Private Placement Fraud is possible because it is short on government regulation and fraught with financial misdirection
Major concerns for individual investors attached to the private placement market include risks of financial fraud, illiquidity, phony valuation figures, sales practice abuses, and inaccurate statements or omitted information.
Fortunately, forensic accountants and financial experts can track billions of dollars in fraudulent private placements sold to individual investors. Broker-dealers often fail to meet their due-diligence responsibilities, but plaintiff lawsuits may be able to recover much of what has been lost.
A broker-dealer is a brokerage firm that buys and sells securities on its own account as a principal before selling the securities to customers.
According to the U.S. Justice Department, many private placement firms operate like a Ponzi scheme. Broker-dealers who fail to carry out their due-diligence responsibilities can be liable to investors for damages and losses from a private placement investment.
The Securities and Exchange Commission (SEC) holds broker-dealers responsible for recommending private placements and a failure to carry out certain duties could result in a violation of anti-fraud provisions and federal securities laws. Investors who have suffered damages in a private placement offering can bring forth claims against their broker-dealers to recover financial losses.
What Are Private Placements?
Private placements are securities sold off-market, without an initial public offering, making them exempt from registration under an exception to the Securities Act of 1933. A typical private placement is sold to select and well-educated investors.
That was the original idea behind the instrument. Nevertheless, private placements have gone beyond old borders, and as a result, dozens of broker-dealers are involved in litigation stemming from sales of allegedly fraudulent private placements in a variety of industries—many of the broker-dealers now have declared bankruptcy.
Often, investors are told their money will be invested in specific fields, though it can be mixed in with other investment money, paid out in classic Ponzi scheme fashion as “dividends” or “returns on capital” to earlier investors, according to reports from the Securities and Exchange Commission (SEC). The SEC has charged many firms with related fraud charges.
What Constitutes Investment Fraud?
- Sloppy Due Diligence
- Reckless investments
- Failure to create readable financial reports for investors
- Non-compliance with federal securities laws or regulations
Other risks associated with private placement fraud:
Inadequate disclosure: marketing materials may be issued with inaccurate statements or omitted information.
Lack of liquidity: Private placements are not liquid investments. Redemption of funds are usually restricted. Since they are not publicly traded, there is no secondary market where the securities can be sold.
Imprecise valuation: Valuation is left up to mathematical models which can be unreliable.
Lack of Private Placement Regulation
Private placements are a form of security fund-raising—private shares, bonds, promissory notes—and under U.S. law, these issues are exempted from financial reporting requirements that govern public offerings. Oversight is scant and the risks of financial fraud are high. Issuers of private placements may provide only basic information to the U.S. Securities and Exchange Commission.
FINRA (Financial Industry Regulatory Authority), on the other hand, has brought several regulatory actions against broker-dealers connected with these private placement that involved fines or restitution to investors. FIRNA is dedicated to investor protection and market integrity through effective regulation of broker-dealers by the following:
- Writing and enforcing rules governing activities of around 3,700 broker-dealers
- Encouraging market transparency
- Educating individual investors of risks
In response to severe financial crime private placement fraud, FINRA filed a new rule proposal with the SEC which would impose new notice and disclosure requirements on private placements, including requirements for transparency regarding the use of the proceeds, as well as full disclosure of expenses and compensation.
Obligations of Broker Dealers & Private Placement Fraud
If a broker-dealer lacks important information about securities it is recommending, the agent must disclose this fact along with the risks that arise from a lack of information. Furthermore, broker-dealers are required to investigate and verify an issuer’s representations and claims.
Even if customers are well-educated investors, they still have a duty to conduct a reasonable investigation. It is recommended that brokers provide information to accredited and non-accredited investors alike to help avoid liability for financial fraud.
Additional responsibilities of broker-dealers are required to fulfill when recommending private placement investments include:
Suitability obligations: An analysis of any investment should consider an investor’s knowledge and experience, not merely net worth or income. Broker-dealers must perform a customer suitability analysis that considers the investor’s holdings, financial well-being, tax status, and investment objectives. Investors should fully understand the risks involved.
Conduct investigations: broker-dealers should conduct a reasonable investigation concerning the private placement issuer, the business prospects of the issuer, the assets held, and the intended use of proceeds of the specific offering. Broker-dealers should retain records documenting the process and results of their investigation.
No conflicts of interest: If a broker-dealer is an affiliate of an issuer, it must ensure that its affiliation does not compromise its independence or a conflict of interest that could hinder its ability to conduct a detailed and independent investigation.
Identify red flags: broker-dealers must note information that could be considered a “red flag” that would encourage further inquiry. Investigation responsibilities obligate it to follow up on any red flags as well as any adverse information about the issuer.
Supervision procedures: Broker-dealers that engage in private placement offerings must have supervisory procedures designed to ensure that the firm:
- Engage in an inquiry that complies with legal and regulatory requirements
- Perform any analysis required FINRA rules
- Qualify customers as eligible to purchase private placement securities
- Does not violate antifraud provisions of the federal securities laws or FINRA rules
If you believe you are a victim of financial fraud involving private placement offerings, and have questions about the legal options available in Ohio, contact The Lyon Firm at (800) 513-2403. You will speak directly with Mr. Lyon, and he will help you answer critical questions regarding private placement fraud and potential plaintiff lawsuits.