In the wake of investor lawsuits over private placements in Medical Capital Holdings and Provident Royalties LLC, the Securities and Exchange Commission (SEC) is considering changes to its offering rules to make it easier to purchase non-public company shares. In addition, the SEC also is looking into whether it should revisit the current ban on public marketing of non-registered offerings as part of an overall review of securities-offering regulation.

As it is, private placements, also known as Regulation D offerings, are exempt from SEC registration. In the past year, the deals have come under increased scrutiny from regulators – with much of the attention generated by failed deals in Medical Capital Holdings and Provident Royalties. In 2009, the SEC charged both entities with fraud.

As reported May 10 by Investment News, in addition to possible changes in the ban on soliciting investors for non-registered offerings, the SEC is examining various restrictions on communications in initial public offerings, the thresholds that trigger public reporting and other regulatory questions that new capital-raising strategies create.

The SEC’s review comes on the heels of a proposal by the Financial Industry Regulatory Authority (FINRA) for a 15% cap on commissions and fees for private placements, as well as more disclosures about offering proceeds.

According to SEC Chairman Mary Schapiro, about 22% of the SEC’s enforcement cases in 2010 year involved investor fraud from securities offerings.

Arbitration claims involving structured investments have become a growing source of contention among investors – many of whom have experienced massive financial losses because of these Wall Street-engineered instruments.

Structured investment products, or SIPs, take several forms. Typically, they entail securities mixed with other derivatives, with a repayment value that is linked to the performance of the underlying assets. The assets can include a single security, a pool of securities, stock, bonds, debt issuances, foreign currencies or swaps.

For years, structured investments have been touted by brokers as a way for risk-wary investors to take advantage of stocks or other investments without having to actually “own” those investments. At the same time, investors could maintain a level of protection in the event of any losses.

What many of these brokers failed to add is that the “protection” in principal-protected notes is contingent on the solvency of the company linked to the note.

Lehman Brothers Holdings is a prime example. When Lehman filed for bankruptcy in September 2008, investors holding Lehman Return Optimization Securities and 100% Principal Protected Notes became stuck with essentially worthless investments. Today, these products are trading for pennies on the dollar.

Many investors who bought structured products are retirees. They sought the investments on the recommendation of their brokers, who touted the “conservative,” “minimal risk,” and “principal-protected” benefits of the products. Those benefits, however, never materialized.

At minimum, investors believed that principal-protected notes like those of Lehman Brothers would allow them to always maintain their principal original investment. Lehman’s own marketing brochures even advertised the products this way.

Lawsuits and arbitration filings over structured investment products have risen significantly in past few years. Among the allegations in the complaints: Investors were never informed about the potential risks of structured investments. Moreover, they never realized that the “investment product” they had put their money and faith behind was actually the unsecured debt of the issuer. If that company went bankrupt, as in the case of Lehman, their investment disappeared, as well.

Sales of risky private placements in Provident Royalties and DBSI Inc. have come back to haunt broker/dealer CapWest Securities, possibly putting its future existence in peril.

As reported April 26 by Investment News, CapWest Securities stated in its latest filing with the Securities and Exchange Commission (SEC) that a number of events – including a rash of lawsuits tied to private placement deals that went south – has “raised substantial doubt” about the company’s ability to meet regulatory net-capital requirements.

CapWest is far from alone. Several other broker/dealers that sold private placements have shuttered in recent months, including QA3 Financial Corp. in February. As a result, regulators are stepping up their oversight of private placements and the broker/dealers that market and sell them to investors.

According to court documents, CapWest brokers sold about $22 million of private placements issued by Provident Royalties LLC. In the summer of 2009, the SEC charged Provident with fraud. CapWest also sold an unknown volume of sales in DBSI Inc., a packager of real estate deals that is now in bankruptcy court.

Plagued by legal woes involving private-placements sales in Medical Capital Holdings and Provident Royalties, Securities America may soon have a new owner. As reported April 25 by Investment News, parent company Ameriprise Financial is looking to sell the troubled independent broker/dealer.

“In reporting its first quarter financial results this afternoon, Ameriprise management said it was looking to shed Securities America – the 17th largest independent broker-dealer in the industry according to Investment News data, which it acquired in 1998. Ameriprise indicated the potential sale of the firm would not have an impact on its $150 million settlement with investors suing the firm over private placements that have gone bust,” the article said.

In recent months, sales of private placements have been under the microscope by the Financial Industry Regulatory Authority (FINRA). Evidence of the new scrutiny became apparent in early April, when FINRA imposed fines and disciplinary actions against a number of firms that sold investments in Medical Capital Holdings and Provident Royalties.

FINRA’s disciplinary actions focused on the failure of broker/dealers to investigate the private placements being sold by their firms. Both Medical Capital and Provident Royalties were charged with fraud by the Securities and Exchange Commission (SEC) in July 2009.

Private placements are high-commission products, oftentimes producing hefty fees and commission for broker/dealers of up to 8%.

Principal-Protected Notes (PPNs) – and the misrepresentation of them – are back in the news. The Financial Industry Regulatory Authority (FINRA) has fined UBS Financial Services $2.5 million over PPNs, requiring the brokerage firm to pay $8.25 million in restitution for omissions and statements made to investors about the products.

According to FINRA, UBS’s statements about the products effectively misled some investors about the “principal protection” feature of 100% Principal-Protection Notes issued by Lehman Brothers Holdings prior to its September 2008 bankruptcy filing.

Principal-protected notes are considered fixed-income security structured products with a bond and an option component that promise a minimum return equal to an investor’s initial investment.

According to FINRA, as the credit crisis worsened during March to June 2008, UBS advertised – and some UBS financial advisors described – the structured notes as principal-protected investments while failing to emphasize they were actually unsecured obligations of Lehman Brothers.

In making its decision against UBS, FINRA found that the firm:

• Failed to adequately disclose to some investors that the principal-protection feature of the Lehman-issued PPNs was subject to the credit risks of Lehman Brothers Holdings;
• Did not properly advise UBS financial advisors of the potential effect of the widening of credit default swap spreads on Lehman’s financial strength or provide them with proper guidance on using that information with clients;
• Failed to establish an adequate supervisory system for the sale of Lehman-issued PPNs;
• Failed to provide sufficient training and written supervisory policies and procedures;
• Did not adequately analyze the suitability of sales of the Lehman-issued PPNs to certain UBS customers; and
• Created and used advertising materials that essentially misled some customers about specific characteristics of PPNs.

UBS neither admitted nor denied the charges levied by FINRA, but consented to the entry of the findings.

A highly leveraged municipal arbitrage fund known as Mat/ASTA has come back to haunt its creator, Citigroup Global Markets. On April 11, a Denver, Colorado-based Financial Industry Regulatory Authority (FINRA) arbitration panel awarded more than $54 million to two clients represented by the laws firms of Aidikoff, Uhl & Bakhtiari and Maddox, Hargett & Caruso.

The award includes punitive damages of $17 million and $3 million in attorney fees. The arbitration panel also assessed the entire cost of the arbitration hearing against Citigroup Global Markets, ordering the firm to pay $33,500 in expert witness fees and $13,168 in court reporter costs.

“This award demonstrates that even the most sophisticated investors were misled by Citi in the marketing and sale of the Mat and ASTA leveraged municipal arbitrage product,” said Steven B. Caruso of Maddox, Hargett & Caruso.

“The fact that the arbitrators also awarded expert witness costs, court reporter costs and all FINRA forum fees is both unusual and important,” Caruso added.

The Mat/ASTA fund was sold through Smith Barney and Citigroup Private Bank to high net worth clients between 2002 and 2007. According to investors, the returns and risks of the funds were represented as “slightly greater” than a typical municipal-bond portfolio.

In reality, the Mat/ASTA funds were highly leveraged, borrowing approximately $8 for every $1 raised.

“Citi misrepresented the known risks of Mat/ASTA to retail investors such as the claimants in this case,” said Dr. Craig McCann of Securities Litigation and Consulting Group. McCann served as an expert witness for the claimants.

Maddox, Hargett & Caruso continues to investigate FINRA arbitration claims on behalf of investors who suffered financial losses in leveraged municipal arbitrage investments, including Mat/ASTA.

Broker/dealers involved in sales of private placements have been put on notice by the Financial Industry Regulatory Authority (FINRA). In the future, the regulator says it will be stepping up its oversight of private-placement deals.

Evidence of the new scrutiny became apparent last week, when FINRA imposed fines and disciplinary actions against a number of firms that sold investments in Medical Capital Holdings and Provident Royalties.

As reported April 10 by Investment News, FINRA’s recent actions focused on the failure of broker/dealers to investigate the private placements being sold by their firms. Both Medical Capital and Provident Royalties were charged with fraud by the Securities and Exchange Commission (SEC) in July 2009.

Private placements are high-commission products, yielding broker/dealers fees of 7% or 8%.

“Senior officials at these firms failed to fulfill their responsibilities to customers by not conducting reasonable investigations of these unrelated offerings, especially in light of multiple red flags suggesting liquidity concerns, missed interest payments and defaults,” said Brad Bennett, executive vice president and chief of enforcement for FINRA.

“FINRA will continue to look closely at sales of both affiliated and unaffiliated private placements to determine whether the selling firms fulfilled their responsibility to customers. Broker-dealers and the executives should have looked at the private-placement offerings much more closely,” Bennett said.

Top executives of various broker/dealers that sold private placements in Medical Capital Holdings and Provident Royalties have been fined and sanctioned by the Financial Industry Regulatory Authority (FINRA).

Among the executives cited for failing to conduct a reasonable investigation of private placement sales offered by Medical Capital Holdings and/or Provident Royalties:

· Robert Vollbrecht, Workman Securities’ former President. Vollbrecht was barred in any principal capacity and fined $10,000.

· Timothy Cullum, former Chief Executive Officer, and Steven Burks, former President of Cullum & Burks Securities of Dallas, Texas, a now-defunct firm. Both men were each suspended in any principal capacity for six months and fined $10,000.

· Jeffrey Lindsey and Bradley Wells, two former executives with Capital Financial Services. Lindsey and Wells have been suspended for six months in any principal capacity and fined $10,000.

· Jay Lynn Thacker, former Chief Compliance Officer for Meadowbrook Securities, LLC (aka Investlinc Securities, LLC). Thacker was suspended for six months in any principal capacity and fined $10,000.

· David William Dube, former Owner, President, Chief Compliance Officer and Anti-Money Laundering (AML) Compliance Officer of (now-defunct) Peak Securities Corporation. Dube was barred for failing to conduct adequate due diligence, as well as a failure as AML Compliance Officer to detect, investigate and report numerous suspicious transactions in 10 customer accounts where “red flags” existed.

According to FINRA, without performing proper due diligence, the broker/dealers that sold the private placements could not identify and understand the inherent risks of the offerings. Moreover, the sanctioned principals did not have reasonable grounds to allow the firms’ registered representatives to continue selling the offerings despite the red flags that existed regarding the private placements.

Investment deals involving collateral-debt obligations (CDOs) have come back to haunt Wells Fargo & Co. Wells has agreed to pay $11.2 million to settle charges by the Securities and Exchange Commission (SEC) that its Wachovia Capital Markets LLC unit sold CDOs to a Zuni American Indian tribe and other investors at prices 70% higher than its own estimate of the mark-to-market value of the securities.

As reported April 6 by Investment News, the SEC’s complaint alleges that Wachovia failed to inform investors in another CDO that it had transferred 40 residential mortgage-backed securities from an affiliate at above-market prices to avoid losses on its own books.

“Wachovia caused significant losses to the Zuni Indians and other investors by violating basic investor protection rules – don’t charge secret excessive markups and don’t use stale prices when telling buyers that assets are priced at fair market value,” said Robert Khuzami, director of the SEC’s Division of Enforcement, in a statement.

Wells Fargo, without admitting or denying the allegations, will pay restitution of $6.75 million and a $4.45 million penalty. A total of $7.4 million will be returned to investors who were harmed by the misconduct, according to the SEC.

Wells Fargo purchased Wachovia in 2008.

A deal may in the works between Securities America and investors who lost hundreds of millions of dollars from soured private-placement deals in Medical Capital Holdings and Provident Royalties. The story was first reported by Investment News on March 28.

Financial problems related to investor lawsuits in the private placements have been a growing source of concern for the broker/dealer. Now, it appears a settlement offer could be on the table.

Details of the offer have not been revealed.

Securities America sold about $400 million in private placements in Medical Capital Holdings. In July 2009, the Securities and Exchange Commission (SEC) charged the company with fraud, accusing it of essentially running a Ponzi scheme. That same month, the SEC also charged Provident Royalties with fraud.

Earlier this month, a federal judge denied a proposed $21 million settlement between Securities America and the plaintiffs in the case. If the settlement had occurred, investors would likely have received only pennies on the dollar.

And while Securities America may not have enough capital to pay plaintiffs 100 cents on the dollar, its parent company, Ameriprise, does.

As reported in the Investment News article, Securities America has reportedly informed its 1,800 brokers of the proposed settlement.