Creating a successful deal requires that you have all your I’s dotted and T’s crossed. That includes more than accurate recordkeeping and having the right business structure. You also need to delve into the backgrounds of every single person involved in the project. Why, though?
The Importance of Transparency
Few things are as critical in the deal-making process as transparency. That applies to things like how you intend to make money and structure the business, but it also includes being upfront about the people involved in the deal.
Imagine this: You hear about a great investment opportunity and are very interested. After doing your due diligence and turning up no red flags, you decide to buy into it. However, after about six months, information comes out that one of the individuals managing the deal has a criminal record, including embezzlement.
Would you be happy about that revelation? No, you wouldn’t. You would probably file a lawsuit against the business for not revealing that data to begin with. This information is important when deciding whether to put your money into a particular deal or not.
Your investors are in the same situation. They need (and deserve) accurate information about everyone involved in the deal so they can make a sound decision that supports their financial goals.
Background Checks: Understanding Their Purpose
Background checks delve into multiple aspects of an individual’s life. It’s not just about identifying things on a criminal record. It’s also about highlighting censures, loss of licensure, reprimands, and more from authorities within the financial and securities industry.
All this information must be disclosed as part of the PPM. These infractions are important information for potential investors. This includes bankruptcies, lawsuits by investors, loans that have gone into default, and anything that might be deemed pertinent to investors.
However, some infractions will also bar an individual from selling investments entirely. If someone has been accused of securities fraud within the previous 10 years, they are not allowed to sell investments.
Other situations can also prevent someone from selling investments, including the following:
• Banned/removed from FINRA
• Loss of broker-dealer license
• Loss of any other FINRA-registered license
Perhaps the single most important situation would be if a regulator makes an allegation of fraud. If they can get a final judgment of fraud, the individual is banned from raising capital in any way at all forever. They can never sell investments again.
Regulators can use some seemingly underhanded tactics in their quest to prove fraud, as well. That’s particularly true if the individual attempts to settle with them. Generally, regulators require a consent order, which is like a settlement agreement. But part of these documents requires that the individual in question agree that certain things occurred – including fraudulent activities.
This comes back to bite the individual if they signed the agreement not realizing what they were agreeing to. The regulator will say that because the individual agreed that this situation happened, they can no longer sell securities under the issuer exemption.
What Is the Issuer Exemption?
The issuer exemption explains that, for all investments, you’re either licensed to sell investments through an investment advisor or broker-dealer or exempt from being registered. If you’re not licensed to sell securities, you’re relying on this exemption. This is also an excuse for regulators to combine all activities under one umbrella and search for any securities law violations.
Additional Fallout Potential
One of the most important things to remember is that no one operating under the issuer exemption can receive any compensation for raising capital. If someone is not licensed to sell an investment, they cannot accept a commission or performance fee for bringing in investor dollars. If they do, they cannot rely on the exemption and may be liable as an unregistered broker-dealer, which can result in being banned from the industry.
In addition to the potential for being banned from selling investments, this can also have dramatic ramifications for the syndication itself. If someone loses their securities exemption from working with unlicensed broker-dealers, it makes them responsible for guaranteeing investors their money. It pierces the corporate veil, and the managers must shoulder that significant financial responsibility.
Guidance Moving Forward
To sum up, only pay people commissions to bring capital if they are licensed and legally able to receive those fees. The downside of fraud charges is being kicked out of the industry or guaranteeing and violating securities laws guaranteeing investors’ funds. It’s a harsh punishment because it’s not something that occurs when capitalizing. The situation will come back to bite you years later when the investors are unhappy that they didn’t get the expected return, or they have losses and are trying to figure out how to recoup funds and start peeling back the layers. If they can figure out that you were paying people to bring in their capital, they have the means to recover at least some of their capital.
Are commissions the same as giving extra shares to a person to bring in more investors? Yes, it can be deemed a commission if you’re giving shares in exchange for people bringing in capital. Regulators consider it the same as paying a commission or performance fee.
In Conclusion
Transparency is crucial at all points of a deal, and that’s particularly true when it comes to the people involved. Anything that might be pertinent to investors must be disclosed in the PPM, but conducting thorough background checks is also about unearthing things that might derail future deals, like charges of fraud.
Unsure how to conduct a thorough background check? Not certain whom should be checked in the first place, or concerned about the issuer exemption? Contact Crowdfunding Lawyers to schedule a consultation. We work with dealmakers to help them structure their offerings correctly and have years of experience conducting in-depth background checks at all levels to provide peace of mind and ensure compliance.