No Silver Linings for Silver Edge: How Not to Sell Pre-IPO Funds
There is in philosophy something called the via negativa. This is a way of trying to explain what something is by describing what it is not. It has traditionally been applied to descriptions of God. The idea is that one can more clearly describe God’s negative attributes than His/Her/Its positive ones. I never thought this was very useful: the characteristics you end up negating are generally so obvious as to be not worth the work, and they don't even scratch the paintwork of God’s infinite number of positive qualities. But sometimes, via negativa is the best you have.
The SEC engages in via negativa when it regulates by enforcement. When the SEC accuses a party of doing something illicit, it can only tell you what you can’t do rather than what you can. That’s what makes enforcement such a poor regulatory tool. The SEC engaged in such an exercise last week in bringing and settling a half dozen enforcement actions against two entities and their affiliated persons in the popular business of buying and selling shares of private companies that, sponsors and investors alike, hope will someday make them rich by going public. The lesson of those cases is how not to sell pre IPO shares -- sort of.
The main culprits in the story are Silver Edge Capital and its principal, Daniel Mackle. Silver Edge was accused of being an unregistered broker-dealer when it sold its own interests to investors. https://www.sec.gov/litigation/admin/2023/34-97034.pdf. These are the two key paragraphs of the SEC’s order:
9. Silver Edge sold the majority of interests in the Silver Edge Funds’ series through a team of unregistered sales representatives who were compensated as independent contractors. From January 2019 through the present, Silver Edge’s sales team solicited investors to purchase pre-IPO shares through series interests in the Silver Edge Funds. Silver Edge raised over $65 million from accredited investors during this time, through offerings of more than 30 different series interests. Silver Edge’s sales staff was paid directly by Silver Edge, and received discretionary bonuses based on their success in selling the shares.
10. Respondents used interstate commerce or the mails to effect transactions in the Silver Edge Funds’ securities or to induce or attempt to induce others to purchase or sell the Silver Edge Funds’ securities. Respondents provided their sales team with lists of accredited investors, which the sales representatives used to cold-call investors nationwide. Respondents provided potential investors with information regarding the companies whose pre-IPO shares Silver Edge was offering, and took steps to secure investments in the Silver Edge Funds by providing investment documentation to potential investors. When necessary, Mackle followed up with investors to answer questions about the investments or to close the investment deals. Silver Edge received a 4% management fee, in addition to a 3% administrative fee and 10% placement agent fee based on the amount of Silver Edge Funds’ securities sold that was used to compensate its sales team. Mackle took the 4% management fee as his compensation for managing Silver Edge.
Basically, Silver Edge charged a 10% placement fee -- that is, a commission -- to its investors, and then used that money to pay compensation to its salesmen based on how much they raised. The salesmen were not mere functionaries, but actually solicited investors and sold them fund interests, which were securities. Looked at that way, it seems pretty obvious that Silver Edge was doing everything that a broker-dealer would do, and did it blithely with not a worry about what was coming for it further up the road. But if it walks and quacks like a broker-dealer, it must register as a broker dealer. It is hard to fathom an easier case.
The second entity charged in this flurry of enforcement actions was Equity Acquisition Corp. (“EAC”) and its principal, Carsten Klein. Klein made a good living buying shares of private companies and selling them to pre-IPO funds like Silver Edge. https://www.sec.gov/litigation/admin/2023/34-97035.pdf. These are the SEC’s money paragraphs against EAC:
4. To date, Klein has conducted transactions in at least 30 different pre-IPO companies, including highly anticipated offerings such as Palantir, Pinterest, 23andMe, TopGolf and Social Finance Inc. In each case, Klein or an associate of Klein’s identified a willing seller, negotiated a purchase price, and worked through the legal process to acquire the shares. In some instances, EAC purchased the shares directly and worked with the Pre-IPO Company to have EAC listed on the company’s capitalization table. In other instances, EAC entered into a forward contract with the seller that gave EAC the right to the shares following a liquidity event.
5. Following EAC’s purchase of shares or entry into a forward contract, EAC identified funds that were interested in buying the shares. EAC has sold to at least 10 different pre-IPO funds or holding companies, most of which were located in the United States. Klein operated EAC out of Florida, purchased shares from individuals and entities located throughout the United States, and sold to funds operating, among other places, in New York and New Jersey. Klein negotiated the quantity and price for the shares with the funds, and entered into a nomination agreement that obligated EAC to transfer the shares to the funds upon the occurrence of the liquidity event. EAC’s profit was the difference between the price for which it purchased the shares and the price for which it sold the shares.
6. Since 2019, EAC has purchased more than 14 million private company shares and sold more than 13.4 million shares to different pre-IPO funds or holding companies. In doing so, EAC has exhibited a regularity of participation in the securities business well in excess of a few isolated transactions. In addition, EAC buys and sells the securities as principal (i.e., not as an agent for the funds), carries a regular inventory of shares, and makes a market in the price of the shares through its negotiated pricing. In each of those instances, EAC has transacted business as a Dealer as that term is defined in Section 3(a)(5) of the Exchange Act.
On the surface, EAC clearly engaged in the business of buying and selling securities, and if that is what securities dealers do then EAC was a “dealer.” However, note an incongruity. The SEC demanded and got lifetime bars against Silver Edge and its people. Klein and EAC, however, are not barred. They have to pay $3.9 million in disgorgement, penalties and interest, but are given 2 years to register as a broker-dealer. Why the difference?
I think because Silver Edge quacks louder as a broker-dealer than EAC does as a dealer. Sure, a securities dealer buys and sells securities for profit. But what do you do when you trade in the market? Klein and EAC were trading for their own account, using their own money. There were no investors involved. The SEC’s key finding was that “in doing so, EAC has exhibited a regularity of participation in the securities business well in excess of a few isolated transactions.” But that’s no answer at all. Hedge funds, family offices, day traders, and many other unregistered entities do the exact same thing, and they are not (yet) deemed “dealers,” but private investors. The only difference I can discern is that they primarily trade in the public markets through registered broker-dealers, while EAC was dealing directly with buyers and sellers in private markets. As such, EAC looks like an OTC market maker -- the classic “dealer.” But it seems a stretch to me, and I’m guessing from the indulgence it offered EAC that it seemed a stretch to the SEC too.
Notice there is no suggestion that Silver Edge or EAC in any way failed to disclose what they were doing. As we know, disclosure cures a multitude of securities law sins. See https://www.brokeandbroker.com/6483/insecurities-aegis-frumento-straightpath/. But when you have a registration requirement, as you do when you act as a broker-dealer, it doesn't matter what you disclose.
So, there are lessons in these cases for pre-IPO funds: It is best to sell your interests through a broker dealer. If you don't, you're on murky terrain and you need to be careful. At the very least, make sure that you're not charging your investors a commission, that your “sales team” are not actually the ones doing the “selling,” and that you don’t pay them based on how much they raise, whether you call that pay commissions, bonuses, or whatever.
However, the lesson for persons who buy private shares for their own account and then resell them at a profit is not so clear. Sure, the safest thing for you to do is register as a broker dealer, with all the FINRA-borne hassles that entails, as EAC agreed to do. But it's harder to say that you absolutely positively have to. Unlike for Silver Edge, there may still be unregulated silver linings for companies like EAC.
ABOUT THE AUTHOR
Aegis Frumento co-heads the Financial Markets Practice of Stern Tannenbaum & Bell, New York City. He represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations). He has decades of experience representing SEC, CFTC and FINRA regulated firms and persons in regulatory enforcement investigations, hearings and lawsuits. Drawing on his five years managing the Executive Financial Services Department of Morgan Stanley Smith Barney, Aegis has more experience than most in the securities and corporate governance laws affecting senior executives of public corporations. When not litigating, Aegis enjoys working with new and existing broker-dealers, registered investment advisers, and private equity funds, covering all legal aspects from formation to capital raising. Those clients now include pre-IPO funds, fintech firms, and industry professionals looking to adapt blockchain technologies to finance and financial market enterprises, including the use of cryptosecurities to represent equity and debt interests.
Aegis's long and distinguished career includes having been a Managing Director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP. He graduated from Harvard College in 1976 and New York University School of Law in 1979. Aegis is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments. He is a Fellow of the American Bar Foundation, rated A-V Preeminent by Martindale-Hubbell, named a New York Metro Area “Super Lawyer,” the current Chairman of the New York City Bar Association's standing Committee on Professional Responsibility, and most recently a Founding Member of the Financial Professionals Coalition.
GUEST BLOG: [In]Securities: No Silver Linings for Silver Edge: How Not to Sell Pre-IPO Funds by Aegis Frumento Esq
Blackbook Capital Versus FINRA: A Decade of Battle (BrokeAndBroker.com Blog)
JOIN the Financial Professionals Coalition, Ltd
Attorney General James Continues Crackdown on Unregistered Cryptocurrency Platforms / AG James Sues KuCoin for Allowing Investors in New York to Buy and Sell Crypto without Registering with the State / Lawsuit Marks AG James’ Eighth Action to Rein in Shadowy Cryptocurrency Platforms (NYAG Release)
Series 7 Exam: can I take it without a sponsor? (YouTube Video from Capital Advantage Tutoring / Kenneth Finnen)
Morgan Stanley Seeks TRO Against Advisor Who Skipped to LPL /
In a court filing, the wirehouse said the advisor took his client list and has been poaching clients, in violation of his employment agreement. (Financial Advisor IG by Glenn Koch)
Former Goldman Sachs Managing Director Sentenced to 10 Years in Prison for His Role in Massive Bribery and Money Laundering Scheme/ Roger Ng Previously Convicted of Conspiracies to Pay More Than $1.6 Billion in Bribes to a Dozen Foreign Officials, and to Launder Billions Embezzled from 1Malaysia Development Berhad (DOJ Release)
Former Wall Street Precious Metal Traders Sentenced for Wire Fraud (DOJ Release)
Justice Department’s Ongoing Section 8 Enforcement Prevents More Potentially Illegal Interlocking Directorates / Antitrust Division Continues to Focus on Competitors Sharing Company Directors in Violation of Section 8 of the Clayton Act (DOJ Release)
Colorado Man Charged with Sports Cards Fraud Scheme (DOJ Release)
Operators And Attorney Of Global Multi-Million-Dollar Cryptocurrency Ponzi Scheme "AirBit Club" Plead Guilty (DOJ Release)
Baton Rouge Man Sentenced to 57 Months in Federal Prison for Fraudulent Investment Scheme (DOJ Release)
Cape Coral Caretakers Plead Guilty To Stealing More Than Half A Million Dollars From Elderly Victim (DOJ Release)
Man Sentenced to 30 Months in Federal Prison for Defrauding Investors of 2 Companies, Evading Taxes (DOJ Release)
Central Florida Man Pleads Guilty To Committing Almost $20 Million In Fraud (DOJ Release)
Four Individuals Arrested for Investment Fraud Scheme Targeting Hawaii Residents (DOJ Release)
Statement Regarding the Commission’s Disapproval of a Proposed Rule Change to List and Trade Shares of the VanEck Bitcoin Trust by SEC Commissioner Hester M. Peirce and SEC Commissioner Mark T. Uyeda
SEC Sues Utah-Based Crypto Asset Company, Its Founder, and a Recidivist Salesperson for Fraud and Registration Violations (SEC Release)
SEC Charges Rio Tinto plc with Bribery Controls Failures (SEC Release)
SEC Charges Pokerstars Parent Company with FCPA Violations (SEC Release)
SEC Files Emergency Action Against Miami Investment Adviser BKCoin and Principal Kevin Kang for Orchestrating $100 Million Crypto Fraud Scheme (SEC Release)
SEC Awards About $500,000 Whistleblower Award to Joint Claimants
Order Determining Whistleblower Award Claim
Meeting the Challenges and Fulfilling The Promise of Global Financial Markets: Remarks before the Institute of International Bankers by SEC Commissioner Mark T. Uyeda
Federal Court Orders Texas Energy Broker, Its Owners, and Affiliated Trading Firms to Pay Nearly $3 Million For Fraud, Trading Against Customers Without Consent and Failure to Supervise (CFTC Release)
FINRA Fines and Suspends Rep For Receiving Unemployment Benefits
In the Matter of Joseph Louis Menotti, Respondent (FINRA AWC)
FINRA Arbitration Panel Dismisses Something Involving Something Against Wells Fargo by Prominent Whistleblower Analyst
In the Matter of the Arbitration Between David William Maris, Claimant, v. Wells Fargo Securities, LLC, Respondent (FINRA Arbitration Award)
The $3.4 Million Tip: (FINRA Blog / FINRA Departments of Member Supervision and Enforcement)