The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

Presenting a live 90-minute webinar with interactive Q&A

Structuring Private Placement Memorandum

for the Private Offering and Sale of Securities Determining Materiality, Assessing Risk Factors and Conducting Due Diligence

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, JUNE 29, 2017

Yelena M. Barychev, Partner, Blank Rome, Philadelphia

Brett G. Evans, Partner, Evans & Kob, Santa Ana, Calif.

Brett A. Cenkus, Cenkus Law, Austin, Texas

Karolyn Ann Knaack, MBA, JD, Member, Karolyn A. Knaack, P.C., Austin, Texas

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-888-450-9970 and enter your PIN when prompted. Otherwise, please

send us a chat or e-mail sound@straffordpub.com immediately so we can

address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the F11 key on your keyboard. To exit full screen,

press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 35.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the ^ symbol next to “Conference Materials” in the middle of the left-

hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a

PDF of the slides for today's program.

• Double click on the PDF and a separate page will open.

• Print the slides by clicking on the printer icon.

FOR LIVE EVENT ONLY

Structuring Private Placement

Memorandums for the Private

Offering and Sale of Securities

June 29, 2017

By: Yelena Barychev, Brett Cenkus, Brett Evans and Karolyn Knaack

6

Brett Cenkus

Brett Evans

Karolyn Knaack

Yelena Barychev

What We’ll

Cover Overview of regulatory framework

Essential elements of a PPM

Determining materiality for disclosure

Assessing relevant risk factors

Due diligence

7

Overview of Regulatory

Framework: 4(a)(2) and Regulation D

1

Presented by

Brett Cenkus & Brett Evans

8

Private Placements Generally

Under Section 5 of the Securities Act, any offering of securities must be registered

with the SEC or be exempt from registration. A private placement is a securities

offering that is exempt from registration.

Benefits of private placements:

▫ Less expensive and quicker than SEC registration

▫ Reduced disclosure requirements

▫ Direct negotiation with investors = easy to tailor to fit the needs of specific

investors

▫ Avoiding certain liabilities (e.g., Section 11 of the Securities Act)

9

Section 4(a)(2) of the Securities Act

▫ First adopted by Congress as a part of the Securities Act in 1933

▫ Rationale: in an offering with a limited number of offerees capable of protecting

themselves, the compliance burden of a public offering is not necessary

▫ Provides a statutory exemption for “transactions by an issuer not involving any

public offering”

Source of the Primary Exemption

“Public offering” is not defined by the statute. Standards have been developed by

courts and the SEC. BE CAREFUL OF PLACING TOO MUCH EMPHASIS ON

THE PLAIN MEANING OF THE WORD, “PUBLIC.”

10

Whether a purchaser can fend for itself is based on factors such as:

▫ The purchaser’s access to the same kind of information that would be included in

an SEC registration statement; and

▫ The purchaser’s sophistication and ability to bear the economic risks of the

investment.

What constitutes a “public offering”?

SEC v. Ralston Purina (1953)

The Supreme Court established the general principle that the exemption under 4(a)(2) is

available only for an offer and sale made privately to persons able to fend for

themselves.

11

What constitutes a “public offering”? (cont’d)

Other factors used in determining availability of the private offering exemption

(developed since Ralston Purina) include:

▫ The number of offerees and their relationship to each other and to the issuer

▫ The number/amount of securities offered - size of the offering

▫ The manner of the offering (e.g., general solicitation)

▫ The sophistication and experience of the offerees

▫ The nature and kind of information provided to the offerees or to which the offerees

have ready access

▫ The actions taken by the issuer to prevent the resale of securities

Each factor is flexible and highly fact-dependent.

No single factor alone is determinative. 12

Regulation D

In 1982, the SEC adopted Regulation D to provide greater certainty regarding

which transactions are exempt from registration.

Funds Raised via Reg. D vs SEC Registered Offerings in 2014

13

Regulation D

Regulation D is a series of nine rules, Rules 500-508, establishing three

transaction exemptions from the registration requirements of the Securities Act

▫ Rule 500 lays out general rules around using Regulation D

▫ Rule 501 sets out certain definitions

▫ Rule 502 sets out four general conditions to be met under the Regulation D

▫ Rule 503 establishes the requirement to file a Form D

▫ Rules 504 and 506 establish the exemptions, each with particular qualifications and

limitations (former Rule 505 is gone and 506 now has two rules - 506(b) and 506(c))

▫ Rule 507 disqualifies an issuer from relying on Regulation D in certain situations

▫ Rule 508 provides that an insignificant failure to comply (when considered in connection

with the offering as a whole) will not disqualify an offering from the exemption.

14

Miscellaneous Private Offering Terms

Accredited investor

General solicitation

Any advertisement, article, notice or other communication published in any

newspaper, magazine or similar media or broadcast over television or radio or any

seminar or meeting whose attendees have been invited by general solicitation.

Includes internet activity.

▫ Salary test ($200K/300K last two years and current)

▫ Net worth test ($1MM+ without equity of primary residence)

15

Rule 502 – General Conditions for use of Reg D

Integration

Several private placements offered within a short period of time, each relying on

separate offering exemptions, may be integrated and, when taken together, may

constitute a single plan of financing for which the private placement exemption is not

available.

The SEC wants to ensure Regulation D is not used as part of a scheme or plan to avoid

Section 5 registration requirements

Information Requirements

If an issuer is selling securities to non-accredited investors, the issuer must comply with

the information requirements set forth in Rule 502. The required information must be

furnished a reasonable time prior to sale.

16

Rule 502 – General Conditions for use of Reg D

Manner of Offering

Until the recent changes pursuant to the JOBS Act, Rule 502 prohibited the issuer or any

person acting on its behalf to offer or sell securities by any form of general solicitation or

general advertising, including:

▫ any advertisement, article or other published or broadcast communication; or

▫ any seminar or meeting whose attendees have been invited by general solicitation

or advertising

Limitations on Resale

Regulation D is available only to issuers and applies only to a particular transaction. Rule

502(d) provides that securities acquired in a Regulation D private placement are “restricted

securities” and cannot be resold by the purchaser without registration under the Securities Act

or compliance with an available registration exemption.

17

Main Regulation D Exemptions

Rule 504

▫ No more than $5MM (recently raised) in any consecutive 12-month period.

▫ No restriction on the number of investors

▫ No restriction on the manner of the offering or resale

▫ Securities may be sold to any type of investor (including unaccredited)

▫ Doesn’t prescribe specific disclosure requirements

Rule 506(b) (a safe harbor)

▫ No general solicitation

▫ Accredited investors and up to 35 non-accredited investors who meet sophistication

requirements (Accredited investor status often confirmed through self-certification)

▫ No specific disclosure requirements for accredited investors, but significant disclosure for

unaccredited investors

▫ Historically, 99% of the Regulation D activity

Rule 506(c) ▫ Removed the prohibition in Regulation D on general solicitation and general advertising in

offerings and sales under Rule 506, provided that all purchasers of the securities sold in these

offerings are accredited investors

▫ Require issuers to take reasonable steps to verify that purchasers are accredited investors,

using methods determined by the SEC

18

Essential Elements

of a PPM 2

Presented by

Brett Cenkus Founding Partner, Cenkus Law

(512) 888.9860

brett@cenkus.com

www.cenkuslaw.com

19

SEC Industry Guides

High-Level Considerations

PPMs serve a dual purpose – compliance and marketing

The contents of a PPM will (should) vary depending on the deal structure, industry, target

audience and specific exemption on which the issuer is relying

❖ Hedge funds

❖ EB5 Visa Deal

❖ Bank holding companies

❖ Real Estate LPs

❖ Unpaid claim adjustment

❖ Mining operations

❖ Oil and gas deals (industry guides)

20

Drafting Tips

✓ Draft in plain English as much as possible

✓ Tailor the length and content to the deal,

but never soften the tone -- PPMs should

strongly communicate risk.

✓ Add the issuer’s logo and a bit of design

21

10 Main Sections of a PPM

1. Notices to Investors

2. Executive Summary

3. Company’s Purpose and Overview

4. Terms of the Offering and Securities

5. Risk Factors

6. Use of Proceeds

7. Financial Information

8. Management

9. Legal and tax matters

10.Exhibits

22

Notices

❖ No registration; reliance on exemption

❖ No public market

❖ High degree of risk

❖ Restrictions on transfer

❖ No one authorized to make representations outside the offering materials

❖ Descriptions and summaries in the PPM qualified by actual documents

❖ No legal, business or tax advice

❖ Right to modify or withdraw the offering

❖ Opportunity to ask questions and receive information

23

Executive Summary

❖ 1-3 page overview of the opportunity

❖ Meant to facilitate quick understanding of the

transaction

❖ Current capitalization of the issuer

❖ Include material terms of the offering and securities

❖ Reference to risk factors

❖ List of documents investors will sign

24

Company Overview

❖ Description of main operations of the business. Be clear about what is currently

being done and what is planned for the future

❖ Target customers

❖ Describe the industry – how companies compete, fragmented vs. concentrated

(include relative size of the issuer), how regulated the industry is

❖ For planned operations, list milestones and challenges to execution (e.g., stages

of product development)

❖ Description of the business processes – how does the company manufacture,

produce, sell, fulfill whatever it does

❖ Overview of marketing plan

❖ Explanation of sales cycle

❖ Identify supply chain risks, seasonality of revenue

❖ Number of employees

25

Terms of the Offering and Securities

❖ Type of the offered securities

❖ Price of the offered securities

❖ Material terms of the offered securities – voting rights, information rights,

liquidation rights, preemptive rights, ownership percentage, mandatory capital

calls, convertibility, call and put rights, if the securities are collateralized

❖ Who may invest

➢ Accredited vs. Non-Accredited

➢ Minimum Investment

➢ Maximum Investment (absolute dollars vs. percentage of net worth)

➢ Risk Tolerance

❖ Plan of Distribution (type of solicitation, finders)

❖ Documentation investors must sign to invest

❖ Possible future dilution

26

Risk Factors

❖ Most important section of the PPM from a risk management

perspective

❖ Always the source of robust conversation with clients

❖ Group into general categories (e.g., risks of the offering and

securities, risks of the company; risks of the industry)

❖ List in order of priority (most significant risks first in each

category)

❖ State each risk in a simple, bold type sentence

❖ Don’t be repetitive (cross-reference as needed)

❖ Avoid generic, boilerplate risk factors

❖ Don’t use risk mitigating language in risk factors

27

Estimated Use of Proceeds

❖ Include at least 4-5 categories and up to 12 (one

should be transaction expenses)

❖ Add footnotes as appropriate

❖ Be sure one category is compensation to related

parties (e.g., salaries, bonuses, etc.), especially if

that money is coming out at or near closing

❖ Display in tabular form

28

Financial Information

❖ Company capitalization

❖ Historical financials

❖ Pro forma financials (include forward-looking

statement language)

❖Management discussion of financial

➢ Timeline to achieve profitability

➢ Specific financial risks

➢ Discussion around declining metrics

29

Management

❖ Biographies

➢ All officers, directors or other important

related parties

➢ Past experience going back at least 5 and

possibly 10+ years

➢ Talk about successes and failures

❖ Compensation

❖ Conflicts of Interest

30

Legal and Tax Matters

❖Litigation

❖Tax Matters

31

Exhibits

❖ Instructions for Investing

❖Subscription/Purchase Agreement

❖Governing documents

❖ Investor questionnaire

❖W-9

32

Determining Materiality for

Disclosure 3

Presented by

Karolyn Knaack Karolyn A. Knaack, P.C.

512-879-7217

Karolyn@Knaacklaw.com

www.knaacklaw.com

33

Core Concepts of Full and Fair

Disclosure

▫ “Is it material?”

▫ Lack of bright line rules or bright line

guidance from the courts and the SEC

▫ Flexible and adaptable to any factual

situation

34

Federal Courts

There is no rigid formula

Materiality determination is a delicate assessment that is inherently

fact and context specific

TSC Industries v. Northway, Inc., 426 US 438 (1976) – omitted facts in a proxy statement

Basic, Inc. v. Levinson, 485 US 224 (1988) – materiality of contingent or speculative events

Current standard are 2 Supreme Court cases:

Information is material if a substantial likelihood exists that a reasonable

investor would consider the information important in making a buy, sell or

hold investment decision or voting decision

35

Total Mix of Information Available

▫ There must be a substantial likelihood that a fact would be viewed by a reasonable

investor as significantly altering the "total mix" of information made available.

▫ Does not require that a misstated or omitted fact would result in a reasonable investor

changing an investment or voting decision

▫ Merely requires that proper disclosure of the misstated or omitted fact would have

assumed actual significance in the deliberations of a reasonable investor

The decision in TSC Industries recognized the need to balance the importance of full and fair disclosure against the pitfalls

of an unnecessarily low materiality standard. A low materiality standard would likely subject a company and its management

to much higher liability for insignificant misstatements and omissions. This could lead to a legitimate fear by management of

overexposure to liability resulting in an “avalanche of trivial information” that could cloud, not aid, the decision-making

process.

For these reasons, the Supreme Court in TSC Industries expressly rejected adopting a materiality standard that focused on

what a reasonable investor “might” consider important.

36

Contingent of Speculative Events

Basic added to the TSC Industries standard a discussion of contingent or

speculative events.

A central issue in Basic revolved around the materiality of preliminary merger discussions, asking specifically

what significance a reasonable investor would place on these discussions given the real possibility that

contemplated transaction discussions can easily never come to fruition.

For contingent or speculative events, materiality determinations must balance both

the:

▫ Probability that the event will occur.

▫ Significance of the event to the company.

As with all materiality determinations, this balancing becomes fact specific. An event that is highly likely to

occur and would be material if it did occur, but is relatively insignificant, may not be considered material

and necessary to disclose until the probability of occurrence becomes higher. Similarly, if an event is

improbable but its significance is so high that it would lead to a major impact on the company, it may be

material and ripe for disclosure.

37

Application of Materiality Standard

Statistical Significance

The Supreme Court has specifically held that adverse events do not necessarily need to be statistically significant to be material (see

Matrixx Initiatives Inc. v. Siracusano, 131 S. Ct. 1309 (2011)). In that case, it was found that a drug company’s failure to make public

reports of adverse drug reactions can constitute securities fraud, even if the number of adverse reactions is not statistically significant.

The Supreme Court did note that something beyond a mere adverse reaction is required in a materiality determination but that

something need not be statistical significance.

Market Reaction

Some courts test materiality by looking at the market’s reaction to a misstatement or omission (see, for example, Oran v. Stafford, 226

F.3d 275, 284 (3d Cir. 2000)). The theory is that in a developed and efficient securities market, a company’s stock price reflects all

available information about the company, its business and its industry. Therefore, information significant to reasonable investors in an

efficient market is immediately incorporated into the stock price. The SEC staff appears to agree with this reasoning.

Statements of Optimism, Opinion and Puffery

Courts often find general statements of optimism and puffery to be immaterial because a reasonable investor would not believe them to

be reliable predictions of expected performance.

38

▫ The adopting release for Regulation FD (SEC Release No. 33-7881 (Aug. 15, 2000)).

▫ SEC Staff Accounting Bulletin: No. 99 - Materiality (SEC Release No. SAB 99 (Aug. 12, 1999)) (SAB 99).

SEC Guidance on Materiality

Relatively little SEC guidance on materiality

▫ SEC Rule 405 under the Securities Act

▫ Rule 12b-2 under the Exchange Act

To those matters where “there is a substantial likelihood that a reasonable investor would attach importance in determining

whether to” buy or sell the subject securities. The definition was derived from the materiality standard first set out and later

expanded in TSC Industries and Basic. The key sources for additional SEC staff guidance available in this area are:

SEC staff guidance universally accepts and adopts the materiality standard of TSC Industries and Basic. Also like the

courts, the staff recognizes the difficulty and sometimes vagueness that can arise in making materiality determinations but

has stopped short of implementing a bright-line rule or test or an exclusive list of items that are per se material. The staff

instead keeps the materiality standard flexible enough to fit the circumstances of each situation.

While most of SAB 99 discusses materiality in the accounting and auditing context, the staff guidance in the release is

indicative of the SEC staff’s view and applicable to materiality determinations generally. Furthermore, many materiality

determinations require at least considering the impact on results of operations and financial statements.

39

Heightened Scrutiny

While the SEC staff does not provide an

exhaustive list of items that are per se

material, it has provided a non-

exhaustive list of items or events that

should be reviewed carefully to

determine whether they are material:

▫ Earnings information.

▫ Mergers, acquisitions, tender offers, joint ventures, or

changes in assets.

▫ New products or discoveries or developments

regarding customers or suppliers (for example, the

acquisition or loss of a contract).

▫ Changes in control or in management.

▫ Change in auditors or auditor notification that the issuer

may no longer rely on an auditor’s audit report.

▫ Events regarding the issuer’s securities, such as:

▫ defaults on senior securities;

▫ calls of securities for redemption;

▫ repurchase plans;

▫ stock splits;

▫ changes in dividends;

▫ changes to the rights of security holders; or

▫ public or private sales of additional securities.

▫ Bankruptcies or receiverships.

The staff makes it clear that even items on this list

require a fact-specific materiality determination. For

example, some new product launches and

developments with suppliers are material and others

are not.

40

Numerical Cutoffs or Thresholds

Statistical Significance

It is common for issuers, their auditors, underwriters and other parties conducting due diligence on issuers or preparing

disclosure to develop rules of thumb that set numerical cutoffs or thresholds to guide when an item may be material.

Common rules of thumb that may be encountered in these situations are:

▫ That misstatements or omissions of an item that fall below a threshold of 5% or 10% of net revenue or total assets

are not material unless there is also evidence that management misconduct is involved.

▫ Another example is if a misstatement or omission of an item would create a deviation in financial statements of less

than 5%, it is not material.

The SEC staff strongly cautions against exclusive reliance on any numerical cutoff or threshold as determinative of

materiality. A numerical cutoff or threshold may be acceptable to aid in financial statement preparation, due diligence

and disclosure, but only as a preliminary assumption that, before considering all relevant circumstances, an item is likely or

unlikely to be material. Therefore, the staff cautions against using numerical rules of thumb beyond the initial step in

determining materiality.

41

Quantitative and Qualitative Factors

Even if a materiality assessment begins with a numerical threshold assessment, a materiality

determination, especially in the context of the effect of financial statements, requires experienced human

judgment of the total mix of information.

This judgment includes:

▫ The size in numerical terms of the misstatement (quantitative factors),

▫ but also of the full factual context in which an evaluator of the effect of the material misstatement or

omission on the company and its financial statements would view the item (qualitative factors).

Qualitative factors can cause small quantitative misstatements to be material. The simplest example of this

is where financial statements are incorrect in one area and only by a small amount, but the misstatement is

caused by management misconduct. Depending on the seniority level of management involved, the

smallest of misstatement could be material.

42

Quantitative and Qualitative Factors (Cont’d)

In this area the SEC staff has provided a non-exhaustive list of qualitative considerations that can cause a

quantitatively small misstatement to be material. These considerations are whether the misstatement:

▫ Arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision

inherent in the estimate.

▫ Masks a change in earnings or other trends or results from attempts to manage earnings.

▫ Hides a failure to meet analysts’ consensus expectations.

▫ Changes a loss into income or vice versa.

▫ Concerns a segment or other portion of the business that has been identified as playing a significant role in operations or

profitability.

▫ Affects compliance with regulatory requirements.

▫ Affects compliance with loan covenants or other contractual requirements.

▫ Has the effect of increasing management’s compensation, for example, by satisfying requirements for the award of bonuses or

other forms of incentive compensation.

▫ Involves concealment of an unlawful transaction.

A full analysis of quantitative and qualitative factors will likely result in small quantitative misstatements being deemed

qualitatively material far more often than large quantitative misstatements being deemed immaterial because the qualitative

significance is too low. However, with the total mix materiality standard, this situation is certainly possible and should be

considered when making materiality decisions.

43

▫ The significance of the items to the

particular company.

▫ The effect on the financial statements

taken as a whole.

Accounting and Auditing Materiality

Standards

There are some special

considerations that should be

kept in mind that are unique to

materiality determinations in the

accounting and auditing context.

44

▫ Total Mix of Information Available

▫ Contingent or Speculative Events

▫ Numerical Cutoffs or Thresholds

▫ Quantitative and Qualitative Considerations

▫ Accounting and Auditing Context

▫ Heightened Scrutiny

▫ General Examples of Materiality Hotspots

Materiality

Checklist

�

45

Total Mix of Information Available

▫ Is there is a substantial likelihood that a reasonable investor would consider the information in

question to be important in making a buy, sell or hold investment decision or a voting decision?

▫ Is there a substantial likelihood that this information would be viewed by a reasonable investor as

significantly altering the “total mix” of information made available?

▫ Irrespective of whether it would change an investment decision, is there a substantial likelihood that

proper disclosure of the misstated or omitted fact would have assumed actual significance in the

deliberations of a reasonable investor?

▫ Would the significance of the information go beyond what a reasonable investor simply “might”

consider important and actually function as an important factor in the investment decision?

These fundamental questions must be asked in any materiality determination:

46

▫ Is the event contingent on something else happening?

▫ Is it possible or likely that the event will not come to fruition or not occur as

expected?

▫ If yes, how does the probability of it occurring balance against the significance

of the event to the company? Is the event:

▫ highly likely to occur with moderate significance to the company; or

▫ moderately probable but with extremely high significance to the company

if it occurs?

Contingent or Speculative Events

47

▫ The SEC staff strongly cautions against reliance on any numerical cutoff or threshold

beyond a preliminary assumption that, before considering all relevant circumstances, an

item is likely or unlikely to be material.

▫ Some examples of preliminary numerical questions that might require further analysis

include:

▫ does the item account for more than 5% of net revenue;

▫ does the item account for more than 10% of total assets; and

▫ does the misstatement or omission create a deviation in the financial statements of

more than 2%?

Numerical Cutoffs or Thresholds

48

Quantitative and Qualitative Factors

Materiality determinations require

experienced human judgment of

the size in numerical terms of the

misstatement (quantitative

factors) but also of the full factual

context of the effect on the

company (qualitative factors).

Because qualitative factors can

often cause small quantitative

misstatements to be material,

questions to ask include:

▫ Are there qualitative considerations that can cause a quantitatively small

misstatement to be material? For example, does the misstatement or omission:

▫ mask a change in earnings or other trends;

▫ result from attempts to manage earnings;

▫ change a loss into income or vice versa;

▫ concern a segment or other portion of the business that has been identified as

playing a significant role in operations or profitability;

▫ affect compliance with regulatory requirements;

▫ affect compliance with loan covenants or other contractual requirements;

▫ have the effect of increasing management’s compensation, for example, by

satisfying requirements for the award of bonuses or other forms of incentive

compensation; or

▫ involve concealment of an unlawful transaction?

▫ Is there a single or isolated event or problem with a product or business line that

can have a significant impact on the company despite the fact that the problem is

not widespread or statistically significant?

▫ Is there a quantitatively small misstatement or omission that is the result of

employee or management misconduct?

▫ Even if the misstatement or omission is extremely insignificant, is it the result of

misconduct by senior level management?

49

▫ Even if there are misstatements that are individually immaterial, could the

multiple misstatements, when aggregated, render financial statements

materially misleading as a whole?

▫ Have materially misstated amounts in the financial statements been netted

with other misstatements with the intent of diminishing materiality?

Accounting and Auditing Context

50

Heightened Scrutiny

▫ Earnings information.

▫ New products or discoveries or developments regarding customers or

suppliers (for example, the acquisition or loss of a contract).

▫ Changes in control or in management.

The SEC staff has provided a non-exhaustive list of items or events that should be

reviewed carefully to determine whether they are material. Any review should look

at:

51

General Examples of Materiality Hotspots

▫ Pending or threatened litigation that can be large in dollar value or impede an issuer’s ability to do

business (for example, intellectual property challenges).

▫ Pending or threatened governmental investigations.

▫ Engaging in prohibited activities with nations on which the US has imposed sanctions, such as Iran and

Syria.

▫ Regulatory approvals or changes in law.

▫ Executive compensation matters (say on pay results, employment agreements, incentive plans).

▫ Labor disputes.

▫ Significant developments with suppliers and customers.

▫ Inventory shortages and manufacturing difficulties.

▫ Product defects or recalls.

▫ Significant developments or adverse side effects in clinical trials.

▫ Impact of natural disasters.

▫ Cybersecurity breaches.

▫ Stock repurchases.

▫ Restatements.

▫ Findings of significant deficiencies or material weaknesses in internal controls over financial reporting.

52

Assessing Relevant

Risk Factors 4

Presented by

Yelena Barychev Partner, Blank Rome LLP

215-569-5737

barychev@blankrome.com

www.securitiesnewswatch.com

53

Assessing Relevant Risk Factors

▫Why do we need risk factors (RFs)?

▫Does the SEC require RFs in the PPM?

▫What are best practices in RF disclosures?

▫What RFs are usually included in the PPM?

54

Why Do We Need Risk Factors?

SEC’s position:

▫ To provide important context for assessing

the company’s financial potential (you may

lose all or part of your investment)

Issuer’s position:

▫ To provide protection in case of investors’

claims

55

Does the SEC Require RFs in the PPM?

No…

▫ if the issuer is selling securities to an accredited investor,

▫ but the issuer should still including risk factors in the PPM to:

▫ provide management’s perspective on factors that may adversely

impact the company and its securities

▫ provide information that is material to an understanding of the

issuer, its business and the securities being offered

▫ Regulation S-K: Item 503(c)

56

What Are Best Practices in RF Disclosures?

✓ Focus on the most significant or principal RFs that make the

company’s offering of securities speculative or risky

✓ RF disclosures must be concise and organized logically (most

significant risks should go first)

✓ Avoid “boilerplate” RFs:

▫ do not present risks that could apply to any issuer or any offering

▫ explain how the risk affects the issuer or the securities being

offered

57

Best Practices in RF Disclosures (cont.)

✓ Use “plain English”

✓ Set forth each risk factor under a caption that adequately describes

the risk

✓ The risk factor discussion must be at the beginning of the PPM

58

What RFs Are Usually Included in the PPM?

Item 503(c) principles-based disclosure:

Risk factors may include, among other things, the following:

▫the company’s lack of an operating history

▫the company’s lack of profitable operations in recent periods

▫the company’s financial position

▫the company’s business or proposed business

▫the lack of a market for the company’s common equity securities

or securities convertible into or exercisable for common equity

securities

59

What RFs Are Usually Included in the PPM?

Business risk factors: company and industry RFs – look for sample industry RFs

▫Challenges posed by competition

▫Reliance on current management

▫Effect of general economic conditions

▫Regulatory requirements

▫Seasonality

▫Reliance on a limited number of customers

▫Reliance on a few suppliers

▫Price fluctuations

Risk factors related to investment in the company’s securities

▫ Concentration of stock ownership – lack of ability to

influence key decisions

▫ Risk of dilution from future rounds of financing or

conversion of convertible debt or exercise of

options/warrants

▫ No liquidity

▫ Anti-takeover provisions in the charter or bylaws

Risk factors related to the terms of the offering

60

Performing

Due Diligence 5

Presented by

Brett G. Evans Partner, Evans & Kob, PC

657-210-2114

brett@eklawpc.com

www.eklawpc.com

61

What is Due Diligence?

"Due diligence":

Procedures and investigative steps by all of the parties involved,

including counsel and the independent public accountants, to

avoid liability under the complex provisions applicable to

securities offerings.

The conduct of, and procedures utilized by a reasonable

person to confirm or verify the accuracy and completeness of

material statements

62

What is Due Diligence?

Why?

❖ Find Material (or Background) Info to Understand and

Complete Offering Documents – Disclosure in PPM

❖ Mitigate Potential Liability under State and Federal

Securities Fraud

❖ Other Reasons: Reputation, E&O, etc.

63

What is Due Diligence? Practical

Principal Focus of Due Diligence:

❖ Compensation

❖ Self-dealing

❖ Background of Management (insiders)

❖ Litigation history or potential litigation

❖ Risks (including potential risks faced by the issuer) and accurate discussion of

the nature of the business

❖ Financial Position and prospects

FINRA Regulatory Notice 10-22 –Reasonable Investigation of:

❖ The issuer and its management

❖ The business prospects of the issuer

❖ The assets held by or to be acquired by the issuer

❖ The claims being made, and

❖ The intended use of proceeds of the offering

64

Historical, Statutory and Regulatory Background

Public Offerings

❖ Section 11 of the Securities Act (and Section 15)

❖ Section 12 of the Securities Act (and Section 15)

❖ Section 10(b) of the Exchange Act (and Section 20)

Private Offerings

❖ Section 12 of the Securities Act?

❖ Section 10(b) of the Exchange Act (and Section 20)

65

Historical, Statutory and Regulatory Background

Reasonableness Standard

❖ Reasonable Investigation and Reasonable Ground for Belief

❖ FINRA Regulatory Notice 10-22

Materiality

❖ Misstatement or omission of material fact

66

Historical, Statutory and Regulatory Background: Case Law

Escott v. BarChris Construction Corp. (Section 11)

❖ Severe financial difficulties at closing of public offering of debentures

❖ Underwriter relied heavily on its law firm, which assigned the work to a junior associate

– inadequate review

❖ Failed to Verify Information (minutes, key contracts, lender relationship)

❖ Rejected defense of good faith reliance on counsel

SEC Rule 176 (codified principles)

Feit v. Leasco Data Processing Equip. Corp.

❖ High degree of care in their investigation, and make independent verification of the

company's representations

In re Worldcom, Inc. Securities Litigation

❖ An underwriter conducting a due diligence investigation must look deeper and question

more where confronted by red flags

67

Historical, Statutory and Regulatory Background: Case Law

Phillips v. Kidder, Peabody & Co.

❖ Extensive underwriter due diligence included reviewing the issuer's financial

statements, forecasts, budgets, and accounting controls (no scienter)

General Points:

1. Independent investigation of the facts.

2. Non-reliance on management representations. Independent verification.

3. The adequacy of a due diligence investigation has historically been evaluated by

courts based on the particular facts and circumstances, each due diligence

investigation should be tailored to the particular issuer and offering.

4. The presence of and response to "red flags."

68

Attorney Liability

❖ Post-Central Bank, Stoneridge and Janus

❖ Document Preparers

❖ Opinion Givers

➢ Tax or other legal opinions

❖ Other Roles

69

Due Diligence – General Guidelines: Preparation

Initial Meeting with Issuer

❖ Budget, Scope and Deadlines

❖ Threshold Issues to Complete Offering

Initial Review

❖ Read and Review all Relevant and Available Materials on Issuer

Identification of Parties/Team/Experts

70

Investigation Based on Particular Facts and Circumstances

No Standardized Checklist

❖ Sample Checklists may still helpful to craft of list of questions and issues

Mold Inquiry to Specific Offering

❖ Investigation appropriate to circumstances, incl. prior relationship to issuer

❖ “Reasonable Investigation and Reasonable Ground for Belief”

Due Diligence – General Guidelines: Custom Investigation

71

Due Diligence – General Guidelines

Outside Auditors = Resource

Integrity of Management

❖ Balance loyalty to client with knowledge that some clients will distort facts

(healthy skepticism)

Hidden Risks

❖ What economic conditions or market forces needed to support business

venture?

❖ Ex: Real estate development pre-1986 Tax Reform Act

Independent Verification (Purpose of DD)

Identify and Follow Up on Red Flags

72

Due Diligence – General Guidelines

Identify and Follow Up on Red Flags

❖ Fact dependent that indicates problems underlying material info and financial

statements

❖ Ex: lack of board minutes, records of transactions, certain info can’t be found

Update, Ongoing Process

Kick the tires

❖ Review physical property, not just issuer’s business, management, and financial

statements

Records Retention

73

Practical Due Diligence

Flexible process, adapted to observations and initial review

Background Inquiry on the Issuer

❖ Organizational documents, financial statements, product advertising, governmental

filings, business plan, management questionnaires, and litigation

❖ Background and credit check, “Bad Actor”

SEC Filings Review, an Internet search, Lexis Nexis, or Westlaw

Financial Statement Analysis

❖ examination of revenues and expenses

❖ Footnotes as guideposts to areas of inquiry

Private Placement Compliance – Systems and Procedures

74

NASD’s (FINRA) Special Report

❖ Nature of the offering

❖ Size of the issuer

❖ Availability of public information about the company

❖ Issuer's operating and business history

❖ Legal structure of the issuer

❖ Type of security being offered

❖ Potential problems relating to particular issuer and industry

❖ Competency of management and inside counsel

75