Regulatory Obligations and Related Considerations
As noted in Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings), as part of their obligations under FINRA Rule 2111 (Suitability) and supervisory requirements under FINRA Rule 3110 (Supervision), firms must conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.” The SEC’s Reg BI became effective on June 30, 2020, and would apply to recommendations of private offerings to retail customers. Reg BI similarly requires, among other things, a broker-dealer to exercise reasonable diligence, care and skill to understand the potential risks, rewards and costs associated with a private offering recommendation and have a reasonable basis to believe that the private offering recommendation could be in the best interest of at least some retail customers.
In addition, firms must make timely filings for specified private placement offerings with FINRA’s Corporate Financing Department under FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities).
- What policies and procedures does your firm have to address filing requirements and timelines under FINRA Rules 5122 and 5123? How does it review for compliance with such policies?
- How does your firm use and evaluate consultants, experts or other third-party vendors’ due diligence reports?
- How does your firm conduct reasonable investigations on private placement offerings, including conducting further inquiry into red flags identified during the reasonable investigation process?
- How does your firm address conflicts of interest identified in third-party due diligence reports?
- How does your firm handle escrowed funds and amended terms in contingency offerings?
- If your firm is engaging in new business, such as Regulation A offerings or SPACs, has it implemented WSPs to address this business? If this business may constitute a material change in your firm’s business operations, has your firm considered whether it needs to file a Continuing Membership Application (CMA)?
Exam Findings and Effective Practices
- Late Filings – Not having policies and procedures, processes and supervisory programs to comply with filing requirements; and failing to make timely filings (with, in some cases, delays lasting as long as six to twelve months after the offering closing date).
- No Reasonable Investigation – Failing to perform reasonable investigations of private placement offerings prior to recommending the offerings to retail investors, including failing to conduct additional research about new offerings, relying on their experience with the same issuer in previous offerings and not conducing further inquiry into red flags identified during the investigation process.
- Concerning Third-Party Due Diligence – Failing to address red flags (such as disciplinary history of the issuer’s management), conflicts of interest (such as undisclosed direct or indirect common ownership of affiliated entities or the issuer) or significant concerns (such as no legitimate operating history for the issuer) identified in third-party due diligence reports.
- Private Placement Checklist – Creating checklists with—or added to existing firm Regulation D and other offering checklists—all steps, filing dates, related documentation requirements and evidence of supervisory principal approval for the filing requirements of FINRA Rules 5122 and 5123.
- Independent Research – Conducting and documenting independent research on material aspects of the offering; identifying any red flags with the offering or the issuer (such as questionable business plans or unlikely projections or results); and addressing and, if possible, resolving concerns that would be relevant to a potential investor (such as tax considerations or liquidity restrictions).
- Independent Verification – Verifying information that was key to the performance of the offering (such as unrealistic costs projected to execute the business plan coupled with aggressively projected timing and overall rate of return for investors); and, in some cases, receiving support from due diligence firms, experts and third-party vendors.
- Mitigating Conflicts of Interest – Using firms’ reasonable investigation processes to mitigate conflicts of interest and developing comprehensive disclosures for offerings involving firm affiliates or issuers whose control persons were also employed by the firm.
- Ownership for Filings – Assigning responsibility for private placement filing requirements to specific individual(s) or team(s) and conducting targeted, in-depth training about the firms’ policies, process and technical filing requirements.
- Automated Alert System – Creating an automated system that alerts responsible individual(s) and supervisory principal(s) about upcoming and missed filing deadlines.
- Private Placement Committee – Creating a private placement committee (at larger firms) or formally designating one or more qualified persons (at smaller firms); charging committee-designated individuals with investigating and determining whether to approve the offering for sale to investors; and conducting research and identifying and highlighting red flags with the offering or the issuer.
- Post-Approval Processes – Using the investigation analysis to establish post-approval processes and investment limits based on the complexity or risk level of the offering.
- Ongoing Monitoring – Conducting ongoing monitoring after the offering to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum, particularly for ongoing sales of an offering after initial closing.
- Regulatory Notice 20-21 (FINRA Provides Guidance on Retail Communications Concerning Private Placement Offerings)
- Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings)
- Report Center – Corporate Financing Report Cards
- FAQs about Private Placements
- Corporate Financing Private Placement Filing System User Guide
- Private Placements Topic Page