In an ideal world, this article would not need to be written. However, any investor is bound to experience a situation where they will lose money on a deal. We all know that, for the most part, investing in the stock market involves the risk that investments will drop in value and barring anything nefarious going on behind the scenes with the company; generally, there’s not much we can do when a stock drops because these are publicly traded securities.
But when it comes to smaller investments, many are unfamiliar with their rights and options when they invest in private offerings. We regularly consult with investors who made an investment that sounded great at the time, but then things go downhill and the so inevitably, they wish to know what their options are against the person that sold them the investment?
First, we are not talking about loans which can be secured by collateral or a partnership in which you are actively involved in the activities of the partnership. Both of those types of deals have different options for protecting your investment. Rather, the investments we are referring to are known as “securities,” meaning you invested your money in a project as a “silent investor” without any or very little say or control over the activities of the project. The average individual investor in many private securities may be unaware that what they are investing in is, in fact, a “security,” and that there are special rules protecting those who invest in “securities.”
A security is generally defined as an investment in a common enterprise with the expectation of profit from the efforts of the promoter or third party. So if you invest money with someone and the success of the investment depends entirely on this third party (unless it is a true loan), most likely it is a security. If the investment is deemed a security, it must either be registered with the SEC or qualified for an exemption. For more on these rules and exemptions, please see this article.
In the case of private securities, you can easily check to see if the investment has qualified for a federal exemption by checking the company out at the SEC website at: https://www.sec.gov/edgar/searchedgar/companysearch.html
Individual states also have their own exemptions under each state’s “blue sky laws.”
Anyone looking to invest in a private security should be aware of law governing securities violations. This is especially true because in many cases by the time you realize something was wrong, its too late. In general, there are three categories of legal claims that can be brought on the promoter who violates securities laws. This article will focus primarily on federal law, but states have similar laws as well.
- Sale of an Unregistered Security – A promoter that sells a security that is not registered with the SEC or qualified for an exemption could be liable for sale of an unregistered security. In general, this is the easiest type of violation to prove because all that needs to be established is that (a) the investment was a security, (b) it was sold to you, and (c) it was not registered or qualified for an exemption. Most of the time, if you were a silent investor in a private investment that didn’t involve a PPM (Private Placement Memorandum) most likely the promoter violated this rule. If you are able to prove these elements, then you may be entitled to a return of your investment. That’s great! However, the drawback is that there is a very short window in which you can bring this type of a claim. Under Federal law, the statute of limitations for this claim is only 1 year after the sale, or under very limited circumstances, the time could be extended to 3 years. This short timeline is partially due to the fact that these types of claims are generally easier to prove and, it is not very difficult from a practical standpoint to determine if your investment was an unregistered security. It is important to be aware of the applicable deadlines because many clients do not realize something was amiss until they lose their money and often times this occurs after the statute of limitations has run.
- Misrepresentation in the sale of securities – This applies to any sale of a security by an untrue statement or concealment of material fact. So if a promoter makes false statements about their prior history (“We’ve already generated $1M in sales!”) or false statements of things that they’ve already done (“We’ve secured the necessary government approvals to break ground”) or even false projections of future success (“We guarantee a 20% return the first year”), all these are potentially grounds for a misrepresentation claim which entitles you to a return of the investment. The timeline to bring this type of claim under Federal law is slightly more generous (1 year after discovery of the untrue statement), but is also subject to an absolute 3 year deadline. These strict deadlines mean that if you suspect anything is amiss relating to your investment, it is essential that you act quickly to evaluate your rights.
- State Remedies – States have their own “blue sky” laws as well as other “common law” claims that often piggyback the securities claims referenced above. Examples may include fraud, negligence, breach of fiduciary duty or breach of contract. All of these claims will have their own time limitations and so you would need to check the requirements in your specific state.
Investments that are “securities” are often the most difficult to conduct your due diligence because by definition, most if not all of the information on the details of the investment come from the promoter and so the information the investor has is frequently limited to only information provided by the person trying to sell you the investment. Furthermore, the purpose of these securities laws is to require the promoter provide the investor with as much information about the risks of an investment so that the investor can make as informed a decision as possible. Anyone who has read a PPM knows it is generally a detailed summary of reasons NOT to invest in the particular offering. So if the promoter that you are dealing with is not complying these rules, the chance exists that the statements and information that the promoter is providing you may paint overly “rosy” or unrealistic picture of the probable success of the investment (because it is unregulated).
This is not to say that you should not invest in private placements nor try to conduct as much due diligence as you can when considering a private security. However, just be aware that these investments generally involve greater risk and speculation and so you need to be on your guard. Make sure you understand the details of your investment and what rights you have (or don’t have) under the governing documents (i.e. the Subscription Agreement, Operating Agreement, etc.), especially with respect to access to information on the progress of the investment. Make sure your agreements give you access to information about the investment’s performance and demand to see this when appropriate. Try to confirm all statements from the promoters in writing as those written statements may be valuable evidence in a future dispute.
Most importantly, if you sense that something may be amiss on deck, don’t sit back and just hope the ship will right its course or you may lose out on valuable rights that exist to protect you, the investor. Get a consult with an attorney immediately and start to have a fall back plan and frankly an ‘attack plan’ if it’s necessary. Again, it’s sad that articles have to be written like this, but it’s the world we live in and we have to pray for the best and plan for the worst.