unchanged for Rule

506(b) offerings. And, there is no change in the concepts, definitions and enforcement

sensitivities as to what may or may not constitute a general solicitation.

3. Other Than the Passage of Time There are no Fixes for a General Solicitation

Arguing “what’s the harm,” issuers (and some lawyers) have long argued that if during the

course of a Rule 506(b) offering there is an isolated general solicitation event, it’s okay to

continue the offerings by circumscribing the tainted offeree pool and rejecting their

participation. For example, suppose a salesperson puts an ad on a local radio show or

newspaper, or makes cold calls to prospective local investors. “What’s the harm” if the

issuer refuses to sell the Rule 506(b) private placement to anyone in the area …and maybe

for a ways beyond? There’s never been SEC comfort for doing so and recent case law

(KCD Financial) supports the position that there is no immediate fix. Better to turn to Rule

502(a) for comfort that waiting six months resolves the matter.

February 2018

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Some Observations about Rule 506 Private Placements

2

There appears to be a resurgence of investment meetings or “seminars” to which people are

cold-called to attend. That violates Rule 502(c) if the offering is under 506(b). Of course, for

a 506(c) offering general solicitation to attend a seminar is permissible, but all actual

investors must be accredited.

4. Rule 506(c) Does Not Dispense with Disclosure Obligations. While there is no mandatory item-specific disclosure obligation in Rule 506(c) offerings, the

reality is that investors invariably expect some sort of explanatory documentation. The

absence of an item-specific Offering Memorandum or Private Placement Memo more typical

in Rule 506(b) offerings does not exempt the issuers and promoters and marketers from

federal and state anti-fraud law. Wisdom and good practice suggest that, at least prior to

closing any Rule 506 offering, issuers should be comfortable that marketing materials,

advertising, oral presentations and road shows, deal summaries, projections and forecasts

and the like provide a fair and balanced view of the investment, consistent with Rule 10b-5

concepts.

5. Accredited Investor Verification May Mean Something More than “Reasonable Basis to Believe.”

Rule 506 has long required issuers to have a reasonable basis to believe that accredited

investors are, indeed, accredited. Although there are surely many ways to reach such a

reasonable belief, industry practice has long been to accept, in the absence of countervailing

evidence, an investor’s signed self-certification ….a questionnaire. Rule 506(c) adds a

gloss that issuers must take reasonable steps to verify that all actual investors (not offerees)

are accredited. That would almost certainly mean that something more is required, and the

SEC added that it must be current; that is, within three months.

Of course, the range of “something more” is extensive. Reviewing tax returns or the like

would surely seem to provide the issuer with verification of accredited investor status. Some

suggest that a letter from a prospective investor’s accountant or lawyer attesting that the

client is an accredited investor is sufficient, but best practice would be to have something

more than a barebones letter that does not explain the basis for the judgment. It likely would

make a difference if it is just some lawyer or accountant, on the one hand, or professional tax

preparer or longtime personal counsel or (registered) investment adviser, on the other.

In addition, a number of services are now offering to “vet” prospective investors and maintain

and update registers of accredited investors, providing both a measure of confidentiality and

efficiency.

Caution is essential if relying on third-party verification. With the short life of verification, the

temptation will be great for “verifiers” simply to ask the prospective investor if anything’s

changed. Although not yet tested, in an instance when “self-certification” is insufficient,

cautious practice would strongly suggest that for Rule 506(c) offerings, short form updates

are likewise inadequate.

The takeaways, at least for cautious Rule 506(c) purposes, are that (1) self-certification is not

sufficient; (2) third party assertions of accredited status without explanation are not sufficient;

and (3) current re-verification is needed.

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Some Observations about Rule 506 Private Placements

3

Moreover, “I’d rather be lucky than good” may not be sufficient if an investor is, in fact,

accredited but the issuer made no attempt at verification. It remains a vexing question

whether in such circumstances a disgruntled accredited investor could successfully assert a

Section 5 violation and get rescission because the issuer made no effort at verification. Time

will tell.

6. Bad Actor Provisions Apply to All Rule 506 Offerings. It has long been thought that only an historical anomaly could explain the absence of Rule

505‘s “bad actor” provision in Rule 506. That anomaly is now consigned to history. In fact,

Rule 506 now houses a far more comprehensive “bad actor” provision than was found in the

deceased Rule 505, and it applies to both Rule 506(b) and Rule 506(c) offerings.

7. Bad Actors Include Virtually Everyone Related to the Issuer and Offering, including 20% Owners.

The two critical pieces of the “bad actor” Rule (Rule 506(d)) are the definitions of “covered

person” and “disqualifying event.” Put simply, an issuer cannot use Rule 506(b) or (c) if a

covered person committed a disqualifying event. So, who’s a “covered person”: anyone

even remotely connected to the issuer (including the issuer itself)1 or to the promotion or

offering process (and that includes sales agents and entities employing the sales agent).

Moreover, a 20% or more shareholder of the issuer is now a covered person irrespective of

any other role in the entity; effectively, 20% ownership is now (at least for these purposes)

treated as an irrebutable presumption of control (as an aside, one has to wonder if this now

expanded concept will become a test for other control determinations).

The definition of “disqualifying event” is pretty straightforward and will surprise few.

Essentially it means a clean record with the SEC, a clean criminal record vis-à-vis securities

matters and a clean record with state securities commissions and the courts with respect to

securities or other finance activities. No real surprises here, but note the inclusion of state

blue sky commission enforcement orders.

8. There’s Another Verification “Requirement”…about Bad Actors. The Presence of Bad Actors May Not Always Destroy the Rule 506 Exemption.

An offering will not lose its Rule 506 exemption when a “bad actor” is included if the issuer

establishes that it did not, and with reasonable care could not, have known that a covered

person was disqualified. Thus, there is a second required verification exercise involving

questionnaires and other mechanisms that will satisfy the need for a factual inquiry and

reasonable care.

In addition, issuers otherwise prohibited from conducting an offering in reliance on Rule 506

by virtue of the “bad actor” rules may still be able to conduct an offering in reliance on Rule

506 if they receive a waiver from the SEC or if they receive a written statement from the

relevant court or regulatory authority stating that disqualification pursuant to the Bad Actor

1 Covered persons include affiliated issuers. In a C&DI, the SEC staff noted that for purposes of Rule 506(d), an “affiliated

issuer” does not mean every affiliate of the issuer that has issued securities. Rather, an “affiliated issuer” for such purposes is an affiliate of the issuer that is issuing securities in the same offering, including offerings subject to integration.

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Some Observations about Rule 506 Private Placements

4

rules should not arise as a consequence of the order, judgment or decree entered by such

court or regulatory authority.

9. There’s No Retroactivity for Bad Actors …Sort Of. In expanding the “bad actor” concept to Rule 506, the SEC was faced with the problem of

whether a past disqualifying event by a covered person would eliminate an issuer’s ability to

rely on Rule 506. Sensibly, the SEC avoided an ex post facto challenge by providing that a

disqualifying event by a covered person before the September 23, 2013 effective date would

not trigger Rule 506 disqualification. BUT in Rule 506(e), the Commission sought to protect

investors from “bad actors” by requiring disclosure of any acts by a covered person that

would be a disqualifying event but for the fact that the acts occurred before the effective date

of Rule 506(d).

10. Nothing’s Changed Yet about Filing Form D. Since the adoption of the Regulation D amendments, changes in the Form D filing

requirements have been to accommodate Rule 506(c). It may not always remain so; the

SEC proposed but has not adopted a scheme to monitor the Rule 506(c) market through

expanded Form D filings that would include descriptive information about how and to whom

the offering was conducted. The SEC has not acted on the Form D proposal and the

proposed “enhancements” do not appear to be a priority.

11. Nothing’s Really Changed about Resale Restrictions on Rule 506 Securities.

Rule 506(b) and (c) are promulgated under Section 4(a)(2) of the Securities Act and, thus,

are issuer registration exemptions. None of this is available to investors for resale of their

securities. And, although Congress added Section 4(a)(7) to the Securities Act codifying

(and then some) so-called Section 4(1 ½) , nothing has really changed for the resale of

securities bought in Rule 506 offerings. Rule 144 and, when appropriate, Section 4(1½) and

now Section 4(a)(7) remain and are the available mechanism in most all instances and are

the first step in any resale analysis.

12. The Definition of Accredited Investor is Up for Grabs. It’s more than 40 years since the SEC fashioned the net worth and current income tests for

determining accredited investors. Much has happened, and the moment is at hand to

reexamine the amounts required to qualify as an accredited investor and whether wealth

should be the sole criterion. Perhaps, instead of a $200,000/$300,000 income test, the

amount should be $500,000/$750,000 and, more radically, perhaps relevant education or

training should substitute for wealth or be required in addition to wealth. These sorts of

proposals (some more radical or novel than others) are being examined by both regulators

and legislators. See the SEC staff’s “Report on the Review of the Definition of “Accredited

Investor,” December 18, 2015.

Other Things to Keep in Mind: • There is no I & I (Rule 507) defense for a non-accredited investor in a 506(c) offering.

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Some Observations about Rule 506 Private Placements

5

• Accredited investor verification is only good for three months.

• A Rule 506(b) offering could be integrated with a previous Rule 506(c) offering requiring a

six month interval.

• Permissible general solicitation for a Rule 506(c) offering could be gun jumping for a

public offering.

• Section 4(a)(2) standing alone (still) is a viable basis for claiming a registration exemption.

• Rule 506 is available to any issuer: public, private, investment company, foreign …except

one with “bad actors.”

• Material non-public information contained in a general solicitation (or in an accredited

investor presentation or memorandum) raises Regulation FD considerations and should

be filed in an 8-K.

• It is possible to lose the Rule 506(c) safe harbor even if all investors are accredited if the

issuer took no steps to verify their accredited investor status and did not have a

reasonable basis to believe they were accredited.

• There is no prohibition on accepting investments from “bad actors.”

• All securities offered under Rule 506 are “covered securities” under NSMIA, but remain

subject to state filing and fee requirements.

• FINRA Rule 5123 requires filing of offering materials or notice (if none) used in Rule 506

offerings through broker-dealers; exemptions for institutions and others but not natural

persons.

• Crowdfunding is not Regulation D; Nor are human-capital (Social Finance) contracts: both

merit discussion in the JOBS Act context.

Authors:

Alan J. Berkeley

[email protected]

+1.202.778.9050

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Some Observations about Rule 506 Private Placements

6

Anchorage Austin Beijing Berlin Boston Brisbane Brussels Charleston Charlotte Chicago Dallas Doha Dubai

Fort Worth Frankfurt Harrisburg Hong Kong Houston London Los Angeles Melbourne Miami Milan Munich Newark New York

Orange County Palo Alto Paris Perth Pittsburgh Portland Raleigh Research Triangle Park San Francisco São Paulo Seattle

Seoul Shanghai Singapore Sydney Taipei Tokyo Warsaw Washington, D.C. Wilmington

K&L Gates comprises approximately 2,000 lawyers globally who practice in fully integrated offices located on five continents. The firm represents leading multinational corporations, growth and middle-market companies, capital markets participants and entrepreneurs in every major industry group as well as public sector entities, educational institutions, philanthropic organizations and individuals. For more information about K&L Gates or its locations, practices and registrations, visit www.klgates.com.

This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.

© 2018 K&L Gates LLP. All Rights Reserved.

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO By Edward Dartley, Anthony R.G. Nolan, Mary Burke Baker, John ReVeal, Amanda M. Katlowitz

Initial Coin Offerings (ICOs) have rapidly emerged as the hottest trend in FinTech financing,

albeit one that is not without controversy. Put simply, an ICO is a method of fundraising

somewhat akin to an initial public offering of securities, except that in an ICO, the fundraiser

uses blockchain technology to issue customized cryptocurrencies (commonly known as

coins or tokens), typically in exchange for other established cryptocurrencies such as Bitcoin

and Ether.1 The proceeds of an ICO can provide kick-start funding to develop the technology

and platforms for the token holder’s access. An ICO that is properly conceived and

structured can provide relatively easy transferability of tokens and the potential for those

tokens to be traded on exchanges or resold and converted to government-issued legal

tender, also known as fiat currency.

The dramatic rise in value of Bitcoin, Ether, and other cryptocurrencies in recent months has

generated great interest in this new form of financing, with new players entering the market

literally every day and raising millions in new financing in very short offering times. At the

same time, ICOs raise a myriad of complex legal issues in the United States and around the

world.

United States regulators and enforcement agencies have recently increased their attention

on this burgeoning market and are trying to determine whether and under what

circumstances offerings of and transactions in cryptocurrency are subject to their rules and

regulations. The regulatory posture of the market for cryptocurrencies has developed quickly

and is likely to continue to evolve as regulators grapple with the important questions about

how to properly categorize the features implicit in each particular token offering. How U.S.

and foreign regulators will eventually come to terms with these issues is difficult to predict.

Among the regulators that have staked claims over the regulation of one or more facets of

token offerings are the Securities and Exchange Commission (the “SEC”), the Commodity

Futures and Exchange Commission (the “CFTC”), the Internal Revenue Service (the “IRS”),

and the Financial Crimes Enforcement Network (“FinCEN”).

In this article, we describe several key considerations for ICO sponsors seeking to navigate

some of the regulatory waters in this rapidly developing space. As described below, we also

discuss how the Simple Agreement for Future Tokens (“SAFT”) may facilitate compliance

with certain legal and regulatory issues in an ICO offering. The SAFT represents an

emerging approach to assisting sponsors to seek to comply with certain securities law, tax

law, and financial services regulatory issues.

26 October 2017

Practice Group(s):

Investment Management, Hedge Funds and Alternative Investments

Banking & Asset Finance

FinTech

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

2

The Securities Laws: Is a Token a Security?

Is a Token a Security? An important threshold question is whether ICO sponsors are offering securities within the

meaning of the U.S. securities laws (specifically, the Securities Act of 1933 (the “Securities

Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). The question is

generally whether the tokens constitute investment contracts under standards established by

the U.S. Supreme Court in SEC v. W.J. Howey Co.2 Under the Howey test, a token is an

investment contract — and accordingly constitutes a security — where there is an

investment of money in a common enterprise with a reasonable expectation of profits to be

derived primarily from the entrepreneurial or managerial efforts of others.

Whether a token is a security depends on the facts and circumstances underlying the ICO,

and in particular the function the token performs. For instance, if the tokens issued in the ICO

can be used solely to purchase existing goods and services from the platform (“utility

tokens”), they may not be an “investment contract” under the consumptive use doctrine

developed by courts and the SEC applying the Howey test. On the other hand, a token that

represents an interest in an enterprise or to-be-formed enterprise will likely be considered to

be a security. The SEC recently addressed the status of one type of digital token under the

U.S. securities laws, confirming that digital tokens issued by a virtual organization known as

“the DAO” were securities.3 Moreover, in recent enforcement actions involving alleged

fraudulent ICO offerings, the SEC alleged that the underlying tokens constituted illegal

offerings of securities for which no registration was filed and as to which no exemption from

registration was available.

The SEC staff in its report on the DAO investigation noted that the question of whether a

token is a security is a facts and circumstances analysis that will differ for each token.

Offering Tokens through Private Placements If tokens are securities, the SEC has made clear that they may only be offered to U.S.

investors in a registered offering or in a transaction that is exempt from registration, such as

through a private placement to accredited investors pursuant to Regulation D under the

Securities Act or an unregistered offering under Securities Act Regulation A+. Tokens that

are securities and offered publicly will need to be offered and sold pursuant to a registration

statement that is filed with the SEC. Because a registered offering involves significant

regulatory hurdles and is costly, among other things, ICO sponsors have generally

conducted their offerings under the private placement regime.

Once the decision has been made to do a private offering, the sponsor needs to decide

whether to conduct the ICO as a traditional private placement, which prohibits the use of

general solicitations and advertising, in compliance with Rule 506(b) of Regulation D, or

alternatively under the relatively new Rule 506(c), which permits the use of general

solicitations and advertising, but requires private placement sponsor to take heightened

steps to ensure that the investors are eligible to participate in the offering. Regardless of the

private offering method selected, a sponsor will also need to consider how the limitation on

the transferability of tokens may impact the ability of the token to be resold in a secondary

market and what impact this may have on prospective investors’ decisions to purchase

tokens in an ICO.

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

3

An ICO could also fall within the SEC’s crowdfunding regulation (“Regulation Crowdfunding”)

if issued by a U.S. person, although the ICO would be limited in other significant respects,

including limitations on the offering amount per 12-month period, the size of the investment

per individual investor, and restrictions on the resale of tokens. As a practical matter,

Regulation Crowdfunding may be unavailable because most ICO issuers are organized

outside the United States and because securities offered under Regulation Crowdfunding

must be offered and sold through funding portals and broker-dealers that are registered

under the Exchange Act.

Private placements are a very common conduit for fundraising, and once the ICO sponsor

makes the determination that the token is a security, an ICO private placement would in

large part proceed as any other such offering. Rule 506’s relaxation on the ban on solicitation

is an attractive alternative for some sponsors, given heightened sponsor interest in being

visible in this rapidly evolving space. As discussed below, the SAFT may mitigate uncertainty

in the application of certain securities laws issues in the case of certain ICOs.

Is the ICO Sponsor an Investment Adviser? Sponsors of ICOs also need to consider whether they are offering investment advice such

that they would be subject to SEC registration requirements applicable to investment

advisers. The Investment Advisers Act of 1940, as amended (the “Advisers Act”), applies to

any person who, for compensation, engages in the business of advising others as to the

value of securities or the advisability of investing in, selling, or purchasing them. Depending

on the structure of a token offering, Advisers Act considerations may be applicable if a token

is a security. The Advisers Act may apply to the sponsor of an ICO if the tokens are a

security and if the platform’s business involves the acquisition of securities, including digital

tokens that are investment contracts. A particularly important consideration for an investment

adviser relates to how such an adviser can comply with the SEC’s custody rule. For instance,

how can a password for a token be stored for purposes of the custody rule? Notably, a

sponsor may be an investment adviser but could be exempt from registration as an Exempt

Reporting Adviser (an “ERA”). An ERA will still remain subject to certain regulations under

the Advisers Act.

Tradability and Intermediaries Often, one of the features desired by ICO sponsors and their potential investors is the ability

to trade the offered tokens after they have been acquired in the ICO. At bottom, there is a

regulatory trade-off in seeking tradability of tokens, and sponsors that want to offer this

feature need to address the added regulatory requirements that arise under U.S. securities

laws and commodity futures laws.

Commodity Exchange Act Considerations Providing for secondary market trading and liquidity for tokens issued in an ICO requires a

consideration of whether the token is a “commodity” under the U.S. commodity laws. A

commodity is typically defined as a reasonably interchangeable good or material, bought and

sold freely as an article of commerce, which includes all services, rights, and interests in

which contracts for future delivery are traded presently or in the future. The CFTC has taken

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

4

the view that Bitcoin and other primary digital currencies are “exempt commodities.” As such,

they are subject to regulation by the CFTC under the Commodity Exchange Act.

If a platform offers a transaction in cryptocurrencies that are considered to be commodities

and the transaction is margined, leveraged, or financed, it needs to “deliver” the relevant

cryptocurrency to the buyer within 28 days or it must register with the CFTC as a futures

commission merchant. The chairman of the CFTC recently announced that the CFTC is

working to provide a suitable definition of “actual delivery” for a virtual commodity. In

addition, sponsors of ICOs that may involve trading in cryptocurrencies that are considered

to be commodities or other commodity interests may be required to register with the CFTC

as commodity pool operators or commodity trading advisors.

Are Intermediaries Securities Exchanges or Broker-Dealers? The Exchange Act regulates securities exchanges and broker-dealers. If a token is a

security, exchanges on which it is traded would have to be registered under the Exchange

Act and intermediaries would have to be registered as broker-dealers under the Exchange

Act or as registered investment advisers under the Advisers Act. Because most — if not all

— cryptocurrency exchanges are not so registered, the exchanges will accept tokens for

unrestricted trading only if they believe the tokens are not securities. As discussed above,

the Exchange Act would also apply to intermediaries and funding portals used in primary

offerings under Regulation Crowdfunding.

Depending on facts and circumstances, an issuance of tokens that are considered securities

may implicate the Investment Company Act of 1940, which, generally speaking, applies to

issuers of securities that invest in securities. A platform that invests proceeds of an ICO in

investment securities pending build-out may inadvertently be an investment company.

Tax Considerations The IRS characterizes digital currencies as “property” rather than as currencies. This means

that the proceeds of an ICO are taxable income to the entity selling the tokens. This might be

mitigated to some extent if the Cryptocurrency Tax Fairness Act of 2017 (the “Act”) becomes

law. This bill, which is currently pending in the U.S. House of Representatives, would exclude

from gross income up to $600 in gains on certain cryptocurrency sale and exchange

transactions while creating a reporting regime for cryptocurrency transactions. However,

sales or exchanges of virtual currency for cash or cash equivalents would not qualify for the

exclusion, so the form of the proceeds of an ICO would affect the taxable gain. Further, since

the Act is intended to facilitate common usage of cryptocurrency, it is unclear whether ICO

transactions would be within its purview. Buyers of tokens also could realize taxable gains if

digital currencies are used to make purchases. Tokens may also be considered interests in

partnerships or unincorporated associations, giving rise to various tax considerations. The

burden of U.S. tax laws could be one reason why token issuers tend to be established in

jurisdictions outside the United States.

Bank Secrecy Act Considerations The ICO market has recently come under criticism from prominent figures within the financial

services industry because of its potential to facilitate money laundering, terrorist financing,

and other criminal activities. Participants in an ICO in the United States or targeted at U.S.

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

5

persons should be sensitive to the U.S. Bank Secrecy Act and its related regulations

(collectively, the “BSA”).

The BSA generally requires entities meeting the definition of “financial institution” to maintain

and develop appropriate programs to assist the U.S. government in detecting and preventing

criminal activities. A “financial institution” under the BSA includes not only banking

institutions, SEC-registered broker-dealers, and CFTC-registered futures commission

merchants, but also includes money transmission businesses. In certain cases, ICO

sponsors and other companies engaged in activities relating to virtual currencies could be

subject to BSA regulation as money transmitters.

General BSA and Anti-Money Laundering Obligations Each financial institution subject to the BSA must maintain a written anti-money laundering

(“AML”) program that is reasonably designed to prevent the business from being used to

facilitate money laundering and the financing of terrorist activities. The AML program must be

commensurate with the risks posed by the location and size of the business and the nature

and volume of its financial services. The program must include policies, procedures, and

internal controls designed to achieve ongoing compliance with applicable BSA requirements,

designation of one or more compliance officers, ongoing training of appropriate personnel,

and independent monitoring. The requirement to verify customer identities creates a tension

in an industry where the purchase of tokens typically involves anonymous or pseudonymous

transactions.

Money Transmitter Licensing Considerations Token sale participants may be money transmitters because the BSA regulations define

“money transmission services” as the acceptance of currency, funds, or other value that

substitutes for currency from one person and the transmission of the currency, funds, or

other value to another location or person by any means. While FinCEN has provided

interpretive guidance and administrative rulings, the issues surrounding whether the activities

of an ICO sponsor might subject it to federal or state regulation are beyond the ambit of this

article. As a general matter, an ICO sponsor in a decentralized virtual currency such as

Bitcoin generally would not be subject to federal regulation as a money transmission

business, but an ICO sponsor running a centralized platform where the sponsor has the

ability to redeem tokens or accept and transmit the virtual currency on behalf of others may

be subject to these regulations. A SAFT may represent a way to help address certain

regulatory issues, including money transmitter licensing concerns.

The SAFT The SAFT is emerging as a device that may address some of the regulatory uncertainties in

ICOs of utility tokens where the utility does not exist on the date of the ICO.

The SAFT is intended to be an investment contract (i.e., a security as defined under the

Securities Act) that provides investors with the right to obtain delivery of digital fully functional

utility tokens once the platform or network is created and the tokens can be used to obtain

goods or services on the platform. The SAFT is modeled on the Y Combinator SAFE notes,

which are widely used to finance early-stage venture companies, with the difference being

that the holder is entitled to receive tokens instead of equity.4

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

6

The SAFT is a framework that seeks to navigate certain of the securities law and money

transmitter regulatory issues discussed above and to enhance the flexibility for issuers and

investors to manage tax liabilities.

With respect to securities law compliance, the SAFT framework is designed to permit an

issuer to comply with the federal securities laws in an exempt offering while having those

requirements (and any concern about underwriter liability) fall away when the SAFT is

redeemed for a utility token (i.e., a token that is not a security). From the perspective of

money transmitter laws, the SAFT is arguably one step removed from a “convertible virtual

currency” and may also reduce the possibility that the issuer or the investors will be

considered to be an exchanger or that the issuer may be considered an administrator. From

a tax perspective, the SAFT is generally intended to be taxed as a forward contract, which

may mitigate — but does not eliminate — tax inefficiencies in token transactions. If that

characterization is upheld, the first taxable event in the ICO would occur only when the

tokens are delivered to the investors upon redemption of the SAFT.

It is important to be mindful that the SAFT has not been endorsed by the SEC, the IRS, or

FinCEN and has not been the subject of any judicial decisions. However, it may be regarded

as representing an emerging consensus on a responsible approach to addressing certain

regulatory issues posed by ICOs.

The Weiji Forward 危机 Notwithstanding the various legal and regulatory considerations, the wave of enthusiasm for

ICOs shows no signs of abating. The Etherium blockchain has rapidly accelerated the

potential of distributed ledger technology by making possible the practical use of smart

contracts to convert Bitcoin (as well as Ether and other cryptocurrencies) into a wide range of

tokens that can represent an astonishing array of decentralized applications providing real

and virtual goods and services. This creates a fascinating tension between the way in which

markets are evolving through new technology and the requirements of regulatory schemes

that were created in a vastly different technological world. The rapid evolution of technology

that has made ICOs possible is matched by a rapid evolution of the views of regulators and

of how to regulate this new market. This will create opportunities for entrepreneurs but also

creates a unique regulatory risk profile for market participants considering participating in

ICOs or other cryptocurrency transactions.

Authors:

Edward Dartley

[email protected]

+1.212.536.4874

Anthony R.G. Nolan

[email protected]

+1.212.536.4843

Mary Burke Baker

[email protected]

+1.202.778.9223

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Initial Coin Offerings: Key Considerations You Absolutely, Positively Need to Know About Before Launching an ICO

7

John ReVeal

[email protected]

+1.202.448.9055

Amanda M. Katlowitz

[email protected]

+1.212.536.3970

K&L Gates is a fully integrated global law firm with lawyers located across five continents. The firm represents leading multinational corporations, growth and middle-market companies, capital markets participants and entrepreneurs in every major industry group as well as public sector entities, educational institutions, philanthropic organizations and individuals. For more information about K&L Gates or its locations, practices and registrations, visit www.klgates.com.

This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.

©2018 K&L Gates LLP. All Rights Reserved.

1 Cryptocurrency refers to decentralized digital assets that use cryptography as a means of securing

transactions independent of clearinghouses while preserving anonymity in the traditional sense. Cryptocurrency typically takes the form of digital coins or tokens that exist on the Ethereum blockchain or distributed ledger, whereby owners receive a key that serves as the password to ownership of the coin or token. 2 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852–53 (1975).

Other standards may apply to the characterization of a token under the Securities Act depending on the characteristics of the token. See, e.g., Reves v. Ernst & Young, 494 U.S. 56 (1990). 3 Report of Investigation Pursuant to Section 21 of the Securities Act. Report linked here.

4 For more information about the SAFT, see the white paper developed by the SAFT Project,

http://saftproject.com/static/SAFT-Project-Whitepaper.pdf.

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Portfolio Media. Inc. | 111 West 19th Street, 5th Floor | New York, NY 10011 | www.law360.com Phone: +1 646 783 7100 | Fax: +1 646 783 7161 | [email protected]

How Tax Authorities Are Responding To Cryptocurrency

By Mark Rush, Claiborne Porter, Joseph Valenti and Simone DeJarnett (May 2, 2018, 1:39 PM EDT)

The features that make cryptocurrencies attractive to their users — relative anonymity and mobility — have created heightened concerns with regulatory agencies in the United States and abroad. Recent enforcement actions highlight a growing focus by regulatory agencies on cryptocurrency businesses and an increased number of enforcement actions and prosecutions. In addition, there are reasons to expect that the scope and character of the violations alleged as part of these government actions may increase. While the vast majority of cryptocurrency-related enforcement actions have been related to anti-money-laundering and securities violations, both American and non-U.S. authorities have signaled that they are deeply concerned about the tax implications of greater adoption of cryptocurrencies without greater accountability procedures and transparency. The IRS’ first foray into cryptocurrency came on March 25, 2014, when the IRS issued guidance explaining that it will treat cryptocurrency as property. In February 2018, the IRS Criminal Investigation Division announced that it formed a new team to focus on international crimes, in particular undeclared cryptocurrency income and assets. When asked about the creation of the new team, the chief of the IRS Criminal Investigation Division stated, “It’s possible to use bitcoin and other cryptocurrencies in the same fashion as foreign bank accounts to facilitate tax evasion.”[1] This statement follows a federal court order, requiring Coinbase — one of the largest virtual-wallet providers in the world — to provide data on thousands of customers to the IRS. In November 2016, the IRS served a “John Doe” summons on Coinbase for all U.S. customers who transferred bitcoin between 2013 and 2015. The IRS stated the subpoena was needed to understand the full scope of previously identified tax noncompliance and underreporting among Coinbase’s customers. Late last year, after a court battle, a California federal court narrowed the scope of the subpoena to all users who have bought, sold, sent or received more than $20,000 through their accounts in a single year and ordered Coinbase to provide the IRS with identifying data on the covered accounts.[2] In the end, Coinbase produced data on 8.9 million transactions and approximately 14,000 customers.[3] The United States is not the only country to be concerned about how the anonymity and mobility of cryptocurrencies will affect the tax rolls. In January 2018, tax authorities in South Korea — the world’s third-largest cryptocurrency market — raided the country’s largest cryptocurrency exchanges due to alleged tax evasion.[4] Announcements by

Mark Rush

Claiborne Porter

Joseph Valenti

Simone DeJarnett

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central banking authorities in Europe suggest that they too are concerned with the potential for tax evasion. For example, in February, the finance ministers and central bank leaders of France and Germany wrote a joint letter to the G-20 calling for greater regulation of cryptocurrencies.[5] The two countries expressed worry that cryptocurrencies “can be vulnerable to financial crime without proper appropriate measures” and called for “transboundary” action to regulate the currencies.[6] Given the recent enforcement actions by the U.S. Securities and Exchange Commission, the Financial Crimes Enforcement Network, the U.S. Commodity Futures Trading Commission, and the U.S. Department of Justice, actors who are offering — or plan to offer — accounts, trading and other services to holders of cryptocurrencies should take necessary precautions to ensure that they are complying with applicable U.S. federal income and foreign tax regulations. To better understand the precautions, we will first discuss the background of cryptocurrencies. The remainder of this article will:

• Outline U.S. federal income tax regulations on cryptocurrencies; • Discuss a series of best practices based on the Swiss Bank Program, which addressed similar

accountability and transparency concerns; and • Briefly discuss cryptocurrency trends abroad.

Background on Cryptocurrency Bitcoin and other cryptocurrencies are decentralized digital currencies. Unlike government-issued fiat currency, cryptocurrency systems lack a central bank and all transactions take place between users — peer to peer. Transactions are recorded on a blockchain, a shared distributed ledger.[7] A blockchain is what ensures that each digital coin is spent only once, allowing cryptocurrency to exist without a central authority. Bitcoin — the first and most valuable cryptocurrency — became available in 2009. There are now over 20 cryptocurrencies with a market capitalization of over $1 billion.[8] Bitcoin is the largest, followed by ethereum and ripple.[9] Users conduct cryptocurrency transactions through a virtual wallet. The wallets store the cryptocurrency and facilitate transactions between parties. Wallets can be hardware-based or software-based, software wallets can be hosted on the cloud, personal computers or mobile devices.[10] There are also cryptocurrency exchanges (such as Coinbase) that permit a person to buy and sell cryptocurrency like a government-issued fiat currency. While bitcoin and its successors were little accepted when they first became available, they have rapidly grown in acceptability. Today, a wide range of businesses accept bitcoin and the other popular cryptocurrencies as payment, including a large software company, public universities and some accounting firms.[11] However, the acceptance of cryptocurrencies is not universal— for example, at least one large U.S.-based bank does not allow its customers to pay for cryptocurrency with funds in its accounts.[12] Also, the recent sharp spike and subsequent fall in the value of bitcoin and other cryptocurrencies prompted some vendors to pull out of the market. A U.K.-based multinational bank and a U.S.-based financial-services corporation blocked their credit card customers from using their cards at cryptocurrency exchanges.[13] Still, interest in cryptocurrencies remains high. Businesses wishing to provide services to users of cryptocurrencies should take proper precautions to ensure that they are not running afoul of relevant

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U.S. federal income tax regulations. U.S. Federal Income Tax Compliance and Cryptocurrency Guidance from the IRS that was published in 2014 clearly states that receiving or transacting in cryptocurrencies is potentially taxable.[14] Essentially, under current U.S. law, cryptocurrency is treated like property, not currency, and the general tax rules applicable to property transactions also apply to cryptocurrency transactions. If taxpayers receive cryptocurrency in exchange for the performance of services, they must include the fair market value of that currency as compensation when computing their gross incomes.[15] If taxpayers use cryptocurrency to purchase goods or services, they are treated as engaging in two separate transactions: (1) the sale of property (cryptocurrency) and (2) using the proceeds of the sale to purchase new goods or property. If taxpayers buy a cryptocurrency at a low price and then sell it at a high price, the difference is generally taxable as capital gain.[16] In early 2018, the IRS announced the creation of a new investigation team that will focus on international crimes, including ones involving cryptocurrency. In particular, the division will focus on tax evasion and unlicensed cryptocurrency exchanges.[17] The creation of this new team signals that the IRS’ interest in cryptocurrencies goes well beyond the proper valuation of such currencies. The IRS fears that widespread tax noncompliance may exist among cryptocurrency users — and these fears are echoed in other countries with large cryptocurrency markets.[18] Indeed, the U.S. secretary of the Treasury recently stated that — without proper regulation — bitcoin could become the next “Swiss numbered bank accounts.”[19] Thus, lessons from the IRS’ Swiss Bank Program that was used to mitigate problems in those accounts may provide guidance to actors in this space. Swiss Bank Program Swiss privacy laws, like cryptocurrency, provide a great deal of anonymity to persons' or entities' relative banking transactions, often allowing account holders to evade U.S. federal income obligations — sometimes with the knowledge or assistance of Swiss banks. The DOJ Tax Division announced the Swiss Bank Program in August 2013. Before the announcement of the program, the IRS and the Tax Division had serious concerns that individuals were evading U.S. federal income taxes and reporting requirements through the use of Swiss bank accounts. The purpose of the program was to create a path for Swiss banks to provide information on the suspect accounts and to reform their practices. In exchange for the banks’ cooperation and often a substantial monetary fine, the Tax Division agreed to not prosecute the banks for tax- or monetary-related offenses.[20] Seventy-eight nonprosecution agreements were made under the program in 2015 and 2016.[21] Lessons From the Swiss Bank Program Looking at the NPAs created as a result of the Swiss Bank Program provides a list of best practices for financial services providers in the cryptocurrency space. Providers should appropriately identify and evaluate persons looking to open accounts/wallets or to engage in other cryptocurrency transactions, assess potential risks associated with the customer or transaction, and make appropriate changes to policies following announcements or enforcement actions by the IRS or other regulators. Notably, the recently announced IRS team is focused on international crimes; thus, these practices can apply to any actor who wishes to offer cryptocurrency services to U.S. citizens or others who are obligated to pay taxes in the U.S. — not just those based in the U.S.[22]

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First, offerors or providers of cryptocurrency services should create policies that will mitigate the risk of facilitating tax evasion. They should ban transactions that could conceal the identity of a client, such as cryptocurrency tumblers or transaction mixing, which combine several accounts/transactions together to obscure the original source and/or eventual destination of the funds. Similarly, cryptocurrency exchanges and wallet providers (“financial services providers”) should hold accounts/wallets only under the U.S. person’s real name — not under nominal structures/trusts or under numbers only. The know-your-customer, or KYC, program should identify the beneficial owners of any cryptocurrency on deposit or being transferred. Employees should be trained to obtain complete identification on an account holder, including the holder’s name and country of citizenship. When opening accounts/wallets, the financial services provider should also conduct a proper risk assessment to ensure that the financial services provider does not open a cryptocurrency account for someone looking to evade U.S. federal income obligations or seeking to engage in other criminal activity. An initial evaluation should consider whether the person appears to be trying to avoid declaring income to the IRS. For example, the KYC program should ask if the person is moving from a provider that recently instituted changes to its privacy and reporting requirements.[23] The institution should identify the origin of the money used to fund the account or cryptocurrency transaction. Finally, the financial institution should set appropriate limits to trigger additional reviews. In setting these limits, the institution may borrow limits from its existing anti-money laundering/Bank Secrecy Act programs. The institution may also coordinate limits and policies addressing cryptocurrencies with anti-corruption, prudential-regulation compliance, and even business risk management programs. Finally, enforcement actions can provide guidance. For example, the IRS’ action against Coinbase may provide a useful benchmark; accounts over $20,000 were subject to the reporting order. Relatedly, cryptocurrency services providers, should keep abreast of enforcement actions and statements by regulators in this space. Several of the Swiss banks were penalized for failing to modify their account practices after the IRS announced its enforcement actions against UBS AG (the first Swiss Bank enforcement action).[24] On the other hand, banks that took steps to improve their practices following the UBS deferred prosecution agreement received a substantial credit for those improvements.[25] Thus, for virtual-wallet providers, the recent decision from the district court ordering Coinbase to provide certain customer data to the IRS may spur an evaluation of policies and practices regarding the collection and reporting of identifying account information. Finally, all employees who handle cryptocurrency accounts should receive appropriate training. This training should include recognizing potential tax evasion, U.S. federal income requirements for cryptocurrencies, and appropriate methods of gathering customer identification information. Existing AML/BSA training should be updated to emphasize that these rules also apply to cryptocurrency.[26] Beyond the United States The United States is not the only country grappling with how best to respond to the growing use of cryptocurrencies. Other countries with large amounts of cryptocurrency transactions have signaled that they too are concerned about potential tax evasion. For example, South Korea recently increased enforcement targeting cryptocurrency exchanges. Tax authorities raided the country’s largest exchanges over concerns of potential tax evasion. Following the raids in January 2018, South Korea also issued new regulations creating greater government oversight, banning anonymous transactions, and announcing continual monitoring of cryptocurrency exchanges.[27] Specifically, parties are only allowed to trade in cryptocurrencies using accounts under

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their real names. Authorities also reminded financial services providers that KYC and AML rules apply to cryptocurrency transactions.[28] The G-20 also addressed the issue of cryptocurrency regulations at its summit in March of this year.[29] The G-20 tasked the Financial Action Task Force, the Organization for Economic Cooperation and Development, and the central bank presidents with developing a series of regulatory recommendations by July 2018. The exact contours of these recommendations are not yet known, but they are expected to focus on the proper taxation of cryptocurrencies and crime prevention, including terrorism financing, money laundering and fraudulent initial coin offerings.[30] Furthermore, like the current stance of the IRS, the G-20 sees cryptocurrencies as property, referring to them as “crypto-assets” rather than a currency.[31] Similarly, the European Union is discussing cryptocurrency regulations. These discussions are only high-level framework talks at this time, but they do include consideration of the need for stricter regulations. France ordered its central bank to design regulations against tax evasion and terrorist funding with cryptocurrencies. Additionally, Germany and France continue to push for the adoption of international regulations of cryptocurrencies.[32] Regulators in the United Kingdom have taken similar positions.[33] Conclusion Regulators and taxing authorities are worried about the greater adoption of cryptocurrencies. They are working to develop new regulations and guidance for financial services providers and account holders. In the absence of cryptocurrency-specific regulations, the U.S. Swiss Bank Program provides useful guidance for financial services providers that wish to offer services to cryptocurrency holders. Providers of financial services to cryptocurrency holders should take steps to ensure that they are not enabling tax evasion. These steps may include ensuring that their clients are fully and accurately identified, developing a policy to identify risky accounts, and fully educating all employees who handle U.S. accounts on the applicable U.S. tax laws and regulations. Given the changing landscape regarding these issues, actors should keep abreast of announcements by U.S. (and applicable foreign) regulators and modify their compliance practices as necessary.

Mark A. Rush is a partner in the Pittsburgh and Washington, D.C., offices of K&L Gates LLP. Claiborne “Clay” Porter is the head of investigations and a managing director in the global investigations and compliance practice at Navigant Consulting Inc. Prior to joining Navigant, he was the acting principal deputy chief of the DOJ’s Money Laundering and Asset Recovery Section. Joseph A. Valenti is a partner and Simone N. DeJarnett is an associate in K&L Gates' Pittsburgh office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] https://www.bloomberg.com/news/articles/2018-02-08/irs-cops-scouring-crypto-accounts-to-build-tax-evasion-cases [2] https://www.forbes.com/sites/kellyphillipserb/2017/11/29/irs-nabs-big-win-over-coinbase-in-bid-for-Bitcoin-customer-data/#6db31061259a

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[3] Id. [4] https://www.cnbc.com/2018/01/10/police-tax-authorities-raid-south-korea-cryptocurrency-exchanges-for-tax-evasion.html [5] https://www.telegraph.co.uk/technology/2018/02/09/france-germany-demand-bitcoin-clampdown/ [6] https://www.reuters.com/article/us-germany-france-g20-crypto/france-germany-call-for-joint-g20-action-on-cryptocurrencies-idusKBN1FT176?il=0 [7] http://www.finra.org/investors/Bitcoin-basics-9-things-you-should-know-about-digital-currency [8] https://coinmarketcap.com [9] Id. [10] https://blockgeeks.com/guides/what-is-Bitcoin/ [11] https://www.coindesk.com/information/what-can-you-buy-with-Bitcoins/ [12] https://www.bitsonline.com/banks-cryptocurrency-ban/ [13] https://www.cnbc.com/2018/01/17/visa-will-not-process-Bitcoin-transactions-says-ceo-alfred-kelly.html; Martin Arnold, “Banks divided on cryptocurrencies card purchases, Financial Times (2/5/2018) https://www.ft.com/content/73042a64-0a79-11e8-839d-41ca06376bf2 [14] Notice 2014-21, 2014-16 IRB 938. [15] https://www.irs.gov/newsroom/irs-virtual-currency-guidance [16] Id. [17] https://www.bloomberg.com/news/articles/2018-02-08/irs-cops-scouring-crypto-accounts-to-build-tax-evasion-cases [18] See Id. [19] Richard Holden and Anup Malani, Why the IRS Fears Bitcoin, Jan 22, 2108, NY Times, https://www.nytimes.com/2018/01/22/opinion/irs-bitcoin-fear.html; https://www.cnbc.com/2018/01/12/mnuchin-wants-to-make-sure-bad-guys-cant-use-cryptocurrencies.html (interview with S. Mnuchin) regarding cryptocurrency. [20] Joint Statement between the us Department of Justice and the Swiss Federal Department of Finance, available at https://www.justice.gov/tax/file/631356/download [21] https://www.justice.gov/tax/swiss-bank-program [22] https://www.bloomberg.com/news/articles/2018-02-08/irs-cops-scouring-crypto-accounts-to-

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build-tax-evasion-cases [23] Nonprosecution Agreement entered into by Bank Sparhafen-Zurich AG and the us DOJ, Tax Division, available at https://www.justice.gov/opa/file/479601/download. The NPA noted that Bank Sparhafen opened several accounts for U.S. persons after those individuals were required to close their accounts at Swiss banks that recently announced stricter reporting requirements for U.S. customers. [24] Id. [25] Nonprosecution agreement entered into by Bank LaRoche Co. G and the us DOJ, Tax Division, available https://www.justice.gov/opa/pr/bank-la-roche-co-ag-reaches-resolution-under-justice-departments-swiss-bank-program [26] FinCEN, Application of FinCEN’s Regulations to Persons Administering Exchanging, or Using Virtual Currencies, FIN-2013-G001. https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf [27] https://www.engadget.com/2017/12/28/south-korea-cryptocurrency-regulations/ [28] https://www.cnbc.com/2018/01/29/south-korea-cryptocurrency-regulations-come-into-effect.html [29] https://www.ccn.com/g20-an-sumary-with-10-topics/ [30] https://www.ccn.com/g20-an-sumary-with-10-topics/ [31] http://www.g20.utoronto.ca/2018/2018-03-30-g20_finance_annex-en.html [32] https://cointelegraph.com/news/g20-and-cryptocurrencies-baby-steps-towards-regulatory-recommendations [33] http://www.businessinsider.com/anti-money-laundering-cryptocurrencies-regulation-eu-uk-identity-2017-12; https://www.theguardian.com/technology/2017/dec/04/bitcoin-uk-eu-plan-cryptocurrency-price-traders-anonymity

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Use of "Finders" to Locate Purchasers in Private Placements and Targets or Acquirers in Private M&A Transactions By Alan J. Berkeley1

Below are a range of typical questions or situations and responses to them that arise in the

context of the use of finders in private placements of securities and acquisitions or

dispositions of entire businesses. These questions and responses are intended for general

educational purposes only; specific factual situations should be addressed individually.

1. What is a "finder"? A finder is generally understood to be a person, be it a company, service or individual, who

identifies investors for a financing transaction or potential targets for a business combination.

At least in theory, a finder limits its activity to avoid being required to register as a broker-

dealer under state and federal securities laws. Finders typically receive a fee for identifying

or introducing the parties, often consulting regarding transaction structure, and generally step

away from the transaction after such preliminaries. The term “finder” is typically used in

contrast to the terms “broker” and “dealer,” the latter two being required to register with the

SEC under the Securities Exchange Act of 1934 (“Exchange Act”). Securities issuers

should use unregistered finders with caution, and when conducting any borderline activities,

should give strong deference to employing only registered broker-dealers. It is not unusual

for lawyers, accountants, and consultants who provide professional services also to serve as

finders; however, their professional status does not insulate them from triggering the broker-

dealer registration requirements.

2. What federal securities laws restrict the use of unregistered finders? Section 15 of the Exchange Act restricts any “broker” or “dealer” from using mail or any

means or instrumentality of interstate commerce to effect transactions in, or to induce or

attempt to induce the purchase or sale of, any security unless such broker or dealer is

registered under the Exchange Act. The term “broker” is defined as any person engaged in

the business of effecting transactions in securities for the account of others, and “dealer”

means any person engaged in the business of buying and selling securities for such person’s

own account through a broker or otherwise.

1 Revised and updated by Frank J. Mazzucco, Associate at K&L Gates LLP.

February 2018

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3. What general types of activities or functions may require a person to register as a broker or dealer, as opposed to operating as an unregistered finder?

A combination of statutes, case law and a series of SEC no-action letters have identified

certain behaviors that may cause a person to be deemed a “broker” or “dealer” or to have

engaged in activities constituting inducement of the purchase or sale of a security, thereby

requiring such person to register. For example, the SEC staff has issued guidance stating

that persons engaged in the following activities or functions may need to register as a

“broker”:2

• Locating investors or customers for, making referrals to, or splitting commissions with

registered broker-dealers, investment companies, or other securities intermediaries;

locating investment banking clients for registered broker-dealers; or engaging in or finding

investors for venture capital or angel financings, including private placements;

• Serving as investment advisers and financial consultants;

• Operating or controlling certain electronic or other platforms to trade securities;

• Marketing real-estate investment interests that are securities;

• Acting as placement agents for private placements of securities;

• Marketing or effecting transactions in insurance or other investment products that are

securities;

• Effecting securities transactions for the account of others for a fee, even when those other

people are friends or family members; or

• Providing support services to registered broker-dealers.

Similarly, the SEC staff has taken the position that persons engaged in the following

activities or functions may need to register as a “dealer”:

• Advertising publicly that a firm makes a market in securities;

• Holding oneself out as being willing to buy and sell a particular security on a continuous

basis;

• Running a matched book of repurchase agreements; or

• Issuing or originating securities that such person also buys and sells.

4. Is a business broker or investment advisor that assists with the purchase or sale of an entire business subject to Section 15 of the Exchange Act?

Yes, subject to limitations. The U.S. Supreme Court has held that, when structured as a

stock transaction, purchases or sales of entire businesses are subject to the federal

securities laws. See Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985). In subsequent

2 See “Guide to Broker-Dealer Registration,” Division of Trading and Markets, U.S. Securities and Exchange Commission

(April 2008).

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no-action letters, the SEC has stated that unregistered “finders” that advise on entire

business transactions must limit the scope of their engagement, including a prohibition on

advising on the structure of the deal. See International Business Exchange Corp., SEC No-

Action Letter (Dec. 12, 1986); Country Business, Inc., SEC No-Action Letter (Nov. 8, 2006).

However, in January 2014, the SEC issued a no-action letter granting conditional relief to so-

called “M&A Brokers” that engage in the business of effecting securities transactions solely

in connection with the transfer of ownership and control of a privately-held company. See

M&A Brokers, SEC No-Action Letter (Jan. 31, 2014). The no-action relief is conditioned on

ten enumerated factors3 and does not apply to transactions involving publicly traded targets.

Nevertheless, this guidance marks a significant reversal in the SEC’s historical trend of

limiting the activities permitted by an unregistered finder.

5. May an issuer engage an agent to locate potential investors for a private placement?

Yes. Rule 502(c) contemplates that an issuer may enlist a person or persons to act on the

issuer's behalf to offer or sell securities in the course of a private placement. Suffice that an

agent cannot engage in conduct in the course of its services that would be improper if done

by the issuer. For example, in a Rule 506(b) offering, neither the issuer nor its agent (e.g., an unregistered finder) can engage in general solicitation.

6. How can an issuer locate a finder? General solicitation and general advertising is prohibited in connection with a private

placement under Rule 506(b). Correspondingly, it appears that a firm cannot engage in

general solicitation to locate unregistered finders based on that exemption. It is quite likely

that the SEC would find that a cold mass mailing of a brochure summarizing a private

placement memorandum which was made to broker-dealers, investment advisers,

accountants and attorneys would be a general solicitation, regardless of whether the

recipients were viewed as investors or merely conduits to investors. See Pennsylvania

Securities Commission, SEC No-Action Letter (Jan. 16, 1990).

However, general solicitation and general advertising is permitted in connection with a

private placement under Rule 506(c), so long as certain additional steps are taken and

qualifications are met to comply with the rule.4 While the SEC has not provided specific

guidance as to the applicability of Rule 506(c) to the solicitation of finders, it is reasonable to

assume that issuers would be permitted to conduct general solicitations of finders under this

new exemption, assuming the issuer otherwise complies with the requirements of the rule.

3 The conditions of reliance on the no-action letter are that the M&A Broker (as defined in the letter) must (1) not have the

ability to bind a party to the transaction, (2) not provide financing for the transaction, (3) not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in the transaction for the account of others, (4) to the extent that the M&A Broker represents both buyers and sellers, provide clear written disclosure as to the parties it represents and obtain written consent from both parties to the joint representation, (5) not facilitate a transaction with a group of buyers unless the group was formed without the M&A Broker’s assistance, and (6) along with any officer, director and employee of the M&A Broker, not have been barred or suspended from association with a broker-dealer. In addition, the no-action letter applies only to transactions (1) not involving a public offering, (2) in which the buyer or group of buyers will control and actively operate the target after completion of the transaction, (3) that do not result in the transfer of interests to a passive buyer or group of passive buyers, and (4) in which no securities are received by the buyer or M&A Broker that are not “restricted securities.” 4 Among other things, Rule 506(c) requires that (1) the issuer takes “reasonable steps” to verify that all purchasers are

accredited investors, (2) all investors are accredited or the issuer reasonably believes they are accredited, and (3) certain other provisions under existing Regulation D are satisfied.

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7. What do case law, SEC no-action letters, and other SEC guidance say about when an unregistered finder must register as a broker-dealer?

In addition to the general functions outlined above, there are limitations on the activities that

may be performed by unregistered finders before they are required to register as broker-

dealers. The limitations have developed through case law, SEC no-action letters, and other

SEC guidance. The SEC’s no-action guidance is fact-specific but can generally be split into

those involving private placements and those involving sales of whole businesses. With

respect to private placements, there has been a trend over the past decade toward

tightening the restrictions placed on unregistered finders. As such, participants in private

placements involving unregistered finders should err on the side of caution when interpreting

the SEC’s no-action guidance and applicable case law. The risk of regulatory enforcement

of broker-dealer registration is particularly high in circumstances involving fraud. See, e.g.,

SEC v. Mowen, Litigation Release No. 22393 (June 13, 2012); SEC v. Gagnon, Litigation

Release No. 22310 (March 27, 2012); In the Matter of Benjamin R. Daniels, Release No.

68369 (December 6, 2012).

With respect to sell-side M&A engagements involving the transfer of securities, the SEC

historically imposed similar limitations on the use of unregistered finders as in private

placement transactions. However, in 2014 the SEC issued a no-action letter granting

conditional relief to unregistered finders with respect to M&A transactions involving privately-

held targets. See M&A Brokers, supra. For whole-business transactions that do not meet

the conditions set forth in the M&A Brokers no-action letter, historical guidance suggests that

a finder will not be required to register as a broker-dealer if (1) the finder has a limited role in

negotiations; (2) the business is sold as a going concern and not a “shell” organization; (3)

the finder does not advise on deal structure; (4) if structured as a sale of securities, the

finder’s role is further limited; (5) the finder’s fee does not vary based on deal structure and

will be paid solely in cash; and 6) the finder has limited involvement in assisting the

purchasers with obtaining financing. More recent SEC guidance has noted qualification as a

“small business” pursuant to the Small Business Size Regulations issued by the U.S. Small

Business Administration as an additional factor in granting no-action relief. However, it is

unclear whether the SEC views this additional factor as an absolute requisite. See

International Business Exchange Corp., supra; Country Business, Inc., supra.

In the context of private placements, existing guidance suggests that a finder does not have

to be registered as a broker-dealer if the finder's activities are sufficiently limited and the

finder does not receive transaction-based compensation. Courts consider certain activities

to be telltale factors indicating that a finder has performed the functions of a broker-dealer.

These factors include: (1) actively soliciting investors; (2) advising investors on the merits of

an investment; (3) analyzing the financial needs of an issuer; (4) involvement in negotiations;

(5) prior involvement in securities transactions; and (6) receiving transaction-based

compensation. See generally, SEC v. Phillip W. Offill, Jr., et al., 2012 WL 246061 (N.D. Tex.

Jan. 26, 2012); SEC v. U.S. Pension Trust Corp., No. 07-22570-CIV, 2009 WL 2365702

(S.D. Fla. July 30, 2009); Cornhusker Energy Lexington, LLC v. Prospect St. Ventures, 2006

WL 2620985 (D. Neb. Sept. 12, 2006); Couldock & Bohan, Inc. v. Societe Generale Sec.

Corp., 93 F.Supp.2d 220, 229 (D. Conn. 2000); Black Diamond Fund, LLLP v. Joseph, No.

08-CA-0883, 2009 WL 1477223 (Colo. App. May 28, 2009). Such factors are in addition to

traditional activities undertaken by broker-dealers, such as purchasing and selling securities

for a customer upon request, handling funds and holding oneself out as having the legal

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authority to legally bind a customer to complete the transaction. The SEC, on the other

hand, has suggested that the following three factors are most significant when evaluating

potential broker-dealer conduct: (1) soliciting investors and promoting investment in a

security, (2) transaction-based compensation and (3) regularity of participation in securities

sales. See SEC v. Kramer, Case No. 11-12510-DD, SEC opening brief (11th Cir.), filed

August 19, 2011. In fact, a split has seemingly begun to emerge between the SEC staff,

which has brought enforcement actions predicated almost solely on the existence of

transaction-based compensation, and the courts, which continue to apply the six-factor test

above. See, e.g., SEC v. Kramer, 778 F.Supp.2d 1320 (2011); Brumberg, Mackey & Wall,

P.L.C., SEC No Action Letter (May 17, 2010) (declining to grant no-action relief to a law firm

that proposed to act as an unregistered finder by assisting a client in locating financing,

because the law firm’s receipt of transaction-based compensation, even in the absence of

other broker-dealer-type activities, was by itself a “hallmark of broker-dealer activity”).

Moreover, the JOBS Act amended the Securities Act to provide that, with respect to

securities sold in compliance with Rule 506 of Regulation D, no person must register as a

broker or dealer solely because: (1) that person maintains a platform or mechanism that

permits the offer, sale, purchase or negotiation of or with respect to securities, or permits

general solicitations, general advertisements or similar or related activities by issuers of such

securities, whether online, in person or through any other means; (2) that person or any

person associated with that person co-invests in such securities; or (3) that person or any

person associated with that person provides “ancillary services”5 with respect to such

securities. This exemption only applies if the person and each of its associated persons does

not receive any compensation in connection with the purchase or sale of such security, does

not have possession of customer funds or securities in connection with the purchase or sale

of such security, and is not subject to a statutory disqualification described in the Securities

Act.

8. Can an unregistered finder introduce issuers to broker-dealers without registering as a broker-dealer?

There is an issue whether such person would be “effecting transactions” in securities and

this question can only be answered on a case-by-case basis. The nature and the extent of

the unregistered finder’s involvement would be governing. But in some cases, assisting in

making introductions and presentations to market professionals, who in turn may participate

in securities offerings, does not appear to require broker-dealer registration.

There are many “wholesalers” in the securities industry who introduce issuers to broker-

dealers that, in turn, offer their securities to the public. Investment company complexes

sometimes rely on wholesalers to locate brokerages that may offer their mutual funds.

Similarly, promoters of direct participation programs and syndicators of investment products

often find that they need assistance in obtaining distribution of their investment products and

turn to wholesalers. In other instances, individual issuers seeking financing may engage a

wholesaler to assist in locating one or more broker-dealers who will assist in offering the

securities, and in subsequent market-making activities if the company is public.

5 Ancillary services means the provision of (1) due diligence services in connection with the offer, sale, purchase or

negotiation of a security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors, or (2) standardized documents to the issuer and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.

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It is fair to say that in the SEC’s view a wholesaler who receives any type of fee (i.e., is

compensated) based on sales by brokers introduced to a fund must register as a broker-

dealer.

In at least some circumstances, unregistered finders have been restricted from acting as

middlemen between issuers and registered broker-dealers. For example, in 1st Global, Inc.,

SEC No-Action Letter (May 7, 2001), the SEC denied no-action relief to accountants that had

arrangements with broker-dealers to receive fees and commissions for references or sales of

securities. The 1st Global letter precludes the sharing or splitting of transaction-based

compensation between unregistered finders and registered broker-dealers. In addition, if a

finder provides “matching services” for profit, the finder may be required to register as a

broker-dealer. “Matching services” generally involve a proactive role in bringing together

companies seeking financing with potential investors by individually assessing their suitability

to each other. The SEC staff has routinely denied no-action relief from the broker-dealer

registration requirements to persons providing matching services for profit. See Progressive

Technology, Inc., SEC No-Action Letter (October 11, 2000); Oil-N-Gas Inc., SEC No-Action

Letter (June 8, 2000). In contrast, the staff has granted no-action relief from broker-dealer

registration to a non-profit corporation providing matching services. See Angel Capital

Electronic Network, SEC No-Action Letter (October 25, 1996). See also, JOBS Act, supra.

As discussed above, given the uncertain current regulatory environment, issuers should

approach using unregistered finders cautiously and, when possible, use registered broker-

dealers when engaging in borderline activities.

9. In the context of a private placement, can an unregistered finder engage in a general solicitation?

Yes. However, the unregistered finder would be expected to comply with the requirements

of Rule 506(c), including, among other things, taking “reasonable steps” to verify that all

purchasers in the private placement are accredited investors. On the other hand, if the

offering is being made pursuant to Rule 506(b), the finder would not be permitted to engage

in general solicitation, since the finder could be found to be acting on behalf of an issuer, and

therefore would be in violation of Rule 502(c) and the offering would not qualify as a valid

private placement. See Arthur M. Borden, SEC No-Action Letter (Oct. 6, 1978). In either

case, such activities would likely constitute broker-dealer activities necessitating registration

under Section 15 of the Exchange Act.

10. If an unregistered finder is relying on Rule 506(b), which prohibits general solicitation, what pool of investors can a finder contact?

An unregistered finder in the context of a private placement under Rule 506(b) can only

engage prospective offerees where a substantial and pre-existing relationship establishing

"sophisticated" or "accredited investor" status is in place. See E.F. Hutton & Co. Inc., SEC

No-Action Letter (Dec. 3, 1985); Bateman Eichler, Hill Richards, Inc., SEC No-Action Letter

(Dec. 3, 1985); H.B. Shaine & Co., Inc., SEC No-Action Letter (May 1, 1987); Woodtrails-

Seattle, Ltd., SEC No-Action Letter (Aug. 9, 1982). For example, an accountant acting as a

finder can only give information about an investment to a client whom the accountant knows

has sufficient expertise and wherewithal to independently evaluate the merits of the

investment opportunity. The situation is fairly analogous to the limits imposed on an issuer

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contacting potential investors itself without employing a finder (outside of the context of a

general solicitation permitted under Rule 506(c)).

11. Can an issuer rely on an unregistered finder's "certification" that the potential investor is accredited and sophisticated?

Probably not. For offerings under Rule 506(b), the issue is whether the issuer “reasonably

believes” that a non-accredited investor purchaser in the private placement, either alone or

with his purchaser representative, has such knowledge and experience in financial and

business matters that he is capable of evaluating the merits and risks of the prospective

investment. If the issuer has some basis beyond the finder's certification for assessing the

prospective investor or if the issuer has properly relied on this finder in the past, there is

more likelihood of a reasonable belief in the current instance. Where the finder is an

established broker-dealer acting as a placement agent and the prospective investor is a

client, it is typical practice to accept the broker-dealer’s “certificate.”

For private placements under Rule 506(c), issuers are required to take “reasonable steps” to

verify that all purchasers in the private placement are accredited investors. In the SEC’s

adopting release (SEC Release No. 33-9415), the SEC declined to require issuers to use

specific methods of verification,6 and instead provided a principles-based approach for

determining what would constitute “reasonable steps” in its view. Under this approach, the

SEC suggested that the following factors be considered: (1) the nature of the purchaser and

the type of accredited investor that the purchaser claims to be, (2) the amount and type of

information that the issuer has about the purchaser, and (3) the nature of the offering, such

as the manner in which the purchaser was solicited to participate in the offering, and the

terms of the offering, such as a minimum investment amount.

12. Can an unregistered finder present the investment to an investor? While there is no clear answer, the recent trending of SEC no-action letters, along with

informal statements of SEC staff members, suggests that unregistered finders should take a

conservative approach with regard to approaching potential investors. In Paul Anka, SEC

No-Action Letter (July 24, 1991), the SEC granted no-action relief where an unregistered

finder merely provided an issuer with a list of names of potential investors. The original

request provided that the finder would make initial contact with the investors, but that

function was removed before the final letter was approved. Moreover, the SEC staff has

since generally disavowed the Anka letter. Depending on other factors relating to a finder’s

role, an unregistered finder should be cautious when approaching investors directly. 6 In addition to the principles-based approach, the SEC also provided four non-exclusive methods for verifying the

accredited investor status of natural persons: (1) on the basis of income, by reviewing any IRS form that indicates the requisite level of income for accreditation, along with a written representation regarding the purchaser’s expected income in the current year, (2) on the basis of net worth, by reviewing any of a number of financial documents for assets (e.g., bank statements) and liabilities (e.g., a consumer credit report) dated within the last three months, along with a written representation that all of the purchaser’s liabilities have been disclosed, (3) on the basis of a written verification from a qualified third party, which would include a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant, stating that such third party has taken reasonable steps to verify the purchaser’s accredited investor status within the prior three months and has determined that such purchaser is an accredited investor, or (4) in the case of a natural person who invested in a Rule 506(b) offering by the issuer prior to the enactment of Rule 506(c), and who remains a security holder, on the basis of a written certification by such person that he or she is still an accredited investor. The foregoing methods are not mandatory, but will constitute “safe harbors” so long as the issuer does not have actual knowledge that a particular investor is not accredited.

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13. How should compensation to finders be based? Except for whole-business transactions that qualify for relief under the SEC’s M&A Brokers

no-action letter discussed above, compensation should be a flat or hourly fee, should not be

tied to the value or consummation of a deal, and should be paid in cash rather than

securities. As noted above, recent SEC no-action guidance suggests that a finder’s receipt

of compensation tied to deal value or consummation (i.e., transaction-based compensation)

is sufficient to require the finder to register as a broker-dealer. In the Brumberg no-action

letter, the law firm was denied relief from the broker-dealer registration requirements even

though it represented that it would not participate in negotiations, would not provide the

potential investors with information about the issuer, and would not advise on any financing

arrangements. Nevertheless, the SEC staff refused to grant no-action relief, because the

law firm would receive fees based on a percentage of the offering proceeds and the receipt

of such transaction-based compensation gave the firm a “salesman’s stake” in the proposed

transactions, thereby creating heightened incentive for the firm to engage in sales efforts

and, as a result, requiring broker-dealer registration. See also Herbruck, Alder & Co., SEC

No-Action Letter (June 4, 2002); FINRA Rule 2040.7

Regardless of the method of compensation, any financial relationship with a finder must be

disclosed to the investor. Moreover, in the context of private placements, Form D requires

disclosure of any recipients of sales compensation and, if such recipient is a registered

broker-dealer, such person’s Central Registration Depository (CRD) number. Since Form D

is required in connection with any Regulation D private placement, this disclosure

requirement has allowed regulators to more easily identify unregistered broker-dealers. An

issuer’s disclosure in Form D of a finder’s name, but without a broker-dealer registration

number, may prompt some states to initiate an investigation.

14. Can an unregistered finder become involved in negotiations? No. If an unregistered finder is involved in negotiations or provides advice with regard to

deal structure, valuation or otherwise, there is an increased likelihood that the finder will be

required to register as a broker-dealer. See, e.g., Mike Bantuveris, SEC No-Action Letter

(Oct. 23, 1975); Fulham & Co., SEC No-Action Letter (Dec. 20, 1972). The question is

whether a finder played an “integral” role in negotiating the transaction or in structuring the

securities aspects of the transaction. If so, then registration is required.

The SEC staff has recognized that “[i]ndividuals who do nothing more than bring merger or

acquisition-minded persons or entities together and do not participate in negotiations or

settlements probably do not fit the definition of a “broker” or a “dealer” and would not be

required to register. On the other hand, persons who play an integral role in negotiating and

effecting mergers and acquisitions, particularly those persons who receive a commission for

their efforts based on the cost of the exchange of securities, . . . are required to register with

the Commission.” Gary L. Pleger, Esq., SEC No-Action Letter (Oct. 11, 1977); See also IMF

Corp., SEC No-Action Letter (May 15, 1978).

7 Effective August 24, 2015, FINRA adopted Rule 2040 “Payments to Unregistered Persons” that prohibits member firms

from directly or indirectly paying any compensation to (1) any person that should be registered but is not registered as a broker-dealer under Exchange Act Section 15(a) or (2) any registered associated person unless such payment complies with all applicable federal securities laws, FINRA rules, and Exchange Act rules. FINRA Rule 2040 specifically allows the payments of finder’s fees to unregistered foreign finders if certain conditions are met.

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For example, in May-Pac Management Co., SEC No-Action Letters (Dec. 20, 1973) and

(May 13, 1974), the SEC denied relief to an M&A intermediary that acknowledged it would

participate in any negotiations required to consummate the transaction and would provide

advice relating to valuation. Conversely, in Victoria Bancroft, SEC No-Action Letter (Aug. 9,

1987), the SEC granted relief to a licensed real estate broker who established lists of

potential acquirers of financial institutions, in part based on representations that the broker

would introduce the parties but would not participate in the establishment of a purchase price

or drafting of materials relating to the purchase or sale.

Moreover, in Corporate Forum, Inc., SEC No-Action Letter (Dec. 10, 1972), a financial

consultant represented that it would locate M&A candidates for its clients and make a

financial analysis of such candidates, but would allow the clients to negotiate and

consummate the transaction found for it by the financial consultant. The SEC staff

predicated its no-action relief on the premise that the financial consultant would not

participate in the negotiation of any transaction involving its client.

In addition, the SEC’s guidance in the recent M&A Brokers no-action letter provides

additional relief for advisors in the context of private M&A transactions.

15. Can an unregistered finder act as financial adviser to a business in connection with the issuance of securities?

Maybe. If an unregistered finder (often designated as a “consultant”) receives appropriate

transaction-neutral compensation, the finder may provide market and financial analyses,

prepare feasibility studies, and prepare or supervise preparation of private placement

memoranda. As discussed above, outside of the purview of the M&A Brokers no-action

letter, finders should not advise on the structure of M&A transactions or otherwise participate

in negotiations that may directly or indirectly affect their compensation, and they should not

advise on whether a transaction falls within the scope of the federal securities laws. See

Victoria Bancroft, supra.

16. Regardless of how an unregistered finder is paid, should an issuer use finders who have previously been involved in effecting securities transactions?

There is some concern in using a finder who has acted as a broker in prior transactions

because it may suggest that the finder is also acting as a broker-dealer in the current

offering. For example, in Rodney B. Price and Sharod & Assocs., SEC No-Action Letter

(Nov. 7, 1982), the SEC denied relief in a situation that presented no obvious signs of

impermissible activity other than prior involvement and discipline relating to the securities

industry. In Price, the finder represented that it would identify potential underwriters in

private placements and would not participate in selling efforts or receive transaction-based

compensation. However, the staff focused on the finder’s prior securities history in denying

relief. See also John DiMeno, SEC No-Action Letter (April 1, 1979) (discussing the staff’s

reversal of opinion after being informed in a follow-up letter that the finder had “not previously

been engaged in any private or public offerings of securities”).

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17. Are there any other types of finders available to issuers in a private placement?

Yes. An issuer can use an "associated person" in connection with the sale of an issuer's

securities. See Bailard, Biehl & Kaiser, SEC No-Action Letter (Aug. 5, 1979); Midland-

Guardian Co., SEC No-Action Letter (Dec. 27, 1978). An "associated person" is a partner,

officer, director, or employee of the issuer or certain companies affiliated with the issuer.

SEC Rule 3a4-1 under the Exchange Act provides a safe harbor for issuer employees who,

in addition to their regular responsibilities (and without special compensation) participate in

the offering process. It is, however, a narrowly-drawn safe harbor that seems more directed

to collateral and clerical assistance in the offering than to allowing meaningful involvement in

raising funds.

18. What are the consequences of using an unregistered finder that is deemed to have violated Section 15 of the Exchange Act?

Along with ramifications for the finder, there are potential consequences for an issuer using

an unregistered finder in violation of Section 15. An issuer using a finder that has failed to

register as a broker-dealer may itself be deemed to have violated Section 15 if the issuer is

aware of the violations and fails to adequately oversee the individual that committed the

violations, limit such individual’s access to key documents and/or monitor or limit the

individual’s contact with investors. See In re Ranieri Partners LLC and Donald W. Phillips,

Order Instituting Administrative and Cease-and-Desist Proceedings, SEC Release No. 34-

69091 (Mar. 8, 2013) (imposing cease-and-desist orders and civil money penalties against a

private fund manager and a former senior executive, as well as a temporary suspension

against the former senior executive).

In addition, using a finder in violation of Section 15 may create a rescission right in favor of

the purchasers of the securities. Section 29(b) of the Exchange Act provides that every

contract made in violation of the Exchange Act, including contracts for which performance

under the contract is a violation of any of the Exchange Act provisions, shall be void as to

“any persons who, in violation of any such provision, rule or regulation, shall have made or

engaged in the performance of any such contract.” While Section 29(b) certainly creates risk

for the finder, the language is broad enough that it can also be interpreted to void the

contract for the sale of the securities to investors located through the use of the finder.

Under federal law, this potential rescission right can be exercised until the later of three

years from the date of issuance of the securities or one year from the date of discovery of the

violation. Many states also regulate the registration of broker-dealers. California, for

example, provides a rescission right to purchasers of securities from an unregistered broker-

dealer, which can be exercised even if the purchaser no longer owns the securities.

19. What other steps can issuers take to protect themselves? Companies contemplating retaining a finder should conduct appropriate diligence regarding

a finder’s previous involvement in or engagement with respect to securities transactions,

including the number of transactions in which the individual or entity has acted as a finder or

as a registered broker-dealer, the type of services rendered or activities undertaken and the

form and type of compensation received for those services.

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A cautious approach would include entering into an engagement letter with an unregistered

finder that (1) explicitly describes the actions permitted to be taken by the finder (and

contains restrictions on the number and type of potential investors that may be contacted),

(2) prohibits the finder from structuring the investment, negotiating terms or presenting

information regarding the issuer or offering to potential investors, (3) prohibits the finder from

advising potential investors with regard to the investment, (4) includes no compensation

other than non-contingent fees and flat rates to cover expenses and administrative costs,

and (5) includes appropriate representations, warranties and covenants (including a

representation that the finder has reviewed and understands the statutory and regulatory

provisions governing brokerage activities and has obtained all licenses required by federal

and state law) and indemnification against losses arising out of any violations of applicable

federal and state securities laws or the breach of any of the representations, warranties or

covenants. Such precautions would increase the likelihood that using an unregistered finder

would not violate the federal securities laws.

20. How do state securities laws impact the role of finders in a private placement?

Many states have added substantial regulations that affect the ability to conduct a private

placement. Moreover, although 1996’s NSMIA (National Securities Markets Improvement

Act) pre-empted state regulation of many private offerings, it did not preempt state broker-

dealer regulation or resolve any of the finder issues. State laws regarding broker-dealer

registration, finders, the participation of unregistered intermediaries and direct sales to

investors vary widely. Only a handful of states have defined “finders” by law or by rule. For

example, as of January 1, 2016, California law permits issuers to compensate unregistered

finders, provided that the finder introduces one or more natural persons who purchase the

issuer’s securities and the finder complies with certain additional requirements.8 Also, as

discussed above, sales through an unregistered "agent" are voidable in some states.

Individual state laws must be analyzed before proceeding with a private offering.

21. Is there relief (or clarity) in sight? There is a current effort to develop a new broker-dealer classification for intermediaries

whose role is limited to finding investors in private placements or investors in small

businesses. The SEC staff has hinted for several years that it intends to adopt a form of

SEC and FINRA registration tailored to finders, but reform has been stalled. The American

Bar Association Task Force on Private Placement Broker Dealers issued a report in May

2005, and re-issued such report in April 2010, recommending that the SEC adopt a form of

“broker dealer lite” registration to cover these activities. In March 2012, the Task Force

again suggested a broker-dealer lite solution, which proposal includes exempting from

federal registration any “securities intermediaries” registered with the states. The proposed

exemption would apply to parties that introduce investors either to the issuer or to registered

brokers, or conduct due diligence, or structure a transaction, or recommend or negotiate,

8 See CAL. CORP. CODE § 25206.1. The law requires, among other things, that (1) the transaction be a sale of securities

by a California-based issuer and the transaction’s aggregate value does not exceed $15 million; (2) the finder must not participate in negotiating the terms of the transaction, advise any party regarding valuation or the advisability of engaging in the transaction, or conduct any due diligence; (3) the finder must file a notice with the relevant state agency; and (4) the issuer, the finder, and the person introduced by the finder must collectively enter into a written agreement that makes certain disclosures.

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even if they receive transaction-based compensation. The proposal anticipates registration

both of the entity and of the operating individuals, entails no net capital requirements, and

includes certain “bad boy” restrictions. However, the proposal leaves open the scope of

permissible transactions, including whether there should be an aggregate or transaction-

based dollar limitation.

In April 2012, the SEC met with the Task Force on this issue, and the American Bar

Association has suggested that the SEC may be receptive to the Task Force’s proposal for a

federal exemption for finders. In September 2015, the SEC’s Advisory Committee on Small

and Emerging Companies recommended rules similar to the ones presented by the Task

Force, and also included a recommendation that a person that receives transaction-based

compensation solely for providing names of or introductions to prospective investors not be

subject to registration as a broker. However, such recommendations remain a work in

process and adoption in any form is not certain.

In August 2016, the SEC approved FINRA rules creating a new category of registered

broker-dealer, known as a “capital acquisition broker” (“CAB”), which is a FINRA member

firm engaged in certain enumerated corporate financing activities, including acting as a

finder. However, CABs are permitted to act as a finder only with respect to transactions (1)

on behalf of an issuer in connection with a sale of newly-issued, unregistered securities to

“institutional investors” or (2) on behalf of an issuer or a control person in connection with a

change of control of a privately-held company. Moreover, accredited investors do not

constitute “institutional investors” for purposes of the new rules, further limiting the scope of

permissible finder-related activities for firms that have elected CAB status.

Authors:

Alan J. Berkeley

[email protected]

+1.202.778.9050

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