Under the federal and state securities laws, most securities must be registered with the SEC before they can be solicited or sold to the investing public. In the issuer’s registration statement and in periodic reports filed after a company goes public, the issuer of securities provides detailed financial information which reasonable investors can use to assess a potential investment.
Certain securities, however, do not have to be registered and are exempt from providing on-going detailed financial disclosure. Under one particular provision of SEC Regulation D, private placements of securities sold to what are termed “accredited investors” are exempt from registration. In theory, although frequently not in practice, “accredited investors” have the financial resources and sophistication to perform their own assessment of the risks and merits of these securities.
There are lots of problems associated with private placements. One can start with the definition of “accredited investor.” Under SEC Rule 501, an accredited investor includes natural persons with a net worth in excess of $1,000,000 at the time of purchase, or an annual income in excess of $200,000 (or $300,000 jointly with a spouse). Let’s get real here. Those numbers are far too low to carry with them any presumption of great financial acumen. (In fact, until the Dodd-Frank Act of 2010, the $1,000,000 net worth requirement could include the investor’s primary residence). Money alone does not translate into investment sophistication. The next problem is lack of transparency; even sophisticated investors need information to make meaningful investment decisions.
The lack of transparency in the private placement market has allowed it to become a fertile breeding ground for fraud. In the recent past, we have witnessed the collapse of bogus hedge funds (sold as private placements) that made extravagant promises and offered little accountability. In the wake of the 2008 market downturn, private placements have promised, but can’t necessarily deliver, higher yields than traditional regulated products such as diversified stock or bond index funds. Elderly investors, whose retirement accounts may qualify them as “accredited,” have been sweet-talked into placing their nest-egg assets into these illiquid private placements in order to produce monthly income to meet living expenses.
Private placements have generated large numbers of investor and regulatory complaints. As FINRA Chairman Rick Ketchum announced on April 20, 2010, “An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests. That initiative has uncovered misconduct, including fraud and sales product abuses.”
One of the primary reasons for the growth of private placements is that many pay high commissions to those who sell them. All too often, brokers are content not to ask too many questions about how an issuer can supposedly deliver higher returns without taking higher risks.
Although private placements are exempt from some rules, brokers who sell them are still subject to laws designed to protect investors from fraud. Thus, a broker who recommends a private placement must tell the truth about it and disclose its risks. Simply by recommending the investment, a broker is deemed to have implied that he has made a reasonable investigation of the issuer and if he has not, or if he has blindly relied on the issuer for information, he may be held liable. The fact that the customer can be considered financially sophisticated does not eliminate the duty to investigate before recommending.
It is also very important to appreciate that under FINRA rules brokers must have a reasonable basis to believe that a recommendation to buy a security is suitable for the customer. There are two components to what is known as the “suitability rule.”
First, the so-called “reasonable basis” suitability test requires the brokerage to have a reasonable basis to believe, based on a reasonable investigation, that the recommendation is suitable for at least some investors. For example, an investment that takes huge risks, imposes substantial costs, is illiquid, and has a limited growth potential may not be suitable for anyone.
Second, the “customer specific” suitability test requires that the broker determine whether the security is suitable for the customer to whom it would be recommended. If an investment carries high risks and is difficult to understand, it is unsuitable for a client whose investment objective is safety.
According to FINRA:
In the context of a Regulation D offering, [the suitability rule] requires broker-dealers to conduct a suitability analysis when recommending securities to both accredited and non-accredited investors that will take into account the investors’ knowledge and experience. The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. The [broker] must make reasonable efforts to gather and analyze information about the customer’s other holdings, financial situation and needs, tax status, investment objectives, and such other information that would enable the firm to make its suitability determination. A [broker] also must be satisfied that the customer “fully understands the risks involved and is … able … to take those risks.”
Certainly there are private placements that are suitable for at least some investors. However, in far too many instances, these investments are sold to clients who are not properly informed of their risks and for whom those risks are not suitable. When those risks are realized, it’s the customers who take the hit. The only saving grace here is that even if the issuer goes out of business, clients who have been the victim of fraudulent or unsuitable sales practices can seek recovery from their brokerage firm through FINRA arbitration.
