Risks of Reg D deals worry state regulators

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.

“Reg D offerings receive virtually no regulatory pre-screening at any level of government,” Denise Voigt Crawford, Texas securities commissioner and president of the North American Securities Administrators Association Inc., said in a speech this month in Denver at a meeting of state regulators.

“As a result of shortsighted state law pre-emption, investors have been exposed to far more risk in private placement offerings than Congress likely could have imagined,” she said.

“NATIONAL DEBACLE’

Because they are so poorly vetted, private placements are “a national debacle,” said Brian Kovack, president of Kovack Securities Inc.

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.

Due-diligence firms typically receive fees ranging from $6,500 for small offerings to $50,000 for complex deals, say brokerage executives familiar with the arrangements.

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,” Mr. Kovack said.

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 Securities and Exchange Commission, 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 lighly 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.

“We’re looking at tons and tons of” offerings governed by Rule 506 of Reg D, said Joseph Borg, director of the Alabama Securities Commission, who added that the problems are numerous.

“There’s no gatekeeper, and the deals have gotten huge,” he said, adding that small businesses are “legitimate users” for Reg D deals. But Mr. Borg scoffed at the belief that accredited investors, especially post-Madoff, are supposed to know better and watch out for themselves.

“It just doesn’t work,” he said.

When the SEC created Reg D offerings in 1982, the intention was to simplify capital-raising for small-business owners. Reg D contains exemptions from federal registration for limited offerings of securities.

The goal was to cut some of the red tape of filing with the SEC.

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 Inc. 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 Ltd. 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 related 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 Inc. with fraud in the sale of $77 million of private securities in the form of notes. Since then, a court ap-pointed 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%.

In a mutual fund transaction, a rep can earn between 1% and 4% of the sale.

According to the private-placement memorandum for one Provident offering, the sales commission was 8% and the due-diligence fee was 1% of the deal’s total value. If Provident offered a 1% due-diligence fee to broker-dealers on all its deals, that means firms collected $4.9 million in fees, and what constitutes broker-dealer due diligence on the Provident offerings and other deals is unknown.

In a Reg D filing for a Medical Capital offering from last year, called Medical Provider Funding Corp. VI, for $400 million, sales commissions were slated to be $21 million, or a little more than 5%. On the filing, there is no mention of a due-diligence fee.

Due-diligence firms defend their role, saying that there is no other way for broker-dealers with limited staff and resources to sell the private offerings. They also stress that these private placements and Reg D offerings are for accredited investors, meaning investors who are both savvy and wealthy.

“The issuer pays our fees,” said Bryan Mick, president of Mick & Associates PC LLO. He stressed that the due-diligence firms have a “code of professional responsibility” to maintain, and that “we represent our broker-dealer clients.”

The issuers of the private placements, known as “sponsors” in the industry, can have contentious relationships with the analysts who write the due-diligence reports. After Medical Capital Holdings blew up in July, one due-diligence professional said in an e-mail to broker-dealers’ clients that Medical Capital was less than forthcoming about information.

“After my visit to Medical Capital last year, they indicated they would require a restrictive confidentiality agreement before I would be al-lowed further access,” Paula Miterko wrote on July 20. “After months of negotiations, they still have refused to sign the agreement they re-quested. We have been unable to conduct further meaningful due diligence and it is unlikely we will be able to at this time.”

In an interview, Ms. Miterko stressed that her contract in this case was with a broker-dealer, and she was not paid by Medical Capital. The company “wasn’t’ very cooperative,” and objected to the fact that she was going to show her report to more than one broker-dealer. After a day and a half of her questions, she said, Medical Capital executives showed her the door. “Nine times out of 10,” the contract to review a deal is with a broker-dealer, not the issuer, she said.

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.

But more important, advisers sold the private placements to their wealthiest clients, some say. Some advisers worry about the damage done to those relationships in the wake of the collapse of the private placements, which were marketed to in-vestors as offering returns of 6%, 8% or more.

Regulators want changes. When Congress passed the National Securities Markets Improvement Act of 1996, it took away the power of state regulators had to screen Reg D offerings and private placements. Now, the state regulators want that authority back, claiming that they have better knowledge of dubious individuals who may try to sell a bogus offering.

“Without question, the most harmful area of state securities pre-emption has been Regulation D offerings,” said Ms. Crawford. “Investors deserve better than this.”

E-mail Bruce Kelly at [email protected].

Related Topics: ING Group, Initial Public Offerings (IPO)