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Shadowland: The Sequel

March 17, 2011

In my post last week entitled “Shadowland“, I wrote about the investing netherworld illuminated – although only impressionistically – by the SEC Form D filings. Under Regulation D of the Securities Act of 1933, certain companies can issue securities and raise money without formal registration and without any disclosure of the details of their offering or their business.

Often with the assistance of broker-dealers, companies raise hundreds of billions of dollars each year in the shadow of Regulation D. Understandably, the SEC and other regulatory bodies worry about the potential Regulation D exemptions offer for securities fraud. In this post, I will tell one story that illustrates the complexity of this vast undermarket for investment capital and the difficulties in evaluating the meaning of an offering from an investor protection perspective.

I have written this essay almost entirely using data from our Knowledge Mosaic research platform. I construct this story from information on our Form D search page, Form ADV search page, SEC Filings search page, and SEC Enforcement Actions defendant search page.

Sales Compensation for Exempt Offerings

In the last week alone, the SEC published 58 Form D filings for the sale of securities – ranging in amounts from $50,000 to $119 million – that named “Sales Compensation Recipients”. These are individuals or organizations that receive a commission or finders’ fee for helping the issuing company sell its securities and raise its capital. For perspective, about 15 percent of all Form D filers offer commissions or finders’ fees for this assistance.

Typically, sales commissions average about 5 percent. But sometimes the sales agent receives a much higher percentage. Presumably, the company pays these commissions as an operating cost and the investors themselves don’t directly bear this burden. Nonetheless, this cost of capital can significantly diminish the value of the capital itself, and particularly because of the variance in the sales compensation associated with these offerings, commissioned sales higher than 5 percent deserve scrutiny and analysis.

For example, of the 58 Form D filings with sales compensation recipients published in the last seven days, five commissions exceeded 10 percent of the offering total. Circumstances can vary and sometimes the notes in these filings mitigate the impression of excess. However, let’s examine one issuance, in particular, in which the sales commission is high and the history of the sales agent is complex and interesting. Our goal here is not to point fingers or impugn agents, but to shed light on a vast landscape that for too long has been shrouded in darkness.

Premier Alliance Group

On March 9, Premier Alliance Group, Inc., a Charlotte, North Carolina, business and technology consulting firm organized as a Nevada Corporation, filed a Form D notice for an exempt offering of convertible preferred stock and warrants in the amount of $5 million. Premier Alliance is a publicly traded company (ticker: PIMO). Its operating and capitalization history is complicated, but it generates meaningful revenues (nearly $10 million annually).

Premier Alliance has issued numerous press releases and SEC filings regarding its success in raising the $5 million from two accredited investors. The company is clearly excited about the growth opportunities this new working capital will offer and grateful for the confidence in their business the two investors have displayed.

However. The sales commission of $650,000 is 13 percent of the total raised — clearly on the outer margins of the norms for commissioned securities offerings. It is true that $5 million is at the low end of the range for offerings of new securities, and commissions and fees charged by investment banks for managing the offering may be correspondingly higher if the offering is a private placement and the amount issued is relatively small. However, it is also worth mentioning that the vast majority of exempt offerings are under $5 million and it may well turn out to be true, as a result, that the vast majority of commissions are at the high end of range. Any way one slices it, 13 percent is a big chunk of the apple. Indeed, Premier Alliance has raised a bit more than $2 million in three far smaller exempt offerings in the past year, and the sales commissions for those offerings totaled only $53,000, about 2.5 percent of the offering amounts.

Maxim Group

Equity Source Partners LLC served as the placement agent for the smaller offerings. For whatever reason, Maxim Group LLC, a FINRA-registered broker-dealer, served as placement agent for the more recent Premier Alliance $5 million offering and received the 13 percent sales commission. Maxim Group is a well-established investment banking, securities, and investment management firm. It has assisted many commercial companies and investment companies in raising funds for their businesses. Maxim lists hundreds of transactions in which it has played the role of placement agent, manager, book runner, adviser, or underwriter. It assists companies small and large. Maxim Financial Advisers, an SEC-registered investment adviser, manages more than $500 million on behalf of 460 accounts.

So everything looks spinorty, more or less. Premier Alliance is a small public company that would not have been able to afford to raise capital using a formal registration process. The Regulation D exemption gave it the flexibility to work with sophisticated individual investors to grow its business while still disclosing basic details of the financing. Maxim Group is a respected investment bank that assists businesses in raising funds they need to grow and prosper, and finds time to operate a charitable foundation to benefit underprivileged children.

So where’s the rub? The rub is that Maxim Group employees have run seriously afoul of the law on at least two occasions. While the SEC has never brought an enforcement action against Maxim itself, it has disciplined the firm’s financial advisory wing for regulatory violations, something that is true for less than 10 percent of all registered financial advisers.

More seriously, civil and criminal charges were brought against employees of the Maxim Group, in one instance for accepting kickbacks to promote the stock of one particular company and in another instance for diverting funds from the account of one major institutional client to the account of another major institutional client.

Maxim may be guilty only of poor hiring judgment and weak internal controls. And Maxim is certainly not the only broker-dealer or financial adviser to hire wayward employees. However, these lapses, in combination with the 13 percent commission, expose more general weaknesses in the exemption regime established by Regulation D. On the one hand, we can agree that overt registration requirements for all offerings would be too restrictive and would stifle the flow of capital. On the other hand, the concept of “placement” and the role and responsibilities of “placement agents” remains uncertain. Even private markets require trust and some level of transparency to operate efficiently.

A final note. Maxim Group has served as a commissioned placement agent for 19 companies issuing securities under Form D since August 2009. These companies have issued more than $131 million in securities, and Maxim has received more than $9 million in commissions, for an average of slightly more than 7 percent All of these issuances involved only accredited investors. For those interested in further scrutiny of these Form D offerings where Maxim Group serves as placement agent, you may download this spreadsheet.

Exempt Offerings and Private Placements: Is There a Problem?

With an average offering of only $7 million for these transactions where Maxim Group serves as placement agent, one can expect the cost of these private placements to be higher than for larger offerings. However, 7 percent (not to mention 13 percent) is a stiff price for any investor or business to absorb out of the gate.

It is not clear that regulatory bodies such as the SEC have the robust staffing and data transparency needed to properly evaluate the ability of these private markets to regulate and police themselves with regard to how fees and commissions are negotiated, standardized, and disclosed. It is certainly true that most exempt offerings do not involve any placement agent or sales commission at all. Does that matter? Probably not. There are certainly situations where a placement agent can offer benefits that justify some kind of sales commission. It may sometimes be more difficult to raise the offered funds without a placement agent.

The problem is that we really don’t know enough to make any judgment. A few small adjustments to the disclosure process might significantly improve our understanding of what happens with these offerings. For example, there is no historical record of the offering once it has been filed. In many cases, it is unfilled when filed. It would be useful and important to know the final outcome of the offering, when it expired, how much money was raised, how many total investors participated, and how many were unaccredited investors. It would be good to get updates on commissions or finders’ fees that are only listed as estimates. Finally, there is an important gray area in Item 16 involving funds dispersed to officers, directors, or promoters. These dispersals can involve significant amounts of money, and we need more information on their origin, if they involve proceeds from sales of existing stock or are received for some other reason. None of these changes to Form D would be difficult to adopt, and they would greatly elevate our understanding of this poorly mapped capital market.

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