15 transformational events: Reg D offerings rear their heads — again

The stock market was hitting record highs, investors were piling into real estate, and oil and gas private…

The stock market was hitting record highs, investors were piling into real estate, and oil and gas private placements were being sold by independent broker-dealers for tax benefits and income.
Financial advisers and broker-dealer executives later would find that illiquid Regulation D offerings carried risks that they either had ignored or failed to fully understand.
No, this wasn’t the 2000s, when dozens of independent broker-dealers sold billions of dollars of high-risk private placements that turned out to be fraudulent. This was the 1980s, when the Reg D chimera of ample reward with little risk for investors first appeared in the independent-broker-dealer marketplace.
And both times, the results for private-placement investors and the broker-¬dealers that sold them were disastrous. Indeed, broker-dealer executives were shocked by what happened to their industry.
Registered representatives can sell private placements and Reg D offerings to accredited investors, meaning their most wealthy and sophisticated clients.
The statistics of Reg D damage in the 1980s and 2000s speak loud and clear.

PHOTO GALLERY 15 transformational events

According to the bestseller “Serpent on the Rock” by Kurt Eichenwald (Harpercollins, 1995), Prudential Securities Inc., which eventually was absorbed into what is now Wells Fargo Advisors, was at the center of a Reg D limited-partnership scandal in the 1980s that allegedly defrauded 340,000 investors out of $8 billion.
Since the financial crisis reached full force in September 2008, when investment banking titan Lehman Brothers Holdings Inc. declared bankruptcy, InvestmentNews has tallied the failure of at least 36 independent broker-dealers that collectively sold close to $4 billion in fraudulent private placements.
Many of the firms couldn’t keep up with the costs of defending themselves against investor arbitration claims. Legal filings show that investors could have lost as much as half that amount, mostly because their principal wasn’t returned.
“I’ve been in the business for 45 years, and nothing has ever come close to the carnage that’s occurred in our industry,” Ron Kovack, chairman of independent broker-dealer Kovack Securities Inc., said in an interview in late 2010.
There is a key distinction, however, between the two epochs.
Congress passed the Tax Reform Act of 1986 in order to simplify the tax code, wiping out a tax shelter benefit in certain limited partnerships that typically gave investors a tax write-off of $3 for every $1 invested. The new tax law also put investors on the hook for back taxes under the revised calculations, effectively killing the market for these products.
In the past decade, the most serious Reg D failures, such as real estate and note offerings by DBSI Inc., notes issued by Medical Capital Holdings Inc. and preferred shares of Provident Royalties LLC were simply frauds.
“What happened in the ’80s was driven by the tax law change rather than malfeasance,” said John Rooney, managing principal of Commonwealth Financial Network, who was in charge of a regional broker-dealer’s product department at the time.
“It was a money-for-nothing type of enterprise. If you’re getting better than a 2-to-1 write-off, it was like taking tax dollars and playing the lottery” with a real estate or oil and gas private placement, Mr. Rooney said.
The collapse and sudden shutdown of GunnAllen Financial Inc. in March 2010 underscored the carnage of the 2000s.
GunnAllen, which sold Provident Royalties notes, was one of the fastest-growing independent broker-dealers in the industry during this period, and was well-known for a culture that catered to advisers, including the types of products they wanted to sell. It boasted as many as 1,000 independent reps before its descent.
In June 2010, Jesup & Lamont Securities Corp., which had 300 reps and a corporate lineage that dated back to the 19th century, closed after violating industry net capital rules.
In February 2011, QA3 Financial Corp., which had close to 400 reps and sold Provident and MedCap notes, suddenly shut down.
That was months after its owner and chief executive Steve Wild wrote to InvestmentNews that his firm had sufficient capital and wasn’t following GunnAllen’s path to extinction.
Even prominent, well-established brokerages like Securities America were singed, to varying degrees, by the sale of private placements.
Regardless of historic differences, a clear similarity between problems from reps’ private-placement sales practices during both eras is apparent, another long-time independent broker-dealer executive said.
“I thought a private-placement meltdown couldn’t happen again, until we saw deals start to go south” in the last decade, said Larry Papike, president of Cross-Search, a recruiting firm for independent reps and the executives of independent broker-dealers.
He owned a broker-dealer that sold limited partnerships in the 1980s.
“Investors and advisers were tired of stocks, so sexy products like Provident Royalties and MedCap with high returns became popular,” Mr. Papike said.
“When you have a new sexy product to sell, it’s very easy. And advisers were filing their pockets with money, too” from the commissions on private placements, Mr. Papike said.
“They were illiquid and exclusive, but no one was really looking underneath the [hood] — in the ’80s and 20 years later,” he said.
Many broker-dealer executives remain fearful of private placements and other illiquid types of securities, despite the recent strong performance of certain nontraded real estate investment trusts.
“Securities are a wonderful instrument. They have liquidity and trade on an exchange,” said Mark Goldwasser, president and vice chairman of National Holdings Corp.
“You can buy and sell them and borrow against them. That’s opposed to private placements, which have zero liquidity, and in a crunch period like 2009, when people wanted to get in touch with their assets, so to speak, it was better to have securities,” Mr. Goldwasser said.
“A lot of private placements and other alternatives like hedge funds lent themselves to bad practices” during the market euphoria of the last decade, he said.
“And that led to some disasters we know too well,” Mr. Goldwasser said.