Regulator's Action Against Securities America Underscores Need to Be Wary of Private Placements

By James Eccleston

ecently the state securities regulator for Massachusetts filed an administrative complaint against Securities America in connection with its sales of promissory notes issued by special purpose corporations wholly owned by Medical Capital Holdings, Inc. ("Medical Capital"). Securities America has denied the allegations of the complaint. Since August of 2008, Medical Capital has defaulted on all of its outstanding note obligations and currently is in permanent receivership following fraud allegations by the Securities and Exchange Commission. Let's examine why investors should be wary of such investments.

According to the complaint, Medical Capital issued more than $1.7 billion in notes from 2003 to 2009. Securities America sold 37% of that total, receiving over $26 million in compensation. It appears to be undisputed that Securities America recognized that it had a duty to conduct due diligence as to the Medical Capital notes before recommending them to any of its investors. It likewise appears to be undisputed that Securities America recognized that it had a duty to determine that the purchasers of the notes were "accredited investors" who needed to show evidence of eligibility to purchase the notes.

The consensus ends there, however. For example, Securities America (in a press release) claims that it did review each purchase to determine accredited investor status. On the other hand, the Massachusetts complaint cites to testimony (obtained during the investigation) of Securities America brokers. They testified that they held dinner seminars to discuss Medical Capital and distributed marketing materials to investors without first ensuring that each investor was accredited. Additional testimony reveals that Securities America brokers sent "flyers, pamphlets and letters" discussing the Medical Capital notes to investors "without ensuring beforehand that each investor who received such information was sophisticated and accredited."

Moreover, there is substantial disagreement as to the level of due diligence conducted. Securities America claims that it conducted considerable due diligence and met all industry standards, noting that, "Fifty or more other broker-dealers independently conducted due diligence, did not detect the alleged fraud committed by Medical Capital, and approved and sold the Medical Capital notes." On the other hand, the Massachusetts securities regulator details in its complaint several pages of specific, material risks that were known to Securities America but never disclosed to current or prospective investors.

Dramatically, the regulator's "smoking gun" may well turn out to be Securities America's "due diligence analyst" whose testimony is frequently quoted throughout the complaint. In sum, "Year after year, the due diligence analyst, retained by Respondent [Securities America] to conduct a review of the various Medical Capital offerings, specifically requested and at many times pleaded that investors be informed of certain heightened risks." Asked during the investigation why Securities America did not follow the recommendations of its due diligence expert to share certain information with investors, the chairman of the firm's due diligence committee and - unfortunately - also the firm's head of sales, testified that giving such information would be a "bad thing."

Apart from how this interesting drama unfolds, there are at least two important lessons to be learned in studying the complaint. First and foremost was the lack of audited financials for Medical Capital. The due diligence analyst raised this concern early on but his concern fell on deaf ears at Securities America. Even though Medical Capital issued over $1.7 billion in securities, it was never subject to audited financials. The Massachusetts complaint states that this meant that "none of the information provided by Medical Capital regarding the value of the assets it purchased or the amount of debt it held was ever verified by an accountant as being accurate." Even if Securities America chose to ignore its own due diligence analyst, it perhaps should have paid attention to the NASD (the National Association of Securities Dealers). This self-regulatory organization for Securities America likewise expressed concern to Securities America - early on, in 2004 -- that Medical Capital did not have audited financials!

Second, investors need to be wary when they are told that a private placement (an unregistered security) is "Fully Secured" and should be included in their "Fixed Income Arsenal." Yet, according to the complaint, Securities America continuously claimed these facts. Unfortunately, "investors continued to pour their life savings into the [Medical Capital] notes amounting to hundreds of millions of dollars." According to the complaint, "[a]ll the while material risk information which would have made clear to investors the high risk associated with the [Medical Capital] notes was kept hidden from them."

Investors beware!

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.