Understanding Private Placements

What are Private Placements?

Private placements investments are sometimes referred to as “non-conventional investments,” “Regulation D investments” or simply “unregistered offerings.” Regardless of the term used, all private placements generally have the same characteristics and risks, which we will address at length below. Examples of private placement investments can include interest in limited partnerships or limited liability companies, notes, debentures, common or preferred stock or bonds.

The key aspect of all private placements is, unlike traditional stocks or mutual funds, private placements are securities offerings that are exempt from the normal registration requirements of the Securities and Exchange Commission, or SEC. Specifically, Regulation D of the Securities and Exchange Act of 1933 contains three rules (Rule 504, 505 and 506), which allows some companies to sell securities without having to registered them with the SEC. In general terms, private offerings are exempt from many of the regulations and rules that were created to protect the investing public. These regulations, include, for example certain disclosure requirements.

Another key distinguishing characteristic of a private placements are their lack of liquidity. Because private placements, unlike traditional stocks and mutual funds, are not sold on an exchange they may not be easily liquidated. This characteristic is extremely important for investors to understand. If you are purchasing a private placement your expectation should be that you will hold the securities indefinitely. According to attorney Marc Fitapelli, “we often hear from our clients that they were promised the ability to sell interests in a private placement within a certain number of years. These promises are often nothing more than lies.”

What is Form D?

“Form D” is a document that is filed with the Securities and Exchange Commission by any issuer who is relying on a Regulation D exemption. Form D will include basic information about the offering, the issuer and its promoters. It is important for investors to understand filing a Form D does not mean a security is registered. In fact, fraudsters often use filed Form Ds to trick investors into believing that a security is registered, and somehow sanctioned, by the Securities and Exchange Commission.

An example of this type of fraud can be demonstrated in a 2014 case filed by the Securities and Exchange Commission against Fleet Mutual Wealth in the U.S. District Court in the Central District of California. In that case, the SEC alleged that the defendants were perpetrating a pyramid scheme. According to the allegations, the firm promoted the fraud by claiming that they were registered with the SEC to sell securities, referring investors to their Form D filing.

What is a Private Placement Memorandum?

A private placement memorandum, which is also called an offering memorandum, is a document that is provided by an issuer that discloses information about a Form D offering. A private placement memorandum is generally not reviewed by the SEC or other securities regulators nor are there any requirements that they even be provided to investors of unregistered offerings. In addition, the facts presented in a private placement memorandum are often skewed towards the issuer and, as a result, are not always fairly balanced. While these documents may resemble a prospectus, it is critical for investors not to rely only on the contents of a private placement memorandum when making an investment decision. Investors, together with their financial advisors and brokers, must conduct independent due diligence on any private placement offering. Investors, together with their broker or financial advisor, should feel comfortable asking any question to the investment sponsor. If your questions are unanswered or inadequately answered, consider this a red flag.

What is an Accredited Investor?In general terms, an individual must be an accredited investor in order to participate in a private placement investment. An accredited investor is a person who can satisfy either of the following:

(1) Your net worth, either alone or with your spouse, is over $1 million. Your net worth is calculated without including the value of your primary residency. The Securities and Exchange Commission provides examples for how investors should be calculating their net worth.

(2) Your earned income exceeded $200,000, or $300,000 if you are married, in each of the prior two years and you reasonably expect the same income for the current tax year.

The definition of an “accredited investor” changed on July 20, 2010 with the passage of the Dodd-Frank Act. Specifically, Dodd-Frank excluded an individual’s primary residence from the calculation of their net worth. This change means that investors who may have been considered “accredited” prior to July 20, 2010 may no longer be for the purposes of any offerings made after that date.

What is My Broker’s Role in the Sale of a Private Placement?

A broker has two basic obligations when they recommend a private placement. First, the broker must conduct a reasonable investigation into the offering in order to feel comfortable that it is a product it wants to sell generally. Second, the broker must believe that the private placement investment is suitable for you, specifically, in light of your age, risk tolerance and need for liquidity. The Financial Industry Regulatory Authority, or FINRA, outlines these obligations in Regulatory Notice 10-22.

With respect to its obligation to conduct a reasonable investigation, FINRA instructs that a broker should not “blindly” rely on the information provided by the issuer, including the private placement memorandum and any marketing materials. A broker’s investigation should include, at minimum, background checks on the investment sponsor, independent verification that the sponsor’s financial assumptions are realistic, understanding the fees of the offering and verification of the claims being made by the issuer. Often brokerage firms hire third-party companies to conduct due diligence on offerings. Investors, prior to investing, should ask to see a copy of the broker’s due diligence, including any third-party due diligence reports.

Brokers do not discharge their obligations simply because it determines that a Regulation D offering is acceptable for sale, generally. A broker must complete the second basic part of its obligations and ensure that the Regulation D offering is suitable for you. In doing so, a broker must consider your financial situation, age, tax status and investment objectives. For example, if you are unwilling to risk your entire principal or need access to your money in the short-term, then a private placement may not be the right type of investment for you.

What Questions Should Investors Should be Asking?

As with any investment, it is critical that you and your financial advisor determine that a private placement is right for you. Investors may want to consider the following, non-exhaustive and general, factors before they invest:

  • Are you willing, and do you really understand, that you may lose your entire investment principal?
  • How long is the investment sponsor’s track record and does it include any bankruptcies, litigations or pending actions by any regulators? Have the sponsor’s other offerings been successful?
  • Do you understand how everyone, including your broker, is being compensated for the offering and on an ongoing basis? Do any of the compensation arrangements present conflicts of interests?
  • Have you been provided with financial statements that were audited by a third party?
  • Are you satisfied with the soundness of the sponsor’s business model? Do you understand the business model and are their factors that may adversely impact it (i.e. competition, regulatory restrictions)?
  • Did you request a copy of any third-party reports that were ordered by your broker?
  • If you are investing in a real estate or oil and gas investment, have you reviewed the underlying documents (i.e. loans, leases, deeds, etc.)? More importantly, were those documents even made available by the investment sponsor?
  • Were you offered the opportunity to ask questions, either directly or through your broker, to the issuer?

The decision to invest in an unregistered offering is a serious one that requires a thorough investigation of many issues, which are outside of the scope of this article. Unfortunately, no two offerings are alike and this list, while a good general guide, is non-exhaustive and should not be relied on as an exhaustive list. Investors are encouraged to work with their financial advisors in order to achieve a deep understanding of the risks and rewards of any Regulation D offering. As with any investment, if you have any doubt, do not be afraid to simply say no.

Can I Sue My Broker if My Investment Goes Bad?

It depends on the specific facts of your case. If, after reading this article, you believe that your broker failed to adhere to FINRA or the SEC’s basic guidelines for the sale of private offerings, feel free to contact Marc Fitapelli at (212) 658-1501 or Jonathan Kurta at (212) 658-1502 for a free consultation.