The sale of securities by an issuer to a small group of accredited investors is known as a private placement, and it has become the preferred method of fundraising for bad brokers, disingenuous dealers, unprincipled promoters, and iniquitous issuers, as noted venture blogger Jeff Joseph has written.
Regulation D (Reg D) is found in Title 17 of the Code of Federal Regulations, Part 230, Sections 501 through 508, and explains the circumstances under which a private placement transaction does not need to be registered with the Securities and Exchange Commission (SEC). This loophole makes Regulation D the preferred method for con artists to defraud naive investors.
These are only a few examples of the most well-known frauds that have been perpetrated using Reg D:
- Losses of $2.7 billion are attributed to Stanford International Bank’s fraudulent certificates of deposit.
- An estimated $485 million in damages resulted from the oil and gas limited partnerships sold by Provident Royalties, LLC.
- There were $1.2 billion in losses due to the default of notes on medical receivables held by Medical Capital Holdings, Inc.
Reg D, an exception established in 1982, has made it easier, cheaper, and quicker for thousands of genuine small businesses to launch or grow their operations by allowing them to access capital markets.
Fast food franchises and digital startups alike have used Reg D private placements to fund their early stages of growth and expansion into sustainable businesses that contribute to the local economy through taxation, employment, and the provision of goods and services.
Politicians and regulators face a Catch-22 because Regulation D has been so successful at spawning new firms, yet it has also become an alluring magnet for less conscientious, dishonest, and fraudulent marketers.
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Securities authorities have complained for years that investments made available under Reg D carry much higher risks than disclosed to clients. Reg D offerings have less stringent screening requirements compared to public offerings.
Politicians have further relaxed rules with the passing of the JOBS Act, which changes or exempts certain issuers from the requirements of the law despite the fact that abuses continue.
The JOBS Act was created with the intent of increasing funding for new businesses. Businesses with access to more funds are more likely to expand their workforce. However, the idea that more money equals better development or even survival for new businesses has been called into question by a number of industry experts.
Instead, they attribute failure to factors like overconfidence, incompetence, and poor planning rather than a lack of resources.
They are concerned that increasing the available funding will only increase the scale of existing scams, waste, and fraud. Investors should be ready to field calls and emails from salespeople pitching the latest and greatest investment regardless of the Act’s ultimate impact.
By creating a new fundraising method known as crowdfunding and enabling widespread solicitation and promotion of potential investors with no regulatory control, JOBS has a profound impact on the investment climate for the private placement of securities.
This synergy is a magnet for con artists, scammers, and white-collar thieves from all over the world, who will target unsuspecting American investors especially the desperate, gullible, or old for financial gain.
While it’s possible to make a lot of money, the vast majority of people who put their money into finding the next Amazon, Apple, or Facebook end up losing a lot of money, if not everything they own.
Before JOBS, Reg D
Regulation D’s exception used to state until JOBS was passed:
- Any given 12-month period may see sales of up to $5 million.
- Only 35 non-accredited investors were allowed to buy shares. To qualify as an accredited investor, a person needed to demonstrate either a net worth of at least $1 million or an annual income of at least $200,000 ($300,000 if purchased jointly with a spouse) in both of the two years prior to the investment year, with the expectation of a similar income in the investment year itself.
- A minimum of two years must have passed since the issuance of the security in order to sell it.
- There was to be no advertising or solicitation.
What Has Changed Since Jobs?
Among the many exclusions and exemptions to Reg D that the JOBS Act offers are:
- Through crowdsourcing, any number of people who aren’t accredited investors can put money in.
- Those with at least $2,000 in liquid assets are eligible to invest in crowdfunded securities. But in any 12-month period, an individual investor may only invest no more than 10% of his or her net worth in all such securities issued by any issuer.
- Securities issued by issuers using the crowdfunding exemption must be reported to the SEC.
- A single issuer may not raise more than $1 million in a calendar year.
- After a year has passed from the date of purchase, the securities may be sold.
- Broad forms of promotion and solicitation are permitted.
- In addition, there are rules governing the broker-dealer who is facilitating the offering, and a new sort of intermediary, a funding gateway, has emerged to facilitate offerings as well.
The Effects of Employment
Preliminary research of the JOBS Act reveals the following:
- Issuers will be limited to tiny, start-up, or first-stage businesses due to the yearly restriction of $1 million. These businesses represent the highest risk category for investors. It’s likely that anyone who puts money into these businesses will see some, if not all of it, wiped out.
- It will be hard to enforce the annual limit on investments in crowdfunded securities.
- Therefore, dishonest brokers won’t bother asking for this information, and they might even tell their clients to lie.
- Crowdfunded securities almost guarantee that many, if not most, investors will purchase non-traded security for the first time due to the lower financial restrictions required to purchase them. That is to say, they probably aren’t accustomed to the norms of privately owned organizations, such as their limited access to capital markets, financial data, and investor protections.
- State securities regulations and the supervision of state securities commissioners and their staff, the most active component of the regulatory agencies, do not apply to securities issued through crowdfunding or to the intermediaries involved in the process, which are funding portals. Therefore, investors in crowdfunded securities are likely to find themselves in a regulatory no man’s land, where security protection regulations are either not enforced at all, or are enforced only after the fact.
Unless they qualify under the crowdfunding clause, securities issuers will remain subject to Regulation D. There are stricter penalties for issuers and broker-dealers that willfully or recklessly disobey any part of this rule, making it a safer environment for investors.
How to Safeguard Yourself
Those who invest wisely have always known that the best defense against fraud and other forms of theft is a combination of personal alertness, a willingness to investigate, and the confidence to say no. Particularly relevant in the realm of private placements is the possession of these qualities.
Predators in the Reg D market are waiting to prey on investors who lack these characteristics. If you’re thinking about investing in a private placement, use these guidelines to zero in on the best prospects and steer clear of costly blunders.
1. There Are No Free Lunches.
According to theorists of human psychology, everyone has an innate need to get richer. People lose their individuality and start to act like the rest of the group when they are encouraged to do so.
Promoters have a deeper understanding of human nature than most people do, and they are skilled at appealing to the avarice of potential buyers by leaking information that the investment opportunity is swiftly being subscribed to.
Understanding when your feelings begin to cloud your judgment is important; for example, while optimism can help you spot opportunities, it can also cloud your evaluation.
Review your motivations for making this investment again:
- Where does this investment get its money from? A common investment fund model is that the fund’s sponsors would use investor money to successfully tap into oil and gas deposits.
- Has the hypothesis been tried and true? If the sponsors have experience in oil and gas drilling, either on their own or for a comparable investment company, then the premise is true.
- Are we on the same page? Investing in an oil and gas fund whose sponsors are unknown to you can make sense if they have a track record of locating adequate oil and gas reserves to prepay your investment.
2. Stick to low-risk investments only
Investors sometimes lose sight of business realities and the long-term success rate of new enterprises because they are so focused on the potential for immediate profits. Consequently, they empty their bank accounts and 401(k)s in pursuit of an instant million.
Unfortunately, only about a quarter of new enterprises make it to their fifth year, and even those that do rarely have enormous market successes that bring huge returns to their stockholders.
Risk is inherent in drilling for oil and gas, and it is extremely unusual for an exploration well to generate a profit after deducting all associated expenses and paying all applicable royalties and overrides.
Finding a new field is incredibly unlikely unless you or your co-investors have millions of dollars to spend on the greatest prospects and cutting-edge drilling equipment and methods.
Opportunities to invest privately are usually risky or fraudulent. This means you should expect a substantial risk of losing your entire investment. The only prudent approach to buying Reg D assets is to invest only what you can afford to lose without significantly compromising your current or future standard of living.
3. Limit Your Offerings to Those That Comply with Regulation D
It is still necessary to register a Regulation D offering even though it does not require approval from the SEC or state securities commissioners. In order to participate, investors must put in a certain minimum amount of money or a certain proportion of their total assets.
Furthermore, no single issuer may sell more than $1,000,000 in securities in a year, or $2,000,000 if you have access to audited financial documents.
Although the extent of regulatory scrutiny has been reduced, the rules themselves remain in effect. If you want to invest in something, you need to make sure it abides by all applicable federal and state securities regulations.
- Verify with the SEC and your state’s securities commissioner that the issuer has filed the necessary paperwork to make the offering legal.
- Verify that the issuer has not issued any offerings for a total amount that exceeds the limit set by Reg D.
- Stop communicating with the promoter immediately if they propose to take less than the minimum allowed by law or combine your investment with another investor to fulfill the minimum required.
4. Exercising Due Care
Information in a Reg D offering should not be taken at face value; instead, it should be independently verified and validated.
Professional issuers will anticipate your queries and work to clear up any confusion or misperceptions you may have about their offerings; doing your due research is not a personal attack or a show of mistrust.
Here are a few things you should look at as part of your due diligence:
- It’s a good idea to research the company and its backers with the BBB and the state securities commissioner in your jurisdiction and the issuer’s home state.
- Check with the state and local CPA societies to make sure the accounting firm has a clean record and that they are authorized to audit financial statements for the issuer.
- Verify the issuer’s lawyer’s expertise and qualifications with the appropriate state and local bar associations.
- Investigate the people who are mentioned in the offering by looking for stories about them online, especially on social media sites like LinkedIn and Facebook.
- Be sure to check the Investment News Fraud Charge Tracker to make sure that neither the persons nor the issuer has been accused of fraud.
5. Be patient.
Unsavory salespeople often use the investment opportunity fast being sold out line to make their target feel pressured into making a decision without giving them enough time to do their due diligence on the company or the investment opportunity.
Promoters are experts at creating the impression that the investment opportunity is unique and irreplaceable. Using promises of wealth and the accouterments that money can buy, they play on people’s desires.
Investors are sometimes so dazzled by the prospect of gain that they neglect to account for the many potential dangers they’ll almost certainly encounter along the way. Financial experts always adhere to the golden rule; Never react to an issuer-imposed deadline.
They are aware that nothing lasts forever and that they will be provided with ten such opportunities before the month is through, all of which will promise them a profit. They’re well-versed in statistics and can calculate the likelihood of a successful prediction.
Therefore, when they feel rushed into making a decision, they immediately stop doing their research, reject the investment, and move on to the next potential offer. Every potential investor ought to follow in their footsteps.
Private placements have been a fruitful way for many people to invest in startups and growing firms, and this trend is only expected to increase in the future.
This is because few entrepreneurs can effectively launch and build their businesses without access to outside funding. The capacity to start and grow a company with support from family, friends and the community is fundamental to the pursuit of the American Dream and should never be denied to anyone.
On the other hand, crooks looking for an easy target can misuse the private placement process with relative ease.
As with venturing into an unfamiliar alley in a bustling metropolis, it’s wise to arm oneself with knowledge before deciding to open one’s investing interests to private placements. In order to avoid harm, follow these guidelines and never underestimate the strength of the word “no.”