Private Placement Fraud: What Investors Need to Know

broker looking at private placement stocks for investors

A private placement refers to a securities offering not registered with the United States Securities and Exchange Commission (SEC) or a state securities regulator. Federal and state securities regulations permit entities to offer securities through an unregistered offering if it meets specific requirements. Very often, private placements are sold to investors by brokers and brokerage firms who have specific obligations when doing so.

Private placements don’t have the information disclosure requirements of public offerings, investors need to get accurate and sufficient information to properly evaluate an offering. If you’ve invested in a private placement through a broker or brokerage firm and you suspect may have been fraudulent or unsuitable contact an investment fraud lawyer from Erez Law, PLLC to discuss your case and legal options during a free consultation.

What Is a Private Placement?

A person or entity wishing to sell securities, including stocks, membership or partnership interests, options, or bonds, usually must register the offering with the SEC. However, a party offering securities may not need to register with the SEC if they qualify for an exemption from registration. An offering that qualifies for an exemption constitutes an unregistered offering, also called a private placement.

Private placements differ from registered securities offerings in several ways. In particular, they do not need to comply with certain laws or regulations, such as comprehensive disclosure requirements that are designed to protect investors against fraud. This lack of regulation can result in fraudulent transactions related to these securities.

However, a private placement does not automatically equate to a fraudulent securities offering. Startups and emerging companies frequently engage in private placements to raise capital for their development and growth because registering a public offering with the SEC can become a complex and expensive process for smaller companies. Hedge funds and other private funds also frequently offer private placements to raise capital they can use to invest in emerging companies or the public stock market.

If you invested in a private placement through a broker or brokerage firm and suspect you may have been defrauded, reach out to our private placement fraud attorneys for a free evaluation.

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 an Investment Fraud Lawyer Today

If you believe you are the victim of private placement fraud, you need an experienced attorney to help you understand your legal options and pursue financial relief and justice from the broker or brokerage firm that recommended and sold you the private placement. Contact Erez Law, PLLC today for a free, no-obligation consultation to learn how a private placement fraud attorney can assist you with pursuing a securities claim.