On the eve of an anticipated increase in private-placement activity as a result of recent reforms made pursuant to the JOBS Act, FINRA issued an Investor Alert on Monday about risks associated with private placements.  The Alert draws on the lessons that FINRA derived from the series of cases it has brought over the last few years against downstream firms and their principals who sold private placement interests in fraudulent or problematic offerings.

The Alert provides a list of issues that investors should consider before investing in a private placement, and questions that investors should ask their brokers.  Firms selling private placements should anticipate that investors will use FINRA’s Alert as a script, and should make sure that their sales force has accurate and useful responses to these questions.  Firms should also expect that FINRA will be examining them to ensure that they are familiar with the lessons of these private placement actions, and that they are treating their customers properly in offering and selling these interests.

FINRA warns investors that “investing in private placements is risky and can tie up your money for a long time.”  FINRA explains that private placement securities are illiquid because they are “restricted” securities and cannot be resold without registration or an exemption from registration.   FINRA also puts investors on notice that under existing rules, private placement documentation offers only limited information about the issuer and management, and limited financial reporting.

In order to help investors mitigate the impact of private placements’ illiquidity and dearth of information, the Alert advises investors to find out everything they can about the issuer’s business and the industry in which it operates.  Investors, FINRA states, should carefully review the private placement memorandum and the issuer’s Form D.

FINRA also provides a list of questions that investors should ask their brokers when they are offered these investments.  Firms selling private placements should take a cue from these questions, and ensure that the registered representatives involved in these sales efforts can answer them. Questions like the ones below should be made a part of any internal training for reps involved in these sales efforts:

  • How difficult is it to liquidate the private placement securities, once the investment is made?
  • What information was the broker able to review about the issuer?  (A number of FINRA’s recent disciplinary actions involved retailing firms that showed little interest in conducting realistic due diligence.)
  • What are the risk factors associated with the company’s business—such as the company’s finances, its competitors or economic risks specific to the company’s business?
  • How does the investment fit in with the mix of the customer’s other investments, and with the customer’s risk profile?
  • For real estate private placements, what is the schedule and source of investor distributions?  Can the company’s income cover those distributions, or will distributions be paid from proceeds of sales of additional shares or borrowings?
  • For oil and gas private placements, what has the issuer’s performance been in prior offerings?
  • Is the private placement being sold on a conditional or contingency basis and, if so, what are the conditions under which the proceeds from sales of securities received prior to the contingency being satisfied may be accessed by the issuer?
  • Is the person selling interests in the private placement properly licensed, and is his or her firm registered with FINRA, the SEC and a state securities regulator?