Private Securities Offering Fraud

First, we need to explain what private securities offerings, also known as “private offerings” or “unregistered offerings” are. Public companies are registered on exchanges the SEC regulates, such as the New York Stock Exchange (NYSE). Private companies are not registered on these exchanges and are subject to different rules, but they can still be the subject of SEC fraud enforcement. The sale of stocks or bonds that happens outside of a registered exchange is called a “private placement.”

You may have heard of companies that have not “gone public” or are “pre-IPO (initial public offering)” – these are private companies. Private companies can still sell shares through private securities offerings, also known as private placements, in order to raise money without going through the process of becoming a public company and meeting all the regulatory requirements necessary to sell their stock on a registered exchange. Recently, many tech startups have chosen to fundraise as private companies. Hedge funds and private equity funds also use private placements; even public companies can do private placements.

The Securities Act generally requires transactions to take place on a public exchange, but it has a “private placement exemption” in section 4(a)(2) for “transactions by an issuer not involving any public offering.” To qualify for this exemption, the issuer of the securities must sell a limited number of shares to a limited number of accredited investors. Accredited investors must meet specific financial criteria related to their net worth and income or professional criteria, such as being a licensed investment professional or having an executive role within the company issuing the stock. Accredited investors include high-net worth individuals, financial institutions, and pension funds – all of them entities with significant financial resources. These accredited investors can’t resell or give the stock to the general public, which makes it a restricted stock. Under Section 4(a)(2), the issuer cannot engage in general solicitation or general advertising about the offering. In other words, they can’t spread the news far and wide to the general public to try to get them to buy.

Regulation D defines specific ways to meet the section 4(a)(2) private placement exemption, so that if an issuer follows the rules in “Reg D,” they know that they are safe from being required to register their security. (But if an issuer doesn’t follow the specific criteria in Reg D, they could still qualify for an exemption if they’re found to have met the general requirements of Section 4(a)(2).)

Reg D requires the issuer to file a Form D with the SEC after completing a securities offering. The level of disclosures required under Reg D are much less stringent than those required for registered offerings. These disclosures are usually made in the form of a private placement memorandum or PPM that provides basic information about the investment.

There are subcategories within Regulation D that outline different routes to a compliant private placement. Under Rule 506(b), the issuer can sell stock to up to 35 non-accredited investors and an unlimited number of accredited investors. The non-accredited investors have to be “sophisticated” – that is, they must know enough about finance and business to competently evaluate the risks of the investment. Under Rule 506(c), the issuing company can advertise securities to the public but can only sell them to accredited investors. Under Rule 504, companies can sell to an unlimited number of both accredited and non-accredited investors, but can raise a maximum of $10 million in a one-year period.

Private securities offerings are easier to do and get less regulatory scrutiny than public offerings. As a result, they have especially low barriers to entry for fraudsters. The SEC has issued an Investor Alert on red flags for scams in unregistered offerings. These include high-pressure sales pitches, unlicensed investment professionals handling the sales, farfetched and unverifiable claims about the qualifications of the people running the issuing company, and lack of requirements for the investor’s net worth or income.

Private placements can be risky. If companies skirt the requirements for selling to accredited and/or sophisticated investors, they can sell to everyday investors who can’t weather a total loss of their investment.

Private securities offering fraud affects investors who stand to lose significant amounts of money based upon false promises from promoters of private securities. Plus, the orderly functioning of financial markets is disrupted when companies who do not truly qualify for exemptions from registration requirements try to claim those exemptions and issue unregistered securities.

The very nature of private securities offering means that they can easily fly under the radar. Whistleblowers play a crucial role in bringing fraud in this arena to the attention of the SEC.