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Private placements allow investors to participate in startup companies, but complaints are rising as small investors get burned
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It's the fantasy of many investors: You get in on the ground floor of a company through a private stock offering available only to a select few. The startup takes off, goes public and makes you a millionaire — or even a billionaire.
Think Microsoft or Google.
That, of course, is when everything goes right. But there are plenty of times when these so-called private placements go wrong.
Investor complaints about private placements more than doubled between 2007 and 2010, according to the Financial Industry Regulatory Authority, the self-policing arm of the securities industry. Investors claim they were sold investments that they didn't understand and that were not appropriate for them.
The complaints prompted the FINRA last year to launch a nationwide investigation. It found that brokerages many times didn't check out the private placements they sold to clients, as required. In some cases investors were steered into Ponzi schemes.
The sweep continues. The FINRA fined two brokerages last month for failing to investigate the private placements they sold. When the companies behind the deals failed, investors lost millions. More sanctions are expected against brokers and their firms.
Private placements were never meant for everyday investors. These securities don't have to be registered with the Securities and Exchange Commission, so the regulatory oversight and financial disclosures are less than with publicly traded investments. Private placements are also riskier and less liquid. That's why to invest in them, individuals are required to have a certain level of assets and sophistication.
An investor must generally have more than $1 million in net worth or more than $200,000 in annual income — $300,000 for married couples — over a certain period.
Plenty of Marylanders fall into that category. Maryland ranks No. 2, behind Hawaii, in the number of millionaires per capita, according to TheStreet.com.
Private placements are rising in Maryland, as well as in other states. Last year, 1,400 private placement offerings were sold to Marylanders, and the figure is expected to hit 2,000 this year, says Melanie Senter Lubin, the state's securities commissioner.
Maryland doesn't track complaints specifically about private placements. But the state has seen its share of problems, from offerings that turned out to be Ponzi schemes to companies not using the capital as promised, Lubin says.
"It's an area [in which] there has been fraudulent activity," Lubin says. "Like any other deal, people need to watch out for themselves."
That advice comes too late for Richard Kaiser. The 52-year-old salesman from Illinois says a friend from college who worked for a Wisconsin brokerage pitched private placements to him a few years ago.
"He said it was a low-risk and high-return investment," Kaiser says.
Kaiser says his goal was to make enough on the investments after several years to pay off his mortgage debt and provide care at home for his wife, who suffers from a degenerative disease.
He drained the equity in his house and turned over $185,000 — nearly half his net worth — to invest in three private placements raising money for real estate developments in Florida and Arizona. The developments never got off the ground, Kaiser says.
"They are all pretty much worthless," says Kaiser, adding that his own home is now in foreclosure.
Kaiser says now that he never belonged in the deals. He says his friend told him to say on the application that he had the assets and income to qualify for a private placement — even though he didn't.
The dispute is now in arbitration. The broker didn't return messages seeking comment for this article. In arbitration documents, the firm, Baker Tilly Capital, says that its broker never instructed Kaiser on how to fill out the application and that Kaiser lied to the brokerage.
Kaiser is a "disgruntled investor who faces potential losses as a result of the recent real estate collapse," the firm claimed in arbitration documents.
Andrew Stoltmann, Kaiser's attorney and a securities lawyer for 11 years, says that up until two years ago he never had a private placement case. Now he's juggling 15.
The increase is due to the fact that private placements are no longer marketed just to the wealthy, Stoltmann says.
"In the last three to five years, we've seen brokers pitch them to mom-and-pop investors in increments of $25,000," he says.
Private placements appeal to investors seeking alternatives to low-yielding bonds and a volatile stock market. But brokerages like them, too, because of their high commissions.
The commission and fees in a private placement can be up to 10 percent of invested assets, Stoltmann says. In comparison, a brokerage earns 1 percent to 2 percent selling a mutual fund.
Concern about what's going on in the private placement market led to some added investor protections as part of last year's Dodd-Frank financial reform law.
The law says the value of a primary residence can no longer be used when calculating an investor's net worth. This will prevent some investors from qualifying for private placements just because of a run-up in home values.
The law also calls for a study of whether the other eligibility criteria need adjusting, too. The income limits, for example, haven't changed since the 1980s, so many more small investors now meet the standard.
And Dodd-Frank bans felons and other "bad actors" from participating in raising money through private offerings. The SEC has yet to issue rules on this.
"This is something states advocated for," says Maryland's Lubin. Many industry players with poor disciplinary records switched to private placements where oversight is far less stringent, she says.
If you are tempted by a private placement, you have your homework cut out for you. Your broker, of course, should be investigating the deal and those behind it, but as the FINRA discovered, some firms failed to do this.
As an investor, you will receive a private placement memorandum from the company issuing the private securities. This is supposed to provide enough information for you to make an informed decision, although it's still less than what you would get in a prospectus for other securities. The memorandum also isn't vetted by regulators.
Contact state securities regulators to see if they have information or complaints about the companies or people promoting the private placement. Marylanders can call 410-576-6882.
Beware of over-the-top claims.
"You should be very careful of any company that promises it will go public through an [initial public offering] in the future," says John Gannon, senior vice president for investor education at the FINRA. "It may not."
And always a good rule when investing in something more speculative: Never invest more than you can afford to lose.
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