Private placement involves securities that are not sold through public offering. These securities are instead sold to a small number of specifically chosen investors. Non-public offerings can be an important source of capital for U.S. businesses – especially small enterprises and start-ups. However, private placement investments can also be risky and tie an investor’s money up for a long period of time.
Some advisors issue promissory notes as a kind of private placement, but they are typically very speculative and therefore high-risk – and those risks are often expensive and difficult to identify. They often involve conflicts of interest due to sponsors doing business with affiliated entities. Notoriously difficult to sell, they have no ready market, they aren’t publicly traded and there is no secondary market. An investor’s money can be tied up for year with these types of private placements.
Private placements don’t have to register with the Securities and Exchange Commission (SEC), meaning they can operate outside of SEC regulations. For this reason, the SEC warns investors that fraudsters can use unregistered offerings to get away with investment scams. On top of scams, firms and brokers may omit material facts regarding investment decisions, release inaccurate statements to investors, or fail to adequately determine whether private placements are suitable for clients.
If you’ve lost a great deal of money after investing in private placements or promissory notes and believe a fraudulent or dishonest broker or firm is to blame, find out if you have grounds for arbitration through the Financial Industry Regulatory Authority. Our private placement fraud lawyers at Erez Law are ready to help you recover your losses, contact us today!
Private Placement Fraud and Sales Abuse
The Financial Industry Regulatory Authority (FINRA) warns potential investors to exercise due diligence when choosing to invest in private placements. FINRA recently uncovered private placement fraud and sales practice abuses, in which brokerage firms and individuals gave investors sales materials and memos that contained inaccurate statements.
By omitting pertinent information and misrepresenting facts, these entities made it impossible for investors to make informed decisions, leading to significant losses.
Protecting yourself and your investments from fraudsters requires vigilance. The best way to avoid someone defrauding you is to educate yourself on private placements and to do your own research.
FINRA gives investors a few tips for protecting against private placement fraud and abuse:
- Find out as much as possible about the company and industry before investing. Ask yourself if you’re comfortable receiving limited information during the investment. Learn when and how you can liquidate your private placement securities.
- Ask your securities broker what information he or she has obtained about the issuing company. Your broker should be knowledgeable about risk factors inherent to the company’s business or industry and to the private placement, itself.
- Ask your broker how a private placement aligns with your current risk profile and other investments. Don’t invest without first having a one-on-one conversation with your broker about why this is the right choice for you.
- Carefully review private placement documents. Statements your broker makes should be consistent with offering documents. They should be balanced, detailed, and easy for you to understand.
- Be extremely cautious of private placements that unknown people promote via spam emails or cold calls. These sales tactics are common tools for fraudsters. Check the background of the promoter or broker. He/she should have proper licensure and SEC registration.
Always ask questions and check facts before making any type of investment. Don’t let high-pressure language or “act now” gimmicks push you into making a decision for which you aren’t prepared. Speak with a trusted financial advisor or registered securities broker to ensure you’re making the best decision for your portfolio with private placements.
Background of Private Placements
Unlike public offerings, where issuers can advertise their offerings through publications, news media, or the internet, private placements are sold through brokerage firms. Brokers who work at brokerage firms sell private placements. Many private placements are real-estate related investments. They often have high commissions, which is why some brokers try to sell them.
Although the SEC has published multiple rules that authorize companies to provide a private placement, most entities conduct unregistered offerings through one of the rules in Regulation D because these rules tend to have less onerous disclosure requirements than other rules authorizing unregistered offerings.
Regulation D exemptions limit private placements, including limiting the amount of money an issuer can raise, restricting the types of purchasers who can buy into the offering, and requiring issuers to issue restricted securities. Restricted securities limit the ability of purchasers to sell their securities to others, which prevents securities sold in a private placement from leaking onto the public markets without a registered public offering.
Reg D offerings typically focus on sales to accredited investors.
A person qualifies as an accredited investor if they:
- Earned over $200,000 in annual income (or $300,000 in conjunction with their spouse) in the previous two years with a reasonable expectation of exceeding that threshold in the present year or,
- Have a net worth of $1 million (alone or together with their spouse), excluding the value of their primary residence.
Brokerage Responsibilities for Private Placements
Even though private placements must not meet all of the same criteria as other securities, brokerage firms still have a responsibility to their investors to conduct reasonable investigations into Reg D offerings, according to FINRA Notice 10-22. Under this guidance, brokers may be required to conduct a more thorough investigation into such offerings than other types of investments because of their novelty. Additionally, they must exercise a “high degree of care” in investigating and independently verifying the private placement issuer’s representations and claims. Broker-dealers must determine the scope of the investigation based on the particular facts and circumstances. The process and results of the investigation should be documented.
If the broker-dealer lacks material information about the offering, they must explain this to the investor, along with the potential risk of investing without knowing this information.
Brokers must still conduct a suitability analysis of private placements, which should indicate that the investment is suitable for some investors and that it is suitable for the specific customer.
To satisfy this requirement, the broker-dealer must investigate at least the following:
- The issuer and its management
- The issuer’s business prospects
- The claims the issuer has made
- The issuer’s assets
- The intended use of the proceeds of the offering
The broker dealer must communicate any red flags they discover during the investigation to the prospective investor. The discovery of red flags may require additional investigation by the broker dealer.
Additional inquiries may be necessary into the following matters:
- The regulatory and litigation history of the issuer and its management
- Representations of past performance of the issuer and identification of any misrepresentations or potentially misleading information
- New material developments, including recent regulatory inquiries or legal proceedings involving the issuer
- Payments between the issuer and its affiliates
Additionally, brokerage firms that deal in Regulation D private placements must have proper supervisory procedures in place. If the broker helps prepare disclosures for these products, this information must be disclosed to customers.
Understanding Regulation D
Most private placements seek exemption from SEC registration requirements under Regulation D. Reg D includes three SEC rules that authorize private placements: Rule 504, Rule 505, and Rule 506. Each rule has specific requirements that an entity must meet to qualify for the exemption from registration.
Rule 504 allows certain issuers to offer up to $1 million in securities in 12 months. Issuers can sell securities to any number and type of investors. Issuers also do not have specific disclosure requirements to make an offering under Rule 504. However, securities sold under Rule 504 qualify as restricted securities unless the offering meets additional requirements.
Rule 505 permits issuers to offer up to $5 million in securities in twelve months. Issuers may sell securities to unlimited accredited investors and 35 non-accredited investors. Issuers who sell to non-accredited investors must disclose certain information, including the issuer’s financial information. However, if an issuer sells only to accredited investors, the investor may choose which information to disclose. Furthermore, the issuer must disclose to non-accredited investors any information provided to accredited investors.
Under Rule 506, an issuer may raise unlimited money in a securities offering. Rule 506 provides two types of exemptions. In a Rule 506(b) offering, an issuer may sell to an unlimited number of accredited investors and up to 35 non-accredited investors. However, unlike Rule 505, an issuer can only sell to “financially sophisticated” non-accredited investors (or non-accredited investors with a financially sophisticated representative or advisor) under Rule 506(b). A Rule 506(c) offering permits issuers to advertise their securities offering publicly. However, the issuer may only sell to accredited investors, and the issuer must take reasonable steps to verify purchasers’ accredited investor status.
Erez Law, PLLC sues brokerage firms that sell Reg D private placements. If you think your broker committed private placement fraud and you have suffered losses because of it, contact our firm today for a complimentary, confidential consultation.
Red Flags in Unregistered Offerings
When reading a private placement offering document, investors should look for red flags that may indicate private placement fraud. Common red flags include:
- The offering promises high returns on investment with little or no risk of loss.
- Unregistered brokers oversee the offering.
- Issuers or brokers engage in aggressive sales tactics to pressure you to invest without consulting with your advisors.
- The offering does not have a private placement memorandum, or the offering documents contain grammatical errors or inconsistencies.
- An issuer will accept your investment without verifying your income or net worth.
- The offering doesn’t involve licensed brokers, legal counsel, or financial advisors.
- The issuer only has virtual offices or mail drops.
- The issuer doesn’t have a corporate charter in good standing.
- You receive an unsolicited offer.
- You cannot verify the background or biographies of the issuer’s managers.
Key Considerations for Investors
Investors considering purchasing a private placement from a broker or brokerage firm should keep critical considerations in mind when evaluating an investment decision.
First, when investing in an early-stage company, investors should remember that they have a high risk of total loss of their investment. Many early-stage companies completely fail despite legitimate efforts at growth, leaving little or no money for investors to recuperate.
Second, because private placements typically involve restricted securities, investors should acknowledge the illiquidity of their investment and the fact that it may take years before the issuer experiences a liquidity event or the investor can cash out their investment.
Finally, investors must remember that private placements have far fewer disclosure requirements than registered public offerings. Investors should insist on conducting due diligence on any prospective investment, including requesting from the issuer any information the investor needs to evaluate the investment.
Contact Erez Law to Speak With a Private Placement Fraud Lawyer
If you believe you’re a victim of fraud or misconduct when dealing with promissory notes or private placements, contact the investment fraud lawyers at Erez Law to discuss your situation. If you aren’t sure what happened but suffered an abrupt and significant loss, call our team. With more than 30 years of experience, we know how to recognize securities fraud and can help you understand your rights as a harmed investor.
We offer free consultations, so you can speak with one of our lead attorneys about your case in more detail at no obligation. Dial (888) 840-1571 or contact us online to schedule your consultation. Currently, we are investigating iCap Equity investment losses.