Tracy Nye, a 50-year-old restaurant owner, said he was forced out of early retirement last year after losing $1.5 million on privately placed investments that were largely unregulated.
The Boise, Idaho, resident said his aim was to keep his retirement nest egg “not only safe, but safe from inflation.” He put $1.1 million into Medical Capital Holdings Inc. and $400,000 into an affiliate of Provident Royalties LLC. In July 2009, the U.S. Securities and Exchange Commission sued the firms for fraud, and most of the investments were wiped out.
Private placements were originally intended for institutional investors and sophisticated individuals. The SEC hasn’t changed most of its net-worth requirements for private placements since 1982, which means they’re being sold to investors, especially retirees, even though they may not be financially savvy enough to understand the risks involved, said Jennifer Johnson, a law professor at Lewis & Clark Law School in Portland, Oregon.
More investors like Nye are lured by private placements, which are loosely regulated equity or debt securities, because they may offer higher yields than traditional stocks or bonds at a time when the Federal Reserve has pushed interest rates to near zero. The securities are issued by companies looking to raise money without going through a public offering.
“There’s nowhere to go, so even very conservative investors are more amenable to the idea of taking greater risk because they feel like they can finally get a payoff,” said Denise Voigt Crawford, former president of the Washington-based North American Securities Administrators Association, which represents state regulators.
Closely held companies, which aren’t subject to the SEC’s periodic reporting requirements, generally offer private placements to retail investors through Rule 506 of the SEC’s Regulation D, Johnson of Lewis & Clark said. Private placements offered under Rule 506 are exempt from federal and state securities-registration requirements.
The securities can be sold to accredited individual investors, who must have a net worth of $1 million or $200,000 in annual income. Public companies may also use Rule 506, generally to offer debt securities to institutional investors, Johnson said.
‘Off the Radar’
Private placements are largely “off the radar screen” since states can’t review offerings under Rule 506 before they’re marketed to investors and the SEC generally doesn’t review them, according to Manning Warren, a law professor at the University of Louisville’s Brandeis School of Law in Kentucky.
“The information investors often get is 99 percent positive, so based on trust they get taken in and end up losing money they’ve saved for retirement,” said Warren. “At best they don’t get enough disclosure to understand the risks involved, and at worst, these investments turn out to be totally bogus.”
Investors lost more than $1 billion by purchasing private- placement securities issued by Tustin, California-based Medical Capital, which financed medical receivables, and about $485 million from Dallas-based Provident Royalties, an oil and gas investment firm, according to the SEC’s estimates. The SEC said the firms made misrepresentations and misappropriated money. Both companies are in receivership and the cases are pending.
Rule 506 requires filing of offering notices with the SEC, which the agency reviews when questions are raised, said John Nester, a spokesman for the SEC in Washington. These notices don’t describe the terms or provide information about the issuer’s financial condition, he said. About 20,000 private- placement notifications are filed with the SEC annually, said Nester.
In 2008, companies planned to issue about $609 billion of private placement-related securities, according to a March 2009 report by the SEC’s Office of the Inspector General. Almost 60,000 companies a year receive $25 billion in funding from individual investors, said Jay Turo, chief executive officer of Los Angeles-based Growthink Securities, which helps private companies raise capital from individuals and institutions.
The number of complaints about private placements to the Financial Industry Regulatory Authority, which oversees brokers and their firms, increased 35 percent this year and more than 50 percent in 2009, the independent regulator said. Nancy Condon, a spokeswoman for Finra in Washington, declined to give specific numbers of complaints.
‘Targeting the Elderly’
States such as Alabama and Texas have anecdotally seen an increase in complaints and enforcement cases involving private placements, according to state securities regulators. In Kentucky, where there had been two investigations since 1997 involving private placements sold by registered brokers, there were 10 this year, said Colleen Keefe, chief of enforcement for Kentucky’s securities division.
In Florida, there were 227 complaints involving private placements in 2009 compared with 197 in 2008, said Amy Alexander, a spokeswoman for the Florida office of financial regulation. The New York Attorney General’s office has received complaints and they’re being reviewed, said Richard Bamberger, a spokesman, who declined to give specific numbers.
“Issuers are targeting the elderly because they’re the ones with retirement accounts and equity in their homes,” said Michael Hines, Utah’s director of enforcement.
Early drafts of the financial-overhaul bill enacted by Congress in July included a provision that would have forced the SEC to review private-placement filings within 120 days. Under the stipulation, later dropped, state regulators could have done their own review if the SEC failed to. The bill does require the SEC to adopt rules by July to prohibit felons and brokers with securities violations from selling them.
The final version of the bill also contains a clause directing the SEC to exclude primary residences from the net worth calculation and directs the agency and the Government Accountability Office to study the accredited investor standards.
While removing homes from the wealth calculation will reduce the number of accredited investors, there isn’t enough oversight by regulators to prevent unsophisticated retail buyers from getting burned by private placements, said Johnson, the law professor.
Finra has a task force investigating more than a dozen brokerages involved with “problematic” private placements, said James Shorris, Finra’s acting enforcement director. Shorris declined to name the firms being investigated. Finra also issued a notice in April reminding brokers of their obligations to conduct due diligence on private placements and ensure that the investments are suitable for their clients.
“We’re very concerned about these offerings following consumer complaints brought to our attention,” Shorris said.
Brokers are taking information at face value from the issuers without doing enough research on their own, according to Carrie Wisniewski, a former Finra examiner, who consults with about 150 broker-dealer firms at Lilburn, Georgia-based B/D Compliance Associates Inc. Smaller, regional firms are most likely to offer private placements to retail investors, Wisniewski said.
Nye, the Idaho investor, said he’s now operating a restaurant that sells smoothies and sandwiches instead of enjoying his early retirement. Brokers at Jackson McClenny Investments, the firm that sold him Medical Capital and Shale Royalties, the affiliate of Provident Royalties, were clear about the illiquidity of the investments, without emphasizing the risks involved, Nye said. The phone number listed for Jackson McClenny has been disconnected and the firm doesn’t appear in Finra’s BrokerCheck.
Investors are attracted to private placements because of the advertised high yields as well as the lack of correlation with the stock market, said Crawford of the North American Securities Administrators Association. Medical Capital and Shale each promised yields as high as 18 percent, Nye said. Private placements related to real estate and oil and gas are popular, and those focused on green energy are becoming more common, said Crawford.
The average retail investment in a private placement for clients of dually registered independent broker-dealer and investment advisory firm Investors Capital Corp., based in Lynnfield, Massachusetts, is $25,000, and the offerings generally provide as much as a 6 percent yield with a 10-year investment horizon, said Danielle Place, senior new business principal for the firm.
One private placement currently being offered by Investors Capital is Reef Oil & Gas Income Fund, an oil and gas limited partnership in North Dallas, Texas. It has a minimum investment of $25,000, provides dividends to investors and has a maximum offering of $30 million. Jeff Gwynn, marketing communications director for Reef, declined to comment citing Finra’s rules.
Private placements are usually illiquid since they can’t be easily resold and often lack transparency, which means investors may not have enough information about the issuer and the track record of its management, said Warren, the law professor.
Even though they’re exempt from registration requirements and can choose what to disclose in their private placement memoranda, issuers of private placements are still subject to the antifraud provisions of federal and state securities laws that prohibit material misrepresentations or omissions, said Lewis & Clark’s Johnson.
The majority of private placements aren’t fraudulent and can be lucrative for appropriate investors who understand the risks involved, according to Turo of Growthink.
Investors should know that a promise of a high fixed payout on investments is a red flag, said Finra’s John Gannon, a senior vice president of investor education.
Even if Finra does order brokerage firms to pay awards to investors, they still may never see the money because the brokers may be inadequately insured or capitalized to compensate everyone involved, said Richard Nervig, an attorney in Fallbrook, California, who represents investors in securities litigation.
One of Nervig’s clients, Iris Berger, won a $355,000 award through Finra’s dispute resolution from Okoboji Financial Services Inc. in Okoboji, Iowa, for selling her securities in Shale. Since Okoboji is out of business, Nervig said he’d be “very surprised,” if Berger, 83, ever receives her money. Okoboji’s Finra registration was terminated, according to a Nov. 4 letter received by Nervig from Finra.
“We knew there was going to be a fire in the forest with these things,” said Joe Borg, director of the Alabama state securities commission. “But we had to watch them light the match and couldn’t do a damn thing.”
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