Private placements – the sale of securities by an issuing company to a limited number of private investors – have become the venue of choice for “bad brokers, disingenuous dealers, unprincipled promoters, and iniquitous issuers,” according to Jeff Joseph, a noted venture blogger.
A private placement transaction is exempt from the registration and regulations of the Securities and Exchange Commission (SEC) under rules detailed in Regulation D (Reg D) found under Title 17 of the Code of Federal Regulations, part 230, Sections 501 through 508. As a consequence of the exemption, use of Regulation D is the favorite vehicle of those looking to fleece unsuspecting investors.
Some of the more noted scams occurring under the cover of Reg D include the following:
- Stanford International Bank offered phony certificates of deposits with estimated losses of $2.7 billion.
- Provident Royalties, LLC offered fraudulent oil and gas limited partnerships with estimated losses of $485 million.
- Medical Capital Holdings, Inc. defaulted on notes on medical receivables with losses of $1.2 billion.
At the same time, the Reg D exemption created in 1982 has enabled thousands of legitimate small business to begin or expand operations by making capital-raising more efficient, inexpensive, and quick. Businesses ranging from local fast food franchises to technology startups have used Reg D private placements to raise initial capital and are now viable, growing companies that pay taxes, hire employees, and provide valuable services and products to the community.
The conundrum for politicians and regulators is that Regulation D has been very effective in stimulating new businesses while becoming an irresistible attraction to less scrupulous, dishonest, and fraudulent promoters.
Jumpstart Our Business Startups (JOBS) Act
Securities regulators have bemoaned the lack of oversight for years as investments offered under Reg D have exposed investors to far more risk than originally anticipated. This is because unlike public offerings, Reg D offerings are subject to minimal regulatory screening. But despite the continuing abuses, politicians have further loosened regulations with the passage of the JOBS Act,which amends or exempts certain issuers from the requirements of the regulation.
The stated purpose of the JOBS Act is to stimulate investment in startup and emerging companies. By having more capital, it is thought that these businesses will hire more employees. Many experts, however, have questioned the premise that more capital will lead to greater growth, even survival, of startup or entrepreneurial companies. Rather, they believe that failure is more due to unrealistic expectations, poor management, and bad execution than the lack of capital. They worry that more capital will instead lead to bigger failures, boondoggles, and frauds. Whatever the consequence of the Act, investors should be prepared to handle a flood of solicitations that will likely appear over the Internet and via the phone from salesmen with the “latest and greatest investment.”
JOBS drastically changes the investment environment for the private placement of securities by introducing a new fundraising process called “crowdfunding,” and allowing wide solicitation (and advertising) of potential investors with minimal regulatory oversight of the process. Undoubtedly, the combination will attract con men, scam artists, and white-collar thieves from around the world to American investors – particularly the greedy, the desperate, the naive, and the elderly.
While there may be opportunities for substantial profits, history suggests that the proportion of winners, even those who get their investment returned intact, will be a small fraction of those who lose substantial sums – or even their life savings – chasing the next Amazon, Apple, or Facebook.
Reg D Before JOBS
Prior to the passage of JOBS, the Reg D exemption provided that:
- Up to $5 million could be sold in any 12-month period.
- Ownership was limited to accredited investors and 35 unaccredited investors. An individual classified as an accredited investor was required to have a minimum net worth of $1 million or income in excess of $200,000 ($300,000 if purchased jointly with a spouse) for each of the previous two years, as well as the expectation of a similar income in the year of the investment.
- Issued securities had to be held a minimum of two years before sale.
- No solicitation or advertising was allowed.
What Changed With JOBS
The JOBS Act provides a number of exemptions and exceptions to Reg D, including:
- An unlimited number of unaccredited investors are allowed through crowdfunding.
- Any individual with a positive net worth can make a minimum investment of $2,000 in a crowdfunded security. However, each individual investor is limited to a maximum amount of 10% of his or her net worth in all such securities by any issuer within a 12-month period.
- Issuers of securities under the crowdfunding exemption are required to file the offering with the SEC.
- The total amount raised by an issuer during any 12-month period is limited to $1 million.
- Issued securities can be sold after one year of purchase.
- Broad solicitation and advertising is allowed.
There are also regulations dealing with the broker-dealer handling the offering, and the introduction of a new type of intermediary who can also conduct an offering, known as a “funding portal.”
The Implications of JOBS
An initial analysis of the JOBS Act suggests the following:
- The $1 million annual limit will restrict issuers to small, start-up, or first stage companies, historically the highest risk category of companies in which to invest. The odds are that investors in these companies will lose a portion or all of their investment.
- The annual individual limit on investments in crowdfunded securities will be impossible to police. As a consequence, unethical and fraudulent brokers are unlikely to seek this information from prospective investors, or may encourage the investor to provide false information.
- The lower financial limits required to purchase crowdfunded securities virtually assure that many, if not the majority of, investors will buy a non-traded security for the first time. In other words, they are not likely to be familiar with the lack of liquidity, financial information, and investor rights which are typically present in privately held companies.
- Crowdfunded securities and intermediaries – funding portals – are specifically exempt from state securities laws and the oversight of state securities commissioners and their staffs, the most active component of the regulatory bodies. As a consequence, enforcement of security protection laws is likely to be uncertain, delayed, or nonexistent, leaving purchasers of crowdfunded securities in a regulatory “no man’s land.”
Issuers of securities will continue to be subject to Regulation D unless exempted by the crowdfunding provision. Under this regulation, the protections for investors are more robust, with greater penalties for issuers and broker-dealers who ignore or intentionally fail to comply with any of its provisions.
How to Protect Yourself
Astute investors have always recognized that their greatest protection from frauds and other thefts is personal vigilance, a willingness to investigate, and the confidence to say no. These traits are particularly important in the world of private placements.
There are predators in the Reg D market quick to seize upon unwary investors who do not possess these traits. The following tips will help you identify the real opportunities and avoid costly mistakes if you consider a private placement investment.
1. There Is No Free Lunch
Psychologists postulate that the desire for increased wealth is ingrained into the human psyche. When that desire is reinforced by those around us, we tend to lose our self-identities and follow the crowd.
Promoters understand psychology better than many, and are adept at triggering a prospective purchaser’s greed, often pressuring him or her to make a quick decision by news that the investment offering is quickly being subscribed. You should recognize when your emotions begin to affect your judgement – while optimism may be a necessary quality if you are to see an opportunity, it can also color your analysis.
Step back and revisit the reasons you are considering the investment:
- What is the underlying premise of the investment? For example, the premise of an oil and gas fund is that the sponsors will take the investment and successfully drill for oil and gas reserves.
- Has the premise been tested? A confirmation of the premise would be evidence that the sponsors have previously and successfully drilled for oil and gas on their own or on behalf of a similar investment group.
- Does it make sense? Whether it makes sense to invest in an oil and gas fund with a group of unknown sponsors would depend on their past success in finding sufficient oil and gas reserves to prepay the investment.
2. Limit Your Investment to Low-Risk Funds
Many investors become so blinded by the promise of future riches that they forget the reality of the business or the long-term success rate of new companies. As a result, they plunder their savings and retirement accounts expecting to become millionaires overnight.
The fact is, less than one-quarter of new businesses survive through the fifth year, and the majority of the ones that do survive are rarely market successes with huge returns to their shareholders. Exploratory oil and gas wells are notoriously risky; wells that return the costs of drilling after payment of attached royalties and overrides are rarer still. Unless you or the group in which you are co-investing have millions of dollars to purchase the best prospects and use the latest drilling technology and techniques, the odds of finding a new field are extremely low.
Private placement opportunities are generally high risk or scams. As a consequence, the likelihood of losing your total investment is very high. Limiting your investment to funds in which you can lose without affecting your present or future lifestyle is the only sensible strategy when purchasing Reg D securities.
3. Stick to Offerings That Meet Reg D Requirements
A Regulation D-exempt offering, while not approved by the SEC or state securities commissioners, must still be registered to take advantage of the exemption. Investors are required to make minimum investments either as a dollar amount or as a percentage of their net worth. And no more than $1 million per year of securities can be sold by a specific issuer, or $2 million if you are provided with audited financial statements.
Even though regulatory oversight has been decreased, these regulations do apply. Be sure that the investment you are considering fully complies with federal and state securities laws by taking the following steps:
- Contact the SEC and your state securities commissioner to verify that the issuer has registered the offering.
- Confirm that the issuer has not issued offerings for more than the maximum allowed under Reg D.
- If the promoters offer to take less than the minimum required by law, or to couple your investment with another investor to meet the minimum amount required, immediately cease communications with this promoter.
4. Do Your Due Diligence
There is no substitution for verification and validation of the information in a Reg D offering – nothing should be taken at face value. Due diligence is not a personal affront or a sign of mistrust; all professional issuers will expect your questions and attempt to resolve any confusion or misperceptions.
Here are some recommended checks with which to start your due diligence process:
- Check with the Better Business Bureau and the state securities commissioner in your location and in the state where the issuer is domiciled to see if the parties have a record of the company and its promoters.
- Verify the accounting firm and its relationship to the issuer, and verify that there are audited statements, as well as the accounting firm’s record, with the local and state CPA association.
- Check the credentials and experience of the issuer’s attorney with the local and state bar associations.
- Search the Internet for articles on any of the individuals mentioned in the offering – particularly via social networks like LinkedIn and Facebook.
- Confirm that neither the individuals nor the issuer have been named in the Investment News Fraud Charge Tracker.
5. Take Your Time
A favorite ploy of unscrupulous promoters is to tell their prospective mark that the investment opportunity is quickly being sold out, sometimes as an explanation as to why there isn’t enough time for the investor to properly investigate the offering. Promoters are adept at making prospective investors feel that the investment is a “once in a lifetime” opportunity which will go away, never to return. They appeal to the emotions with promised riches and the trappings those riches will bring.
Entranced by the sizzle of success, the investor often overlooks the more likely pitfalls and probability of failure. An inviolate rule of professional capitalists is “Never react to an issuer-imposed deadline.” They understand that nothing is forever, and that 10 more offerings will be presented to them before the end of the month – each with the same assurance of profitability. They also know the odds of picking a winner.
As a consequence, their first reaction when pressured to make a premature decision is to halt their due diligence, turn down the investment, and move on to the next deal. Their actions should be copied by every prospective investor.
Many people have successfully invested in startups and growing businesses through private placements, and will continue to do so in the future, as few entrepreneurs are able to bootstrap their companies or exploit their ideas without the availability of outside capital. The ability to build a business with the help of your friends, neighbors, and the general public is critical to the American Dream, and should never be restricted or dismissed.
At the same time, the private placement mechanism is easily misused by criminals seeking an easy living. Opening one’s investment interests to private placements is akin to walking down a dark alley in a big city – it makes sense to be prepared for whatever may be lurking in the shadows. Following these tips will help keep you safe – and always remember the power of “no.”