Investment & Regulatory Risks in Private Placements: Due Diligence, Investor Fraud and Protections

Private placements are a method of raising capital in which securities are sold directly to a select group of investors, typically institutional or accredited, instead of through a public offering. These transactions are usually exempt from the registration requirements of the Securities Act of 1933, enabling issuers to bypass the extensive disclosures and regulatory challenges associated with public offerings. Private placements are commonly utilized by startups and privately held companies, but occasionally, they are also used by well-established firms aiming to raise funds without going public.

The primary exemptions utilized for private placement offerings are found under Regulation D of the Securities Act. Rules 504 and 506 of Regulation D provide the most common pathways for issuers to sell securities without registering with the Securities and Exchange Commission (SEC). Rule 506(b) allows issuers to raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 non-accredited but sophisticated investors, provided they do not engage in general solicitation or advertising. Rule 506(c), introduced by the Jumpstart Our Business Startups (JOBS) Act, permits general solicitation, but all purchasers must be accredited investors, and the issuer must take reasonable steps to verify their status. Rule 504 allows for offerings up to $10 million in a 12-month period but is subject to various state securities regulations.

Despite the exemptions from registration, private placements are still subject to antifraud provisions under federal securities laws, particularly Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, which prohibit fraudulent or misleading statements in connection with the sale of securities and the requirements of Regulation Best Interest (Reg BI). The SEC oversees compliance with these rules and may bring enforcement actions against issuers and intermediaries who violate them. The Financial Industry Regulatory Authority (FINRA) also plays a critical role in regulating private placements by enforcing federal securities laws and its own rules.

Financial professionals and firms have significant responsibilities when recommending private placements to investors and must comply with Reg BI. Specifically, Rule 15l-1(a)(1) of Reg BI requires that all firms and financial advisors act in the best interest of retail customers at the time they make recommendations without placing the financial or other interests ahead of the interest of their retail customers. In the context of private placements—where public disclosures are inherently limited—this obligation takes on even greater significance. Among other things, Reg BI requires that financial professionals understand the potential risks, rewards, and costs associated with a recommendation to invest in private placements. And, as a threshold legal matter, brokers must have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. Crucially, neither brokers nor their firms can satisfy this threshold requirement without first conducting reasonable due diligence.

Consequently, financial professionals need to conduct reasonable due diligence before making any recommendations. How much and what constitutes reasonable due diligence will depend on the facts and circumstances of each offering. However, the relative complexity, higher risk profile, and limited public information associated with these offerings demand a thorough evaluation of the issuer’s disclosures in the offering documents and an understating of their business model and financial health. Importantly too, while reviewing offering materials such as private placement memoranda is an important starting point, brokers and their firms must also recognize that document review alone is not sufficient. First, it is critical to approach the review of these documents with a discerning and critical eye, rather than assuming that every statement is accurate or complete. Secondly, in many cases, the due diligence process requires going beyond the paperwork to investigate underlying assertions, verify claims, and understand the full context of the information provided. Reg BI underscores the necessity for brokers and firms to critically assess the information presented, validate underlying claims, and perform additional research and inquiries when discrepancies and “red flags” are identified.

In its Regulatory Notice 10-22, FINRA provided several non-exhaustive examples of what it considered reasonable due diligence should involve. These included investigating the issuer and its management, the issuer's business prospects, the assets held by or to be acquired by the issuer, the claims being made, and the intended use of the offering's proceeds.

Failure to conduct adequate due diligence can have serious consequences for both brokers and investors. For brokers, a lack of thorough investigation not only jeopardizes client outcomes but also exposes them to civil lawsuits, FINRA arbitration claims, and scrutiny from FINRA and the SEC. Inadequate due diligence may trigger investigations and lead to disciplinary actions—including fines, suspensions, or other sanctions—that can irreparably damage their professional reputation. For investors, the repercussions are equally significant; insufficient due diligence increases the risk of financial losses as unverified information and hidden risks may result in misguided investment decisions.

In these challenging circumstances, legal expertise is vital. At AMW Law PLLC, we provide expert legal representation for those involved in securities disputes and regulatory challenges related to private placements. Whether you are facing a FINRA securities arbitration, need a dedicated FINRA enforcement defense attorney, or need to recover investment losses due to stock broker fraud, investment account mismanagement, or other misconduct, we can help to protect the rights of investors and financial professionals alike. We are equipped to navigate the complexities of securities laws, offering guidance and representation when securities disputes arise, ensuring that our clients' interests are safeguarded during all stages of the investment process. We understand the grave consequences that can come from failure to meet due diligence requirements, and we are committed to helping individuals and firms responsibly address and resolve such issues.