Private Placements – Regulation D

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“private placements provide limited information for investors to evaluate”

Private placements are investments that are non-registered securities that are not publically traded. Private Placements are governed by the Securities Act of 1933 under Regulation D. Brokerage firms are regulated by federal securities laws and the Financial Industry Regulatory Authority (FINRA) which both require a duty to investigate the securities they recommend to investors. Private placements are not sold to investors through the use of Prospectuses filed with the SEC. Instead, Private Placement Memorandums (PPMs) are used to communicate the specific details related to the securities offering.

Brokerage firms accept enormous responsibilities promoting and recommending a private placement to investors because the offering has not been scrutinized to extent that an Initial Public Offering (IPO) for traded securities leaving investors reliant upon brokerage firm representations. Private placements designed to raise under $50 million tend to be underwritten and sold by smaller, less capitalized financial brokerage firms because the offering size is too small for larger Wall Street firms to underwrite. This fact presents challenges and risks to investors, in addition to business risks. Over recent decades, FINRA arbitration claims have grown from investor losses caused by sales practice violations related to Private Placements sold under Regulations D.

Investor Qualifications

Most private placements have limited information that is provided to investors. Because of the limited scrutiny of audited financials found in IPOs, only accredited investors who are deemed able to understand and assume the risks associated with securities issued under Regulation D. Accredited investors have been defined by the Securities Exchange Commission (SEC) with certain financial standards that are assumed to qualify them for this type of investment. Accredited Investors are defined under Regulation D to include:

  • Individuals with $1 million net worth (excluding residence);
  • Individuals income in excess of $200,000 ($300,000 Joint) over two last years with same income level for current year; and
  • Certain entities with Assets in excess of $5 million (Charities, Trusts, Corporations and Partnerships).

Suitability Responsibilities

Brokerage firms are not exempt from performing suitability determinations for customers who are accredited investors. The suitability determination process is considered to have steps; first, a reasonable investigation of the private placement’s investment merits must be determined and understood by their financial advisors, and second, a “customer specific suitability” determination must be made. After a customer is qualified as an accredited investor, financial advisors are required to make a suitability determination taking into consideration a customer’s personal situation, including:

  • sources of income;
  • tax status;
  • financial situation;
  • forecasted liquidity needs; and
  • portfolio holdings.

Due Diligence Requirements

Brokerage firms who recommend private placements to accredited investors have a duty to conduct a reasonable investigation concerning the accuracy of the information contained in the private placement memorandum. Even for sophisticated investors, Brokerage firms still have an obligation to investigate and perform an independent due diligence review. According to FINRA Regulatory Notice 10-22, brokerage firms in a Regulation D offering should, “conduct a reasonable investigation concerning:

  • the issuer and its management;
  • the business prospects of the issuer;
  • the assets held by or to be acquired by the issuer;
  • the claims being made; and
  • the intended use of proceeds of the offering.

Brokerage firms cannot passively accept the representations in the Private Placement Memorandum made by the issuer of the private placement. Factors which affect the nature and scope of a due diligence review of the PPM include:

  • brokerage firm’s relationship with issuer;
  • brokerage firm’s role in the transaction; and
  • relationship of party that performs the due diligence review to issuer.

A brokerage firms due diligence review must determine whether the information that it relies upon is credible and whether further any further investigation is required. Brokerage firms must review Private Placement Memorandums prepared by legal counsel and experts hired by the issuer. The qualifications and expertise of the parties that prepare the PPM must be evaluated along with the completeness of the analysis. Any deficiencies in the analysis must be further investigated by brokerage firms related to any conflicts of interest or misrepresentation nor omission of material facts before they can make any representations to investors about the private placement.

KlaymanToskes can help you determine whether an investment loss in a private placement is the result of securities fraud or FINRA sales practice violations. If an investor suffers losses from a private placement they may be able recover their losses in a FINRA arbitration claim for damages.

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