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

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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

But there is another issue with private placements—a portion of them can be sold to investors that are not “accredited,” if they are deemed a “suitable” investment for those investors. One has to wonder just how “suitable” an illiquid investment

like a private placement would be, even for an accredited individual investor, let alone one that is older and/or not accredited. The SEC and FINRA should take a much closer look at how these higher-risk securities are marketed and sold, and perhaps further refine just who is allowed to sell and but these securities.

Even some institutional investors are not equipped to understand the lack of transparency and risk these securities often carry, or to do the required due diligence that these securities would need. And so they trust that the due diligence is being done by the firms that offer these securities. But was it?

FINRA set new “Guidance for Investigating Private Placements” in 2010, noting that “in 2008, companies intended to issue approximately $609 billion of securities in Regulation D offerings.”

FINRA also issued, in January, a Regulatory Notice requiring BDs to disclose “in the offering document of the intended use of offering proceeds, expenses, and the amount of selling compensation to be paid to the broker-dealer and its associated persons, in any private placement in which a participating broker-dealer is the issuer,” or a participant.

These regulatory proposals are very small steps in the right direction, but more should be done to prevent private placement securities—which are exempt from registration, are far less transparent, more complex and carry more risk than many public securities—from ending up in the hands of investors who do not understand the risks, illiquidity or complexity involved.

And the regulatory view needs to be from the investor perspective: What makes an investor “sophisticated” enough to purchase private placement securities—and, are investors are being “advised” to buy them? If so, is that “advice” in the investor’s best interest? And if they are being sold those securities—are the investors aware that they are dealing with a salesperson who is selling something—like a car—rather than an advisor who is advising in an investor’s best interest, as a doctor or lawyer would? What is the title on that investment professional’s card? Does it confer an advisory or sales relationship? These things all matter—to the investor as well as to the financial services industry and recovery of investor confidence.


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