A well-known method for companies to raise capital is an Initial Public Offering (IPO), in which the company sells its stock publicly for the first time. As opposed to IPOs, many business entities use “Private Placements” as an alternative route to raise capital. (The term Private Placement is a catch-all term, that can also refer to Private Equity, Illiquid Alternative Investments, Direct Placements, Limited Partnerships, non-traded REITs, and a variety of other terms.) While many of these entities seek funding primarily from commercial/institutional investors, the Private Placements that seek capital from individual investors are often concentrated in the oil and gas, real estate, and equipment-leasing industries.
It’s important for investors to understand that Private Placements differ from IPOs in significant ways, from how they are regulated by the Securities and Exchange Commission (SEC), to the amount of information that must be disclosed to investors. If you believe you were sold an unsuitable Private Placement investment, or that you may even be the victim of fraud in connection to your purchase of a Private Placement, you should speak to an experienced FINRA arbitration lawyer about filing a claim for compensation. Read on to learn more about risky Private Placement investments, how FINRA is related – and how investors can get help.
How Do Private Placements Work?
In the financial industry, the term “securities” refers to assets like equity (such as stocks), debt (such as bonds), and derivatives (such as options). Under most circ*mstances, securities must be registered with the SEC, whose job is to protect investors’ rights while keeping the marketplace fair and transparent.
One of these exceptions pertains to Private Placements. Under an SEC rule known as “Regulation D,” or simply “Reg D,” businesses may lawfully sell unregistered securities, provided such businesses do not exceed federal limits capping the number of investors to whom the securities may be sold. These limited number of investors must also generally be higher net worth and/or more experienced in investing than the general public. In other words, Reg D makes it legal to sell unregistered securities to small pools of select investors.
This system can pose serious financial pitfalls to individual investors who are not extremely sophisticated. Unfortunately, some investors are unaware of this fact until it is already too late – in large part due to the threadbare regulations that control Private Placements.
What Are the Risks of Private Placements?
All investments carry some degree of financial risk. However, for many investors the risks may not be worth the potential rewards when it comes to Private Placements.
1 – High Upfront Sales Commissions and Fees
Many Private Placements contain eye-popping upfront fees. Often, the investor must pay a sales commission to a broker, generally ranging from 5% to 10%. In addition, the investor usually pays an upfront fee to the company (or its affiliates) sponsoring the Private Placement, which may total another 3.5% to 10% (or even higher). These fees vary wildly and can be difficult to determine when reading the “offering plan” or “memorandum” that describes the investment. What many investors discover after purchasing a Private Placement is that a $100,000 investment has been reduced to an $80,000 (or smaller) stake in the company, after all of the upfront fees and commissions have been added up.
2 – Unaudited and Self-Reported Numbers
To decide whether to buy a Private Placement, an investor is supposed to receive an offering plan or memorandum detailing the investment. This document usually includes impressive forecasts of how the investment is expected to perform, and numbers detailing how well similar investments/funds have performed in the past. However, these figures may not be wholly accurate. Because these documents are not subject to careful regulation, the company sponsoring the investment is free to publish self-reported figures. While (hopefully) not fraudulent, these numbers may be massaged or used in a selective manner to paint a rosier picture than is justified. Further, they are often not audited or verified by a neutral party. So, these self-reported numbers are akin to those a friend gives while bragging about his or her income. They may be based in truth but skewed to an overly optimistic outlook.
3 – Questionable and Secret Due Diligence Reports
The broker who sells a Private Placement is required to conduct due diligence and have an informed basis for recommending the investment as suitable and appropriate for the investor. This places a legal obligation on the broker to research the Private Placement, understand the risks involved with the investment, and to be familiar with the investor’s financial profile.
However, instead of conducting a careful, independent investigation into a Private Placement, many brokers simply rely on a “due diligence report” generated by a third party. Unfortunately, these reports are often paid for by the same company that sponsors the Private Placement – creating a conflict of interest.
And that’s not the only problem. Even if the firm creating the report is trying to be careful and objective, it usually relies on the company’s self-reported numbers and projections. It can be difficult or impossible for the firm to independently verify the company’s numbers.
Perhaps even more troubling: Due diligence reports are often secret or privileged, meaning that the industry expressly prohibits the broker from sharing the report with the potential investor. Clearly the odds are stacked against an informed decision by the investor.
4 – Distribution Payments: Return OF Capital or Return ON Capital?
A common issue with Private Placements is the confusion over how investors recover their money. Generally, investors receive a distribution check from the Private Placement, either monthly or quarterly.
For example, an investor buys a $100,000 stake in a Private Placement and starts receiving $500 checks each month. This will total $6,000 per year; what appears to be a 6% annual return on the investment. These distribution checks are comforting, and it may appear that the investor is getting a 6% return on the investment. In fact, investors in a Private Placement may see their distribution checks increase; it could appear that they are receiving an 8%, 12%, even 20% return. However, this appearance gives rise to a common and fundamental misunderstanding of the investment.
These checks are usually NOT income or profit. They are simply distributions – money that the manager of the Private Placement decides, at his or her discretion, to send the investor. These distributions could be (1) all profit, (2) a mix of profit and a small repayment of the investor’ initial invested money, or (3) simply a partial return of the original invested money.
Often an investor believes he or she is getting a 6% return, when in reality the investor is just slowly receiving the initial investment back, in 6%, 8% or 10% annual increments.
So, in essence, an investor could be paying $10,000 or more in commission and fees to have someone else keep his or her $100,000. That investor slowly gets that money back, when and how the company sees fit – if he or she is lucky. Often, the money is never fully returned. Our firm has seen investors lose as much as 70% of their investment in Private Placements, all the while believing they were earning a 6% or 8% return on their investment. (We have also seen investors double their money in Private Placements, but this type of return is rare.)
Brokers who sell Private Placements to individual investors often portray them as buying an “income stream.” But most Private Placements lock up your money for a long time (often 7 years or more). It can take years of receiving distribution checks (the income stream) before an investor can determine how the investment has performed. So, it could take 7 years or more to determine whether or not you even made back your initial investment. If you haven’t, what was sold as an “income stream” ended up being a significant loss on your investment. And since these investments are so risky, the “income stream” could pause or end at any time.
5 – Overconcentration: how much money should be placed in Private Placements?
If an investor is willing to purchase a Private Placement, how much is a prudent investment? There is no strict rule of thumb, but many states have their own rules or guidelines. Some states essentially advise that their residents should not invest in Private Placements. Other states recommend (or require) that their residents should not invest more than 10% of their net worth in Private Placements. In our firm’s view, investing more than 10% of your liquid net worth is a recipe for trouble.
Despite these dangers, some brokers routinely sell Private Placements to individual investors in amounts that far exceed the 10% net worth ratio. These aggressive sales may be due to the high sales commissions, or perhaps reflect the brokers’ own fundamental misunderstanding of these risky investments.
6 – Should elderly investors purchase Private Placements?
A younger investor, with financial sophistication and a high net worth, may legitimately decide that investing up to 10% of his or her liquid net worth in a Private Placement is worth the risk. However, these investments almost never make sense for an elderly investor. Why? In addition to their extraordinary risks, Private Placements usually pay out slowly, over a period of 7 years or more. And if an investor cannot wait to see if they make a profit over those years, selling a Private Placement can be difficult or impossible. Some Private Placements flat out forbid the investor from selling. Other Private Placements will repurchase the investor’s share, but often only under very limited circ*mstances and at a deep discount. Even if there are no restrictions on a sale, there is generally little or no secondary market for Private Placements.
Despite all of these reasons, unscrupulous brokers are often happy to push these products to older investors.
What is FINRA, and How Can it Help Investors?
If you suffered major financial losses after your stockbroker or financial advisor persuaded you to invest in a Private Placement, you should speak with a lawyer who represents investors in FINRA arbitration proceedings, like the attorneys of Epperson & Greenidge. To understand why FINRA arbitration may be worth exploring, you need to have some background about what FINRA is and how the organization serves investors.
The acronym FINRA stands for “Financial Industry Regulatory Authority.” As this name suggests, FINRA is responsible for regulating brokerage firms, individual stockbrokers, and investment advisors. As of mid-2018, FINRA regulates approximately 630,000 members throughout the United States.
Though itself not a government organization, FINRA operates under the SEC. When an investor has lost money due to the negligence of a financial professional, such as a stockbroker, the investor may be able to file a claim with FINRA. After reviewing the investor’s claim, FINRA may agree to schedule a time and date for a hearing, giving the investor an opportunity to prove that his or her broker sold an unsuitable investment, or engaged in other wrongdoing. If a FINRA arbitrator/s agree, the investor can be awarded financial compensation. In other words, FINRA arbitration gives investors the chance to recover their losses, if they’ve been the victim of wrongdoing by their broker or advisor.
FINRA Arbitration Attorneys for Private Placement Losses
FINRA arbitration can help investors recoup financial losses, while simultaneously holding the right people accountable for issues like financial negligence, trade churning, and the recommendation of unsuitable investments. If you were financially harmed because your advisor or broker sold you an unsuitable Private Placement, you should discuss your legal options with an attorney right away.
The FINRA lawyers of Epperson & Greenidge have years of experience handling FINRA arbitration cases. To learn more about how we can help you, contact us online or call (877) 445-9261 for a free consultation today.
