SEC issues Investor Alert: 10 Red Flags that a Private Placement May be Fraudulent or a Scam

Simon Riveles SEC

August 2014

Earlier this month, the Securities & Exchange Commission’s (the “SEC” or “Commission”) Office of Investor Education and Advocacy released a list of ten red flags investor’s should be wary of when evaluating a private offering. Under the securities law, sales of securities in a fund, a company or other issuer that have not been registered with the SEC are not subject to the same level of scrutiny, disclosure requirements, and other investor protections. The full release can be found here, but the following is a synopsis of some of the indicia of potential scams relating to sales of private funds.

1. Claims of High Returns with Little or No Risk
Investors should be wary of offerings with improbable risk profiles. Risk and return are generally highly correlated. Promises of high returns with little or no risk or improbably consistent long term returns with little volatility. In either case, such results should only be accepted if they’ve been independently audited.

2. Problems with Sales Documents/No one else is Involved
The SEC also warned investors to avoid private offerings without a clear summary of the offering’s terms, the fees associated with the offering and compensation of the manager, the risks of the offering and all relevant details of the offer. This information is generally provided in the private placement memorandum or offering memorandum in connection with the issuance. The Commission also noted that poorly drafted offering or other legal documents, when provided, may indicate the offering is suspect.

3. No Net Worth or Income Requirements
With limited exceptions, state and federal securities laws place strict income or net worth requirements on private offerings. The absence of such requirements in a private offering is in an indicator that it may be fraudulent. An investor in a private offering should expect to fill out a comprehensive subscription document, which requests information about the investor’s financial sophistication and accreditation. Failure of an issuer to request net worth or income information from an investor in a subscription documents is a clear danger sign.

4. No One Else Seems to be Involved
Offerings where the manager is the only party involved heighten the potential that it may be a scam. In the hedge fund context, the offering memorandum should list the fund’s law firm, auditor, and administrator. Use of these parties by a manager helps to ensure that the fund is properly structured and that there are third parties involved in overseeing its operations. Potential fund investors are advised to confirm that these services providers have been engaged.

5. Unsolicited Investment Offers
Investors should be very careful when receiving unsolicited investment offers. Although the securities laws have recently been changed to allow for “general solicitation” of private offerings in so far as hedge fund managers can advertise their fund to the general public, this new avenue of advertising also enables unscrupulous managers take advantage of unsuspecting investors. The SEC also pointed out that investors should be especially suspicious if they are told to the keep the investment opportunity confidential or a secret.

6. Sham or Virtual Offices
Many emerging manager begin their operations from their home address or maintain a virtual address to obtain mail. While this may only indicate a manager trying to contain expenses, a manager establishing a mailing address within a state in which it has no legitimate operations in an attempt to qualify for an exemption from registration is certainly a red flag. If a manager’s business address is a mail drop and you are unable to verify that the company has any actual operating presence within the same state, be wary.

7. Suspicious or Unverifiable Biographies of Managers or Promoters
Finally, the Commission warned investors regarding managers with suspicious or unverifiable backgrounds. Prospective investors should consider the internet their friend when researching a manager. If the details of what you’ve been told are contradicted by what you’ve found in the fund’s offering materials or have been told by the manager, consider another investment. FINRA also maintains a comprehensive database on all financial industry professionals that can be used to review the background of a manager BrokerCheck.

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