Why Regulators Should Take a Closer Look at Risks of Private Placement Securities

Private placement securities in Provident Royalties or Medical Capital Holdings have been cited in a number of lawsuits against some of the broker-dealers that sold the securities. Indeed, as AdvisorOne’s Janet Leveaux points out in her coverage of lawsuits against Securities America over sales of these securities, “Recently, these private-placement lawsuits have contributed to the demise of QA3 LLC in February 2011 and GunnAllen in May 2010.”

On March 18, according to an AdvisorOne article, “U.S. District Judge Royal Furgeson rejected a class action settlement under which independent broker-dealer Securities America would have paid $21 million to settle charges that it didn’t conduct the proper due diligence on investments sold by Securities America reps from Provident Royalties LLC and Medical Capital Holdings Inc.”

This court decision will allow arbitration to continue in states in which regulators had sued Securities America, some of its officers and certain registered representatives, the article continues. Massachusetts and Montana sued Securities America in 2010 for “misleading” investors.

As Ameriprise said in a statement on March 23, Securities America is one of "many firms that distributed Medical Capital and Provident Shales securities."

But How Did We Get Here?

Private placement securities have long been a boon and a bane for brokers and investors. They offer the option to companies to raise capital without the responsibility of filing public offering documents with the SEC and opening their books to regulatory and public scrutiny. Brokers and broker-dealers (BDs) make money offering and selling these securities. But this leaves investors without enough information about what they are being sold. Are private placement issuers and sellers doing enough due diligence?

Private placements are mainly supposed to be sold to “accredited investors,” institutions—banks, investment and insurance companies. But employee retirement accounts or charitable organizations with assets of over $5 million—not so very large anymore, are also considered accredited investors. And they can be sold to “accredited” individuals who meet certain income and net worth criteria.

The Dodd-Frank Act required a change to the definition of “accredited” individual investors, now excluding the investor’s “primary residence” when calculating net worth to see if an investor qualifies as “accredited,” and the SEC proposed a rule to that effect in January. The SEC defined individual investor qualifications this way:

1. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
2. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
3. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Sales of Private Placements to Non-accredited Individual Investors