News that two firms have been charged with fraud related to large private-securities deals could lead to a serious headache for many midsize to large independent broker-dealers whose financial advisers sold the products to wealthy investors.
On July 16, the Securities and Exchange Commission charged Medical Capital Holdings Inc. of Tustin, Calif., with fraud in the sale of $77 million of private securities in the form of notes. The same day, the Financial Industry Regulatory Author-ity Inc. of New York and Washington sent a sweep letter to broker-dealers looking for details into the sale of the product.
On July 7, the SEC charged Provident Asset Management LLC of Dallas with operating a fraud and a Ponzi scheme in the sale of $485 million of preferred stock and limited partnership offerings in oil and gas deals.
According to brokerage executives with the firms, industry sources and documentation, the firms that sold either one or both of the investments include American Portfolios Financial Services Inc., Capwest Securities Inc., GunnAllen Financial Inc., J.P. Turner & Co. LLC, National Securities Corp., Next Financial Group Inc. and Securities America Inc.
The outcome for broker-dealers whose advisers sold private securities and face fraud charges is unknown. They could face investor lawsuits or arbitration claims, and securities regulators may increase scrutiny of the firms.
In addition, executives and industry observers said that they wonder whether errors and omission insurance will cover any of the potentially millions of dollars in losses from the soured investments.
Finra is already turning up the pressure on some firms that sold the Medical Capital Holdings offering, called Medical Provider Funding VI. The same day that the SEC filed its complaint against the firm, Finra issued a “sweep” letter to firms that sold the offering, looking for information about the clients.
Executives with American Portfolios and National Securities acknowledged that their advisers sold offerings from Medical Capital Holdings and Provident Asset Management, but stressed that the amounts were extremely small in comparison with the firms' overall business.
Executives with GunnAllen, J.P. Turner of Atlanta and Next Financial of Houston said that they sold Provident Asset Management offerings but didn't sell Medical Capital Holdings. Likewise, the executives stressed that their advisers sold a small amount of the Provident offerings.
Lon Dolber, chief executive of American Portfolios, said that while the firm approved other Medical Capital offerings, it didn't approve the sale in the specific fund that the SEC is charging was fraudulent.
“There was a change in the business model,” he said.
The offering in question, Medical Provider Funding VI, didn't consist solely of medical receivables, as the firm's other offerings did, Mr. Dolber said. This offering had 60% of its assets in medical receivables or payables, while the remaining amount “deviated” into other investments, including real estate.
According to a 2007 SEC filing by Provident Asset Management, Capwest is listed as a seller of Shale Royalties 5 Inc., one of Provident's many deals. Dale Hall, Capwest's chief executive, didn't return calls seeking comment.
Meanwhile, a number of industry observers said that Securities America representatives sold the Medical Capital Holdings and Provident Asset Management deals.
When asked if that was accurate, Securities America's chief marketing officer, Janine Wertheim, said that the firm wouldn't comment “one way or the other” about clients' investments.
Such private-placement deals typically offer brokers extremely high commissions, from 7% to 10%, and broker-dealers also commonly receive a fee of 1% — commonly dubbed a “due-diligence” fee — when their reps sell the offerings. Advisers and reps sell the deals to accredited investors, those high-net-worth individuals with $1 million or more in assets.
Broker-dealers that offer their reps extremely high payouts, in the range of 95%, are more likely to allow brokers to sell the deals because of the lucrative fees that the firm could gain, industry executives and observers said.
Some brokerage executives said that the blowup over private placements was reminiscent of the limited partnership fiasco of the late 1980s, which sent some broker-dealers teetering on the edge of insolvency and pushed others from the business altogether.
Others, however, noted that right now, alternative investments such as private placements make up a much smaller percentage of a firm's mix of assets. Twenty years ago, many independent broker-dealers based the lion's share of their business on selling private placements.
Provident Asset Management, which is a broker-dealer, operated the fraud from June 2006 to January, the SEC said.
The firm made a series of fraudulent offerings of preferred-stock and limited partnership shares to generate promised returns through investments in oil and gas assets, the SEC said. In its complaint, the commission said the firm promised high returns and misrepresented how investors' funds would be used.
The SEC alleged that $18.5 million of a total $76.9 million raised through the sale of securities by Medical Provider Funding VI was used to pay administrative fees to Medical Capital.
Original offering documents issued by Medical Provider Funding VI failed to disclose that administrative fees would be paid out of the proceeds of the sale of notes, according to the SEC.
Officials at Medical Capital and Provident Asset Management didn't return calls seeking comment.
E-mail Bruce Kelly at [email protected].
