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Rising Fraud in Private Placements Signals Need for Thorough Research

December 24, 2000|KATHY M. KRISTOF

Conrad Myers admits he was gullible--and he's paid the price.

Myers, a retiree from Newport, Ky., invested roughly $143,000 in a dozen so-called private placements over the past two years, thinking he was finally going to get in on "ground-floor" opportunities that would make him wealthy. Instead, the investments went sour, and now it's unclear whether he'll get any of his principal back, much less investment earnings.

Unfortunately, he's far from alone. Thousands of investors are getting taken by what are known as offering frauds each year, regulators say. In fact, some 120 companies were sued by federal securities regulators this year in cases that alleged the companies making the offerings either falsified or fabricated their financial statements or that they improperly sold securities of dubious quality to unsophisticated investors. Some of the cases have been settled and others are pending.

"Our sense is that as the [stock] market got particularly frothy, you saw more and more folks who had next-door neighbors or other people they knew getting rich, and they decided they were missing the boat," says Stephen Cutler, deputy director of enforcement with the Securities and Exchange Commission.

"Investment opportunities that they otherwise would have ignored became an appealing way to get on that boat."

The SEC says offering frauds have accounted for 20% to 25% of the agency's enforcement activity for the last several years. These bogus offerings are typically sold by high-pressure salespeople who telephone potential investors.

That's what happened in Myers' case. He has received dozens of calls in the last two years from brokers, supposedly giving him a great opportunity to invest in a fledgling enterprise.

"Offering frauds are an area where a large number of reasonably unsophisticated investors end up losing money," says Valerie Caproni, regional director of the SEC's Pacific Regional office in Los Angeles. "They are sold with the idea that you'll get in on the ground floor of some great something. Investors need to be extremely careful."

A private placement is the sale of debt or equity securities, usually to a small group of investors, without going through the expense and regulatory scrutiny of an initial public stock offering. Private placements are a way for small companies to raise capital to finance growth while remaining private. Investing in one can be profitable if the company grows into a successful enterprise.


But individual investors rarely get that opportunity, says Mark Rothschild, president of KnowledgeAdvisors in Chicago, which recently completed a successful private placement of its own.

In fact, legitimate private placements are generally sold only to friends, family members and company insiders and advisors, he says.

"If you don't know someone on the team or you are not an expert in the industry, you don't have much business investing in an early stage like this," Rothschild says.

"If a stranger calls you with an early-stage investment idea, that's a sign that you should hang up--unless you are being called because of your expertise in that area."

Even if you assume you're being called because of your expertise, you need to investigate before putting your money on the line, Cutler says. That means you need to call state securities regulators to get as much information as possible about the people involved in the deal.

Among the things you should find out: what other companies they've been involved with, what happened to those companies and whether they've had any run-ins with regulators.

In addition, determine whether the company's financial statements are audited. An audited financial statement is not an assurance that all will go well, but it's at least an indication that somebody with some financial savvy has looked at the company's numbers and believes they're accurate.

If the investment is sold by a broker, you should also get the broker's regulatory history by calling the National Assn. of Securities Dealers ([800] 289-9999). If any of the individuals involved in the deal--principals, brokers, dealers or directors--have been charged with wrongdoing by regulators, steer clear.


Even if all those signs are good, you need to do more digging to determine whether the deal is a potential money maker, Rothschild says. He suggests that all initial-stage investors ask five questions:

* Is there a business need that this company fulfills in a unique and viable way? Beware of firms that offer the corporate equivalent of vitamins--a business that will "improve" the performance of something that works just fine today.

* Does the company have a solid business model with realistic projections? "When they say, 'All we need to do is capture one-half of 1% of this market,' you should consider it a red flag," Rothschild says. "They act like that's an easy thing to do. It's incredibly difficult. Stop and think, 'If it was so easy, why wouldn't everybody do that?' "

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