Many legitimate companies use private placements to raise capital, and individuals must meet certain financial guidelines to participate. Still, questionable practices are on regulators’ radar

April 28, 2013|By Becky Yerak, Chicago Tribune reporter

With interest rates near record lows, older savers are finding it harder to stomach bank CDs or Treasury bonds. But Belvidere, Ill., retiree Miles Fryar would be having fewer sleepless nights if he had parked his cash in those traditional investment sanctuaries.

He and his wife, both 73, lost a combined $75,000 in what are known as private placements. Unlike publicly traded stocks, bonds and mutual funds that can be easily sold, Fryar and his wife, Helen, sank a chunk of their retirement savings into limited offerings of securities, including one for a company planning to build power plants fueled partly by poultry manure.

The North American Securities Administrators Association says private placements are the most common cause of crackdowns by state regulators. States brought more than 200 enforcement actions involving private placements in 2011, the association said in a report last year. Although that’s down from 2010, the numbers have generally risen in recent years and have more than doubled since 2007.

And when state securities regulators are asked about troublesome “trends,” private placements top that list too.

The Fryars, in a claim filed with the Financial Industry Regulatory Authority, allege that a broker in the Rockford office of Chicago-based B.C. Ziegler & Co. dangled returns of 11 percent to 12 percent but minimized or didn’t disclose the risks, including how their cash would be tied up for years and how, in case of a bankruptcy, they’d be unlikely to recover anything. Furthermore, the private placements were supposed to be sold to only “accredited” investors who meet certain net worth or income requirements, they said.

The 110-year-old Ziegler said it has “remained grounded” in its “principles of integrity, teamwork and ensuring” that its clients receive “tailored advice, sound products and the highest level of service.”

‘Unproven allegations’

Like any claim filed with FINRA, which handles arbitration disputes between financial services firms and their account holders, “this claim is nothing more than a series of unproven allegations which are being disputed,” Ziegler spokeswoman Christine McCarty said. “Although Ziegler can’t comment on facts relating to each individual claimant, it disputes all of their allegations and intends to vigorously defend itself.”

Ziegler is “confident of a positive outcome when this matter gets to an arbitration hearing,” the spokeswoman said.

Ziegler’s outside lawyer, Alan Wolper of Ulmer & Berne in Chicago, formerly worked for the National Association of Securities Dealers. He said most of the customer complaints he has seen generally are driven by losses.

“Just because someone has lost money doesn’t mean that there was misconduct by a broker” and doesn’t mean that the client is entitled to compensation, Wolper said.

“You can get sued in arbitration for anything,” Wolper said. “Unfortunately, alternative investments of these sorts have resulted in losses over the past few years.”

Ziegler is an “excellent broker dealer,” he said. Clients are given documents that are replete with disclosures, and they must sign forms stating that the investments are suitable for them, Wolper said. Additionally, Ziegler also walks through the investments with their clients, Wolper said.

Private placements, officially known as Regulation D or Rule 506 offerings, may be exempt from federal securities requirements that publicly traded companies must meet.

While many legitimate companies use private placements to raise capital, the investments are risky and typically less transparent than publicly traded securities, the trade group of state regulators said.

That’s why, under federal law, private placements are supposed to be offered to people who have sufficient wealth or access to information that would presumably allow them to make completely informed investment decisions. Those investors are known as “accredited” or “sophisticated” investors and generally have liquid net worth of at least $1 million or who have consistent annual income exceeding $200,000, the North American Securities Administrators Association says.

Private placements are considered part of the larger class of alternative investments, which also include private equity, hedge funds and nontraded real estate investment trusts. Wealthier people and institutions such as pension funds commonly put significant sums into alternative investments. But with interest rates so low on fixed-income products and with the stock market volatile, a broader class of consumers finds such pitches tempting.

“People are looking for alternatives,” said Tanya Solov, Illinois’ securities director. “They hear that markets aren’t reliable and are volatile, but private investments carry their own hazards,” such as their money being locked up, or illiquid, for long time periods, or even indefinitely.

“It’s a big issue,” she said.

In November 2011, for example, FINRA sanctioned eight firms and 10 individuals for selling interests in what it said were “troubled private placements.” The firms and individuals were in Texas, Massachusetts, New Jersey, North Dakota, Washington state, Vermont, Nebraska, Florida, Mississippi and Louisiana.

A February 2014 arbitration hearing is scheduled for the Fryars as well as four other investors who have filed a claim against Ziegler. Five live in the Rockford area and are friends. They’re seeking combined restitution of $429,000 for their money-losing investments in private placements and real estate investment trusts that weren’t publicly traded.

Miles Fryar, who made a six-figure income when he worked but who said he wouldn’t qualify as an accredited investor now, said he is “agonizing” over the investments gone bad.

“I go to bed early, wake up at 10 p.m., think about all this stuff, and can’t go back to sleep until 3 or 4 in the morning,” he said in an interview this month. “All of a sudden you’re wondering how long your 401(k) is going to last while you’re pulling money out of it, and it’s getting to the point now where the cash is almost gone.”

Alternative investments “have massive fees and commissions, aren’t understood by clients, and have an intoxicating pitch investors love to hear,” said Chicago investors lawyer Andrew Stoltmann, who is representing the six investors. Stoltmann, a former Merrill Lynch broker, said half his 125 pending cases involve alternative investments, up from about 5 percent five years ago.

The 26-page FINRA claim alleges, and Ziegler disputes, that none of the six has or had enough income to qualify as accredited investors, and only one of the six had sufficient net worth. The Ziegler broker isn’t named as a party in the claim. Citing FINRA records, Ziegler notes that the broker hasn’t been the subject of any previous complaints.

The six are claiming violations of Illinois securities law’s suitability requirement, and of the Illinois Consumer Fraud Act; breach of fiduciary duty; negligence; failure to supervise; and breach of contract.

Miles Fryar once worked for Greenlee Tool, which is now owned by Textron. That’s where, in the late 1980s, he first met his Ziegler broker, who was then a sales representative for a company that sold computer equipment to Greenlee. After leaving Greenlee, Fryar eventually started his own window-making company.

He and his wife say they lost money in two investments they bought through Ziegler.

They lost a combined $50,000 in an unsecured $50 million private debt offering by Erickson Retirement Communities of Baltimore. They were told the unsecured debt would provide an 11 percent return, the FINRA claim says. They said they were assured by their broker that it was a safe investment. They also said they weren’t told that their money would be tied up for years.

By late 2009, Erickson filed for bankruptcy reorganization and investors received only three of the 20 interest payments they were due, the FINRA claim alleges.

An affidavit in the bankruptcy said sales and occupancy had been suffering at Erickson properties, partly because of the struggling economy making it tougher for prospective senior residents to sell homes so they could move into an Erickson property.

Miles Fryar, who receives Social Security and a small pension from Greenlee, said he was told that Ziegler “doesn’t usually deal in these kinds of investments, so for them to go into it, it would have to be golden.” He also said they were offering it to their best customers and that senior retirement communities were a “can’t miss” investment.
The broker said he didn’t meet the net worth requirements but that he’d overstate the value of his home so he could qualify, according to the claim filed with FINRA.

His wife, Helen, is a retired school administrator. One day in 2008, the broker visited her at work and told her he had a great investment opportunity but time was of the essence, the FINRA claim alleges. The business would develop, build, own and operate power plants fueled by poultry litter, including manure. It had already developed one such plant, in Minnesota, and its founders had built some overseas in the 1990s

When she said she wanted to talk to her husband, the broker said she had to do it immediately, the FINRA claim alleges. She acquiesced and invested $25,000, which is now valued at zero.

“This is a person we’ve known for 20 years, so I trusted him when I shouldn’t have,” Helen Fryar said in an interview last week.

The poultry litter plant sought to raise $25 million by selling notes that were going to pay 12 percent interest and mature in five years, the FINRA claim says. But one company document showed that it raised only $5 million, of which $2.4 million would pay expenses related to the offering, including sales commissions.

Helen Fryar had a 401(k) of $170,000, but it’s mostly depleted.

The couple have been trying to sell their 4,000-square-foot home in Belvidere for three years. They plan to downsize to a 700-square-foot residence as their savings are dwindling.

“It was worth $400,000 and now it’s $300,000,” Helen said. “We have to constantly take money from our retirement accounts to get by until we can sell it.”

She said she can’t believe that she and her husband are in this position, because they were good about saving money.

“This happens to people in California,” said Helen, who had a nearly six-figure income when she worked.

Asked what she learned from the experience, Helen advises people to avoid making investments that aren’t traded on a stock exchange.

Also, “You have to be careful even if you’ve known the person for years,” she said.

‘Put on the dog’

Daniel Crain, 75, first became acquainted with the broker in 2001 or 2002 when he worked for another firm. When the broker joined Ziegler, Crain, who had worked as an industrial engineer for 14 years before starting his own home heating business, transferred his accounts there.

The two would ride to downtown Chicago together when Ziegler hosted client dinners at the Union League Club. They also went to the Milwaukee Art Museum a couple of times, as well as such finer Rockford restaurants as Giovanni’s and Altamore Ristorante, where Ziegler would host about a dozen investors.

“They put on the dog for us pretty well,” Crain said.

In 2003 and 2006, Crain invested in two bond offerings of Erickson Retirement Communities LLC. The investments made all their scheduled interest payments, which were as high as 13 percent.

But he later lost $25,000 on the unsecured Erickson retirement communities offering.

Crain also invested $75,000 in a Dividend Capital Diversified Property Fund real estate investment trust. He said he wasn’t told that they were illiquid.

He bought them at about $10 a share.

In a recent report to shareholders, Dividend Capital said that its shares, which aren’t traded publicly, peaked in the fourth quarter at $6.70.

It also disclosed a risk for investors: “Our shares should be considered as having only limited liquidity and at times may be illiquid.”

Crain, now retired, still has Social Security, other investments and rental properties but is seeking compensatory damages of $25,000 for his loss in the Erickson investment and $23,000 for his loss in connection with the Dividend Capital Diversified Property REIT.

Real estate investments represent the second-biggest cause of enforcement actions by securities regulators, according to NASAA.

In February, LPL Financial agreed to pay $2 million to settle allegations by Massachusetts’ securities regulator that it failed to supervise brokers who sold stakes in nontraded REITs.

“LPL Financial worked cooperatively with the commonwealth of Massachusetts to appropriately resolve all of the issues raised, and we are glad to put this matter behind us,” the company said in a statement. “Under the terms of the consent agreement, certain customers, at their discretion, will have an opportunity to sell their shares of non-traded REITs to LPL for the price they originally paid.”

Crain said the experience with private placements and nontraded REITS has made him more guarded.

“My antenna is up all the time, when it used to be up half of the time,” he said. “I wake up mad and want to fight with somebody.”

Tips on alternative investments

•If a broker or seller can’t satisfactorily answer your questions about the company, its business model or executives’ backgrounds, be wary.

Get all representations about the investment in writing from the broker or financial adviser. Make sure that the broker’s verbal representations don’t contradict the terms of the investment.

Ask how much the financial adviser is getting paid. With a mutual fund, the broker might get paid percentages in low single digits. Fees and commissions on traditional products have been squeezed through the years, but with alternative investments, the compensation and commissions to the recommending broker are higher than those of many traditional investments.

Find out how long the investment has been sold. Many alternative investments weren’t around when the market crashed in 2008 or 2000, so it’s uncertain how they’ll perform under stress.

Limit exposure to alternative investments to, say, 5 percent of the portfolio.

Don’t complete a subscription agreement or accredited-investor questionnaire unless you understand it and agree with the entire document.

If asked to falsify your financial information in order to qualify as an accredited investor, walk away.

SOURCES: Andrew Stoltmann; North American Securities Administrators Association

http://articles.chicagotribune.com/2013-04-28/business/ct-biz-0428-alt-investments-20130428_1_private-placements-allegations-financial-industry-regulatory-authority

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