"What's interesting is some of the access to opportunity that we have, i.e. companies like Groupon, Facebook, we had LinkedIn before the IPO, things of that nature," Carmel told a prospect he had never met, according to court documents.

"So if you have a moment or two, if you could give me a buzz, I'd love to touch base."

But Carmel, who does not dispute making the call, was touting companies that were not publicly traded. His employer, Felix Investments, was not a typical investment firm, but one capitalizing on a new and rapidly growing realm for U.S. markets: trading in the shares of privately held companies.

It hasn't taken long for that business, super-charged by the hunger for Facebook shares, to become problematic.

At issue is the lack of protection for investors who are largely investing blind. They are often not getting basic financial information about the companies they are investing in and have precious little knowledge about some of the vehicles they are investing through.

Felix and co-owner Frank Mazzola were sued Wednesday by the Securities and Exchange Commission, which accused Mazzola of taking hidden commissions and misleading investors about how many Facebook shares Felix funds had been able to buy.

Carmel's phone message had surfaced in a now-settled lawsuit by his former employer, Advanced Equities, which objected to him calling its customers after joining Felix. Carmel, who is not accused of any wrongdoing, said in an interview that he was not selling anything at the time. "I didn't know them," he acknowledged, but added: "It was just to introduce myself."

Also on Wednesday, one of the largest exchanges where pre-initial public offering stock can be traded, SharesPost, was censured by the SEC and fined $80,000. Executives at Advanced, which is also a big reseller of stakes in private companies, are also likely to face enforcement action, according to records on file with the Financial Industry Regulatory Authority.

Regulators and some securities attorneys warn that those actions won't do much to tamp down an exploding market that is ripe for abuse.

They also say a package of proposed laws that has passed the House and drawn support from some Senate Democrats and the Obama administration would make fraud easier by allowing advertisements for private stock sales and raising the maximum number of investors to 999 from 499 before public financial filings are required.

"At a time when you have a record number of scams going on in private placements and hurting people, you are rolling back the protections. You are simplifying fraud," said Lynn Turner, a former chief accountant at the SEC who is now managing director at consulting firm LitiNomics.

Many Silicon Valley investors support loosening regulations to make it easier for private companies to raise money.

But others warn that Congress is headed toward helping to inflate a bubble in private stock. "If these markets don't get more regulated - which I think is a reasonable thing to do - they are almost certainly going to get shut down" in the wake of scandal, said Scott Sandell, a general partner at big venture firm New Enterprise Associates.

Last year, some $9.3 billion in stock in private companies changed hands, up four-fold in two years. Ownership in such companies was historically limited to venture capital funds, wealthy angel investors and early employees, but the emergence of private exchanges for non-public shares has changed the game dramatically.

The private sales, which allow employees and early investors to cash out before a public offering, don't come with anything resembling the disclosures required with an IPO. In most cases investors see hardly any financial information.

The trading can also serve as a form of guerilla marketing, as reports of escalating valuations in private deals drive anticipation of a future debut on the public markets.

Most CEOs - who are barred from hyping the prospects of their companies after they begin the IPO process - are glad that resellers are pushing their valuations up, said Geoff Yang of venture capital firm Redpoint Ventures, who sits on a dozen boards.

In the most prominent example, Facebook shares have continued to move higher in auctions on SharesPost, even though Facebook is in a mandated pre-IPO quiet period and the company can't boast of its prospects without elaborate disclaimers. SharesPost, which has more than 60,000 registered users, agreed to pay the $80,000 SEC fine over its failure to register as a broker-dealer before late last year.

Regulators say that there has been no rash of investor complaints only because most pre-IPO stocks have gained value since their purchase amid a broader rally in U.S. equities. When that changes, lawyers could challenge the legality of the transactions.

In the meantime, securities law experts and veteran Silicon Valley investors say operators like Felix are gaming the system with tactics such as creating limited liability companies to hold the private shares and then selling interests in the LLCs. That sidesteps regulations barring resale of the stock itself for six months or more.

"You have got to worry about the fly-by-night operations," said Ian Sobieski, managing director of the Band of Angels venture fund and an investor in SharesPost. "They are doing a work-around of the SEC rules."

SPECIAL RULES FOR THE RICH

The nation's major securities laws were enacted after the 1929 stock market crash and a wave of interstate investment scams that bankrupted thousands of smaller investors. The laws generally forbid companies from selling stock to the public without SEC-reviewed and audited disclosure of their finances and business risks.

There are some important exceptions, most notably the use of unadvertised private placements in which so-called accredited investors can buy shares. Individuals must have a net worth of $1 million or earn more than $200,000 ($300,000 for couples) to meet the standard for being accredited, though in most cases no proof is required. The assumption is that wealthy investors can fend for themselves.

The best-known means of selling private stock are SharesPost and New York-based SecondMarket. SharesPost, based south of San Francisco in San Bruno, was founded in 2009 and said it did $184 million in transactions last quarter with a matchmaker approach for buyers and sellers.

SecondMarket, which said it is not a subject of the SEC probe, began offering a trading platform for private stock in 2008, and processed more than $500 million in such deals last year.

Both work closely with the companies whose stock they deal, and SecondMarket won't allow any transactions in shares of companies that object.

SecondMarket said a third of its sales volume last year came from "asset managers," including funds dedicated to buying up a single company's stock. Another 9 percent came from funds devoted to owning stock in a series of private companies.

Gary Ream, a sporting goods executive who invested $100,000 through Felix for Facebook shares in early 2010, said he never saw any financial statements from the company. Instead he listened to a telephone presentation by Felix and followed his gut instinct. "We sat through a conference call and they laid out where they were," he said. "It was not typical financials that you would see."

Mazzola says that Felix does not claim to have any special access to inside information for its clients. "The traditional due diligence doesn't exist," Mazzola said.

In some cases, the secondary funds can't even assure investors that they will be able to buy the stock that they are seeking. In Felix's case, according to the SEC suit, the company's "false and misleading solicitations" included claims that it was buying Facebook shares at $66 when that deal never closed. Mazzola didn't respond to questions about the suit.

Among Felix's potential customers is Pre-Game Partners LLC, created in December by investment bank Laidlaw & Co (U.K.).

According to its confidential offering memorandum seen by Reuters, the fund said it plans to spend as much as $2.5 million on a stake in a Felix fund holding Twitter shares. It also said it intends to buy stakes in private companies "such as Foursquare Labs Inc, Palantir Technologies Inc, ZocDoc Inc, Liquidnet Holdings Inc, Kabam Inc, Chegg Inc" and others, though no deals are signed.

Pools created without guaranteed holdings "have always turned out to be horrendous investments," said former SEC accountant Turner. "I can't comprehend why any investor would go into that."

For now, SEC rules clearly prohibit general solicitation for private stock sales, though not all-purpose introductions. Felix executive Carmel's phone message surfaced in a now-settled lawsuit by his former employer, Advanced Equities, which objected to him calling its customers.

Felix and two of its three largest owners, Mazzola and William Barkow, along with Vice President of sales Emilio DiSanluciano, settled FINRA's accusations. The men agreed to fines totaling $80,000 and suspensions from the industry for two to three weeks.

FINRA said they had cold-called investors and sent mass emails without learning whether their funds would be suitable investments for the recipients. It also said a "Facebook Due Diligence Report Presented by Felix Investments," which it sent to 125 people, "was only based upon favorable, publicly available information" and that it failed to disclose that Felix had no access to Facebook financial data or management.

Barkow has left Felix and did not return calls seeking comment. DiSanluciano likewise didn't respond to messages.

In an interview before the SEC action, Mazzola maintained he had acted appropriately. "If there was something of real concern, they would have shut us down a long time ago," he said. "We haven't defrauded anyone."

Though Felix is accused of flouting several securities laws, many more brokers that are being more careful could still leave investors badly burned, venture capitalists and lawyers warned.

"There is a nearly infinite variety of things that could be wrong with a private company that you don't know anything about," said Robert Robbins of Pillsbury Winthrop Shaw Pittman, who teaches an annual joint course on private stock sales for the American Law Institute and American Bar Association.

"Environmental claims, labor claims, trademark claims. You've never seen their accounting, so you can't even know if you feel good about their financial statements."

Those pushing the envelope in selling secondary market interests have overlapping histories.

For example, Felix vice president DiSanluciano worked at J.P. Turner of Atlanta - which operates 200 retail brokerages nationwide - for eight years, through the end of 2009.

Turner made a $25 million Facebook fund offering, according to media reports, saying it would collect 12 percent in fees and could not guarantee that it would obtain the shares. It is unclear whether the offering was ever completed. Turner representatives declined to comment.

Turner has had repeated run-ins with regulators and unhappy clients. In 1998, Arkansas regulators issued a cease-and-desist order to the firm after an agent told a customer that shares in a pre-IPO company called Cartoon Saloon would quintuple when the company went public.

In 2006, Turner paid $195,000 and agreed to a consent order with New Jersey regulators who found that its agents had engaged in unsuitable trading for clients and misled them about risks. The same year, the National Association of Securities Dealers fined Turner $211,000 after two brokers sold private placements in a hedge fund without disclosing the commissions they would get from trading in its accounts.

Current Felix executives Mazzola and Carmel used to work at Laidlaw, home of the Pre-Game Partners fund. They and former executive Barkow also previously worked at Chicago-based venture banker Advanced Equities, which is known for paying a premium for stakes in companies that have run into difficulty and may never go public. Unlike most venture firms, which raise money and then decide where to invest it, Advanced Equities buys stakes, adds commissions and resells to its clients.

In one spectacular case, the company raised more than $20 million and took a 12 percent commission as the main backer of a company called Pixelon, which a 1999 offering memorandum said was patenting a revolutionary means for sending video over the Internet.

Pixelon blew more than $16 million on an all-star concert with The Who rock band that was meant to showcase the transmission capability. The broadcast failed, the technology turned out to be cribbed from others, and the company's CEO was soon found to be a convicted fraudster who was on the lam. The CEO was arrested and returned to jail.

Advanced Equities and three of its leaders later joined three Pixelon representatives in settling an investor class-action suit for $2.6 million, though executives said Pixelon's insurance company picked up the tab.

Those settling included Advanced Equities co-founders Keith Daubenspeck and Dwight Badger, who received so-called Wells Notices from the SEC this year warning of likely enforcement action over a private 2009 offering.

Daubenspeck didn't respond to an interview request. "We don't have any comment at this time," Badger said Wednesday.

(Reporting by Joseph Menn; Additional reporting by Alistair Barr; Editing by Martin Howell, Gary Hill)

• A Permanent Economic Emergency