As a general rule, offers of securities to the public (which includes offers made over the internet) must be registered with the Securities and Exchange Commission (“SEC”) under the Securities Act of 1933 (“‘33 Act”). However, under federal securities law, the SEC recognizes certain instances where companies seeking to raise capital are exempt from registering securities. Securities offerings exempt from registration are sometimes referred to as “private placements.”
Private placements are not subject to the same laws and regulations which apply to registered offerings and that are designed to protect investors, including the requirement for comprehensive disclosure of material information. As an individual retail investor, you may be presented with an opportunity to participate in a private placement investment. You may be told this opportunity is exclusive, and the solicitation to invest may come from a financial advisor, or even a relative or acquaintance.
An investor presented with an opportunity to partake in a private placement should proceed with the utmost caution and seek to conduct extensive due diligence before committing money to the unregistered investment. Given the nature of a private placement, as further discussed below, such an investment if often very risky and illiquid.
How Does Regulation D Govern Private Placements?Securities exempt from registration may be offered pursuant to Regulation D (“Reg D”) as promulgated by the SEC in 1982. Essentially, Reg D sets forth a series of rules establishing certain transactional exemptions from the securities registration requirements of the ’33 Act. Two of the more commonly utilized Reg D Rules, Rule 504 and Rule 506, are explained below in detail.
Rule 504 - allows for equity raises up to $1 million
Rule 504 of Reg D permits certain issuers to offer and sell up to $1 million of securities in any 12-month period. These securities may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements. In general, securities issued under Rule 504 will be treated as “restricted securities” unless the offering satisfies other requirements.
Typically, an investor in a private placement will receive restricted securities. This means that the securities will be highly illiquid, such that an investor should not expect to be able to easily and/or quickly resell restricted securities (in fact, an investor should expect to hold restricted securities indefinitely).
Under Rule 504, only where one of the following circumstances is met, may an issuer sell unrestricted securities:
The issuing company effectively registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of substantive disclosure documents to investors;
A company registers and sells the offering in a state that requires registration and disclosure delivery, and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or
The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to “accredited investors.”
According to the SEC, an accredited investor, in the context of a natural person, is defined to include anyone who: (1) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, or (2) has a net worth of over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
Rule 506 - allows for an unlimited equity raise
Companies seeking to raise money under Rule 506 can raise an unlimited amount of investor capital. There are actually two distinct exemptions that fall under Rule 506, including 506(b) and 506(c), as further described below.
Under Rule 506(b), a company can be assured it qualifies for exemption by satisfying the following standards:
The issuing company cannot use general solicitation or advertising to market the securities;
The issuing company may sell its securities to an unlimited number of accredited investors and up to 35 other purchasers. All non-accredited investors, either alone or with a purchaser representative, must be sophisticated -- that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
The issuing company must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But, a company must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors, as well;
The company must be available to answer questions by prospective purchasers; and
In the event that the issuer sells its securities to non-accredited investors, the issuer must disclose certain information about itself, including its financial statements.
Under Rule 506(c), a company can broadly solicit and generally advertise the securities offering, but qualify for exemption by satisfying the following standards:
The investors in the offering are all accredited investors; and
The issuing company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
There are numerous risks associated with investing in private placements. Some of these risks include lack of readily available information, the illiquid nature of a private placement, as well as the fact that unscrupulous and predatory individuals have engaged in fraudulent schemes under the guise of conducting a private placement offering. Given these risks, among others, the Financial Industry Regulatory Authority (“FINRA”) has issued the following guidance to investors considering a private placement investment (note that the following list is non-exhaustive):
Conduct due diligence and understand how information may be limited: find out as much as you can about the company's business, including the industry in which it operates to make an informed decision. Also ask yourself whether you are comfortable getting limited information for the duration of the investment.
Ask your financial advisor for their guidance: ask your broker what information he or she was able to review about the issuing company. Expect your broker to be knowledgeable about any risk factors associated with the company’s business, including its competitors, as well as economic risks specific to the company’s business. Other risks might include risks associated with the issuing company itself, such as a weak balance sheet, use of leverage, or a limited operating history.
Does this investment fit my risk tolerance? Ask your broker how this investment fits in with the mix of other investments you hold. How does it align with your risk profile? Be extremely wary if you receive paperwork to sign without first having a personalized discussion with your broker about why such an investment is right for you.
Ask for a Private Placement Memorandum (“PPM”): you should be provided with a PPM or other offering document; if not, ask for a PPM and carefully review it. Make sure that statements by your broker or in other sale materials are consistent with it. The offering document, as well as any sales materials associated with the private placement, should be detailed and balanced. If you don't understand them, don't invest.
Review the Company’s Form D: read the issuing company’s Form D, which is available through the SEC’s online EDGAR database. While it contains only limited financial information, it does identify the company’s executives and describes other matters of consequence. You may also contact your State Securities Regulator for information.
Potential Red Flag for Fraud: be extremely wary of private placements you hear about through spam email or cold calling. They are often fraudulent. Further, a legitimate broker must be properly licensed, and his or her brokerage firm must be registered with FINRA, the SEC and a state securities regulator, based on the type and scope of business the firm conducts.
As members and associated persons of FINRA, brokerage firms and their financial advisors must ensure that adequate due diligence is performed on any investment that is recommended to investors- including private placements under Regulation D. Further, firms and their brokers must ensure that investors are informed of the risks associated with an investment, and must conduct a suitability analysis to determine if an investment meets an investor’s stated investment objectives and risk profile. Either an unsuitable recommendation to purchase an investment or a misrepresentation concerning the nature and characteristics of the investment may give rise to a claim against a stockbroker or financial advisor.
The attorneys at Law Office of Christopher J. Gray, P.C. have significant experience in representing investors who have incurred losses in connection with private placement offerings, including investments in oil and gas drilling funds and hedge funds. Investors may contact our office at (866) 966-9598 or newcases@investorlawyers.net for a no-cost, confidential consultation.