It is not unusual for a brokerage firm to attempt to raise capital for legitimate business purposes such as expansion of its business or upgrading of its systems.  However, not all capital raises are transparent.  It is for that reason that we have included this post.  Please keep in mind that the information discussed below is general in nature and is not designed to be complete in all material respects.  Thus, it should not be relied upon as legal or investment advice.  If you have any question, concerning the contents of this post, you should contact a qualified expert.

As indicated above, brokerage firms utilize private securities offerings of their own or an affiliates’s securities to raise money.  These types of offerings are usually categorized as broker-dealer self-offerings (BDOs).  They can take the form of registered public offerings or private placements. This post addresses issues raised by a broker’s private placement of its own or its affiliate’s securities (private BDOs), particularly to firm customers.

While private BDOs can be legitimate investments, recent FINRA enforcement actions highlight the potential for abuse in private BDOs. Actions were brought against several individuals and firms that have sold more than $36 million in private BDOs to investors that involved fraud or other serious misconduct. Some of these cases involved the use of high-pressure sales tactics targeted at elderly or retired investors.

What is a Private BDO?

The money that brokerage firms raise in private BDOs is usually used to finance their operations or those of an affiliate. However, some firms attempt to disguise their need for additional capital to pay off such things as subordinated loans by stockholders or potential results of anticipated or pending arbitration awards.  So you need to keep in mind that  when you invest in a private BDO, you are investing in the brokerage firm itself or its affiliate. As such, you share in the risks that the business will be unsuccessful or unprofitable or you could participate in successful operations of the firm or its affiliates when the increased value of the firm or affiliate’s equity is reflected in the value of its securities.

SEC rules place certain limitations on the way private BDOs and other private placements of securities can be sold to investors. Brokerage firms generally are not permitted to advertise the BDO and the number of small investors to whom the securities can be offered is usually limited. The securities sold in private BDOs are not registered with the SEC or filed with FINRA and they are not publicly traded. Private BDOs, therefore, are subject to significantly fewer disclosure requirements and less regulatory oversight than registered public offerings, and they are illiquid.

Why are Private BDOs Risky?

Investing in a private BDO can involve significant risk. And private BDOs that are publicized through spam emails or cold calling are often fraudulent or otherwise problematic. Before investing, consider the following:

  • The Offering May Be Illegal-Any company that offers or sells securities in a public offering must either register the securities with the SEC or meet one of the exemptions from registration. Otherwise the offering is illegal. Private BDOs may qualify for an SEC Regulation D exemption, which provides some of the most common exemptions from registration. But to meet these exemptions, the securities often cannot be advertised to the general public.
  • You May Not Be Able to Sell Your Investment-Sometimes the reason that a brokerage firm is conducting a private BDO is that the firm or its affiliate whose shares it is selling is not a public company. The risks of buying securities in a private BDO are increased when none of the company’s stock is publicly traded. You cannot be certain when, or even if, the company will take steps that could result in a public market for the securities. That means you cannot be sure that you will be able to sell the shares. Even if the company does go public through an initial public offering (IPO), federal and state laws often require that unregistered or private securities that are acquired in transactions such as private BDOs must be held for a year or more before investors can sell them. Private companies also are often new and untested, without revenue, or experienced management. So even when they are legitimate, they are highly risky.
  • The Brokerage Firm or the Affiliate Has a Conflict of Interest. The brokerage firm benefits a great deal from your investment in it. While brokers generally benefit when you buy any investment from them, this is particularly true for private BDOs where the firm or its affiliate gets all your money rather than just a commission. Find out why the brokerage firm wants to raise money. Is it because the firm has been losing money or needs capital to meet regulatory requirements?

Red Flags that Could Signal Fraud

Regulatory investigations reveal patterns in the way problem private BDOs are promoted to investors:

  • Cold-Calling or Spam. Brokers selling problem private BDOs often use unsolicited telephone calls or email to sell private BDOs. In one case, a firm obtained customer accounts from defunct brokerages and used the firms’ customer lists to identify potential victims.
  • High Pressure Sales Tactics. Dishonest brokers often use high pressure, “boiler room” sales tactics, hounding you to invest in a private BDO.
  • Claims that an Initial Public Offering (IPO) is Imminent. Beware of brokers who tell you that the brokerage firm will soon conduct an IPO and that you will reap large profits once the firm’s securities are publicly traded.
  • Promises of Unusually High Returns. Brokers make optimistic price projections and predications about future performance, often with no documentation to back them up.
  • “Risk-free” Investments. Some private BDO frauds involve promises that you can’t lose money. Don’t believe it.
  • Refusal to Provide Current Financial Documents on Request. Brokers should provide financial statements on the request of potential investors.

Be advised: firms using these red-flagged tactics often provide little or no supervision of their sales people. Such firms may materially misrepresent management experience and other aspects of the company, omit information pertaining to disciplinary actions against the firm or individuals, and are in dire financial straits.

Protecting Yourself

The following steps will help protect you from making an investment decision you later regret:

1. Check out the brokerage firm, the broker, and other individuals before you invest. You can get information from the following sources:

    • FINRA. Use FINRA BrokerCheck to make sure the brokerage firm and broker are properly registered and to research the disciplinary history of a firm or registered individual. Many of the individuals and firms involved in fraudulent BDOs have had run-ins with securities regulators. In one case, an individual involved in a private BDO had been barred from the securities industry.
    • SEC. Obtain a copy of the brokerage firm’s report on Form X-17A-5. Form X-17A-5 is the audited financial report that every registered broker or dealer must file annually with the SEC. You also should check to see if the firm has filed a Form D or offering circular with the SEC. If a Form D or offering circular is not on file with the SEC, this may mean that the private BDO is illegal.

Use the SEC documents to verify information that has been provided to you in connection with the BDO and to check on the financial condition of the brokerage firm or its affiliate.

2. Ask your broker these questions

  • How does this investment match my investment objectives? What is the risk that I could lose the money I invest?
  • How easily can I sell? What is the price I would get if I sold immediately? Will the securities be restricted? How long before I can sell my shares if the firm went public?
  • What will the proceeds of the offering be used for?
  • How was the price of the security determined?
  • How long has the firm or its affiliate been in business? Are they making money? Have they experienced any financial difficulties?
  • Has the firm had problems meeting its minimum net capital requirements with the SEC and FINRA?
  • Do you, the firm, its affiliate or their management have any legal or regulatory problems or filed for bankruptcy protection?
  • Will you be paid a commission or receive any type of compensation, including stocks, stock options, or warrants, for selling the shares in the BDO? How much?

Remember: Be skeptical. Verify any information you learn from your broker. Individuals and firms that promote fraudulent or problematic private BDOs may make false or misleading statements to lure you into making an investment.