On Advice

Asking the SEC's Michael Piwowar to reconsider who will end up the real 'forgotten investors'

His proposal to allow more Americans to invest in private placements is fraught with risk, mostly to retirees who fall prey to brokers motivated to sell these deals by high commissions

Mar 10, 2017 @ 6:00 pm

By Bruce Kelly

Michael Piwowar
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Michael Piwowar

The investment advice industry should pause for a moment and consider acting Securities and Exchange Commissioner chairman Michael Piwowar's recent, potentially disastrous call to loosen up the market for sales of high-risk, illiquid private placements to ordinary investors.

Such a notion, essentially to ease restrictions on investors who can buy private placements, assuredly brought smiles to brokers on Wall Street. The fees and commissions attached to private placements, typically 7% to the registered rep and 1% to the independent broker-dealer selling the deal, are among the highest in the securities industry. And in the era of the fiduciary adviser that is causing commissions to collapse at brokerage firms, some broker-dealers are hungry to return to freely selling high-commission products, including private placements.

That's why easing the restrictions on who can buy private placements is dangerous. The product is riddled with conflicts.

Conjuring the specter of a so-called "forgotten investor," an investor who has "suffered in a number of contexts over the years," in a speech in Washington a few weeks ago, Mr. Piwowar noted that requirements for investors to buy private placements, at least $200,000 in annual income or a net worth of $1 million, had changed only once since 1992. That's when the commission adopted Regulation D.

No home equity

The Dodd-Frank financial reform law later disallowed the counting of home equity in the net worth calculation, raising the bar even higher for potential buyers of private deals, he noted.

The "world of private offerings" is divided "into two categories: those persons accorded the privileged status of 'accredited investors' and those who are not," he said, according to a transcript of his speech.

This is somehow harmful to the small investor, according to Mr. Piwowar. "In my view, there is a glaring need to move beyond the artificial distinction between 'accredited' and 'non-accredited' investors," he said. "I question the notion that non-accredited investors are truly protected by regulators that prevent them from investing in high-risk, high-return securities available only to the Davos jet-set."

"Prohibiting non-accredited investors from investing in high-risk securities amounts to a blanket prohibition on their earning the very highest expected returns," he said.

It also prohibits investors, particularly retirees, from being exposed to the highest risk. Accredited investors, the common wisdom goes, can afford to lose money on high risk deals; non-accredited investors can't.

A spokeswoman for the Securities and Exchange Commission, Judith Burns, did not comment when I asked her about Mr. Piwowar's affinity for private placements.

But I wonder if he would like to see one of his elderly relatives end up with one of these private placements, typically sold to retirees in places like Boca Raton, Fla. and Phoenix, Ariz. Would he like to see his relatives stuck with a private illiquid real estate deal, one that promises lofty returns and also pays the registered rep a commission of 7% and the dealer manager another 2% to 3%?

Of course he wouldn't. He knows that the huge incentive for the broker turns into a huge hurdle for the client. Does the manager have a strategy to get back to par and then achieve sound returns over time? Does the investor have the time horizon to stay stuck in deal for seven to 10 years, or even longer?

(More: Financial advisers bristle at SEC's pitch to redefine 'accredited investor')

Would Mr. Piwowar allow his Aunt Louise or Uncle Lou to buy a private oil and gas deal that has not been independently vetted by the broker-dealer that sells it?

Of course he wouldn't. The due diligence process for private placements is riddled with conflicts of interest and the analyses can be shoddy.

Due diligence reports

Broker-dealers often perform no independent due diligence on private placements. Instead, they receive "due diligence" reports from third-party attorneys that are underwritten and paid for by the manager of the private oil and gas deal, known as the sponsor. To top it off, the sponsor pays the broker-dealer a "due diligence" fee of 1% for selling the product.

Conflict after conflict here.

And remember, broker-dealers that sold private placements in the run-up to the credit crisis often flouted the accredited investor rule, with reps at times doing suspicious back of the envelope math that turned middle-class investors — a couple in their late fifties who owned a home, a couple of cars and a boat — into millionaires.

Of course, not all private placements are lousy investments. But they are fraught with risk and disclose that prominently in sales documents. Is Mr. Piwowar paying enough attention to the damage such deals can create?

Since 2009, numerous elderly investors have reached out to me about private placements that promised high returns only to collapse, wiping out all or a portion of their life savings. They wanted to know if they could get all or at least some of their money back; they were all distraught and ashamed that they had been duped by that convincing broker in Boca Raton or Phoenix.

(More: Morgan Stanley debuts fiduciary product for small 401(k) plans, with eye toward DOL rule)

If Mr. Piwowar wants an education on private investing, he should leave the SEC offices in Washington and speak to investors in Florida or Arizona who used their life savings to buy Medical Capital notes or Provident Royalties preferred shares, both of which turned out to be Ponzi schemes despite due diligence reports. A call to any number of plaintiff's attorneys who represented hundreds of investors who filed arbitration claims against firms that sold such disastrous deals would do the trick.

If he made such an effort, chairman Mr. Piwowar would meet the real forgotten investors. Not just the ones he talks about.

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