Summaries of SEC interpretations & court decisions dealing with Section 4(2). “Basic requirements for private placements”.

 All of the offerees must have access to meaningful current information concerning the issuer (i.e. the partnership). The fact that an offeree has considerable financial resources or is a lawyer, accountant or business person, & thus may be considered sophisticated, does not obviate the need for appropriate information to be made available!

 Regulation D in no way relieves issuers of their obligation to furnish investors whatever materiel information may be needed to make any required disclosures not misleading. (SEC interpretation 1992)

 SEC vs. Ralston Purina Co. 346 U.S. 119 (1953) “Private offering exemption for employees would exist only to the extent that the employees had access to substantially the same information concerning the issuer which registration would provide and who are able to fend for themselves.”

 All offerees & purchasers must have access to the same kind of information concerning the issuer which would appear in an SEC registration statement; these persons must be able to comprehend & evaluate such information. (It must be kept in mind that any offer to an offeree who would not qualify, as well as any sale to a purchaser who would not qualify, may destroy the private placement exemption and result in a violation of Section 5 of the Securities Act.)

 The issuer and any parties acting for the issuer, including the Broker-Dealer, must take all reasonable steps to insure that the information given to offerees & purchasers is COMPLETE & ACCURATE. This is “due diligence”. All information passed on in the course of the private placement, either orally or by memorandum (or offering circular) is subject to the anti-fraud provisions of the Federal Securities laws.

 The fact that an offering memorandum is not reviewed by the SEC does not lower the standards for accuracy which would be applicable to any registered offering.

 What is readily apparent from the foregoing is that current and accurate information about the offerees in a private placement transaction is absolutely essential for the making of judgments as to suitability, ability to evaluate an offering & investment and investment intent!

 ACCREDITATION IS NO SUBSTITUTE FOR DISCLOSURE. In other words, just because an investor is accredited (sophisticated, rich and smart), the requirement and need for full disclosure is still very apparent! An offering to accredited investors is exempt from registration, not disclosure.




 The investment in mutual funds recommended by brokerage firms is, of course, subject to the risks of general stock market volatility, the risks of concentrating in a specific sector(s), the risks entailed in the stocks of the individual companies comprising the fund, the risks attendant to the increased volatility of small capitalization companies and the additional volatility of exposure attendant to any foreign stocks in the funds.  These risks are rarely disclosed to the client (Report of the Mutual Fund Task Force – April 2005).

 Furthermore, neither the brokerage firm or the broker typically explains the material difference between Class A, Class B and Class C shares to the client.  These differences include first the front end load.  Class A shares incur an initial sales charge. However, this can be substantially reduced or eliminated by breakpoint discounts.  Class B and Class C shares have no front end load.  Second is the Contingent Deferred Sales Charge (CDSC).  Class A shares do not have one.  With respect to Class B shares, the CDSC declines over several years.  With Class C shares, there is usually a lower CDSC than Class B shares that is eliminated after one year.  Third is 12b-1 fees.  Class B & C shares have this ongoing servicing fee that is much higher than with Class A shares.  Fourth, is Conversion to Class A shares.  For Class A shares this is N/A.  Class B shares convert to Class A shares after 8 – 10 years, thereby reducing expenses.  Class C shares do not and their annual expenses remain at the same level.

 In June 25, 2003, in an NASD Investor alert:  Class B Mutual Funds; Do They Make the Grade?, pointed out that given the fact that senior citizens frequently require funds as a result of declining health, placing funds in an investment that carries a large load, whether up-front or deferred, is suspect.

 While Class B shares do not incur an up front sales charge, they do have a contingent deferred sales charge (the commission paid to the brokerage firm) of typically 4-5%.  If the shares are held for a specified period (generally 6 years),   With each year, the buyer continues to hold the investment in the fund, the deferred sales charge decreases, e.g., assuming a 5% sales charge, the customer is charged 5% if sold during the first year, 4% if sold during the second year, 3% if sold during the third year, and so on.  While Class A shares carry an up-front commission, the customer is provided break-points for investing more than a specified amount (generally $50,000) in a family of funds so that investments of large size ($250,000 to $500,000) range from 1.5% to 2.5%(which is the lower commission paid to the brokerage firm).  The broker’s  commission is determined by the sales charge whether in the form of upfront commissions for Class A shares or the deferred sales charge of Class B shares.  Therefore, the broker has a financial incentive not to inform the customer of the lower commissions available through the breakpoint pricing of Class A shares.

Furthermore, the fees charged the fund by the manager (known as 12b-1 fees) are generally higher (two to three times larger) for Class B shares so that the fund company can recapture the commission paid the brokerage firm.  The brokerage firm may also be engaged with undisclosed revenue sharing (selling “shelf space”) to the mutual fund and/or paying its registered representatives a cash incentive (“cash differential”) to promote certain funds, again without disclosure even though both may lead to the broker’s decision to recommend the fund’s purchase.

 While Class B shares eventually convert to Class A shares. the conversion can take 8 to 10 years so that even after the six year holding period, to avoid the deferred sales charge, expires, the customer continues to pay the higher 12b-1 fees for a period of years.  Given the breakpoint pricing and the lower 12b-1 fees available with the purchase of Class A shares, the justification for recommending the purchase of Class B shares is inherently suspect and is never the best answer for the investor ( Edward S. O’Neal, Mutual Fund Share Classes and Broker Incentives, 9/1/99 Fin. Analysts J.76 (September 1999).

 Assuming the class A shares have a 3% front-end break-point for purchases between $100.000 and $249,000, the respective sales charge would be $5,000 for the Class B shares and $2,000 for the Class A shares.  Further, assuming a 0.80% management fee for the fund and 12b-1 fees of 0.25% for the Class A shares and 1% for the Class B shares, if the Customer intends to withdraw the income from the account, Class B shares are never appropriate.  For example, assuming that the fund earns a 6% annual return, over 8 years the shares perform as follows:

 With Class A shares, the amount invested each year would be $97,000.  The 6% return each year would be $5,820, the 12b-1 fees would be $257 annually, the management fee would be $823 each year and the net earnings  would be $4,740.  Over 8 years, that totals $37,923.  With Class B shares we have the full $100,000 invested for each of the 8 years, instead of $97,000.  The 6% return is $6,000 rather than $5,820 per year.  However, the 12b-1 fee is a whopping $1,060 each year instead of $257!  The management fee increases from $823 per year to $949.  The Net Earnings decline from $4,740 per year down to $4,092.  Over the 8 years, the net earnings after all expenses are only $32,736 instead of $37,923 a decline of  $5,187 or nearly 14%.  Even though “all” of the invested funds go to work in the Class B shares, the Class A shares earn the investor a 14% greater annual return.  Since the 12b-1 fees for mutual funds are generally 65% to 85% higher than the Class A 12b-1 fees, when income is the objective, Class A shares outperform Class B shares because the additional income generated by the “extra” 5% invested cannot offset the additional 12b-1 fees charged on the entire investment.

 In a down or breakeven market, the Class A shares catch up to the Class B shares at the end of the third year and outperform those shares thereafter.  And, with the declining deferred sales charge, liquidating the Class B shares is losing proposition even in those first three years.  Similarly, reinvesting the dividends or interest, provides the same preference for Class A shares.  They catch up with the Class B shares after the fourth year and outperform them thereafter while providing a distinct advantage if liquidated during the first four years.

 The only “winner” involving the purchase of Class B shares is the brokerage firm.  In our example where the sales credit is only $2,000 greater for Class B shares ($5,000 as opposed to $$3,000) the firm would generate an additional $7,354 in 12b-1 fees until the shares converted.  That, the 12b-1 differential, is the motivation, even for pushing Class B shares for even relatively modest accounts.

 Both the NASD and SEC hhave initiated enforcement proceedings as a result of Class B sales abuses.  (See e.g. Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers regarding Discounts on Front-End Sales Charges on Mutual Funds, (March 2003).  Since the broker is compensated on the basis of the deferred sales charge foe Class B shares (and. perhaps, trailing credits on a portion of the 12b-1 fees), the broker has a vested interest in recommending the seemingly “commission free” Class B share purchase so that “all” the money can “work” for the investor and to never disclose the true economic realities.