The stock market is soaring but it's a little early to sing, “Happy days are here again.” Uncertainty and risk surround us. We face chronic high unemployment, pervasive under-employment, expanding income inequality, and a perverse failure to fix the banking system that nearly wrecked the global economy in 2008.
Now, adding to this, the government is making it easier to invest in private placements; an inherently higher risk investment. To be fair, the private placement market is a vital source of capital for businesses, particularly small or start-up companies. Each year, these companies raise billions of dollars selling securities in non-public offerings.
That said, I have seen a dramatic rise in financial fraud tied to investments in private placements. Often, private placements are the investment of choice in Ponzi schemes. They are often commonly found in cases of affinity fraud, theft using phony securities, and the practice of “selling away”; the sale of investments not approved by a financial professional's firm. According to recent enforcement statistics from the North American Securities Administrators Association, private placement offerings are the most frequent source of enforcement cases state securities regulators conduct.
What is a Private Placement? Under the federal securities laws, unless an exemption is available, a company or private fund may not offer or sell securities unless they first register them with the United States Securities and Exchange Commission ( SEC ) . The data required of a company in the registration process provides an investor with detailed information about the company.
Private placements are offered pursuant to an exemption from the federal securities registration requirements. The most common exemptions used are found under Regulation D of the Securities Act of 1933, which allow a company to raise money by selling its stocks, bonds, and other instruments without registering them with the SEC.
Depending upon the exemption used, a company can sell its unregistered securities to an unlimited number of “accredited” investors and can sell its unregistered securities to a limited number of “non-accredited” investors. To qualify as an accredited investor a person must have either a net worth ( excluding the value of a primary residence ) of at least $1 million or have an income exceeding $200,000 in each of the two most recent years ( or joint income with a spouse exceeding $300,000 ) with an expectation of the same income level in the current year.
Under Rules 505 and 506 of Regulation D, a private placement issuer is not required to provide any specific written information concerning the offering to accredited investors. But, private placement issuers must provide specified information to non-accredited investors. In practice, these issuers often provide a “private placement memorandum” that describes the offering to all prospective purchasers, including accredited investors. However, the information provided in a private placement memorandum is not pre-approved by the SEC and is usually not as in-depth as the information provided in the formal registration process.
Rule 506 is one of the most popular exemptions to registration. Prior to the 2012 JOBS Act, Rule 506 did not permit general solicitation or advertising of private placement offerings. However, in September 2013, pursuant to the JOBS Act, the SEC issued rules allowing general solicitation and advertising of private placement offerings made under Rule 506 ( c ) . We are beginning to see advertising for opportunities to invest in private placements on the Internet, in social media, at free lunch or dinner seminars, through cold calls, in newspapers and magazines, on radio, and on television.
There are many risks inherent with private placement offerings. Because issuers provide limited information, investors know much less about the investment and the people behind it. No regulator has reviewed the offerings to make sure the risks are adequately disclosed. There may not be regulatory background checks of the sellers and officers of the company issuing the investment. Private placement offerings often project higher rates of return to induce purchasers, which may not be justified by the facts.
Securities offered through private placements are generally illiquid, meaning there are limited opportunities to re-sell the investment. This could be critical if an investor needed to raise cash quickly or if the company was going under and the investor wanted to limit their loss. Due to this illiquidity investors may be forced to hold the investment indefinitely.
Historically, private placements have been promoted through familiar sources such as a friend, current financial professional, or fellow members of a church or social organization. This close connection often gives rise to affinity fraud.
Affinity Fraud refers to investment swindles that prey upon members of groups. For better or worse, people have a tendency to listen to people with whom they have something in common. Many con artists join groups to develop the affinity that creates trust. If the con artist is not a member of the group, they first sell to a few prominent members of the group and use those investors' names to gain credibility with the others. Often, these prominent members spread the word about the investment to others and become the con-man's unwitting sales force. Many of the Ponzi schemes and investment theft cases I have seen involve groups of people victimized by the same thief.
Here are some things you can do to protect your savings when investing in private placements:
● Be wary of any salesman who does not take steps to verify your accredited investor status or allows you to participate in the offering even though you do not meet the income or net worth criteria. Walk away if you are asked to falsify your financial information to qualify as an accredited investor.
● Read carefully all information that is provided to you including any offering memorandum, private placement memorandum, or Form D. The Form D is publicly available through the SEC's EDGAR database. See if the information given conflicts or fails to corroborate the verbal representations made to you about the investment.
● Determine how this investment fits in with your overall portfolio. Does it align with the amount of risk you can tolerate? Does it make up a large percentage of your overall net worth?
● Be wary of private placements you hear about through spam emails or cold calling.
● Determine whether the private placement is being sold on a contingency or conditional basis. These types of private placements are concluded only when certain conditions are met, such as a certain dollar amount raised by a given date. If the private placement is sold on a contingency or conditional basis determine whether and when you will get all your money back.
● Use Google, social media, the Securities and Exchange Commission's EDGAR database, and morningstar.com to learn the essential facts about a company, its key employees, and management. Examine the issuer's governing documents, including its incorporation documents or partnership agreement. Ask about the length of time the issuer has been in business and whether the focus of its business has changed. Check the expertise of the issuer's management and the extent to which management has changed. Ask about executive compensation and any loans made to the issuer by key employees. You do not want your investments used to pay off insider loans or pay for bloated executive salaries. Check about the issuer's business plan and review management's assumptions upon which any business forecast is based. Ask about the business of affiliates and the extent to which any cash needs for its affiliates affect the business prospects of the issuer. Inquire about pending litigation of the issuer or its affiliates. Also, inquire about any previous or potential regulatory problems of the issuer.
● If a financial professional is selling you the private placement use FINRA's broker check at www.finra.org/Investors/ToolsCalculators/BrokerCheck and the S.E.C.'s website at: http://adviserinfo.sec.gov/IAPD/Content/Search/iapd_Search.aspx to study their background.
The new regulations make it easier to invest in private placements but also make it easier for thieves to use private placements to steal your savings. Always investigate before you invest. Contact an attorney as soon as possible if you suspect you have been the victim of investment fraud as all cases have statutes of limitation that can bar your claims if you wait too long.