What are unregistered securities or stocks?

Before securities—like stocks, bonds, and notes—can be offered for sale to the public, they first must be registered with the Securities and Exchange Commission (SEC). Any stock that does not have an effective registration statement on file with the SEC is considered “unregistered.”

Exceptions to the Legality of Unregistered Securities

However, certain exemptions apply. For example, a privately-owned corporation may issue shares of stock to its executives and board members. However, the new stockholders must notify the SEC before selling the stock to anyone else.

In addition, companies can raise capital by soliciting investments from individuals outside the company who are considered to be “qualified investors.” The SEC defines a qualified investor as someone who has a net worth of at least one million dollars or an annual income in excess of $200,000.

Unregistered Securities Scams

Individuals who meet “qualified investor” status can sometimes become victims of unregistered securities scams that are advertised as “private offerings.” In April 2019, Investment News published an article called “Sales of unregistered securities are a growing problem that’s harming every investor—and the industry.”

Bruce Kelly uses the example of Castleberry Financial Services Group. The company managed to raise $3.6 million from investors by offering what they called an “alternative investment fund” that promised up to a 12.2% annual yield.

However, an investigation by the Securities and Exchange Commission (SEC) revealed that some of the money they’d raised had been used to pay the personal expenses of the firm’s principals. Funds were also transferred to family members and other businesses that the principals controlled. The SEC eventually took the company to court and shut them down.

However, Kelly points out that this kind of scheme—where private, unregistered securities are sold to wealthy investors and institutions—is not unusual and is, in fact, actually rampant in the industry:

What’s growing alongside this legitimate, if risky, market is a seedy side of the financial advice industry. Investment funds promising above-market returns that employ networks of brokers, former brokers, insurance agents or others lurking on the fringes of the industry to sell their investments are taking advantage of unsuspecting investors.

The marketplace for unregistered securities has grown, partially because private securities can be sold over the internet and companies can solicit clients via social media. This results in unregistered, private securities being sold to investors who do not meet the SEC’s criteria for “qualified investors.” And according to Kelly, this is damaging the reputation of the financial advice industry.

The SEC and the Financial Industry Regulatory Authority, Inc. (FINRA) are working on increasing oversight for finance professionals who sell private, unregistered securities.

How to Identify Unregistered Offerings Scams

Investors can consult a bulletin, released by the SEC, that provides an overview of ten red flags that an unregistered offering is a scam.

Claims of High Returns with Little or No Risk

Promises of high returns, with little or no risk, are classic warning signs of fraud. Every investment carries some degree of risk, and the potential for greater returns comes with greater risk. You should be skeptical of any investment that is said to have no risks.  

Unregistered Investment Professionals

Unregistered persons who sell securities perpetrate many of the securities frauds that target retail investors. Always check whether the person offering to sell you an investment is registered and properly licensed, even if you know them personally. An investment professional’s registration, background, and qualifications are available through the Investment Adviser Public Disclosure website and FINRA’s BrokerCheck.

Aggressive Sales Tactics

Scam artists often pitch an investment as a “once-in-a-lifetime” offer to create a false sense of urgency. Resist the pressure to invest quickly and take the time you need to investigate thoroughly before sending money or signing any agreements. Any reputable investment professional or promoter will let investors take their time to do research and will not pressure for an immediate decision.

Problems with Sales Documents

Avoid an investment if the salesperson will not provide you with anything in writing. A legitimate private offering will usually be described in a private placement memorandum, or PPM. Similarly, sloppy offering documents that contain typographical, spelling, or other errors can be a red flag that the investment could be a scam.

No Net Worth or Income Requirements

The federal securities laws limit many private securities offerings to accredited investors. Be highly suspicious of anyone who offers you private investment opportunities without asking about your net worth or income.

No One Else Seems to Be Involved

Be cautious if no one besides the salesperson appears to be involved in the deal. Usually, brokerage firms, accountants, law firms, or other third parties are involved in a private offering. Similarly, be cautious if you are told not to contact someone who is supposedly involved with the investment.

Sham or Virtual Offices

A company may establish a mailing address within a state in which it has no legitimate operations in a fraudulent attempt to qualify for an exemption from registration. If the company’s corporate address is a mail drop and you are unable to verify that the company has any actual operating presence (such as a headquarters building, plant or other physical operations) within the same state, be wary.   

Not in Good Standing

Any company, including limited liability companies and limited partnerships, seeking your investment should be listed as active or in good standing in the state where it was incorporated or formed. Every company must file and pay annual taxes in order to maintain its good standing. Each state, usually under the offices of its Secretary of State, maintains a publicly accessible online database of its companies. 

You should be wary if the company you are being asked to invest in can’t be found in the records of the state it claims to have been formed in or if it’s not listed as active or in good standing. 

Unsolicited Investment Offers

You should be very careful when you receive an unsolicited—meaning you did not ask for it—investment offer. Whether from a total stranger or from a friend, trusted co-worker, or even family member, always consider the motivation of the person offering the investment. 

Fraudsters often exploit the trust and friendship that exist in groups of people who have something in common, sometimes called affinity fraud. You should be especially suspicious if you are told to keep the investment opportunity confidential or a secret.  

Suspicious or Unverifiable Biographies of Managers or Promoters

To appear legitimate, fraudsters may represent that they have had a successful career in the relevant industry when nothing could be further from the truth. Don’t just take the promoter’s word on their background. Try to independently verify any claims, including by asking for references or conducting a simple Internet search. 

On the other hand, even if the promoter is truthful about their background, if they appear to lack relevant experience, consider this a red flag as well.