August 29, 2013 / 12:01 PM / 6 years ago

COMPLY-FINRA tackles private securities as investors seek yield

Aug 29 (Reuters) - Schemes involving shady offerings of privately-issued securities are a perpetual problem on Wall Street, even during the sleepy end of summer.

The Financial Industry Regulatory Authority has been juggling a slew of disciplinary cases this month involving improper sales of “private placements” - securities that are privately issued (typically by small and start-up companies) and sold privately to selected investors without being publicly traded or registered with regulators.

Sales of these often illiquid securities are perfectly legal if they comply with industry rules, but some have left investors penniless.

In August alone, eight cases involving private placements have surfaced in the disciplinary database run by FINRA, the industry-funded Wall Street watchdog. Some have ended with brokers being thrown out of the business and firms being reprimanded for not supervising brokers involved in the deals.

More cases could be coming at a quicker pace - fast enough to save some investors from losing money.

Recent changes to industry rules require brokerages to hand over private offering documents to FINRA within 15 days of the first sale. That makes it easier for the regulator to sniff out possible wrongdoing, said J. Bradley Bennett, FINRA’s enforcement head, in an interview on Tuesday.

The regulator has received 1,900 offerings since December, 2012, when the rule took effect, Bennett said, who added that FINRA’s staff has referred numerous concerns to its enforcement unit for review because of the new trove of information.

Some red flags that can trigger a closer look by FINRA’s enforcement team include offerings tied to fields that are the subject of a lot of hype, such as natural gas extraction, said Bennett. Routine FINRA examinations sometimes yield other signs of possible trouble, such as a surge in business or a brokerage set up specifically to push one company’s private offering.

One notable case pending against a New York broker shows the potential for harm. FINRA alleges that he made fraudulent misrepresentations while selling about $5 million in notes in two private offerings between 2009 and 2012. He allegedly did not tell investors about the issuers’ financial problems, including $3-million in tax liens, according to an Aug. 9 complaint.

The notes defaulted and the investors lost their principal, FINRA alleges. The broker, who has denied the allegations, also allegedly diverted some investors’ money to a personal bank account. The case will proceed before a FINRA hearing officer.

While the events that spurred recent cases pre-date the new FINRA rule, they highlight behavior that regulators expect to see continue as investors seek lucrative alternatives to the low yields available in savings accounts and many other conventional investments.

“It’s a ripe area where there’s a potential for a lot of harm,” Bennett said.


Selling unregistered securities is allowed under a safe harbor in industry rules known as “Regulation D” that exempts issuers from having to register certain securities offerings with regulators. The rules do require that issuers and brokers selling private placements meet various conditions, such as selling only to “accredited investors” who top certain income and net worth thresholds.

Individuals, for example, must have a minimum annual income of more than $200,000 or a net worth exceeding $1-million, excluding their home, to qualify to invest in these offerings.

The U.S. Securities and Exchange Commission last month lifted a ban on advertising private securities deals. Issuers will still be required, however, to sell securities only to individuals who meet the accredited investor standards. Another rule change coming in September will bar private placement sales by felons and those kicked out of the securities business.

Private placements can be especially attractive to small brokerages, which can earn commissions of between 10 percent and 20 percent of the sale, say industry sources.

But that can create powerful incentives to sell dubious investments.

Two former Arizona-based brokers, for example, allegedly promised returns from 14 to 56 percent for investments in a business that would buy cars at U.S. auctions and ship them to Russia for resale. But the deal went bad in 2008, according to an Aug. 8 FINRA order.

The brokers then allegedly used the investors’ money for personal expenses and other purposes, FINRA said. They were fired in 2011, after allegedly pushing the securities without their firms’ knowledge, according to FINRA documents.

Such covert sales, a practice known as “selling away,” is a violation of securities industry rules and common in sales of private placements, say compliance experts. Neither broker responded to FINRA’s allegations.


Some start-up company lawyers voice concerns that improper sales practices in the brokerage industry are giving private placements a bad name. Many start-up company founders avoid brokers altogether by promoting investments in their businesses directly to affluent individuals known as “angel investors” or venture capital firms, said William Carleton, a Seattle-based lawyer who advises start-ups.

The model eliminates financial incentives that could motivate some brokers to promote dubious investments, Carleton said. “You don’t get into people flogging the deal to generate a commission for the broker,” said Carleton.

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