By Kaiser Wahab

With 506(c) and a variety of other major securities overhauls, the U.S. Securities and Exchange Commission (SEC) has loosened many of the most restrictive regulations addressing Regulation D private placement offerings. Now more than ever, private securities from private issuers will be making their way to the portfolios of individual and institutional investors alike. And as a result, investors, placement agents, and brokers need to be equipped to properly vet offerings before risking their capital.

One high profile case illustrates the pitfalls that await unwary investors. For example, Medical Capital Holdings’ multiple private offerings were billed as safe by brokers and banks, raising upwards of $2BB through private offerings, but MCH ultimately imploded with thousands of investors completely fleeced.

One of the primary safeguards against losing wealth when investing in private securities is to be wealthy to begin with (i.e., at least an accredited investor) Obviously, that advice won’t work for everyone and won’t take the sting out of a loss. Clearly the best way for any person, irrespective of their own personal wealth, to avoid investing in bad private offerings is to engage a qualified independent professional such as a lawyer, financial analyst, or financial planner to assist you as investor in doing real due diligence.

In terms of what due diligence for private placements should entail, the Financial Industry Regulatory Authority (FINRA), the financial industry’s self-regulation association, recently posted an investor alert. It’s a worthwhile read for anyone buying private securities and the below provides a brief summary:

Here’s what you need to know:

  1. First and foremost, do the offering docs (i.e., the private placement memorandum) provide a realistic window into the various “risk factors” that could undermine the value of the investment? Does the issuer Form D provide information regarding the parameters of the offering?
  2. What does the investor exit look like, in other words, how do you recoup your investment and how do you realize gain? Will the issuer provide routine distributions, or does there have to be a sale of all assets to accomplish return (e.g., sale of a real estate project)? What does that mean in terms of the investor’s timeframe to recoup?
  3. Are the securities restricted from resale, if so to what extent and what “hoops” must the investor jump through to offload its investment to a third party buyer?
  4. Is the private placement based on a minimum threshold or other contingencies (e.g., all monies are held in escrow until the issuer reaches a certain amount of capital)?  If so, is the issuer adhering to these conditions? FINRA states “if any specified conditions or contingencies are not met, the offering document should clearly state that investors will be refunded their investment amount. If there are no contingencies, be wary. An offering that may proceed without a minimum level of investments or other conditions could be a red flag, as the issuer can use the proceeds immediately, regardless of the amount raised from other investors.”
  5. Who is selling the securities? How did they find you (cold calls, emails, etc.)? Usually one of the best indicators of the viability of a private offering is the management and sales team. Are the brokers reputable, are they licensed? Do the principals of the issuer have a track record? Is the offering made through emails or cold calling? FINRA states “A legitimate investment broker must be properly licensed, and his or her firm must be registered with FINRA, the SEC and a state securities regulator,” FINRA’s BrokerCheck is an online database to help you research the broker.