According to forensic accountant and frequent expert witness Gordon Yale, the billions of dollars in allegedly fraudulent private placements sold to investors resulted partly from broker-dealers’ massive failure to meet their due-diligence responsibilities.

Yale is certified public account and principal of Yale & Co. who has worked on more than 50 lawsuits brought by investors against broker-dealers after failed deals. He has served as an expert witness for a dozen different plaintiff’s lawyers in lawsuits pursuing more than $100 million in claims.

Last year Yale testified in a suit in which an investor was awarded of $1.2 million in damages and legal fees against Securities America Inc. and an affiliated broker. He discussed due diligence in a report by Investment News on Nov. 25.

The report discussed allegedly fraudulent private placements issued by DBSI Inc., Medical Capital Financial Corp. and Provident Royalties LLC, now Shale Royalties.

Private Placements

Private placements are securities sold without an initial public offering. They are exempt from registration under an exception to the Securities Act of 1933, the rationale being that the typical private placement is sold to a few select and sophisticated investors.

Yet the case of Provident Royalties shows that private placements may have crept beyond their traditional borders. Provident is in bankruptcy and the website of its liquidating trust shows that a total of 52 broker-dealers are enmeshed in litigation stemming from sales of the allegedly fraudulent oil and gas private placements. Twenty of these broker-dealers have shut their doors.

Between 2006 and 2009, Provident raised $485 million from 7,700 investors through these placements. Although investors were told their money would be invested in oil and gas exploration and development ventures, it was co-mingled with other investment monies and some was paid out in classic Ponzi scheme fashion as “dividends” or “returns on capital” to earlier investors, according to an Securities and Exchange Commission (SEC) complaint charging the company various counts of fraud plus unjust enrichment.

The SEC also charged Medical Capital Financial with fraud in 2009, and DBSI filed for bankruptcy protection in 2008.

Incredibly Sloppy Due Diligence

Yale said that the broker-dealers’ due diligence in these instances was incredibly sloppy, comparing it to the recklessness of major investment banks during the mortgage-backed-securities debacle.

With private placements, Yale told Investment News that the reckless players were middle- or lower-tier firms, many of whom relied on third-party due-diligence vendors.

The broker-dealers relied on these third-party reports rather than viewing them as just a starting point as they should have, Yale said. He mentioned Notice 05-48 to members of the Financial Industry Regulatory Authority (FINRA) that says members may outsource any function, but they cannot outsource their responsibility for compliance with federal securities laws or regulations.

Another problem is that in many instances, the issuers pay these third-party due-diligence vendors. True due diligence requires an accountant to dig into the offering documents, Yale said.

Those assigned to conduct due diligence need to understand enough about the underlying business and management’s representations about its performance in that business to assess whether the facts back up the representation.

Regarding the Medical Capital fraud, Yale told Investment News that the broker-dealers seemed to rely on the fact that the company was making payments in a timely way, but this indicates exactly nothing about the soundness of an investment. Yale pointed out that this is how all Ponzi schemes work. They pay until they don’t.

FINRA Regulatory Actions

FINRA has brought several regulatory actions against broker-dealers connected with these private placement that involved fines or restitution to investors. The broker-dealers neither admitted nor denied the findings.

Broker-dealers sold some $3.6 billion in Medical Capital notes, Provident Royalties preferred shares, and DBSI tenant-in-common exchanges, partnerships and notes. The broker-dealers maintain they performed the appropriate due diligence.

In one example of a regulatory action, Brian Boppre, the former president of Capital Financial Services Inc., submitted a Letter of Acceptance, Waiver to and Consent (AWC) to FINRA. He was fined $10,000 and suspended from association with any FINRA member for six months, until March 2012. Capital Financial was a leading seller of both Medical Capital Financial and Provident Royalties private placements.

Without admitting or denying anything, Boppre consented to findings that, acting on his firm’s behalf, he failed to conduct adequate due diligence of a Medical Capital offering. Without the due diligence, his firm knew nothing about the inherent risks and had no reasonable basis to sell the offering. By failing to conduct due diligence, Boppre also failed to supervise his brokers’ sales, the AWC said.

FINRA also found that Boppre allowed his firm’s brokers to continue selling a Medical Capital offering despite the issuer’s failure to make principal and interest payments, and other red flags.

FINRA Files New Rule Proposals

Perhaps in response to large scale fraud of the kind surrounding the private placements of companies like Medical Capital and Provident, on Oct. 5, FINRA filed a new rule proposal with the SEC that should make due diligence easier if it’s adopted.

Proposed FINRA Rule 5123 would impose new notice and disclosure requirements on private placements, including requirements for transparency regarding the use of the proceeds, as well as full disclosure of expenses and compensation.

Section (a) and the proposed rule would prohibit a member firm, or any person associated with a member firm, from offering or selling any private placement security unless the member or associated person provides a private placement memorandum, term sheet or other such documentation to each investor before the sale, according to the proposal filed with the SEC.

This documentation must describe the anticipated use of the offering proceeds, the amount and type of expenses, and the amount and type of compensation to be provided to sponsors, finders, consultants and member firms and their associated persons in connection with the offering,

Proposed Rule 5123(b) would require member firms to file the disclosure documents, including exhibits, with FINRA no later than 15 calendar days after the date of the first sale. Any material amendments to the disclosure documents would need to be filed with FINRA no later than 15 calendar days after the date the amended document is provided to an investor or prospective investor.

Any person who participates in the preparation of private placement memoranda, term sheets or other disclosure documents related to private placements would also be subject to these disclosure requirements, the rule proposal says.

Guiliano Law Firm

The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Firm, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost to unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.

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