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Due Diligence Lacking in Private Placement Deals

Recent failures of private placement deals, including notes issued by Medical Capital Holdings, has brought to light the issue of due diligence performed by broker-dealers. The issue that has been raised is that there is little to no pre-screening of private placement investment products by a regulatory body. This lack of regulatory oversight has exposed investors to far more risk in private placement offerings than could likely be imagined.

Broker-dealers often leave the analysis of securities products to third-party due-diligence firms. Such firms normally consist of attorneys who are paid by the issuer to write a report evaluating the viability of the issuer’s deal. The potential for a conflict of interest is high as due diligence firms receive fees from the companies they must objectively vet. In addition to this, due-diligence firms often produce superficial reports that provide a perfunctory review of the issuers and their finances. This issue is compounded because many broker-dealers fail to read these reports.

Despite such concerns, both the market and investors’ appetites for such deals have increased exponentially. Last year over 26,000 private placement offerings were filed with the Securities and Exchange Commission, which requires little information about this type of investment. This has led to a precipitous climate for investors, leading to large scale exposure, and in some cases fraud.

In July of this year the SEC charged Medical Capital Holdings Inc. with fraud in the sale of $77 million of private securities in the form of notes. Since then, a court appointed receiver has said that $543 million worth, or about 87%, of all the accounts receivable Medical Capital controlled are “nonexistent.”

There’s no way to tally the potential cost to broker-dealers who sold clients Medical Capital deals. Investors have begun to file arbitration claims against the firms who sold the private placement products. Though broker-dealers worry of the damage done between them and their respective clients, the real damage has been to investors themselves.