PRIVATE PLACEMENT PITFALLS

On September 2, 1998, the Securities and Exchange Commission (SEC) issued an Opinion in the Matter of Richard H. Morrow, 34-40392, Admin. Proc. 3-8304,in which it was determined that registered representative Morrow (RR):

• offered and sold securities beyond the deadline set forth in the offering document for raising the required minimum offering proceeds; and
• failed to properly disclose his anticipated compensation from the sale of those securities.

As a consequence, RR was ordered

• to cease and desist from committing or causing any violation or future violation of Section 10(b) of the Exchange Act, Rule 10b-9, and Sections 17(a)(2) and (3) of the Securities Act; and
• suspended from association with any broker or dealer for one year (but the SEC specifically declined to collaterally suspend RR with any municipal securities dealer, investment company, or investment adviser).

RR participated on an independent basis and not through a broker-dealer in the sale of limited partnership interests in a real estate development project through a private placement offering (PPO) seeking to raise a minimum of $600,000 (Mini) and a maximum of $800,000. The PPO funds raised were to be held in escrow until the Mini was raised, or through January 31, 1990 (the Closing Date), whichever occurred first. In the event the Mini was not raised by the Closing Date all investor funds were to be promptly returned from escrow unless written permission to retain the funds was granted to the General Partner (GP) by each Limited Partner (LP).

RR briefly skimmed through the Private Placement Memorandum (PPM) and asked for a copy of the marketing material that another selling RR (RR2) had utilized. RR forwarded those materials to his clients on January 12, 1990. In a cover memorandum, RR stated:

This is a small private placement and will not be available much longer. (RR2 has already committed $400,000). Please call me as soon as possible after you receive this to let me know if you are interested.

Notwithstanding the representations in the cover memorandum, only $187,000 had been raised by Closing Date.

Because written consent to extend the offering had not been obtained from all existing investors on or before the Closing Date, the offering expired and all funds then committed should have been returned promptly to investors. However, no funds were returned and between February 1, 1990 -- the day after the Closing Date -- and March 6, 1990, RR sold PPO interests to thirteen clients, raising $400,000. All of RR's sales occurred after the Closing Date. RR had been told by RR2 and others associated with the PPO that an extension application had been applied for and the necessary addendum to the PPM was being filed. However, investors were not asked until mid-March 1990 to sign an addendum to the PPM that purported, among other things, to extend the Closing Date through April 15, 1990. Further, although the PPM specified that the investors' funds were to be maintained in an escrow account until after the offering's completion, the designated escrow agent never received custody of the funds and as a result of a misappropriation of those funds, investors lost approximately $575,000.

Courts and SEC have repeatedly stressed the importance of the Rule 10b-9 requirement that a Mini-Max offering will go forward only if enough investors demonstrate by their purchases that the risk associated with the offering is worth taking and the price being paid for the securities is fair. Consequently, investor funds must be promptly returned if the required minimum proceeds are not raised by the stated offering deadline.

RR had a duty to investigate the PPO before recommending the investment to his clients. That duty was particularly important here because no broker-dealer was involved in the offering and, accordingly, there was no due-diligence file to which RR could refer. In choosing to sell independently, RR thus became responsible for conducting his own investigation into the offering.

RR was reckless in failing to investigate whether the offering had been validly extended before engaging in sales after the Closing Date. Although he had been told that an addendum to extend the offering was being prepared, RR did not see a copy of the addendum, nor did he request one. Further, he made no effort to ascertain whether written consent to extend the offering had been obtained from each existing investor. A salesman may not satisfy his duty to investigate the securities he recommends by relying "blindly" on information supplied by persons connected with the issuer. RR was reckless in accepting such assurances when an extension required the consent of independent, third party investors.

RR essentially relied upon the representations of RR2 and other interestedparties connected to the PPO. By failing to make any inquiry with disinterested parties, RR failed to properly investigate if the PPO had been legally extended. Further, RR's failure was compounded by his January 12^th cover memorandum, which implied to his clients that $400,000 in proceeds had been "committed" and that the offering would "not be available much longer." He thereby gave his clients the impression of a successful PPO and further undercut the protections that Rule 10b-9 was designed to provide.

Securities Act Section 17(a)(2) prohibits the sale of securities by means of any untrue statement of or any omission to state a material fact. A material fact exists when there is a substantial likelihood that a reasonable investor would consider it important to an investment decision. Securities Act Section 17(a)(3) prohibits a seller of securities from engaging in any transaction, practice, or course of business that operates or would operate as a fraud or deceit upon the purchaser.

From the beginning, RR anticipated that he would receive compensation based upon his total sales in the offering. RR received a proposal that the GP pay each seller an 8% selling commission and a 10% backend equity kicker fee. RR's failure to explain to his customers the nature of his anticipated compensation was exacerbated by the affirmative disclosure in the PPM: "NO SELLING COMMISSIONS WILL BE PAID BY THE PARTNERSHIP IN CONNECTION WITH THE SALE OF UNITS." The PPM did not alert RR's clients to the fact that sales compensation or an equity kicker would be paid and RR had an obligation to disclose that arrangement to his clients.

SEC was particularly troubled by RR's failure to disclose to his clients -- potential limited partners -- that he expected to receive an equity kicker paid out of the limited partners' shares of the appreciation of the partnership property. None of his clients suggested that they anticipated that RR would receive any equity interest, and certainly not from their share of the partnership. Moreover, payment of an equity kicker could have an effect on the ultimate profitability of the clients' investment in the partnership.

For Further Reference:

In the Matter of Alfred M. Bauer and J. Stephen Stout, Initial Decision 134, Admin. Proc. 3-9034 (January 7, 1999).

In the Matter Alfred M. Bauer and J. Stephen Stout, Order Making Findings and Imposing Remedial Sanctions, 63 SEC Docket 0040 (Oct. 15, 1996).