The collapse of two high-risk private placement deals over the summer has shed light on the process by which broker-dealers bring these deals to market. Many are questioning the due diligence performed on private placements - known as "Reg D" offerings because of how they are filed with the SEC - as well as the fees earned by broker-dealers for such work.
Broker-dealers often leave the actual analysis of the offerings to outside, third-party due-diligence firms. Those shops typically consist of attorneys who are paid by the issuer to write a report that evaluates the viability of the issuer's deal.
In addition to a possible conflict arising from receiving fees from the companies they analyze, due-diligence firms often produce superficial reports that provide only the most cursory review of the issuers and their finances, say industry executives and lawyers.
The concept behind broker-dealers being paid a due diligence fee, usually 1%, when they sell the deal, is for "time spent and to read the report and to ask questions," according to an industry source. The reality is often different, he added, echoing other brokerage executives. "A lot of firms don't even bother reading the due-diligence reports."
Despite such concerns, both the market and investors' appetites for such deals have ballooned. According to the Alabama Securities Commission, 26,485 Reg D offerings were filed last year with the SEC which requires scant information about the private placements. That compares with more than 11,000 such offerings in 1996. According to a report this year from the SEC, the division of corporate finance identified total estimated offerings last year of $609 billion.
What's more, private deals are expensive, lack liquidity and carry risk - while being lightly regulated and receiving little oversight. More deals are showing signs of stress, brokerage insiders and securities regulators say, particularly real estate deals and some involving oil and gas that could be harmed by the weak overall economy.
The types of Reg D offerings and private placements are all over the map, and they have had a history of problems. Brokerage executives still recall with dread the disastrous Prudential Securities private placements. In the late 1980s, more than 100,000 investors put $1.4 billion into Prudential Securities limited partnerships that wound up being worth almost nothing.
And Reg D offerings aren't the small potatoes that the SEC perhaps imagined back in 1982. For example, Stanford International Bank filed its certificates of deposit offerings with the SEC under Reg D. In 2007, the bank filed a $2 billion offering with the agency. In February, the SEC said that the bank's parent company, Stanford Financial Group, which claimed to have $8.5 billion in assets, was running a "massive Ponzi scheme" based, in large part, on publicizing and promising phony returns on its CDs. In July, the SEC charged two firms with fraud relating to large private-placement deals with an estimated value of $2.7 billion.
On July 7, the SEC charged Provident Royalties LLC and a number of its related entities with operating a fraud and a Ponzi scheme in the sale of $485 million of preferred stock and limited-partnership offerings in oil and gas deals. The deals were sold from 2006 to 2009. About a week later, the SEC charged Medical Capital Holdings with fraud in the sale of $77 million of private securities in the form of notes. Since then, a court appointed receiver has said that $543 million worth, or about 87%, of all the accounts receivable Medical Capital controlled are nonexistent. In total, Medical Capital sold $2.2 billion in notes from 2003 to 2008.
Registered reps and advisers typically earn an extremely high commission when they sell Reg D private placements, which often deliver commissions of 5% to 8%. By comparison, in a mutual fund transaction, a rep can earn between 1% and 4% of the sale. There's no way to tally the potential cost to broker-dealers who sold clients the Provident and Medical Capital deals. Investors have begun to file arbitration claims against the firms who sold the private placements, with plaintiff's lawyers looking for a windfall.
Investors beware of private placement problems.
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